Basic Economics

by Thomas Sowell

  Belatedly, Lenin saw a need for people “who are versed in the art of administration” and admitted that “there is nowhere we can turn to for such people except the old class”—that is, the capitalist businessmen. In his address to the 1920 Communist Party Congress, Lenin warned his comrades: “Opinions on corporate management are all too frequently imbued with a spirit of sheer ignorance, an antiexpert spirit.”{171} The apparent simplicities of just three years earlier now required experts. Thus began Lenin’s New Economic Policy, which allowed more market activity, and under which the economy began to revive.

  Nearly a hundred years later, with the Russian economy growing at less than two percent annually, the same lesson was learned anew by another Russian leader. A front-page story in the New York Times in 2013 reported how, “with the Russian economy languishing, President Vladimir V. Putin has devised a plan for turning things around: offer amnesty to some of the imprisoned business people.”{172}

  Chapter 6

  THE ROLE OF PROFITS

  —AND LOSSES

  Rockefeller got rich selling oil. . . He found cheaper ways to get oil from the ground to the gas pump.

  John Stossel{173}

  To those who run businesses, profits are obviously desirable and losses deplorable. But economics is not business administration. From the standpoint of the economy as a whole, and from the standpoint of the central concern of economics—the allocation of scarce resources which have alternative uses—profits and losses play equally important roles in maintaining and advancing the standards of living of the population as a whole.

  Part of the efficiency of a price-coordinated economy comes from the fact that goods can simply “follow the money,” without the producers really knowing just why people are buying one thing here and something else there and yet another thing during a different season. However, it is necessary for those who run businesses to keep track not only of the money coming in from the customers, it is equally necessary to keep track of how much money is going out to those who supply raw materials, labor, electricity, and other inputs. Keeping careful track of these numerous flows of money in and out can make the difference between profit and loss. Therefore electricity, machines or cement cannot be used in the same careless way that caused far more of such inputs to be used per unit of output in the Soviet economy than in the German or Japanese economy. From the standpoint of the economy as a whole, and the well-being of the consuming public, the threat of losses is just as important as the prospect of profits.

  When one business enterprise in a market economy finds ways to lower its costs, competing enterprises have no choice but to scramble to try to do the same. After the general merchandising chain Wal-Mart began selling groceries in 1988, it moved up over the years to become the nation’s largest grocery seller by the early twenty-first century. Its lower costs benefitted not only its own customers, but those of other grocers as well. As the Wall Street Journal reported:

  When two Wal-Mart Supercenters and a rival regional grocery opened near a Kroger Co. supermarket in Houston last year, the Kroger’s sales dropped 10%. Store manager Ben Bustos moved quickly to slash some prices and cut labor costs, for example, by buying ready-made cakes instead of baking them in-house, and ordering precut salad-bar items from suppliers. His employees used to stack displays by hand: Now, fruit and vegetables arrive stacked and gleaming for display.

  Such moves have helped Mr. Bustos cut worker-hours by 30% to 40% from when the store opened four years ago, and lower the prices of staples such as cereal, bread, milk, eggs and disposable diapers. Earlier this year, sales at the Kroger finally edged up over the year before.{174}

  In short, the economy operated more efficiently, to the benefit of the consumers, not only because of Wal-Mart’s ability to cut its own costs and thereby lower prices, but also because this forced Kroger to find ways to do the same. This is a microcosm of what happens throughout a free market economy. “When Wal-Mart begins selling groceries in a community,” a study showed, “the average price of groceries in that community falls by 6 to 12 percent.”{175} Similar competition by low-cost sellers in other industries tends to produce similar results in those industries. It is no accident that people in such economies tend to have higher standards of living.

  PROFITS

  Profits may be the most misconceived subject in economics. Socialists have long regarded profits as simply “overcharge,” as Fabian socialist George Bernard Shaw called it, or a “surplus value” as Karl Marx called it. “Never talk to me about profit,” India’s first prime minister, Jawaharlal Nehru, warned his country’s leading industrialist, “It is a dirty word.”{176} Philosopher John Dewey demanded that “production for profit be subordinated to production for use.”{177}

  From all these men’s perspectives, profits were simply unnecessary charges added on to the inherent costs of producing goods and services, driving up the cost to consumers. One of the great appeals of socialism, especially back when it was simply an idealistic theory without any concrete examples in the real world, was that it sought to eliminate these supposedly unnecessary charges, making things generally more affordable, especially for people with lower incomes. Only after socialism went from being a theory to being an actual economic system in various countries around the world did the fact become painfully apparent that people in socialist countries had a harder time trying to afford things that most people in capitalist countries could afford with ease and took for granted.

  With profits eliminated, prices should have been lower in socialist countries, according to theory, and the standard of living of the masses correspondingly higher. Why then was it not that way in practice?

