Microeconomics:A Free Market ApproachEdited by Thomas Rustici, Carrie Milton,and Nathanael Snow

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MICROECONOMICS

A Free Market Approach

Revised Edition

Edited by Th omas Rustici, Carrie Milton, and Nathanael Snow

George Mason University

Copyright © 2010 by Th omas Rustici, Carrie Milton, and Nathanael Snow. All rights reserved. No part of this publication may be reprinted, reproduced, transmitted, or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying, microfi lming, and recording, or in any information retrieval system without the written permission of University Readers, Inc.

First published in the United States of America in 2010 by Cognella, a division of University Readers, Inc.

Trademark Notice: Product or corporate names may be trademarks or registered trade-marks, and are used only for identifi cation and explanation without intent to infringe.

14 13 12 11 10 1 2 3 4 5

Printed in the United States of America

ISBN: 978-1-935551-11-9

SECTION ONE:Introduction/Spontaneous Order 1

Introduction By Th omas Rustici 3

I, Pencil By Leonard E. Read 13

Rinkonomics: A Window on Spontaneous Order By Daniel B. Klein 19

Order from Chaos By Th omas Rustici 25

SECTION TWO:History of Ideas 31

Greed Versus Compassion By Walter Williams 33

Morality as Cooperation By Peter J. Boettke 37

Capitalist Ethics—Tough or Soft? By Jack Hershleifer 43

Contents

SECTION THREEPrice Formation 49

Th e Formation and Function of Prices

By Hans Sennholz 51

Th e Economic Organization of a POW Camp By R. A. Radford 57

Th e Use of Knowledge in Society By F. A. Hayek 69

SECTION FOURPrice Control 79

Price Controls

By Hugh Rockoff 81

Rent Control By Walter Block 87

Th e Energy Crisis Is Over! By Charles Maurice and Charles Smithson 93

SECTION FIVEOpportunity Cost and Comparative Advantage 109

A PETITION From the Manufacturers of Candles, Tapers, Lanterns, sticks, Street Lamps, Snuff ers, and Extinguishers, and from Producers of Tallow, Oil, Resin, Alcohol, and Generally of Everything Connected with Lighting By Frédéric Bastiat 111

Th e Balance of Trade By Frédéric Bastiat 115

On Foreign Trade By David Ricardo 119

SECTION SIXTh e Firm 123

Th e Social Responsibility of Business is to Increase its Profi ts

By Milton Friedman 125

Th e Nature of the Firm By Ronald Coase 131

Production, Information Costs, and Economic Organization By Armen A. Alchian and Harold Demsetz 147

SECTION SEVENCompetition and Monopoly 169

Antitrust

By Alan Greenspan 171

Antitrust By Fred S. McChesney 177

John D. Rockefeller and the Oil Industry By Burton Folsom 185

Competition (Except Where Prohibited by Law) By Th omas J. DiLorenzo 197

Occupational Licensure By Milton Friedman 205

SECTION EIGHTInformation/Middlemen/Speculators 221

Why Speculators?

By Percy L. Greaves, Jr. 223

Schools Brief: Pennies from Hell By Uncredited, Th e Economist Staff 231

Middlemen By Frédéric Bastiat 237

Advertising By Israel M. Kirzner 243

Defeating Drug Lag By Julie DeFalco 253

Th eory, Evidence, and Examples of FDA Harm By Th e Independent Institute 257

SECTION NINEIncome Determination 267

Introduction:Th e Heroic Enterprise

By John Hood 269

Entrepreneurs Are the Heroes of the World By Johan Norberg 279

Job Safety By W. Kip Viscusi 285

Puzzling Questions of Vital Concern for 2,155,000,000 Individuals By Henry Grady Weaver 289

Th ree Myths About Labor Unions By Isaac DiIanni 295

Outrageous CEO Pay By Hans Sennholz 299

Th e 59¢ Fallacy By Jennifer Roback 303

Profi t and Loss By Ludwig Von Mises 309

Gumball Now or Ice Cream Later? Th e Formation of Interest Rates by Subjective Time Preference

By Nathanael D. Snow 331

SECTION TENEnvironmental Economics 337

Nature’s Entrepreneurs By Terry Anderson 339

To Drill, or Not to Drill, Let the Environment Decide By Dwight R. Lee 345

Th e Endangered Species Act: Making Innocent Species the Enemy By Richard Stroup 355

Chemicals and Witches: Standards of Evidence in Regulation By Robert Nelson 367

Enclosing the Environmental Commons By Fred Smith 373

Bootleggers and Baptists—Th e Education of a Regulatory Economist By Bruce Yandle 389

Resolving the Tragedy of the Commons by Creating Private Property Rights in Wildlife

By Robert J. Smith 397

SECTION ELEVENPublic Choice/Government 421

School Brief: State and Market By Uncredited, Th e Economist Staff 423

Th e Federalist No. 51 By James Madison 429

Loot By Leonard E. Read 433

Th e Federalist No. 10 By James Madison 437

Not Yours to Give By Davy Crockett 443

Cloaking the State’s Dagger By Robert Nisbet 449

Th e Economic View of Regulation By Robert Rush 455

SECTION TWELVEMarkets and Liberty 461

Ungenerous Endowments By Uncredited, Th e Economist Staff 463

Economic Freedom: Of Liberty and Prosperity By Uncredited, Th e Economist Staff 471

Political Economy of the U.S. Constitution By Dwight Lee 477

What Is Capitalism? By Ayn Rand 491

SECTION THIRTEENApplied Economics 509

A Public Choice View of the Minimum Wage By Th omas Rustici 511

Exploitation in the Jim Crow South: Th e Market or the Law? By Jennifer Roback 537

