PDF Summary:Basic Economics, by Thomas Sowell

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Economics is a study of causes and effects. Therefore, economic policies are important to judge by their consequences and incentives, rather than their goals and motivations. A well-meaning policy can have terrible unintended consequences, sometimes buried in second-order and third-order consequences.

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In this way, a market economy is self-regulating, allowing real-time coordination across millions of goods and services, without any central authority knowing and setting all the prices.

How Prices Allocate Resources

Prices provide financial incentives - profits and losses - to affect behavior in the use of resources and their resulting products. Profits motivate people to provide more of a product that people want, and profits are often the focus of popular press (“greedy capitalists!”).

But just as importantly, losses force the producers to stop producing what consumers don’t want. Losses prevent the inefficient use of scarce resources, allowing those resources to be used elsewhere where they will produce better output.

In general, a producer will try to maximize her profits and produce as many units as possible without incurring a loss per unit. She will bid higher for resources until she starts losing money per unit - when the cost to produce exceeds the amount people are willing to pay. As she bids up the price of resources, these resources become more expensive for other producers, which increases the cost of their products.

However, the producer will...

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Further, market economies have automatic limitations on losses - companies that perform poorly run out of money and go bankrupt, limiting their damage in misuse of resources. But in centrally planned economies, companies that would normally go bankrupt are propped up by the government. Leaders could continue to make the same mistakes indefinitely, with the consequences being a lower standard of living for a nation.

Because the past century has shown the success of market economies, historically central planning-based economies have shifted to market economies and enjoyed the ensuing growth. This has played out often in the 20th century, including in China, India, and South Korea.

(Shortform question: using the growing power of large datasets and AI, could central authorities eventually do a job comparable to markets in pricing goods to allocate resources?)

Artificial Price Ceilings

To popular approval, governments may sometimes cap the maximum price of a good, setting an artificially low price relative to what it would be on the open market. This market distortion leads to unintended consequences.

Rent control is a common example. While popular because it...

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Here are other situations that are commonly seen as unsavory and greedy, but occur for good market reasons:

• In areas of famine or emergency, the prices for scarce goods can rise (e.g. the price of bottled water rises after a hurricane). Merchants who supply goods at prices higher than other areas seem greedy.
  • In reality, the high prices and profits are necessary to incentivize vendors to supply their goods; without this incentive, people might starve. It is apparently not uncommon for food supplied by nonprofits to sit spoiling on the docks while people starve inland, because the prices are too low to support distributors.
  • Furthermore, higher prices cause healthy self-rationing - a family may buy only enough water as necessary until the next shipment, rather than hoarding and depleting supply for other families.
• In low-income neighborhoods, prices for loans and goods tend to be higher.
  • However, profit rates per store are no higher in low-income neighborhoods than elsewhere, and stores may actually be leaving these neighborhoods because they couldn’t make the financials work. (If profits were so easy, you’d expect an abundance of...

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Through incentives provided by profits and losses, business owners have a personal stake in the value their businesses create and monitor themselves closely, without needing authorities to dictate what they do.

Throughout all this competition between businesses vying for profits, consumer welfare as a whole tends to improve, with lower prices and higher standards of living.

In this sense, knowledge and insight are some of the scarcest of all resources in the economy, giving large advantages to those with insight. In a market economy, the best ideas tend to win through competition, even if the ideas originate from the less powerful. An economy that can tap talent throughout its population becomes more powerful over more restrictive societies, where masses with good ideas aren’t able to compel authorities to change anything.

Businesses vs Non-Market Producers

Non-market producers are organizations like non-profits or government agencies who can also provide goods and services.

Why have businesses displaced non-market producers in many countries around the world? The simple answer - businesses are more efficient.

**If profit-minimizing economies like socialism were...

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Specialization and Middlemen

A company is limited in the range of functions it can perform efficiently. Only a certain number of links in the value chain can be mastered and operated efficiently by the same set of people.

General Motors is excellent at making automobiles, but it leaves tire manufacturing and car sales to others. Compared to local dealerships, it is too much for GM to track local conditions across the United States, decide where a lease location is most effective, understand the trade-in value of a Honda in Seattle vs Miami, etc. Similarly, authors don’t own their own bookstores, and companies often hire outside marketing agencies.

Middlemen exist when they can do their part of the chain more efficiently than others can. Put another way, middlemen are able to get more value from a company’s output than the company itself can, so it bids the price of the output higher than the company would be willing to buy from itself.

