Basic Economics

by Thomas Sowell

  It is the profit on the whole investment that matters to the investor. When someone invests $10,000, what that person wants to know is what annual rate of return it will bring, whether it is invested in stores, real estate, or stocks and bonds. Profits on particular sales are not what matter most. It is the profit on the total capital that has been invested in the business that matters. That profit matters not just to those who receive it, but to the economy as a whole, because differences in profit rates in different sectors of the economy are what cause investments to flow into and out of these various sectors, until profit rates are equalized, like water seeking its own level. Changing rates of profit allocate resources in a market economy—when these are rates of profit on investment.

  Profits on sales are a different story. Things may be sold at prices that are much higher than what the seller paid for them and yet, if those items sit on a shelf in the store for months before being sold, the profit on investment may be less than with other items that have less of a mark-up in price but which sell out within a week. A store that sells pianos undoubtedly makes a higher percentage profit on each sale than a supermarket makes selling bread. But a piano sits in the store for a much longer time waiting to be sold than a loaf of bread does. Bread would go stale and moldy waiting for as long as a piano to be sold. When a supermarket chain buys $10,000 worth of bread, it gets its money back much faster than when a piano dealer buys $10,000 worth of pianos. Therefore the piano dealer must charge a higher percentage mark-up on the sale of each piano than a supermarket charges on each loaf of bread, if the piano dealer is to make the same annual percentage rate of return on a $10,000 investment.

  Competition among those seeking money from investors makes profit rates tend to equalize, even when that requires different mark-ups to compensate for different turnover rates among different products. Piano stores can continue to exist only when their higher mark-ups in prices compensate for slower turnover in sales. Otherwise investors would put their money elsewhere and piano stores would start disappearing.

  When the supermarket gets its money back in a shorter period of time, it can turn right around and re-invest it, buying more bread or other grocery items. In the course of a year, the same money turns over many times in a supermarket, earning a profit each time, so that a penny of profit on the dollar can produce a total profit rate for the year on the initial investment equal to what a piano dealer makes charging a much higher percentage mark-up on an investment that turns over much more slowly.

  Even firms in the same business may have different turnover rates. For example, Wal-Mart’s inventory turns over more times per year than the inventory at Target stores.{198} In the United States in 2008, an automobile spent an average of three months on a dealer’s lot before being sold, compared to two months the previous year. However, in 2008 Volkswagens sold in about two months in the U.S. while Chryslers took more than four months.{199} Although supermarkets tend to have especially low rates of profit on sales, because of their high rates of turnover, other businesses’ profit rates on sales are also usually lower than what many people imagine. Companies that made the Fortune magazine list of the 500 largest companies in America averaged “a return on revenues [sales] of a penny on the dollar” in 2002, compared to “6 cents in 2000, the peak profit year.”{200}

  Profits on sales and profits on investment are not merely different concepts. They can move in opposite directions. One of the keys to the rise to dominance of the A & P grocery chain in the 1920s was a conscious decision by the company management to cut profit margins on sales, in order to increase the profit rate on investment. With the new and lower prices made possible by selling with lower profits per item, A & P was able to attract greatly increased numbers of customers, making far more total profit because of the increased volume of sales. Making a profit of only a few cents on the dollar on sales, but with the inventory turning over nearly 30 times a year, A & P’s profit rate on investment soared. This low price and high volume strategy set a pattern that spread to other grocery chains and to other kinds of enterprises as well. Consumers benefitted from lower prices while A & P benefitted from higher profits on their investment—further evidence that economic transactions are not a zero-sum process.

  In a later era, huge supermarkets were able to shave the profit margin on sales still thinner, because of even higher volumes of sales, enabling them to displace A & P from industry leadership by charging still lower prices.

  Conversely, a study of prices in low-income neighborhoods found that there were larger than usual mark-ups in prices charged their customers but, at the same time, there were lower than usual rates of profit on investment.{201} Higher profits on sales helped compensate for the higher costs of doing business in low-income neighborhoods but apparently not completely, as indicated by the avoidance of such neighborhoods by many businesses, including supermarket chains.

  A limiting factor in how high stores in low-income neighborhoods can raise their prices to compensate for higher costs is the fact that many low-income residents already shop in stores in higher-income neighborhoods, where the prices are lower, even though this may entail paying bus fare or taxi fare. The higher the prices rise in low-income neighborhoods, the more people are likely to shop elsewhere. Thus stores in such neighborhoods are limited in the extent to which they can offset higher costs and slower turnover with higher prices, often leaving them in a precarious financial position, even while they are being denounced for “exploiting” their customers with high prices.

  It should also be noted that, where there are higher costs of doing business in low-income neighborhoods when there are higher rates of crime and vandalism, such additional costs can easily overwhelm the profit margin and make many businesses unsustainable in such neighborhoods. If a store clears a penny of profit on an item that costs a quarter, then if just one out of every 25 of these items gets stolen by shoplifters, that can make it unprofitable to sell in that neighborhood. The majority of people in the neighborhood may be honest consumers who pay for what they get at the store, but it takes only a fraction as many who are shoplifters (or robbers or vandals) to make it uneconomic for stores to locate there.