Th e Emergence of Nonperforming Loans: From the Commons of Risk By Carrie T. Milton 549

Public Goods and Public Choice By Th omas Rustici 561

SECTION ONE:

Introduction / Spontaneous Order

3

ECONOMIC LITERACY

E conomics is often thought of as the application of mathematics to social science. While economists make heavy use of mathematical tools, for the sake of logical rigor, economics as a science has a rich literary heritage. Consider the wealth of insight

shared by the classical economists such as Adam Smith and David Ricardo, classical liberals similar to Frédéric Bastiat, leaders of the marginal revolution like the Austrian, Carl Menger, articulators of essential economic truths such as Leonard Reed, Nobel Laureates such as Milton Friedman, Friedrich von Hayek and George Stigler, and fi nally, today’s writers like Walter Williams, Terry Anderson, Hugh Rockoff , Th omas DiLorenzo, and Daniel Klein. Far too often this literature is overlooked, many students come to despise the graphs and equations of textbooks, and the rich insights to be gained from the economic way of thinking are never absorbed. Th is anthology consists of selections from this literature highlighting the fundamental principles of microeconomics.

Th e editors of this volume are unapologetically free market economists. Our attitude refl ects a belief in emerging systems, such as prices, which effi ciently communicate relevant bits of information throughout the economy and all of society. We have discovered these essays to be some of the best literature available for grasping the subtleties of the market process. Th ey range from very simple to very technical and everything in between. Even the most complicated of these, however, may be grasped by novice students with the guidance of an instructor reinforc-ing fundamental principles. Th e readings have been broken down into 13 sections: 12 of basic principles, and a fi nal section on applied economics.

SPONTANEOUS ORDER

Economics may be described as the science of spontaneous unplanned order emerging from seeming chaos. Leonard Read demonstrates how even the humble pencil is a product of these emerging systems in the classic I, Pencil. Economics has no designed plan yet activities are co-ordinated in a logically coherent fashion such that life is made possible. Th is is the window into the science of microeconomics. It is the art of seeing what you don’t see, the life behind things. Economics is about hidden order, or what Adam Smith in An Inquiry Into the Nature and Causes

Introduction

By Th omas Rustici

4 Microeconomics: A Free Market Approach

of the Wealth of Nations calls “the Invisible Hand.” Th ese essays illustrate the spontaneous nature of market emergence.

HISTORY OF IDEAS

How do we get things in life that we need? What are the moral ground rules by which people engage with each other? What are the economic consequences of relationships based on diff erent institutions? Th e normative aspect of the history of ideas and social cooperation is explained through the essays in this section. Mercantilistic, or pre-economic ways of looking at life, understood human relations as a zero-sum game, where if anyone were to gain, necessarily someone else must lose. But markets can only exist where there are mutual gains and creation of new wealth unconstrained by the zero-sum perspective. To cooperate well with others may be the most relevant demonstration of morality regularly practiced. Every peaceful exchange contributes to the moral institutional infrastructure of the marketplace that makes civilization appreciable.

PRICE FORMATION

Th e crown jewel of economics, the positive contribution to scientifi c inquiry, is price theory. Th e formation, function, and interaction of relative prices direct the choices of individuals. Th e relevance of the basic theory is illustrated in practice. Even in the most unlikely of places markets and prices emerge as R. A. Radford shows in Th e Economic Organization of a POW Camp.

Nobel Laureate Friedrich von Hayek’s Th e Use of Knowledge in Society is possibly the richest essay in this book. Hayek shows that the price system is a grand information system. Prices communicate information about human values in a world with scarce resources for storing information and making calculations. Th ey tell us what we don’t know. Prices allow us to give knowledge in ways we could never access through reason alone. Th e price system is spontane-ous, unplanned, undefi ned. It is, “the result of human action but not of human design.” Th is essay deserves multiple readings.

PRICE CONTROLS

Often government will try to manipulate the human values expressed in the price system and use coercion to dictate terms of trade that do not refl ect the underlying reality of values of buyers and sellers. Th ere are consequences of course. Economics is about revealing the law of unintended consequences. Whether well-intentioned or not, price controls force institutional-ized chaos on a dynamically emergent market process, creating surpluses and shortages of vital goods and services, and hurting people in the process. Specifi cally, where prices are held too high relative to the market, surpluses are created; where held below market equilibrium, short-ages are created.

Introduction 5

Th e essay Th e Energy Crisis is Over! by Charles Maurice and Charles Smithson clearly outlines the process by which price controls created the energy crisis of the 1970’s, and the proliferating array of excuses and desperate policy measures created to deal with the consequences of price controls. Th e student will learn the crisis did not end until price controls were repealed in the early 1980’s.

Prices tell us about the trade-off s, opportunities, and values of other people when not con-trolled by coercive threat. When prices are controlled misinformation creates disharmony and disorder. Th e price system is like the thermometer attached to the thermostat in your home. Th e temperature in the room is gauged by the mercury in the thermometer. But the mercury in the thermometer does not directly aff ect the temperature in the room.

If the room is on fi re and the mercury reads 120˚F, we don’t cool the room by artifi cially sticking a needle in the thermometer and taking out mercury until it reads 30˚ F. Causation does not run from the mercury to the room, but from the room to the mercury. Misinformation gets forced into the system by such a control. If there is a fi re in the room we should call the fi re de-partment to change the underlying variables—put the fi re out. However, there are unintended consequences of policy adjustments, one of which is unintended feedback. Th e thermostat reads 30˚ F when it is really 120˚ F in the room. Exactly when we want the room cooler, it gets hotter, the heater comes on when thermostat is tricked into believing the temperature is only 30˚ F, exactly the opposite of what we would want to have happen.