(Shortform note: changing capabilities mean the company can both bring a capability in-house and outsource something formerly in-house. Eyewear brand Warby Parker sells direct to consumers (using the Internet as distribution)...

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A monopoly exists when a specific person or organization is the only supplier of a particular good or service. This causes a market distortion and reduces consumer welfare.

In common parlance, large companies and market leaders are often misconstrued as monopolies. But if a company faces competition to produce the good, has substitutes for its product, or cannot control the price of the good, it is not a monopoly.

Large Companies Are Not Automatically Monopolies

Size and economies of scale have been misconstrued as “squeezing suppliers.” A large buyer like Wal-Mart might be able to procure goods at lower prices than a neighborhood family store, and this has sometimes been seen as unfair or anti-competitive.

However, larger buyers actually do lower costs for vendors - through lower overhead per unit, more predictable production schedules, and thus smoother labor management. These cost reductions reflect reduction of use of scarce resources, freeing them for use elsewhere.

The result of such economies of scale may be competitor stores that go out of business when they can’t offer such low prices, but the economy becomes more efficient overall.

Companies...

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Some people earn more than others. Much is said about the difference in pay between the top and bottom income brackets.

In fact, income distributions tend to reflect people in different stages of life - namely, older people earn more. Older people acquire more skills, allowing them to take on more complicated jobs or do a job more efficiently. Further, they improve their job finding skills and develop reputations that lead to better job offers. Lower income brackets tend to be made of younger people in entry-level jobs.

When looked at in this way, the top earners don’t seem to be in outrageous positions - a household income of $100k would be in the top 20%. But for a couple, with each person earning $50k a year after a 30-year career, this doesn’t seem all that well-off.

Which income bracket you belong to is fluid. It is less common for people to stay in the same income bracket for life than it is for people in the lowest bracket to rise to higher brackets.

Furthermore, statistics based on American households are misleading, because household size varies across cultures, age brackets, and income brackets. **Per capita income may rise while household income...

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Politically, minimum wage laws seem superficially beneficial to voters, since the wage is an obvious first-order improvement, but unemployment is a more subtle second-order problem that isn’t tied to minimum wage laws. (Shortform note: furthermore, there are likely vicious cycle effects wherein the employed are more likely to vote, and the employed are more likely to support minimum wage laws, thus further increasing unemployment and entrenching the voting power of the employed.)

If there were no minimum wage laws in the United States, more people would be employed, with the median person earning lower wages than with minimum wage laws. This “spreads employment more evenly.” And the workers still retain free choice - if they were clearly better off not working for the employer at a lower wage, they would choose not to work. Instead, minimum wages tend to make low-wage workers worse off by closing off one of their already limited options.

Working Conditions and Benefits

The above reasoning applies to mandatory working conditions, benefits, and job security laws. **These costs are factored into the total cost of hiring workers and tend to increase cost per worker...

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Safety Laws

Thomas Sowell admits that one aspect of labor regulation has special exemption - safety laws that protect the general public. Examples include working hour limits for pilots and truck drivers, where accidents can endanger many others. Employers and employees may not consider the externalities of their work, so safety laws are useful safeguards.

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Therefore, people are willing to buy bonds (lending their money to the bond issuer) at a certain interest rate considering the above factors. If you are willing to part with $100 to earn $104 a year from now, this sets your interest rate at 4%. Naturally, in the bond market, people bid different prices based on what the bond is worth to them.

Higher interest rates lead people to save money and decrease borrowing, and bond prices go down because there are more attractive places to put money. Likewise, low interest rates lead people to spend money and borrow money to spend today, and bond prices go up since they become relatively better investments.

Payday loans appear to have astronomical annual rates, but they are rarely held for as long as a year - they’re meant to be bridge loans to the next paycheck. The overhead fees for each small transaction also inflates the apparent rate.

Laws that make loans difficult (forbidding interest or collecting on debts) limit those loans from being made in the first place.

Stocks and Venture Capital

**Stocks tend to have higher rates of return than bonds because of their variable rate of return, while bonds have guaranteed...

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• Adverse selection, where riskier people tend to buy insurance while non-risky people don’t, in ways that are currently opaque to the insurer. If the insurance company assumes the risk level over the entire population, but only riskier people buy insurance, the insurer may underprice insurance and discover later their costs are higher than expected.

Government regulation can increase or decrease these problems. By requiring all drivers to have insurance, this reduces adverse selection problems. However, requiring all banks to buy insurance increases moral hazard and risky investments by banks, since depositors don’t apply as much due diligence to risky behaviors by banks. This contributed to the savings & loan association losses in the 1980s.