  COSTS OF PRODUCTION

  Among the crucial factors in prices and profits are the costs of producing whatever goods or services are being sold. Not everyone is equally efficient in production and not everyone’s circumstances offer equal opportunities to achieve lower costs. Unfortunately, costs are misconceived almost as much as profits.

  Economies of Scale

  First of all, there is no such thing as “the” cost of producing a given product or service. Henry Ford proved long ago that the cost of producing an automobile was very different when you produced 100 cars a year than when you produced 100,000. He became the leading automobile manufacturer in the early twentieth century by pioneering mass production methods in his factories, revolutionizing not only his own company but businesses throughout the economy, which followed the mass production principles that he introduced. The time required to produce a Ford Model T chassis shrank from 12 man-hours to an hour and a half.{202} With a mass market for automobiles, it paid to invest in expensive but labor-saving mass production machinery, whose cost per car would turn out to be modest when spread out over a huge number of automobiles. But, if there were only half as many cars sold as expected, then the cost of that machinery per car would be twice as much.

  Large fixed costs are among the reasons for lower costs of production per unit of output as the amount of output increases. Lower costs per unit of output as the number of units increases is what economists call “economies of scale.”

  It has been estimated that the minimum amount of automobile production required to achieve the fullest economies of scale today runs into the hundreds of thousands of cars per year.{203} Back at the beginning of the twentieth century, the largest automobile manufacturer in the United States produced just six cars a day.{204} At that level of output, the cost of production was
so high that only the truly rich could afford to buy a car. But Henry Ford’s mass production methods brought the cost of producing cars down within the price range of ordinary Americans. Moreover, he continued to improve the efficiency of his factories. The price of a Model T Ford was cut in half between 1910 and 1916.{205}

  Similar principles apply in other industries. It does not cost as much to deliver a hundred cartons of milk to one supermarket as it does to deliver ten cartons of milk to each of ten different neighborhood stores scattered around town. Economies in beer production include advertising. Although Anheuser-Busch spends millions of dollars a year advertising Budweiser and its other beers, its huge volume of sales means that its advertising cost per barrel of beer is less than that of its competitors Coors and Miller.{206} Such savings add up, permitting larger enterprises to have either lower prices or larger profits, or both. Small retail stores have long had difficulty surviving in competition with large chain stores charging lower prices, whether A & P in the first half of the twentieth century, Sears in the second half, or Wal-Mart in the twenty-first century. The higher costs per unit in the smaller stores will not permit them to charge prices as low as the big chain stores’ prices.

  Advertising has sometimes been depicted as simply another cost added on to the cost of producing goods and services. However, in so far as advertising causes more of the advertised product to be sold, economies of scale can reduce production costs, so that the same product may cost less when it is advertised, rather than more. Advertising itself of course has costs, both in the financial sense and in the sense of using resources. But it is an empirical question, rather than a foregone conclusion, whether the costs of advertising are greater or less than the reductions of production costs made possible by the economies of scale which it promotes. This can obviously vary from one firm or industry to another.

  Diseconomies of Scale

  Economies of scale are only half the story. If economies of scale were the whole story, the question would then have to be asked: Why not produce cars in even more gigantic enterprises? If General Motors, Ford, and Chrysler all merged together, would they not be able to produce cars even more cheaply and thereby make more sales and profit than when they produce separately?

  Probably not. There comes a point, in every business, beyond which the cost of producing a unit of output no longer declines as the amount of production increases. In fact, costs per unit actually rise after an enterprise becomes so huge that it is difficult to monitor and coordinate, when the right hand may not always know what the left hand is doing.{xiv} Back in the 1960s, when the American Telephone & Telegraph Company was the largest corporation in the world, its own chief executive officer put it this way: “A.T. & T. is so big that, if you gave it a kick in the behind today, it would be two years before the head said ‘ouch.’”

  In a survey of banks around the world in 2006, The Economist magazine reported their tendency to keep growing larger and the implications of this for lower levels of efficiency:

  Management will find it harder and harder to aggregate and summarise everything that is going on in the bank, opening the way to the duplication of expense, the neglect of concealed risks and the failure of internal controls.{207}

  In other words, the risks inherent in banking may be well under control, as far as the top management is aware, but somewhere in their sprawling financial empire there may be transactions being made that expose the bank to risks that the top management is unaware of. Unknown to the top management at an international bank’s New York headquarters, some bank official at a branch in Singapore may be making transactions that create not only financial risks but risks of criminal prosecution. This is not a problem peculiar to banks or to the United States. As a professor at the London Business School put it, some organizations have “reached a scale and complexity that made risk-management errors almost inevitable, while others had become so bureaucratic and top-heavy that they had lost the capacity to respond to changing market demands.”{208} Smaller rivals may be able to respond faster because their decision-makers do not have to go through so many layers of bureaucracy to get approval for their actions.

