Notes LESSON 3

¹There are apparently rare cases in which even modern doctors would recommend blood-letting as an effective treatment, but clearly the earlier practice was not, in general, good for the patient.

²We’re not saying people are using language in a sloppy manner in everyday conversation, we’re merely pointing out that the term preferences has a very precise meaning in economics. By analogy, in physics the term work has a very precise, scientific meaning as well, and it doesn’t overlap perfectly with the everyday use of the term work in conversations.

³At this stage of the book, these examples may seem tedious, but it’s important for you to grasp the point now, before we explain how prices are formed in later lessons.

⁴To explain the difference in friendship rankings, we don’t even have to assume that Joe and Bill act differently depending on whether they are with Sally or Larry. Even if Joe and Bill are each “the same person” whether hanging out with Sally or Larry, it’s still perfectly sensible for them to be ranked differently because—you guessed it—preferences are subjective. Maybe Joe is always making gross noises with his armpit, and Sally thinks it’s disgusting while Larry thinks it’s hilarious.

LESSON 4

¹Modern readers might identify more with Tom Hanks’s character in the 2000 movie Cast Away.

²If Crusoe burns the stick as kindling, then he can’t knock down coconuts with it. But gravity will still operate just the same, regardless of his actions.

³Notice that leisure doesn’t necessarily imply lounging around on the beach, and labor (or work) doesn’t necessarily imply physical exertion. Crusoe might love swimming in the ocean, which gives quite a good workout and can even leave his muscles sore the next day. But before he can enjoy himself in this activity, he first engages in the extremely boring—but physically undemanding—task of gathering small twigs for the night’s fire.

⁴Both components of this definition are important. If Crusoe created goods that were not factors of production, they wouldn’t be capital goods—they would be consumer goods. And if Crusoe had goods that were factors of production, but which he hadn’t created, then they wouldn’t be capital goods either—instead they would be natural resources.

⁵Logically speaking, the very first capital good ever produced in human history, must have been made when someone used his labor to transform the raw gifts of nature into a factor of production.

⁶Technically, gross income refers to the maximum amount of consumption during a specified time interval, whereas net income is the maximum amount of consumption possible, after sufficient investment has been made to maintain next period’s gross income at the same level.

⁷We can assume that the coconuts don’t taste nearly as good, but are still edible, by the tenth day after being knocked down from the tree.

⁸Notice that the sharp rock is a natural resource that Crusoe uses with his labor in order to produce a capital good, the sawed-off branch.

⁹Starting on his first day of using the pole, Crusoe has 30 coconuts in the stockpile. If he only consumes 15 out of his daily income of 20 coconuts, it will take him two full weeks to accumulate a stockpile of 100 coconuts. After that point—i.e., on the fifteenth day after he has constructed the pole—Crusoe can begin consuming the full 20 coconuts of his income per day.

¹⁰To make the story work out, technically Crusoe would have to use the fifth working hour of the seventh day, as well as the first working hour of (the next week’s) first day, in order to swap out the two battered end branches and retie the whole pole with the new vines. This complication comes from the fact that even though Crusoe takes 7 hours to repair a broken pole, he can’t spread that work out evenly as the last hour of each day for the course of a week, because the last tasks—swapping out the end branches and retying it all together—take more than an hour, according to the description we gave earlier. If you are a purist and really want to plot out exactly what Crusoe would do with his time for each day of the cycle, keep in mind that Crusoe has the option of devoting more than 4 hours of a given day to coconut collection (while still only consuming 20 that day), so that the stockpile temporarily exceeds 100. Then, on a later day when Crusoe needs to devote more than the fifth hour to pole maintenance, he can draw down on the stockpile. With proper planning, all the numbers work out: the stockpile never falls below 100, and Crusoe never needs to eat a coconut older than five days.

¹¹Remember that with his pole, Crusoe can gather 5 coconuts per hour, which means he gathers 1 coconut every 12 minutes.

¹²In other words, if the watch had already been outside, Crusoe would have chosen to rescue the coconut.

¹³Remember that Crusoe works the first four hours of the day gathering coconuts. At that point, he has 20 hours remaining in his day. If he works a fifth hour gathering vines, than he only has 19 hours remaining for leisure—and that includes sleep.

LESSON 5

¹At least in the United States, the term “private property” sometimes means, “Stay away!” For example, if you and your friends are wandering through the woods and come across a barbed wire fence with a sign saying, “Keep out! Private Property,” you probably don’t want to mess with the guy who posted the sign. But in terms of capitalism versus socialism, even the parking lot of a mall is “private property.” The owner(s) of the mall are simply giving blanket permission for all potential customers to use their property while they browse. Of course, if you and your friends are loitering in the parking lot and harassing customers as they park, the owners of the mall have the legal right to boot you from their property.