The situation is worse when prices are clearly distorted. The public National Flood Insurance Program insures homes where private insurers would not, and charges premiums far below what is necessary to cover costs. This means taxpayers pay for risky behaviors, often because it is politically beneficial to provide disaster relief. Unlike insurance, which is meant to reduce risk, **mispriced government aid can create more...

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GDP comparisons between nations can be inaccurate.

• The quality of output may differ, even if the quantity is identical.
• Different age distributions will show younger nations to have less output, because younger people do not require healthcare costs that are counted in output.
• Different currencies require conversions, where official exchange rates may not reflect actual purchasing power of currencies.
• Free or subsidized goods provided by governments are valued at cost of production (usually higher than the price), while private goods are counted at the price of sale. This inflates the output of socialist economies.

Comparing bulk GDP vs GDP per capita.

• GDP per capita is a better metric of standard of living.
  • China has the 2nd largest GDP, but likely not a higher standard of living than #3 Japan.
• However, GDP per capita can be misleading - Bermuda has a high GDP per capita, primarily from the wealth of a small minority of investors that may not distribute into the population at large.

National output and real income are one and the same - real income is the goods and services that can be purchased by the nation; the nation’s output...

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The bank’s leverage and creation of credits means that a bank’s collapse would cause credits to disappear, reducing monetary demand.

The Federal Reserve is a central bank run by the government. It determines the reserve requirement, lends money to the banks at interest rates it specifies, thus indirectly controlling the interest rate the general public receives.

Finally, banks also finance consumer purchases by extending consumers credit and paying for purchases.

In countries with lower trust in banks, like in India, much money is held in gold, which means a large portion of wealth does not finance investment to create additional output. Further, in countries with primarily state-run banks, money is often lent at a low interest rate to subsidize government projects, rather than finding the best use of the money with the highest returns.

Bank Regulation

The government tries to reduce banking risks, but may create policies with unintended consequences.

• State deposit insurance laws forbade banks from having branch offices. While intended to protect local banks from larger banks headquartered elsewhere, it concentrated risk by forcing a bank’s depositors and...

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Government can promote honesty through laws, education, and examples set by public officials.

If laws are poorly enforced or bad laws are created, it can be far more profitable to violate laws than to abide by them. Inevitably resources will flow to those who can profit most from them, lawbreaking will occur, and social order takes a penalty. For example, in rent control areas, unscrupulous landlords can turn an otherwise unprofitable building into a profitable one by accepting bribes from tenants unable to find housing, or by burning it down to make room for a commercial building.

Property Rights

Chief among economically useful laws is property rights. Allowing individuals to have private property and keep what they earn creates powerful incentives for productive behavior. Property rights create self-monitoring, which is more effective and less costly than third-party monitoring.

In contrast, the Soviet Union lacked property rights and the ability to freely make use of profits. Thus, neither profits nor losses connected back directly to the individual, thus removing the incentive to work efficiently.

Another contrast to the value of property rights is...

... The national debt can increase in size to a tipping point that discourages further investment. When the debt is large enough, investors will worry about the creditworthiness of the nation, as well as its ability to turn over these bonds without raising interest rates, which would in turn raise interest rates economy wide as other investment funds compete for investor funds, which would in turn reduce credit and aggregate demand.

Tax Rates and Revenues

Counter-intuitively, raising tax rates may not lead to higher tax revenues. Higher taxes may cause people to move to lower taxed jurisdictions, like other states, or buy less of a heavily taxed good.

Similarly, lower tax rates may not lead to lower tax revenues. Lowering the capital gains tax in 1997 increased capital gains tax revenue since people increased their investments and diverted funds from tax-exempt bonds to higher-return investments.

In essence, changes in taxation can have nonlinear effects beyond the literal change in tax rates. Beware of proposals with definite numbers like a “$500 billion tax cut” since these are often based on (politically biased) assumptions. Congress provides assumptions to...

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Even worse, political timelines are often much shorter than economic timelines, preventing the full consequences of policies from being connected to the original policies. For instance, changes to education can take over a decade to show material results. Thus politicians may push for shorter-term, less effective programs like building fancier buildings, rather than refreshing the curriculum.

Mistakes are handled differently by government vs market players. In the market, companies must reverse mistakes quickly or perish. In politics, admitting mistakes loses votes, and mistakes take long legislative periods to correct. So it becomes easier to disguise mistakes or merely find a scapegoat.