Conversely, if there is a hole in the roof in the winter, which allowed snow and ice to accumulate in the room, so that the temperature is only 10˚ F in the room, we would have a maintenance company come fi x the hole, changing the underlying variables. If the mercury reads 10˚ F we don’t make it warmer by putting a lit match under the mercury. Th e thermom-eter would then be communicating false information. Exactly when we want it warmer the thermostat starts the air conditioning. Now we not only have ice and snow, but it is even colder, the exact opposite of what we wanted.

OPPORTUNITY COST AND COMPARATIVE ADVANTAGE.

Economics has always sought to be practical. Th e economic way of thinking has helped shift public opinion on many issues, leading to better effi ciency, and higher standards of living. Among the oldest of insights, David Ricardo in On Foreign Trade, and Frédéric Bastiat in Th e Candlemaker’s Petition, and Th e Balance of Trade used opportunity cost and comparative advan-tage to play key roles in destroying mercantilist myths.

Many resources are scarce. Using a quart of milk to make ice cream requires that we forego the use of that milk in making cheese. Every choice therefore must consider the trade-off s of multiple options. Th e fi nal course of action always involves sacrifi ced opportunities. To get some goods or services, we always have to give up others. Th e next best option; what you would have done if your fi rst preferred course of action were made impossible: this is the opportunity cost of that decision.

Comparative advantage is applied opportunity cost. Why do people engage in the activities they do? What is the economic logic of the division of labor? Specialization in production

6 Microeconomics: A Free Market Approach

increases the benefi ts of exchange. Th is has implications for social cooperation locally, nation-ally, and internationally. Were you and a friend to paint a room together you might fi rst have a little competition to see who was better at cutting in the edges and who was better at rolling. By so discovering your comparative advantages you can work together to fi nish the job more quickly. Such trade is mutually benefi cial regardless of where one lives and works.

Many times politicians and journalists will spread the idea that trade defi cits are harmful. Such thinking refl ects a zero-sum game mentality. Once nations began working to improve standards of living, and stopped focusing on national cash reserves, trade relations improved and all parties were better off . Unfortunately, these lessons are often forgotten or misunderstood.

THE FIRM

Why do fi rms exist and what is their functional role in the marketplace? Why can’t we rely on the price system alone to allocate all scarce resources? Why do we fi nd, in every market economy, entrepreneurs running businesses instead of everyone operating as sole proprietors?

Firms exist to make money, a profi t. Firms not in the market for profi t go bankrupt and leave the market. Ronald Coase received his Nobel Prize for showing in Th e Nature of the Firm how transaction costs lead to the creation of the fi rm. Entrepreneurs internalize market externalities and replace the price system when they are effi cient. When they are not, the market replaces them through bankruptcy. Factors of production revert to other entrepreneurs in the open market.

Th e essay by Nobel Laureate Milton Friedman, Th e Social Responsibility of Business to Increase its Profi ts, illustrates this process and why it is good they do so.

Th e prisoner’s dilemma is an idea we owe to John Nash, about whom the book and movie A Beautiful Mind were written. His insights into game theory explain strategic behavior in group settings. Among the applications of this theory is Alchian and Demsetz’s Production, Information Costs, and Economic Organization. While rather technical for the principles student, this paper is profound, and worth working through. Alchian and Demsetz argue there is an alternative explanation for the formation of the fi rm. Th ey do not deny Coase’s transactions costs explana-tion, but they address the prisoner’s dilemma and shirking costs problems. Students should get an appreciation for entrepreneurs and how they help each of us actualize our full productive potential by pulling us out of dilemmas.

COMPETITION AND MONOPOLY

Th ere are many myths surrounding the issue of market structure in a free market economy. Among these is a fear of monopoly, or competitive behavior which forces all of one fi rm’s competitors out of its industry, and gives it the power to restrict output and raise prices inde-terminately. Fear of monopolists has spawned much anti-monopoly policy by government, but these policies may have horrible unintended consequences.

Monopoly, rightly understood, is actually a creation of privilege on the market by the state, and yet many people believe that the competitive marketplace never existed based on historical

Introduction 7

myths. Th ese essays, including an early work of Alan Greenspan’s, former Chairman of the Board of Governors of the United States Federal Reserve, and a rousing history of J. D. Rockefeller and the Oil Industry by Burton Folsom, deal with the theory of antitrust, the policy of antitrust, as well as the history of the origin of the Sherman Act.

Competition comes from greed in a world of scarcity. Other capitalists greedy to earn abnor-mally high returns on the capital market guarantee the process of competition will discipline the behavior of fi rms unless government prohibits it. Historically, those whom trust-busters accuse of being monopolies have actually been those who have lowered prices, and expanded output. In fact, the Th omas DiLorenzo article Competition (Except Where Prohibited by Law) points out that the main reason the Sherman Act passed was because outputs were expanding and prices were falling! Other fi rms which were not able to match the productivity of the dominant fi rm pushed for government favor to keep them, ineffi ciently, in business.

Finally, the essay Occupational Licensure by Milton Friedman illustrates the many ways the government creation of monopoly is guised under the public interest to serve consumer quality, when really it is an expense to consumers.