LESSON 6

¹You may find some of the material in this section too difficult to fully understand. If that is the case, just read it and absorb as much as possible. The important take-away message is not for you to know exactly how economists can explain actual barter prices, but just to know that they can do so, if they know the preference rankings of the potential traders (and make a few assumptions).

²Alice would also want to engage in a further trade on these terms, moving her to the 6th most preferred combination of having 2 Snickers and 4 Milky Ways. From analyzing Billy’s point of view, we know that that won’t occur. Some economists might say that therefore the price ratio of 1 Snickers for 2 Milky Ways doesn’t lead to a true equilibrium, since Alice can only partially complete her desired transactions at this price. (Similar reasoning applies to Billy, for the hypothetical price ratio of 2 Snickers for 1 Milky Way.) This complication will make more sense to you after you study supply and demand curves in Lesson 11.

³On this point we again have to be careful because Alice can only partially complete her desired trades for the price of 1 Snickers for 3 Milky Ways. Although we didn’t show it because of space constraints, Alice could very plausibly prefer a combination of (2S, 6M) to (3S, 3M), meaning that she would have preferred another round of trading in the gray equilibrium.

LESSON 7

¹Strictly speaking, the astute trader would keep his or her eyes open for an arbitrage opportunity, even in a monetary economy. Yet even here, the calculations would be much easier than in an economy with no single medium of exchange lying on one side of each transaction. One of the exercises in the Teacher’s Manual spells out this difference.

LESSON 8

¹For example, Marcia might sell $50 of clothes at the retail price, but she in turn had to spend $30 (all things considered) for those clothes in terms of the original wholesale price, as well as the overhead expenses of renting the store space, paying the electric bill, etc. In a more advanced textbook you can learn the precise ways that businesses treat different expenses and calculate the earnings from a particular sale.

²The Teacher’s Manual contains an exercise explicitly illustrating the application of comparative advantage to international trade in Lesson 19.

LESSON 9

¹In the real world, the distinction between entrepreneurs and capitalists is blurry. If a business loan were truly risk-free, then the capitalist would earn a guaranteed return on his or her loan and would be selling “services” for an agreed-upon price just as the utility company sells electricity to the entrepreneur. Yet in reality, the capitalist who lends to a new business always partakes in the entrepreneurial risk of the venture, regardless of the terms of the contract. It’s always possible that the business fails and the capitalist loses everything.

²We are referring to monetary profit and loss to avoid confusion with the broader concepts of subjective (or psychic) profit and loss, which are ultimately what the entrepreneur cares about. For example, if an entrepreneur spends 60 hours a week putting his heart and soul into a new business, and ends up with monetary profits of $100 per month, then he will probably abandon the business. Even though he is taking in more dollars than he pays out, his opportunity cost of using his labor in such a manner is quite high. The entrepreneur could earn much more than $100 per month by closing his own business and working for someone else—namely, a more successful entrepreneur!

³Once again, the distinction between these roles can be blurry in the real world. For example, a retired man might operate a Little League baseball field and charge the young children a modest fee to defray the expenses of hiring umpires and buying t-shirts, but the whole effort could be recreational for the man, who simply loves baseball. Especially if the man spent his own money to transform his (huge) backyard into a baseball field, it would be clear that the operation wasn’t really a for-profit business and that the man wasn’t looking for a certain monetary return on his investment.

⁴We have put “fair” in quotation marks because in a pure market economy, every transaction is voluntary and fair in a very important sense. Even if an entrepreneur sells a product for a price much higher than the amount of money he spent in procuring the item, the customer still values the product more than the money he spends on it—both the customer and the entrepreneur subjectively benefit from the trade.

⁵Again, we have put “fair” in quotation marks because every labor contract is fair in the free market, in the sense that it is voluntary and the worker subjectively values the wages more than the leisure he or she gives up by accepting the job.