Some believe that politics is more democratic since each person gets one vote, as opposed to the marketplace where people with more dollars get more votes. But this ignores how wealthier people have better education and more time and resources to devote to political activities.

Finally, few people put as much time into deciding who to vote for as they do into deciding what job to take or whether to buy a house. (Shortform note: this is probably caused by a feeling that your vote has...

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Comparative Advantage

A country might be so efficient that it produces anything more cheaply than another country. In this case, it still benefits the more efficient country to focus on what it is relatively more efficient at producing, and to export that in exchange for other goods . This allows more total goods to be produced than if both countries tried to produce everything themselves.

For instance, consider a surgeon who is quite capable at washing his car as well as removing brain tumors. Putting his personal enjoyment of washing cars aside, it’s much better for the surgeon to spend 2 hours in the surgical room than washing his car - he produces more relative value, and can trade the money he earns for other goods.

Here’s an example at a national level. The US and Canada both need chairs and TV sets. Here’s what it looks like if they both produce what each of their nations need:

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There are also misleading accounting practices. When countries have a trade surplus, they have more of a foreign currency, which they often use to invest in the local economy of that currency. If Americans buy more Japanese goods than the opposite, then Japan gets US dollars, which often never leave the US - the dollars are invested in American factories and employing workers, or in goods like Rockefeller Center. Therefore, an American trade deficit could mean another country’s trade surplus, and those dollars are kept within the United States.

However, standard accounting practices consider only physical goods that move in the international trade balance. This ignores trade of services and investments that “don’t move” like Rockefeller Center. Thus, typical accusations of trade deficits and surpluses are often deceptive. Naturally, the US exports more services than it imports, which isn’t counted. So popular media descriptions of trade balance may be inaccurate.

Similarly, when people in other countries buy American bonds, the US can be considered a “debtor,” which sounds scary. But in reality this is a sign of faith in investments in America - the more prosperous it is,...

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*   Calmer, flatter, contiguous, more consistent waters like European or Chinese rivers were far more helpful than sub-Saharan rivers that suffer huge plunges in elevation, vary dramatically in depth and width by season, and don’t connect continuously; or Eastern European rivers that flowed inward into inland seas or the Arctic Ocean (rather than outward into the more useful Atlantic) and were more likely to be frozen.
*   Even though Africa is twice the size of Europe, it has a shorter coastline due to fewer twists and turns and less surface area. 
*   It’s cheaper to load large volumes of goods directly onto ships docked near shore, rather than requiring large vessels to anchor offshore and require loading and unloading with smaller vessels.

• Water is also drinkable, used for irrigation, and provides marine food.

Mountains and Isolation

• The slow speed and cost of traveling through mountains means less open trade, exchange of ideas, and economic opportunities. Thus mountainous regions tend to lag behind lowland areas and become insular communities.
• Cultural differences (language, way of life) and skill differences that develop over centuries in...

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An economist would argue - the profits an owner earns are exactly the measure of the owner’s contribution to production. If the same contributions were available from others at lower cost, then those options would already exist.

Myth: Different Prices for the Same Thing

It may seem befuddling that an identical product is priced differently at two different stores. How can this exist in an efficient market?

Physically identical things often have different prices because of different conditions. Cheerios may be more expensive in a modern supermarket with warm customer service, generous refund policy, in a location with more expensive real estate, and more consistent inventory; than in a remote budget warehouse store with spotty inventory.

Myth: “Reasonable” or “Affordable” Prices

Saying prices should be more reasonable is to say that economic realities should adjust to our budget or what we are willing to pay. This, of course, is wishful thinking in a world of scarce resources.

In an effort to reduce prices, governments may forcibly lower prices without lowering corresponding costs. The costs to produce something are what they are; instead the costs are...

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*   This was expressed precisely through differential calculus.

• 20th Century: Equilibrium theory arose to illustrate the complex interdependencies of economic activities.
  • Even though the real world is seldom in equilibrium, the theory usefully illustrates what happens when things are not in equilibrium.
• 1936: John Maynard Keynes published The General Theory of Employment Interest and Money, giving rise to Keynesian economics, which explained changes in aggregate output and employment, and argued for government intervention to restore an economy in depression. It allowed tradeoffs between rates of unemployment and rates of inflation in the Phillips Curve.
• 1970s: Milton Friedman and the Chicago school of economics found the market more rational and responsive than Keynesians assumed.
  • Inflation and unemployment simultaneously rising in 1970s undermined the Phillips Curve tradeoff concept.