Basic Economics

by Thomas Sowell

  This might seem to be the ideal situation in which to “eliminate the middleman,” since the petty traders were camped right outside stores selling the same merchandise, and the consumers could simply walk right on past them to buy the same goods inside at lower prices per unit. But these traders would sell in such tiny quantities as ten matches or half a cigarette, {221} while it would be wasteful for people in the stores behind them to spend their time breaking down their packaged goods that much, in view of the better paying alternative uses of their labor and capital.

  The alternatives available to the African petty traders were seldom as remunerative, so it made sense for these traders to do what it would not make sense for the European merchant to do. Moreover, it made sense for the very poor African consumer to buy from the local traders, even if the latter’s additional profit raised the price of the commodity, because the consumer often could not afford to buy the commodity in the quantities sold by the European merchants.

  Obvious as all this may seem, it has been misunderstood by renowned writers and—worse yet—by both colonial and post-colonial governments hostile to middlemen and prone to creating laws and policies expressing that hostility.

  Socialist Economies

  As in other cases, one of the best ways of understanding the role of prices, profits, and losses is to see what happens in their absence. Socialist economies not only lack the kinds of incentives which force individual enterprises toward efficiency and innovation, they also lack the kinds of financial incentives that lead each given producer in a capitalist economy to limit its work to those stages of production and distribution at which it has lower costs than alternative enterprises. Capitalist enterprises buy components from others who have lower costs in producing those particular components, and sell their own output to whatever middlemen can most efficiently carry out its distribution. But a socialist economy may forego these advantages of specialization—and for perfectly rational reasons, given the very different circumstances in which they operate.

  In the Soviet Union, for example, many enterprises produced their own components, even though specialized producers of such components existed and could manufacture them at lower costs. Two Soviet economists estimated that the costs of components needed for a machine-building enterprise in the U.S.S.R. were two to three times as great as the costs of producing those same components in specialized enterprises.{222} But why would cost matter to the individual enterprise making these decisions in a system where profits and losses were not decisive? What was decisive was fulfilling the monthly production quotas set by government authorities, and that could be assured most readily by an enterprise making its own components, since it could not depend on timely deliveries from other enterprises that lacked the profit-and-loss incentives of a supplier in a market economy.

  This was not peculiar to machine-building enterprises. According to the same Soviet economists, “the idea of self-sufficiency in supply penetrates all the tiers of the economic administrative pyramid, from top to bottom.”{223} Just over half the bricks in the U.S.S.R. were produced by enterprises that were not set up for that purpose, but which made their own bricks in order to build whatever needed building to house their main economic activity. That was because these Soviet enterprises could not rely on deliveries from the Ministry of the Industry of Construction Materials, which had no financial incentives to be reliable in delivering bricks on time or of the quality required.

  For similar reasons, far more Soviet enterprises were producing machine tools than were specifically set up to do so. Meanwhile, specialized plants set up for that purpose worked below their capacity—which is to say, at higher production costs per unit than if their overhead had been spread out over more units of output—because so many other enterprises were producing these machine tools for themselves.{224} Capitalist producers of bricks or machine tools have no choice but to produce what is wanted by the customer, and to be reliable in delivering it, if they intend to keep those customers in competition with other producers of bricks or machine tools. That, however, is not the case when there is one nationwide monopoly of a particular product under government control, as was the situation in the Soviet Union.

  In China’s economy as well, when it was government-planned for decades after the Communists took over in 1949, many enterprises supplied their own transportation for the goods they produced, unlike most companies in the United States that pay trucking firms or rail or air freight carriers to transport their products. As the Far Eastern Economic Review put it: “Through decades of state-planned development, nearly all big Chinese firms transported their own goods, however inefficiently.”{225} Although theoretically firms specializing in transportation might operate more efficiently, the absence of financial incentives for a government monopoly enterprise to satisfy their customers made specialized transport enterprises too unreliable, both as to times of delivery and as to the care—or lack of care—when handling goods in transit. A company manufacturing television sets in China might not be as efficient in transporting those sets as a specialized transport enterprise would be, but at least they were less likely to damage their own TV sets by handling them roughly in transit.

  One of the other side effects of unreliable deliveries has been that Chinese firms have had to keep more goods in inventory, foregoing the advantages of “just in time” delivery practices in Japan, which reduce the Japanese firms’ costs of maintaining inventories. Dell Computers in the United States likewise operates with very small inventories, relative to their sales, but this is possible only because there are shipping firms like Federal Express or UPS that Dell can rely on to get components to them and computers to their customers quickly and safely.