INFORMATION, MIDDLEMEN, AND SPECULATORS

If we assume information is a free economic good it can be diffi cult to justify the presence of middlemen and speculators. However, as Nobel Laureate George Stigler showed, information is a scarce economic good that must be economized. People only search for information until the marginal benefi t of searching is equal to its marginal cost. Middlemen specialize in searching for relevant information, bringing it to consumers at less cost than they would incur from searching for it themselves.

Speculators are messengers of the future that forewarn what is to come based on best guesses. Th ey take on the risk of getting the guesses right, and relieve the rest of us of much of that risk. Th ey help bring future information to bear on current prices, which then transmit this information to the rest of the market. Speculators are the shock absorbers for any economic system. Th ey further coordinate trade through time and thus expand the gains from trade.

Other market institutions provide information as well. Israel Kirzner in Advertising illus-trates how advertising is benefi cial not only to producers, but also to consumers who are not necessarily knowledgeable of all their choices. No one can make use of an opportunity they don’t know about. Advertising bridges this gap, and can no longer be viewed as social waste but as a necessary component for an effi cient large economy.

Finally, public policy in information acquisition for drug licensing by the Food and Drug Administration (FDA) is examined in two of these readings. Th e FDA claims to help people by keeping bad drugs off the market. Th ey want to avoid the Type I error of allowing a drug to go to market even though it may have harmful eff ects. Th ey spend a great deal of time testing and observing the side eff ects of medicines to avoid this mistake.

But as a result, they fall into the Type II error of excessive skepticism. Th ey often keep a good drug off the market far too long. All of the people who could have benefi ted from the use of

8 Microeconomics: A Free Market Approach

the medicine will then never have the opportunity. Many of them will have already died while waiting.

It is easier to see and measure the consequences of a Type I error. You see the patient suf-fering from the side eff ects. It is harder to notice the person who suff ers due to a Type II error. Government agencies therefore receive more pressure to avoid Type I errors than Type II. We want public health to be protected by regulation, yet regulation hurts public health because information about potentially useful drugs is held back from consumers, and is not free.

INCOME DETERMINATION

Who gets what? What are the economic forces involved? What determines the division of income? Businesses derive profi ts, workers receive real wages, and savers receive interest. Th ese three are not each hermetically sealed, people usually draw from multiple sources. Economics can explain the basic determinates in each.

Entrepreneurs earn profi ts by serving society, but also may take losses to capital if they do not it do well. With respect to real wages, an important concept emerges: what are the determinate variables that make workers real standard of living rise? In economics it is called marginal productivity of labor. Based on that, the worker receives the value of their contribution to the revenues of the fi rm. If for any reason workers receive less than their marginal productivity their greed leads them to say, as the old Johnny Paycheck song says, “Take this job and shove it.” Who has ever quit a job because they were being paid too much? Yet, many quit jobs in search of higher wages every year. Th e underpaid worker’s greed leads them to quit. On the other hand, if workers are overpaid by entrepreneurs the fi rm moves toward bankruptcy. Wages tend toward marginal productivity over the long run.

Wage is a composite variable. What a worker receives for his work is not just the money, but also non-monetary in-kind benefi ts, working conditions, and amenities. Th e total of these describes the real wage. What makes marginal productivity increase is the message of Th e Wealth of Nations: division of labor, human capital, education, and improvements in tools.

Th ese essays also deal with certain fallacies on labor markets that politicians and journalists often make about why workers are paid what they are. Much of this is shrouded in the mythol-ogy of unions. Th e essay by Isaac DiIanni Th ree Myths About Labor Unions shows that unions are labor cartels which hurt most non-union members.

Finally, savers receive interest. Gumballs Now or Ice Cream Later? by Nathanael Snow illus-trates how goods though time are not the same, even if identical, because people dislike waiting. If time is scarce it has a price; the interest rate. Th e present value of goods, services, and fi nancial instruments forms markets to better satisfy our inter-temporal desires.

ENVIRONMENTAL ECONOMICS

What can an economist say about the environment? Students are regularly turned toward biol-ogy or ecology to answer questions about the environment, however economics can bring its unique way of thinking to illuminate often overlooked truths about the environment. We are

Introduction 9

dealing with humans, their values, and scarce resources. We can look at unintended conse-quences which result from interactions among these variables.

Why are some species endangered? How might laws to protect them accelerate their rates of extinction? Th e essay Th e Endangered Species Act by Richard Stroup illustrates this point very clearly. Communal resources have no real owners. Unlike private property whose owner protects its value, communal resources are free for the taking, thus end up on a race to the bottom through the fi rst extraction rule: Individuals line up to extract the maximum out of communal resources and minimize any future reinvestment.

Incentives matter. Ownership matters. People take care of what they own because they are greedy. Future residual claimants, because they are greedy, will not trash what they own. Property rights channel investment into the future quality and quantity of land, water, air, and other environmental resources. Th e commons quickly dive to the bottom.

Other issues on environmental economics become very clear here. Public policy which tries to manage an endangered species habitat often overrides private property rights and leads to the “Th ree S’s Rule”: Shoot, Shovel, and Shut up. Th ese essays illustrate that under current environmental regulations the presence of an endangered species on one’s property is a liability and not an asset. Th e essay Enclosing the Environmental Commons by Fred Smith deals with these broad issues from several angles.

In politics we have the phrase “politics makes strange bedfellows.” Many times public policy for environmental protection looks well-intentioned on the surface and yet certain alliances are created with diametrically opposite values. Why might a coal company support an envi-ronmental group that is ostensibly anti-coal? Th is phenomenon is described by Bruce Yandle in Bootleggers and Baptists. Regulation imposes costs and benefi ts. Just as the environmentalists may believe targeting certain types of coal use is a good thing, so does the competitor who has an advanced technology. If the government will restrict his competitor’s use of coal, he will have an advantage in the marketplace. One desires clean environment the other desires to monopolize.