⁶Things are not as simple as we made them sound in the text above. In some cases there are several factors that are indispensable for the final output, so it is difficult to isolate the “marginal productivity” of any one factor. (How do The Beatles split up the proceeds from their concert performances and record contracts? It wouldn’t really work to ask, “How much would sales fall if Paul McCartney didn’t play?” because then McCartney and Lennon would each seem to deserve more than half of the proceeds.) Another complication is that the addition of more workers can change the marginal productivity of the original workers, meaning that competition will have to change their wages too if they had previously been paid a “fair” amount. Finally there is the complication that workers won’t have the same marginal productivity in different businesses. For example, if Bob the busboy would add $12 to Rita’s operation, but only $10 to the next restaurant that needs a busboy, then competition really only ensures that Bob gets paid at least $10. You will need to consult a more advanced book on economics to learn the solution to these complications.

LESSON 10

¹Note that because we are still in the section of the book describing a pure market economy, we are not discussing taxes. In the real world, various definitions of income account for pre- and after-tax calculations.

²Business firms too can invest in order to boost future earnings. We do not discuss this in the text, however, because it would quickly lead to many accounting technicalities that are beyond the scope of this discussion.

³In any period of time, investment can’t be higher than savings. Some economists would say that investment can be lower than savings, however. For example, if someone earns $100,000 in income, spends $80,000 on consumption, and invests $15,000 in stocks, then some economists would say the remaining $5,000 sitting in the bank account is part of savings but not part of investment. However, other economists would argue that investment is necessarily always equal to saving. In our example, they would say that the person had $20,000 of total savings, and invested $15,000 in stocks and the other $5,000 in “cash.” This hair-splitting debate is relevant when economists argue over whether an economy can get stuck in a situation where savings is higher than investment.

⁴In the tables, note that parentheses are an accounting convention to denote negative numbers.

LESSON 11

¹Some economists view the “law” of demand as an empirical tendency, similar to a physicist who observes, “Gravity tends to make things fall.” In this view, there are occasional exceptions to the law of demand, because we can imagine someone buying fewer silver bars if their price were very low, or buying fewer units of a designer handbag if its price were too low and hence it ceased to be a status symbol. Other economists interpret the Law of Demand as just that—a law. For them, it is not an empirical tendency, referring to physical objects and sales figures. Rather, they prove the Law of Demand is true by thinking through the logic of economizing action. As a consumer buys more units of a good, each successive unit is less important, and so it is only natural that a consumer who spends his or her money in order to satisfy the most important goals, will necessarily buy at least the same number of units as a good’s price falls. The apparent counterexamples are explained away as “different goods,” because it’s not the physical properties of a designer handbag that matter, but the subjective happiness it gives to the buyer. In this book we won’t take a stand on this controversy, and will avoid any confusion by having all supply and demand schedules and curves obey their respective “laws.”

²Of course in the real world, different markets have different degrees of price “stickiness.” A gasoline station can actually change prices very quickly, even from minute to minute if need be. Other markets, such as housing, usually see much slower price changes. The same principles apply, but to be realistic the story would involve a home buyer lowering his or her asking price after (say) several months of finding no buyers.

³In reality, we could come up with complicated stories of why some oil purchasers—particularly speculators who might stockpile oil based on their estimates of future prices—might have their individual demand schedules change because of the OPEC announcement itself. However, this is a subtle mechanism and lies outside the scope of our basic discussion in the text. Clearly the OPEC announcement is much more about a supply shift than a demand shift.

⁴On the other hand, a complement is a good that goes hand-in-hand with another. For example, peanut butter is a complement to jelly. If other influences stay the same, a fall in the price of jelly will increase the demand for peanut butter. So the connection between price and demand for complements is the opposite of the connection in the case of substitutes.

⁵A standard economics textbook will usually distinguish between short-run and long-run supply curves. We will not go down this route because it would involve more graphical analysis.

⁶We say eventually the supply curve will shift left because it’s possible that the most paranoid of leather shoe owners try to unload their inventory the day of the announcement, at whatever price they can get. This technically would constitute a rightward shift in the supply curve. But in the text we are focusing on the more permanent situation, looking at producers who stay in business and continue to sell shoes months after the initial announcement.

⁷In other words, in a given exercise you will be able to decide (a) that the quantity definitely goes up, but you won’t know for sure which way the price moves,

(b) that the quantity definitely goes down, but you won’t know about the price,

(c) that the price definitely moves up, but you won’t know which way quantity moves, or (d) that the price definitely goes down, but you won’t be sure which way the quantity moves.

ADVANCED LESSON 12

¹You can check that $95.24 x 1.05 = $100.00.

²Note that if a merchant allows a customer to buy merchandise “on credit,” you can break the overall transaction into two separate events: First the merchant lends money to the customer on certain terms, and then the customer uses the borrowed money to buy merchandise from the merchant.