  The net result of habits and patterns of behavior left over from the days of a government-run economy is that China spends about twice as high a share of its national income on transportation as the United States does, even though the U.S. has a larger territory, including two states separated by more than a thousand miles from the other 48 states.

  Contrasts in the size—and therefore costs—of inventories can be extreme from one country to another. Japan carries the smallest inventories, while the Soviet Union carried the largest, with the United States in between. As two Soviet economists pointed out:

  Spare parts are literally used right “off the truck”: in Japan producers commonly deliver supplies to their ordering companies three to four times a day. At Toyota the volume of warehoused inventories is calculated for only an hour of work, while at Ford the inventories are for up to three weeks. {226}

  In the Soviet Union, these economists said, “we have in inventories almost as much as we create in a year.”{227} In other words, most of the people who work in Soviet industry “could take a year’s paid vacation”{228} and the economy could live on its inventories. This is not an advantage but a handicap because inventories cost money—and don’t earn any. From the standpoint of the economy as a whole, the production of inventory uses up resources without adding anything to the standard of living of the public. As the Soviet economists put it, “our economy is always burdened by the heavy weight of inventories, much heavier than those that weigh on a capitalist economy during the most destructive recessions.”{229}

  Yet the decisions to maintain huge inventories were not irrational decisions, given the circumstances of the Soviet economy and the incentives and constraints inherent in those circumstances. Soviet enterprises had no real choice but to maintain these costly inventories. The less reliable the suppliers, the more inventory it pays to keep, so as not to run out of vital components.{xv} Nevertheless, inventories add to the costs of production, which add to the price, which in turn reduces the public’s purchasing power and therefore its standard of living.

  Geography can also increase the amount of inventory required. As a result of severe geographical handicaps that limit transportation in parts of sub-Saharan Africa,{xvi} large inventories of both agricultural produce and industrial output have
had to be maintained there because regions heavily dependent on rivers and streams for transportation can be cut off if those rivers and streams fall too low to be navigable because the rainy season is either delayed or ends prematurely.{230} In short, geographic handicaps to land transportation and drastic differences in rainfall at different times of the year add huge inventory costs in sub-Saharan Africa, contributing to that region’s painfully low standard of living. In Africa, as elsewhere, maintaining large inventories means using up scarce resources without a corresponding addition to the consumers’ standard of living.

  The reason General Motors can produce automobiles, without producing any tires to go on them, is because it can rely on Goodyear, Michelin, and whoever else supplies their tires to have those tires waiting to go on the cars as they move down off the production lines. If those suppliers failed to deliver, it would of course be a disaster for General Motors. But it would be even more catastrophic for the tire companies themselves. To leave General Motors high and dry, with no tires to go on its Cadillacs or Chevrolets, would be financially suicidal for a tire company, since it would lose a customer for millions of tires each year, quite aside from the billions of dollars in damages from lawsuits over breach of contract. Under these circumstances, it is hardly surprising that General Motors does not have to produce all its own components, as many Soviet enterprises did.

  Absurd as it might seem to imagine Cadillacs rolling off the assembly lines and finding no tires to go on them, back in the days of the Soviet Union one of that country’s own high officials complained that “hundreds of thousands of motor vehicles stand idle without tires.”{231} The fact that complex coordination takes place so seemingly automatically in one economic system that people hardly even think about it does not mean that coordination will be similarly automatic in another economic system operating on different principles.{xvii} Ironically, it is precisely where there is no one controlling the whole economy that it is automatically coordinated by price movements, while in deliberately planned economies a similar level of coordination has repeatedly turned out to be virtually impossible to achieve.

  Reliability is an inherent accompaniment of the physical product when keeping customers is a matter of economic life and death under capitalism, whether at the manufacturing level or the retail level. Back in the early 1930s, when refrigerators were just beginning to become widely used in the United States, there were many technological and production problems with the first mass-produced refrigerators sold by Sears. The company had no choice but to honor its money-back guarantee by taking back 30,000 refrigerators, at a time when Sears could ill afford to do so, in the depths of the Great Depression, when businesses were as short of money as their customers were. This situation put enormous financial pressure on Sears to either stop selling refrigerators (which is what some of its executives and many of its store managers wanted) or else greatly improve their reliability. What they eventually did was improve the reliability of their refrigerators, thereby becoming one of the leading sellers of refrigerators in the country.{232}

  Chapter 7

  THE ECONOMICS OF

  BIG BUSINESS

  Competition always has been and always will be troublesome to those who have to meet it.