PUBLIC CHOICE AND GOVERNMENT

Why does government exist? Why not allow private anarchy to allocate all scarce resources? Why do we allow a coercive agent called “the state” to take our money? Th e economic defense for government is usually the need to supply public goods. Th e essays in this section will deal with the role and limits of governments constitutionally, economically, and morally. From the Federalist Papers 10 and 51, by James Madison to the “Schools Brief ” from Th e Economist magazine these limits are explored.

Th e essay by Robert Rush explores the economics of regulation. Students wishing to pursue regulatory economics or public policy courses should examine this essay and those cited in it, especially Nobel Laureate George Stigler’s Th e Th eory of Economic Regulation, to understand how producers will lobby the government for entry restrictions against competitors. Th is cre-ates a monopoly at the expense of consumers. Th is is exactly opposite of any “Civics Course” notion of government regulation for the public good. Rather it is about private greed, using

10 Microeconomics: A Free Market Approach

government, under guise of serving the public, through taxes, fees, permits, licenses, and barri-ers, limiting the entry of competitors.

MARKETS AND LIBERTY

We must address certain myths about markets, capitalism, and economic growth on positive and normative grounds. Th e two essays from Th e Economist magazine, “Ungenerous Endowments,” and “Economic Freedom, of Liberty, and Prosperity” deal with some of the positive fallacies, such as natural resources as the cause of wealth of nations, or government central planning as an improvement on markets for prosperity. Th e essay by Dwight Lee, Political Economics and US Constitution, ties together public choice insights with the founders’ original intent in the U.S. Constitution. Th e last essay, What is Capitalism?, by philosopher Ayn Rand ties together positive and normative elements about market capitalism, what it is dependent on, and what it is not. It explains that the wisdom of the founding fathers was to limit government power and what the economic and moral implications of these limits are.

APPLIED ECONOMICS

Technical in nature yet understandable to students with guidance from a professor, these essays take the lessons learned in previous sections and demonstrate how all the tools of the economic science can be brought to bear in harmony on particular issues. First, A Public Choice View of the Minimum Wage by Th omas Rustici, ties together income determination, price theory, price controls, government in politics, public choice in government, and markets in liberty.

Jennifer Roback’s Exploitation in the Jim Crow South: Th e Market or the Law is an applied historical case study of labor markets in the time of segregation. Again, many of the same broad themes are tied together in this essay with relevant empirical data. Our view of segregation and economics under segregation starts to change when we read Roback. Th e culprit was certainly the state and not the market.

Carrie Milton applies microeconomic concepts to the current fi nancial crisis (2008-9) in markets in Th e Emergence of Nonperforming Loans: From the Commons of Risk. Concepts such as moral hazard, the fi nancial commons, regulatory economics, and many diff erent micro-economic tools are employed here to explain larger macroeconomic movements. Th is essay illustrates how government policies laid the foundation for our current crises.

In the fi nal essay Public Goods and Public Choice by Th omas Rustici all the tools of micro-economics: price theory, history of ideas, competition, environment, and public choice are woven together and applied within the broad economy. Th is chapter is a good introduction to international economics. Students taking future classes in economics will fi nd this analysis helpful in dissecting new material.

Introduction 11

CONCLUSION

We know these readings will provide the reader a strong literacy in economics. Th e economic way of thinking is useless if it is not put into practice. Essays like these should prompt the reader to observe economics in action in their daily lives, applying the lessons to personal decisions, and directing their analysis of public policy. With a strong foundation in economic literacy the economic intuition is formed, and the mysteries of complex theory are revealed. We are confi dent this anthology provides such a foundation, and does so while maintaining the interest and curiosity of the reader.

13

I am a lead pencil—the ordinary wooden pencil familiar to all boys and girls and adults who can read and write.

Writing is both my vocation and my avocation; that’s all I do. You may wonder why I should write a genealogy. Well, to begin with, my story is interesting.

And, next, I am a mystery—more so than a tree or a sunset or even a fl ash of lightning. But, sadly, I am taken for granted by those who use me, as if I were a mere incident and without background. Th is supercilious attitude relegates me to the level of the commonplace. Th is is a species of the grievous error in which mankind cannot too long persist without peril. For, the wise G. K. Chesterton observed, “We are perishing for want of wonder, not for want of wonders.”

I, Pencil, simple though I appear to be, merit your wonder and awe, a claim I shall attempt to prove. In fact, if you can understand me—no, that’s too much to ask of anyone—if you can become aware of the miraculousness which I symbolize, you can help save the freedom mankind is so unhappily losing. I have a profound lesson to teach. And I can teach this lesson better than can an automobile or an airplane or a mechanical dishwasher because—well, because I am seemingly so simple.

Simple? Yet, not a single person on the face of this earth knows how to make me. Th is sounds fantastic, doesn’t it? Especially when it is realized that there are about one and one-half billion of my kind produced in the U.S.A. each year.

Pick me up and look me over. What do you see? Not much meets the eye—there’s some wood, lacquer, the printed labeling, graphite lead, a bit of metal, and an eraser.

Innumerable Antecedents

Just as you cannot trace your family tree back very far, so is it impossible for me to name and explain all my antecedents. But I would like to suggest enough of them to impress upon you the richness and complexity of my background.