³In modern times, most governments have institutionalized the practice of fractional reserve banking, in which banks really do create new money when they advance a loan. This is a complex topic that we will not discuss in this introductory book.

⁴Strictly speaking, the distinction between a secured and an unsecured loan doesn’t match up perfectly with the different types of borrowing behavior. For example, someone could get a secured loan with his car (which he previously purchased with cash) serving as the collateral, and then use the money to finance a vacation cruise. On the other hand, a dentist could use her personal credit card in order to purchase a new computer for her office receptionist. It’s still the case, however, that a person’s credit report will penalize him or her more heavily if a given amount of debt is unsecured, because there are no assets “backing up” the loans.

ADVANCED LESSON 13

¹We are speaking loosely. Technically, a cold snap per se doesn’t cause prices to rise, and even a reduction in physical supply doesn’t cause prices to rise. More accurately, we should say that the cold snap changes the situation of the orange producers, and then their new subjective valuations interact with the original subjective valuations of buyers in the market, such that the equilibrium price of oranges is higher than it was before. But it is obviously much simpler to say, “Supply fell so the price rose.”

²As always, these examples should be interpreted as tendencies that will only lead to actual changes so long as other things remain equal. If the drop in orange supply were accompanied by a new report showing that orange juice causes cancer, then the price of orange juice might end up falling. On the other hand, even if the earnings of orthodontists rise because of a higher demand for braces, it’s still possible that fewer students go into the field if a popular movie depicts orthodontists as having dirty and unfulfilling jobs.

³We’re ignoring the slight complication that she can pay back most of the loan before 12 months have actually passed, in which case the interest expense would not be a full $500.

⁴Most economists would also include the implicit salary that the entrepreneur “pays herself” as an item to be subtracted from gross or accounting profit, to compute net or economic profit. But in the Christmas tree example, we assumed that the owner didn’t have to do any work except wait 12 months for the trees to mature.

⁵Of course, the owner might hire workers to run the theater while he stays home with his family. In this case, we have to understand why the workers find it “profitable” to agree to such a shift instead of spending all of Christmas Day with their own families.

ADVANCED LESSON 14

¹We are ignoring such complications as the possibility that Acme’s bonds are callable, meaning that Acme has the contractual ability to pay off the $100 million earlier than the original ten-year schedule specifies, and hence avoid being locked into the 5% rate for the entire time.

²Note that the market value of Bill’s stock may very well increase because of the deal, even though his proportional share in Acme itself has fallen. It’s true that (loosely speaking) Acme’s assets now must be divided into 4 million pieces instead of 2 million, and in that respect the market price of each share would be expected to fall. On the other hand, the new stock issuance brought in an additional $100 million which Acme officials intend to use to make the corporation more productive. This would tend to drive up the stock price, and hence the market value of Bill’s 200,000 shares. Only time will tell if Acme’s decision is wise, but the point for our purposes is that existing shareholders do not necessarily find their financial interests hurt whenever a corporation issues new stock. Unfortunately financial press accounts often give this impression when a corporation in the real world issues new stock.

³Of course, corporate stock is riskier than bonds. The market price of a stock can be very volatile, whereas the return on a bond is contractually fixed, meaning the investor (lender) only must face the risk of the bond issuer defaulting. (Bond investors also face interest rate risk, which is the risk that interest rates will change and affect the current market price of the bonds they hold. But so long as the investor holds a given bond to maturity, his flow of cash payments is fixed, absent a default by the issuer.)

⁴Even here, the distinction is blurry. Someone might think a particular stock is underpriced because the company has such strong “fundamentals” and is likely to enjoy strong earnings in the future. Such a person could be classified as a speculator if he bought the stock, not because he wanted to partake in a long stream of dividend payments, but because he expected other investors to soon see things from his perspective, and bid up the price of the stock.

⁵Even speculators who originally own no shares of Acme can profit from a perceived overvaluation. They can engage in a short sale in which they borrow shares of stock from existing owners, sell them to collect the current market price of $40, and then buy the shares back at a lower price and return them to the original owners.

⁶Even very rich investors will likely hold a relatively small portion of Microsoft, if they are not knowledgeable in the computer industry. Rather than holding a large share of the company (and having to vote on important decisions affecting software development and so forth) such investors would probably diversify their savings among the stock of many other corporations, deferring to true experts in any particular one.

LESSON 15

¹There are some socialist thinkers who are also anarchists, meaning they propose the abolition of the State along with the abolition of private property. Obviously this type of socialist does not advocate that the government seize control of all resources. To keep things simple we will continue to assume in the text that we are dealing with government control, but much of the economic analysis would apply to the “anarcho-socialist” proposals as well. You should be aware, however, that many self-described socialists would deny that their system entails State power over workers.