  During General Motors’ long tenure as the largest manufacturer of motor vehicles in the world, its cost of production per car was estimated to be hundreds of dollars more than the costs of Ford, Chrysler, or leading Japanese manufacturers.{209} Problems associated with size can affect quality as well as price. Among hospitals, for example, surveys suggest that smaller and more specialized hospitals are usually safer for patients than large hospitals treating a wide range of maladies.{210}

  Economies of scale and diseconomies of scale can exist simultaneously in the same business at various levels of output. That is, there may be some things that a given company could do better if it were larger and other things that it could do better if it were smaller. As an entrepreneur in India put it, “What small companies give up in terms of financial clout, technological resources, and staying power, they gain in flexibility, lack of bureaucracy, and speed of decision making.”{211} People in charge of a company’s operations in Calcutta may decide what needs to be done to improve business in that city but, if they then have to also convince the top management at the company’s headquarters in New Delhi, their decisions cannot be put into operation as quickly, or perhaps as fully, and sometimes the people in New Delhi may not understand the situation in Calcutta well enough to approve a decision that makes sense to people who live there.

  With increasing size, eventually the diseconomies begin to outweigh the economies, so it does not pay a firm to expand beyond that point. That is why industries usually consist of a number of firms, instead of one giant, super-efficient monopoly.

  In the Soviet Union, where there was a fascination with economies of scale and a disregard of diseconomies of scale, both its industrial and agricultural enterprises were the largest in the world. The average Soviet farm, for example, was ten times the size of the average American farm and employed more than ten times as many workers.{212} But Soviet farms were notoriously inefficient. Among the reasons for this inefficiency cited by Soviet economists was “deficient coordination.” One example may illustrate a general problem:

  In the vast common fields, fleets of tractors fanned out to begin the plowing. Plan fulfillment was calculated on the basis of hectares worked, and so it was to the drivers’ advantage to cover as much territory as quickly as possible. The drivers started by cutting deep furrows around the edge of the fields. As they moved deeper into the fields, however, they began to lift the blade of the plow and race the tractor, and the furrows became progressively shallower. The first furrows were nine to ten inches deep. A little farther from the road, they were five to six inches deep, and in the center of the field, where the tractor drivers were certain that no one would check on them, the furrows were as little as two inches deep. Usually, no one discovered that the furrows were so shallow in the middle of the field until it became obvious that something was wrong from the stunted nature of the crop.{213}

  Once again, counterproductive behavior from the standpoint of the economy was not irrational behavior from the standpoint of the person engaging in it. Clearly, the tractor drivers understood that their work could be more easily monitored at the edge of a field than in the center, and they adjusted the kind and quality of work they did accordingly, so as to maximize their own pay, based on how much land they plowed. By not plowing as deeply into the ground where they could not be easily monitored by farm officials, tractor drivers were able to go faster and cover more ground in a given amount of time, even if they covered it less effectively.

  No such behavior would be likely by a farmer plowing his own land in a market economy, because his actions would be controlled by the incentive of profit, rather than by external monitors.

  The point at which the disadvantages of size begin to outweigh the advantages differs from one industry to another. That is why restaurants are smaller than steel mills. A well-run
restaurant usually requires the presence of an owner with sufficient incentives to continuously monitor the many things necessary for successful operation, in a field where failures are all too common. Not only must the food be prepared to suit the tastes of the restaurant’s clientele, the waiters and waitresses must do their jobs in a way that encourages people to come back for another pleasant experience, and the furnishings of the restaurant must also be such as to meet the desires of the particular clientele that it serves.

  These are not problems that can be solved once and for all. Food suppliers must be continuously monitored to see that they are still sending the kind and quality of produce, fish, meats, and other ingredients needed to satisfy the customers. Cooks and chefs must also be monitored to see that they are continuing to meet existing standards—as well as adding to their repertoires, as new foods and drinks become popular and old ones are ordered less often by the customers. The normal turnover of employees also requires the owner to be able to select, train, and monitor new people on an on-going basis. Moreover, changes outside the restaurant—in the kind of neighborhood around it, for example—can make or break its business. All these factors, and more, must be kept in mind, weighed by the owner and continuously adjusted to, if the business is to survive, much less be profitable.

  Such a spectrum of details, requiring direct personal knowledge and control by someone on the scene and with incentives going beyond a fixed salary, limits the size of restaurants, as compared to the size of steel mills, automobile factories, or mining companies. Even where there are nationwide restaurant chains, often these are run by individual owners operating with franchises from some national organization that supplies such things as advertising and general guidance and standards, leaving the numerous on-site monitoring tasks to local owners. Howard Johnson pioneered in restaurant franchising in the 1930s, supplying half the capital, with the local manager supplying the other half.{214} This gave the local franchisee a vested interest in the restaurant’s profitability, rather than simply a fixed salary for his time.