I, Pencil

By Leonard E. Read

Leonard E. Read, “I, Pencil,” from Th e Freeman, 46, 5, May 1996, pp. 1–3. Copyright © 1996 Th e Foundation for Economic Education. Permission to reprint granted by the publisher.

14 Microeconomics: A Free Market Approach

My family tree begins with what in fact is a tree, a cedar of straight grain that grows in Northern California and Oregon. Now contemplate all the saws and trucks and rope and the countless other gear used in harvesting and carting the cedar logs to the railroad siding.Th ink of all the persons and the numberless skills that went into their fabrication: the mining of ore, the making of steel and its refi nement into saws, axes, motors; the growing of hemp and bringing it through all the stages to heavy and strong rope; the logging camps with their beds and mess halls, the cookery and the raising of all the foods. Why, untold thousands of persons had a hand in every cup of coff ee the loggers drink!

Th e logs are shipped to a mill in San Leandro, California. Can you imagine the individuals who make fl at cars and rails and railroad engines and who construct and install the communica-tion systems incidental thereto? Th ese legions are among my antecedents.

Consider the millwork in San Leandro. Th e cedar logs are cut into small, pencil-length slats less than one-fourth of an inch in thickness. Th ese are kiln dried and then tinted for the same reason women put rouge on their faces. People prefer that I look pretty, not a pallid white. Th e slats are waxed and kiln dried again. How many skills went into the making of the tint and the kilns, into supplying the heat, the light and power, the belts, motors, and all the other things a mill requires? Sweepers in the mill among my ancestors? Yes, and included are the men who poured the concrete for the dam of a Pacifi c Gas & Electric Company hydroplant which supplies the mill’s power!

Don’t overlook the ancestors present and distant who have a hand in transporting sixty carloads of slats across the nation.

Once in the pencil factory—$4,000,000 in machinery and building, all capital accumulated by thrifty and saving parents of mine—each slat is given eight grooves by a complex machine, after which another machine lays leads in every other slat, applies glue, and places another slat atop—a lead sandwich, so to speak. Seven brothers and I are mechanically carved from this “wood-clinched” sandwich.

My “lead” itself—it contains no lead at all—is complex. Th e graphite is mined in Ceylon [Sri Lanka]. Consider these miners and those who make their many tools and the makers of the paper sacks in which the graphite is shipped and those who make the string that ties the sacks and those who put them aboard ships and those who make the ships. Even the lighthouse keepers along the way assisted in my birth—and the harbor pilots.

Th e graphite is mixed with clay from Mississippi in which ammonium hydroxide is used in the refi ning process. Th en wetting agents are added such as sulfonated tallow—animal fats chemically reacted with sulfuric acid. After passing through numerous machines, the mixture fi nally appears as endless extrusions—as from a sausage grinder—cut to size, dried, and baked for several hours at 1,850 degrees Fahrenheit. To increase their strength and smoothness the leads are then treated with a hot mixture which includes candelilla wax from Mexico, paraffi n wax, and hydrogenated natural fats.

My cedar receives six coats of lacquer. Do you know all the ingredients of lacquer? Who would think that the growers of castor beans and the refi ners of castor oil are a part of it? Th ey are. Why, even the processes by which the lacquer is made a beautiful yellow involve the skills of more persons than one can enumerate!

I, Pencil 15

Observe the labeling. Th at’s a fi lm formed by applying heat to carbon black mixed with resins. How do you make resins and what, pray, is carbon black?

My bit of metal—the ferrule—is brass. Th ink of all the persons who mine zinc and copper and those who have the skills to make shiny sheet brass from these products of nature. Th ose black rings on my ferrule are black nickel. What is black nickel and how is it applied? Th e complete story of why the center of my ferrule has no black nickel on it would take pages to explain.

Th en there’s my crowning glory, inelegantly referred to in the trade as “the plug,” the part man uses to erase the errors he makes with me. An ingredient called “factice” is what does the erasing. It is a rubberlike product made by reacting rape-seed oil from the Dutch East Indies [Indonesia] with sulfur chloride. Rubber, contrary to the common notion, is only for binding purposes. Th en, too, there are numerous vulcanizing and accelerating agents. Th e pumice comes from Italy; and the pigment which gives “the plug” its color is cadmium sulfi de.

No One Knows

Does anyone wish to challenge my earlier assertion that no single person on the face of this earth knows how to make me?

Actually, millions of human beings have had a hand in my creation, no one of whom even knows more than a very few of the others. Now, you may say that I go too far in relating the picker of a coff ee berry in far-off Brazil and food growers elsewhere to my creation; that this is an extreme position. I shall stand by my claim. Th ere isn’t a single person in all these millions, including the president of the pencil company, who contributes more than a tiny, infi nitesimal bit of know-how. From the standpoint of know-how the only diff erence between the miner of graphite in Ceylon and the logger in Oregon is in the type of know-how. Neither the miner nor the logger can be dispensed with, any more than can the chemist at the factory or the worker in the oil fi eld—paraffi n being a by-product of petroleum.

Here is an astounding fact: Neither the worker in the oil fi eld nor the chemist nor the digger of graphite or clay nor any who mans or makes the ships or trains or trucks nor the one who runs the machine that does the knurling on my bit of metal nor the president of the company performs his singular task because he wants me. Each one wants me less, perhaps, than does a child in the fi rst grade. Indeed, there are some among this vast multitude who never saw a pencil nor would they know how to use one. Th eir motivation is other than me. Perhaps it is something like this: Each of these millions sees that he can thus exchange his tiny know-how for the goods and services he needs or wants. I may or may not be among these items.