  Frédéric Bastiat{233}

  Big businesses can be big in different ways. They can be big absolutely, like Wal-Mart—with billions of dollars in sales annually, making it the biggest business in the nation—without selling more than a modest percentage of the total merchandise in its industry as a whole. Other businesses can be big in the sense of making a high percentage of all the sales in their industries, as Microsoft does with sales of operating systems for personal computers around the world. There are major economic differences between bigness in these two senses. An absolute monopoly in one industry may be smaller in size than a much larger company in another industry where there are numerous competitors.

  The incentives and constraints in a competitive market are quite different from those in a market where one company enjoys a monopoly, and such differences lead to different behavior with different consequences for the economy as a whole. Markets controlled by monopolies, oligopolies or cartels require a separate analysis. But, before turning to such analysis, let us consider big businesses in general, whether big absolutely or big relative to the market for their industry’s products. One of the general characteristics of big businesses has already been noted in Chapter 6—economies of scale and diseconomies of scale, which together determine the actual scale of production of companies that are likely to survive and prosper in a given industry. Another of the general characteristics of big businesses is that they typically take the form of a corporation, rather than being owned by a given individual, family, or partnership. The reasons for this particular kind of organization and its consequences require examination.

  CORPORATIONS

  Corporations are not all businesses. The first corporation in America was the Harvard Corporation, formed in the seventeenth century to govern America’s first college. Corporations are different from enterprises owned by individuals, families or partners. In these other kinds of enterprises, the owners are personally responsible for all the financial obligations of the organization. If such organizations do not happen to have enough money on hand to pay their bills or to pay any damages resulting from lawsuits, a court can order the seizure of the bank accounts or other personal property of those who own the enterprise. A corporation, however, has a separate legal identity, so that the individual owners of the corporation are not personally liable for its financial obligations. The corporation’s legal liability is limited to its own corporate assets—hence the abbreviation “Ltd.” (for limited liability) after the names of British corporations, serving the same purpose as “Inc.” (incorporated) after the names of American corporations.

  This limited liability is more than a convenient privilege for corporate stockholders. It has major implications for the economy as a whole. Huge companies, doing billions of dollars’ worth of business annually, can seldom be created or maintained by money from a few rich investors. There are not nearly enough rich people for that to happen, and even those who are rich would seldom risk their entire fortune in one enterprise. Instead, gigantic corporations are usually owned by thousands, or even millions, of stockholders. These include not only people who directly own shares of corporate stocks, but also many other people who may never think of themselves as stockholders, but whose money paid into pension funds has been used by those funds to purchase corporate stock. Directly or indirectly, about half of the American population are investors in corporate stocks.

  Like many other things, the significance of limited legal liability can be understood most easily by seeing what happens in its absence. Back during the First World War, Herbert Hoover organized a philanthropic enterprise to buy and distribute food to vast numbers of people who were suffering hunger and starvation across the continent of Europe, as a result of blockades and disruptions growing out of the military conflict. A banker whom he had recruited to help him in this enterprise asked Hoover if this was a limited liability organization. When Hoover said that it was not, the banker resigned immediately because, otherwise, his life’s savings could be wiped out if the organization did not receive enough donations from the public to pay for all the millions of dollars’ worth of food that it would buy to feed all the hungry people across Europe.

  The importance of limited liability to those particular individuals creating or investing in corporations is obvious. But the limited liability of stockholders is of even greater importance to the larger society, including people who do not own any corporate stock nor have any other affiliation with a corporation. What limited liability does for the economy and for the society as a whole is to permit many gigantic economic activities to be undertaken that would be too large to be financed by a given individual, and too risky to invest in by large numbers of individuals, if each investor became liable for the debts of an
enterprise that is too large for all its stockholders to monitor its performance closely.

  The economies of scale, and the lower prices which large corporations can achieve as a result, and the correspondingly higher standards of living resulting from these economies of scale, enable vast numbers of consumers to be able to afford many goods and services that could otherwise be beyond their financial means. In short, the significance of the corporation in the economy at large extends far beyond those people who own, manage, or work for corporations.

  What of creditors, who can collect the debts that corporations owe them only to the extent of the corporation’s own assets, and who cannot recover any losses beyond that from those who own the corporation? The “Ltd.” or “Inc.” after a corporation’s name warns creditors in advance, so that they can limit their lending accordingly and charge interest rates adjusted to the risk.

  Corporate Governance

  Unlike other kinds of businesses, where those who own the enterprise also manage it, a major corporation has far too many stockholders for them to be able to direct its operations. Executives are put in charge of corporate management, hired and if need be fired by a board of directors who hold the ultimate authority in a corporation. This arrangement applies beyond business enterprises. Colleges and universities are usually also managed by administrators who are hired and fired by a board of trustees, who hold the ultimate legal authority but who do not manage day-to-day operations in the classrooms or in academic administration.