  Profits as Incentives

  Let us go back to square one. The hope for profits and the threat of losses is what forces a business owner in a capitalist economy to produce at the lowest cost and sell what the customers are most willing to pay for. In the absence of these pressures, those who manage enterprises under socialism have far less incentive to be as efficient as possible under given conditions, much less to keep up with changing conditions and respond to them quickly, as capitalist enterprises must do if they expect to survive.

  It was a Soviet premier, Leonid Brezhnev, who said that his country’s enterprise managers shied away from innovation “as the devil shies away from incense.”{178} But, given the incentives of government-owned and government-controlled enterprises, why should those managers have stuck their necks out by trying new methods or new products, when they stood to gain little or nothing if innovation succeeded and might have lost their jobs (or worse) if it failed? Under Stalin, failure was often equated with sabotage, and was punished accordingly.

  Even under the milder conditions of democratic socialism, as in India for decades after its independence, innovation was by no means necessary for protected enterprises, such as automobile manufacturing. Until the freeing up of markets that began in India in 1991, the country’s most popular car was the Hindustan Ambassador—an unabashed copy of the British Morris Oxford. Moreover, even in the 1990s, The Economist referred to the Ambassador as “a barely upgraded version of a 1950s Morris Oxford.”{179} A London newspaper, The Independent, reported: “Ambassadors have for years been notorious in India for their poor finish, heavy handling and proneness to alarming accidents.”{180} Nevertheless, there was a waiting list for the Ambassador—with waits lasting for months and sometimes years—since foreign cars were not allowed to be imported to compete with it.

  Under free market capitalism, the incentives work in the opposite direction. Even the most profitable business can lose its market if it doesn’t keep innovating, in order to avoid being overtaken by its competitors. For example, IBM pioneered in creating computers, including one 1944 model occupying 3,000 cubic feet. But, in the 1970s, Intel created a computer chip smaller than a fingernail that could do the same things as that computer.{181} Yet Intel itself was then constantly forced to improve its chips at an exponential rate, as rivals like Adv
anced Micro Devices (AMD), Cyrix, and others began catching up with them technologically. More than once, Intel poured such huge sums of money into the development of improved chips as to risk the financial survival of the company itself.{182} But the alternative was to allow itself to be overtaken by rivals, which would have been an even bigger risk to Intel’s survival.

  Although Intel continued as the leading seller of computer chips in the world, continuing competition from Advanced Micro Devices spurred both companies to feverish innovation, as The Economist reported in 2007:

  For a while it seemed that AMD had pulled ahead of Intel in chip design. It devised a clever way to enable chips to handle data in both 32-bit and 64-bit chunks, which Intel reluctantly adopted in 2004. And in 2005 AMD launched a new processor that split the number-crunching between two “cores”, the brains of a chip, thus boosting performance and reducing energy-consumption. But Intel came back strongly with its own dual-core designs. . . Next year it will launch new chips with eight cores on a single slice of silicon, at least a year ahead of AMD.{183}

  Although this technological rivalry was very beneficial to computer users, it has had large and often painful economic consequences for both Intel and AMD. The latter had losses of more than a billion dollars in 2002 and its stock lost four-fifths of its value.{184} But, four years later, the price of Intel stock fell by 20 percent in just three months,{185} and Intel announced that it would lay off 1,000 managers,{186} as its profits fell by 57 percent while the profits of AMD rose by 53 percent.{187} All this feverish competition took place in an industry where Intel sells more than 80 percent of all the computer chips in the world. {188}

  In short, even among corporate giants, competition in innovation can become desperate in a free market, as the see-saw battle for market share in microchips indicates. The dean of the Yale School of Management described the computer chip industry as “an industry in constant turmoil” and the Chief Executive Officer of Intel wrote a book titled Only the Paranoid Survive.{189}

  The fate of AMD and Intel is not the issue. The issue is how the consumers benefit from both technological advances and lower prices as a result of these companies’ fierce competition to gain profits and avoid losses. Nor is this industry unique. In 2011, 45 of the Fortune 500 companies reported losses, totaling in the aggregate more than $50 billion.{190} Such losses play a vital role in the economy, forcing corporate giants to change what they are doing, under penalty of extinction, since no one can sustain losses of that magnitude indefinitely.

  Inertia may be a common tendency among human beings around the world—whether in business, government or other walks of life—but businesses operating in a competitive market are forced by red ink on the bottom line to realize that they cannot keep drifting along like the Hindustan Motor Corporation, protected from competition by the Indian government.