No Master Mind

Th ere is a fact still more astounding: Th e absence of a master mind, of anyone dictating or forcibly directing these countless actions which bring me into being. No trace of such a person can be found. Instead, we fi nd the Invisible Hand at work. Th is is the mystery to which I earlier referred.

16 Microeconomics: A Free Market Approach

It has been said that “only God can make a tree.” Why do we agree with this? Isn’t it because we realize that we ourselves could not make one? Indeed, can we even describe a tree? We can-not, except in superfi cial terms. We can say, for instance, that a certain molecular confi guration manifests itself as a tree. But what mind is there among men that could even record, let alone direct, the constant changes in molecules that transpire in the life span of a tree? Such a feat is utterly unthinkable!

I, Pencil, am a complex combination of miracles: a tree, zinc, copper, graphite, and so on. But to these miracles which manifest themselves in Nature an even more extraordinary miracle has been added: the confi guration of creative human energies—millions of tiny know-hows confi gurating naturally and spontaneously in response to human necessity and desire and in the absence of any human masterminding! Since only God can make a tree, I insist that only God could make me. Man can no more direct these millions of know-hows to bring me into being than he can put molecules together to create a tree.

Th e above is what I meant when writing, “If you can become aware of the miraculousness which I symbolize, you can help save the freedom mankind is so unhappily losing.” For, if one is aware that these know-hows will naturally, yes, automatically, arrange themselves into creative and productive patterns in response to human necessity and demand—that is, in the absence of governmental or any other coercive masterminding—then one will possess an absolutely es-sential ingredient for freedom: a faith in free people. Freedom is impossible without this faith.

Once government has had a monopoly of a creative activity such, for instance, as the delivery of the mails, most individuals will believe that the mails could not be effi ciently delivered by men acting freely. And here is the reason: Each one acknowledges that he himself doesn’t know how to do all the things incident to mail delivery. He also recognizes that no other individual could do it. Th ese assumptions are correct. No individual possesses enough know-how to perform a nation’s mail delivery any more than any individual possesses enough know-how to make a pencil. Now, in the absence of faith in free people—in the unawareness that millions of tiny know-hows would naturally and miraculously form and cooperate to satisfy this necessity—the individual cannot help but reach the erroneous conclusion that mail can be delivered only by governmental “masterminding.”

Testimony Galore

If I, Pencil, were the only item that could off er testimony on what men and women can ac-complish when free to try, then those with little faith would have a fair case. However, there is testimony galore; it’s all about us and on every hand. Mail delivery is exceedingly simple when compared, for instance, to the making of an automobile or a calculating machine or a grain combine or a milling machine or to tens of thousands of other things. Delivery? Why, in this area where men have been left free to try, they deliver the human voice around the world in less than one second; they deliver an event visually and in motion to any person’s home when it is happening; they deliver 150 passengers from Seattle to Baltimore in less than four hours; they deliver gas from Texas to one’s range or furnace in New York at unbelievably low rates and without subsidy; they deliver each four pounds of oil from the Persian Gulf to our Eastern

I, Pencil 17

Seaboard—halfway around the world—for less money than the government charges for deliver-ing a one-ounce letter across the street!

Th e lesson I have to teach is this: Leave all creative energies uninhibited. Merely organize society to act in harmony with this lesson. Let society’s legal apparatus remove all obstacles the best it can. Permit these creative know-hows freely to fl ow. Have faith that free men and women will respond to the Invisible Hand. Th is faith will be confi rmed. I, Pencil, seemingly simple though I am, off er the miracle of my creation as testimony that this is a practical faith, as practical as the sun, the rain, a cedar tree, the good earth.

19

“An important quality of collision is mutuality. If I collide with you, then you collide with me. And if I don’t collide with you, you don’t collide with me. In promoting my interest in avoiding collision with you, I also promote your interest in avoiding collision with me.” At a roller rink you can see something that holds insights into great questions of politics and society.

At a roller rink you see 100 people skating—but wait!— Rather than imagine what you know happens at a roller rink, imagine that you have never

seen or heard of a roller rink. Nor an ice-skating rink. Long ago people didn’t know anything of skating. Imagine yourself one of them. Imagine that a friend walks up to you and tells you with great enthusiasm about his new idea for a business:

“I’ll build a huge arena with a smooth hard wooden fl oor and around the perimeter a naked iron hand-rail. I’ll invite people to come down to the arena and strap wheels onto their feet and skate round n’ round the arena fl oor. Th ey won’t be equipped with helmets, shoulder-pads, or knee-pads. I won’t test their skating competence, nor separate skaters into lanes. Speedsters will intermingle with toddlers and grandparents, all together they will just skate just as they please. Th ey’ll have great fun. And they’ll pay me richly for it!”

Knowing nothing of skating, you would probably expect catastrophe. You exclaim:

“How are 100 people supposed to skate around the arena without guidance or direc-tion? Each skater traces out a pattern, and the patterns must mesh so skaters avoid injury. Th at’s a complex problem. It would require smart leadership. But it won’t get solved! Th e arena will be a scene of collision, injury, and stagnation. Who will pay for that?!”

Rinkonomics: A Window on Spontaneous Order

By Daniel B. Klein

Daniel B. Klein, “Rinkonomics: A Window on Spontaneous Order,” from Library of Economics and Liberty, 2006, pp. 1–3. Copyright © 2006 Liberty Fund, Inc. Permission to reprint granted by the publisher.

20 Microeconomics: A Free Market Approach

If you knew nothing of skating, you would expect catastrophe. Before they knew of skat-ing, people knew of dance performance such as ballet, and to achieve a complex coordination requires a choreographer. Everyone knows that.