  Even in India, the freeing of markets toward the end of the twentieth century created competition in cars, forcing Hindustan Motors to invest in improvements, producing new Ambassadors that were now “much more reliable than their predecessors,” according to The Independent newspaper,{191} and now even had “perceptible acceleration” according to The Economist magazine.{192} Nevertheless, the Hindustan Ambassador lost its long-standing position of the number one car in sales in India to a Japanese car manufactured in India, the Maruti. In 1997, 80 percent of the cars sold in India were Marutis.{193} Moreover, in the now more competitive automobile market in India, “Marutis too are improving, in anticipation of the next invaders,” according to The Economist.{194} As General Motors, Volkswagen and Toyota began investing in new factories in India, the market share of Maruti dropped to 38 percent by 2012.{195}

  There was a similar pattern in India’s wrist watch industry. In 1985, the worldwide production of electronic watches was more than double the production of mechanical watches. But, in India the HMT watch company produced the vast majority of the country’s watches, and more than 90 percent of its watches were still mechanical. By 1989, more than four-fifths of the watches produced in the world were electronic but, in India, more than 90 percent of the watches produced by HMT were still the obsolete mechanical watches. However, after government restrictions on the economy were greatly reduced, electronic watches quickly became a majority of all watches produced in India by 1993–1994, and other watch companies displaced HMT, whose market share fell to 14 percent.{196}

  While capitalism has a visible cost—profit—that does not exist under socialism, socialism has an invisible cost—inefficiency—that gets weeded out by losses and bankruptcy under capitalism. The fact that most goods are more widely affordable in a capitalist economy implies that profit is less costly than inefficiency. Put differently, profit is a price paid for efficiency. Clearly the greater efficiency must outweigh the profit or else socialism would in fact have had the more affordable prices and greater prosperity that its theorists expected, but which failed to materialize in the real world.

  If in fact the cost of profits exceeded the value of the efficiency they promote, then non-profit organizations or government agencies could get the same work done cheaper or better than profit-making enterprises, and could therefore displace them in the competition of the marketplace. Yet that seldom, if ever, happens, while the opposite happens increasingly—that is, private profit-making companies taking over various functions formerly performed by government agencies or by non-profit organizations such as colleges and universities.{xiii}

  While capitalists have been conceived of as people who make profits, what a business owner really gets is legal ownership of whatever residual is left over after the costs of production have been paid out of the money received from customers. That residual can turn out to be positive, negative, or zero. Workers must be paid and creditors must be paid—or else they can take legal action to seize the company’s assets. Even before that happens, they can simply stop supplying their inputs when the company stops paying them. The only person whose payment is contingent on how well the business is doing is the owner of that business. This is what puts unrelenting pressure on the owner to monitor everything that is happening in the business and everything that is happening in the market for the business’ products or services.

  In contrast to the layers of authorities monitoring the actions of those under them in a government-run enterprise, the business owner is essentially an unmonitored monitor as far as the economic efficiency of the business is concerned. Self-interest takes the place of external monitors, and forces far closer attention to details and far more expenditure of time and energy at work than any set of rules or authorities is likely to be able to do. That simple fact gives capitalism an enormous advantage. More important, it gives the people living in price-coordinated market economies visibly higher standards of living.

  It is not just ignorant people, but also highly educated and highly intellectual people like George Bernard Shaw, Karl Marx, Jawaharlal Nehru and John Dewey who have misconceived profits as arbitrary charges added on to the inherent costs of producing goods and services. To many people, even today, high profits are often attributed to high prices charged by those motivated by “greed.” In reality, most of the great fortunes in American history have resulted from someone’s figuring out how to reduce costs, so as to be able to charge lower prices and therefore gain a mass market for the product. Henry Ford did this with automobiles, Rockefeller with oil, Carnegie with steel, and Sears, Penney, Walton and other department store chain founders with a variety of products.

  A supermarket chain in a capitalist economy can be very successful charging prices that allow about a penny of clear profit on each dollar of sales. Because several cash registers are usually bringing in money simultaneously all day long in a big supermarket, those pennies can add up to a very substantial annual rate of return on the supermarket chain’s investment, while adding very little to what the customer pays. If the entire contents of a store get sold out in about two weeks, then that penny on a dollar becomes mo
re like a quarter on the dollar over the course of a year, when that same dollar comes back to be re-used 25 more times. Under socialism, that penny on each dollar would be eliminated, but so too would be all the economic pressures on the management to keep costs down. Instead of prices falling to 99 cents, they might well rise above a dollar, after the enterprise managers lose the incentives and pressures to keep production costs down.

  Profit Rates

  When most people are asked how high they think the average rate of profit is, they usually suggest some number much higher than the actual rate of profit. Over the entire period from 1960 through 2005, the average rate of return on corporate assets in the United States ranged from a high of 12.4 percent to a low of 4.1 percent, before taxes. After taxes, the rate of profit ranged from a high of 7.8 percent to a low of 2.2 percent.{197} However, it is not just the numerical rate of profit that most people misconceive. Many misconceive its whole role in a price-coordinated economy, which is to serve as incentives—and it plays that role wherever its fluctuations take it. Moreover, some people have no idea that there are vast differences between profits on sales and profits on investments.

  If a store buys widgets for $10 each and sells them for $15 each, some might say that it makes $5 in profits on each widget that it sells. But, of course, the store has to pay the people who work there, the company that supplies electricity to the store, as well as other suppliers of other goods and services needed to keep the business running. What is left over after all these people have been paid is the net profit, usually a lot less than the gross profit. But that is still not the same as profit on investment. It is simply net profits on sales, which still ignores the cost of the investments which built the store in the first place.