Intuition leads us to think that complex problems require complex, deliberate solutions. In a roller rink, the social good depends on getting the patterns to mesh. But no one is minding that good. As your friend describes the business idea, not even the owner intends to look after it. How can the social good be achieved if no one is looking after it?

Yet, we have all witnessed roller skating, and we know that somehow it does work out. Th ere are occasional accidents, but mostly people stay whole and have fun, so much so that they pay good money to participate. Th e spectacle is counter-intuitive. How does it happen?

Suppose you and I step into roller-skates and join the other skaters on the fl oor of the rink. In skating, I do not aim to solve the big problem of coordinating all the skaters. I do not try to get all 100 patterns to mesh. I show common courtesy, but basically I am out for myself. I want to have fun, and so certainly don’t want to get hurt. Looking out for myself, I promote my interest in avoiding collision with you.

An important quality of collision is mutuality. If I collide with you, then you collide with me. And if I don’t collide with you, you don’t collide with me. In promoting my interest in avoiding collision with you, I also promote your interest in avoiding collision with me.

Th e key to social order at the roller rink is this coincidence of interest. I do not intend to promote your interest. I am not necessarily even aware of it. Still, by looking out for myself I am to that extent also looking out for you. My actions promote your interest.

Skating on the fl oor of the roller rink is an example of what Friedrich Hayek called spontane-ous order. Th e process is benefi cial and orderly, but also spontaneous. No one plans or directs the overall order. Decision making is left to the individual skater. It is decentralized.

Th e contrast is centralized decision making. Again, intuition tells us that the only way the complex social good can be achieved is by central planning. Yet Hayek tells us that sometimes another way it can work is “decentral” planning. He tells us, in fact, that, often, decentral planning is the only way it can work.

Suppose the social good on the fl oor of the roller rink were entrusted to central planning. Th e rink owner appoints a really smart, really nice guy to look out for the social good. He hires a man with the reputation of a saint, and with two PhDs from Yale, one in Civil Engineering and one in Ethics. Th is smart saint stands in the organ booth, holds a bullhorn up to his mouth, and calls out directions: “You in the blue jacket, speed up and veer to the left.” “You in the black overalls, I want you to slow down and move toward the inside.” And so on.

Th e results would be terrible. Th e smart saint could not come close to achieve the brisk dynamic order that spontaneous skating achieves. Th e main reason he could not is that he lacks knowledge of individual conditions. Using his Yale learning, he looks closely and does his best. But he has 100 skaters to watch, and the conditions of each are changing moment by moment. Th e planner’s college knowledge is useless in informing him of the particular conditions of your situation. Th e planner tries to apply engineering principles, but each skater has principles of motion all his own: Do I feel like going faster? Am I losing my balance? Can I handle this turn? Do I have to go to the bathroom? Am I content to follow the planner’s directions?

Rinkonomics: A Window on Spontaneous Order 21

Your local conditions—your opportunities, constraints, and aspirations—are best known by you. No one else comes close. College knowledge is no substitute for what Hayek called local knowledge.

Moreover, even if somehow the smart saint from Yale has all the local knowledge of the indi-vidual skaters, what would he do with it? How would he interpret it? How would he integrate it? And if he came up with orders for how to direct our skating, how would he communicate those orders to 100 people simultaneously?

Being smart and saintly, the planner would recognize his limitations and just slow things down. To prevent collisions, he would have to impose regimentation. Skating would be slow and simple. Skaters would be bored. Moreover, they would not fi nd the joy and dignity that come from making one’s own course.

On the fl oor of the roller rink, the social good can only be achieved by spontaneous order. As Hayek explained, the case for leaving action spontaneous is stronger the more complex social af-fairs are, because greater complexity only exacerbates the planner’s knowledge problems. When the situation is simple, central planning can succeed. If there were just four skaters on the fl oor of the rink, central planning might not be so bad. But with 100 skaters, it is preposterous.

If, besides being smart and saintly, the planner were also wise, he would beseech the rink owner to relieve him of his assigned task. He would renounce central planning. He would recommend spontaneous order.

Th e principles fi nd direct application in economics. Just as we want to discourage collisions, we want to encourage voluntary exchange. In both cases, the key is mutuality. Gains from trade are mutual, giving rise to coincidence of interest: In promoting my interest in gaining in a voluntary exchange with you, I also promote your interest in gaining in a voluntary exchange with me. You would not enter into the exchange if you did not stand to gain.

Once again, actors buzz about spontaneously to advance their own interest, but in the process advancing the social good. As merchants, we garner the honest dollar by serving our customers—that is, by serving society. As consumers, we obtain stuff by rewarding suppliers for services rendered.

Again, individuals act on their knowledge of local conditions, which change moment by mo-ment. A chief component of your local conditions is the array of prices you face. If you produce comic books, you mind the prices of the ink, the paper, the labor that go into your comic books, and you mind the prices you can command for your product. Th e array of prices, for inputs and outputs, is how the business owner adjusts his activities to the activities of the vast number of players. Myriad players work to satisfy the comic reader, who, after all, provides the funding for all the activities fl owing into comic book production. If you don’t adjust properly, the reader will buy from another comic-book provider, who off ers better quality or lower prices.

Again, if someone were to presume to plan the economy, the result would be disaster. Th e social patterns in an economy are fabulously complex, making decentral planning all the more necessary.

In economics, the substance of “spontaneous” is liberty. Liberty means freedom from others messing with your stuff , including yourself, your person. When the government tells you that you can’t enter certain contracts, can’t use your property in certain ways, and can’t keep 35