²The great Austrian economist Ludwig von Mises made this argument in his classic work Socialism, originally written in German in 1922 (Indianapolis: Liberty Fund, 1981, pp. 192–94).

³Even if this were to happen, the people in charge of compensating DMV branch managers wouldn’t themselves be able to pocket the extra revenues from issuing more licenses.

⁴Ludwig von Mises systematically laid out the calculation objection, which we are about to summarize in the text, in a 1920 article.

LESSON 16

¹Barbara Demick, Nothing to Envy: Ordinary Lives in North Korea (New York: Spiegel & Grau, 2009), pp. 3–5.

LESSON 17

¹Even though (in the short run) the physical number of apartment units doesn’t shrink, the number that owners put on the market for rent can definitely drop because of the new rent control law. Most obvious, homeowners who were willing to rent out a spare bedroom to a stranger at $800 per month, might keep it vacant (and available for their kids coming back on college breaks or for other out-of-town guests) if they can only charge $650. Even the owners of dedicated apartment buildings might prefer to rent out only some of the units at the lower price, to a group of tenants who have passed more rigorous background credit checks and so forth.

²There are also an additional 2,000 people who are frustrated because of the shortage, but in a sense they are not really losing out (except for their headaches and time spent searching fruitlessly for an apartment). If the price were allowed to rise to its market-clearing level, they would have fallen out of the market and not gotten an apartment in that scenario, either.

³Farmers are also beneficiaries of price supports, in which the government assures a guaranteed minimum price for certain agricultural products. However, typically the government establishes this floor by using tax dollars to artificially boost the demand for the privileged items. Rather than punishing people who pay less than $10 per bushel of wheat, the government steps in and buys up wheat (and stores it in silos) whenever the market price would otherwise fall below $10. The analysis of this type of “price floor” is much different from the situation we are analyzing in the text.

⁴Our analysis of a wage floor explicitly enforced by the government largely applies to the case where a union threatens violence or property destruction in order to raise the wages of its members above the market-clearing level. Many economists view this as a form of government intervention, because governments typically do not punish unions for criminal intimidation the way they would punish other attempts (by employers during labor negotiations for example) to disturb voluntary transactions. However in the text we will restrict the discussion to the purer intervention that comes directly from the government.

⁵Or at least, they will desire to do so, just as soon as contractual obligations allow. In practice there might be other constraints, such as the loss of employee morale if the boss lets 10% of the staff go in response to a minimum wage hike. Nonetheless, other things equal a minimum wage increase will reduce the profit-maximizing number of (low-skilled) employees for a given business.

⁶To say that the demand (not just the quantity demanded) falls in the long run means two things: First, at the constant minimum wage, the number of workers who can find jobs will fall. Second, even if the government eventually removed the minimum wage, the equilibrium number of workers hired (at that point) would initially be lower than the original number of workers before the imposition of the minimum wage.

⁷Note that at the original wage of $5 per hour, the renovation would only save the owner $15 an hour in reduced labor costs. Depending on the expense of renovation (properly accounting for interest and the depreciation of the new equipment), the minimum wage law could be the difference between designing a restaurant to be run by 8 employees versus 5.

LESSON 18

¹Strictly speaking, the accountants wouldn’t be able to attribute the profitability (or lack thereof) to a specific decision that the management made. For example, suppose that a gambling scandal ruined the good name of Mickey Mouse, just at the same time that Disneyland built a new ride. It’s possible that ticket revenue drops by 10% after the new ride opens, when it would have dropped 20% had Disneyland not opened the new ride (and partially offset the impact of the scandal involving Mickey). Even so, the accountants can objectively declare whether the business is earning a monetary profit or loss in absolute terms.

²We acknowledge that we are violating are own rule of tying action to the individual: In reality, “the government” doesn’t build a library. Instead, certain people make decisions, which sets in motion certain repercussions because of who those decisionmakers are and the obedience they command from other people in the community. But for the sake of brevity we will often say “the government” spends money, raises taxes, etc.

³There is a subtlety to this claim: It very often happens that private individuals refrain from investments because they anticipate the government will step in. For example, if the government funds the construction of a new sports stadium, people will often say, “This wouldn’t have existed without help from the government.” It’s possible however that the reason private investors “needed” government help is that they knew they could shunt some of their expenses onto the shoulders of the taxpayers.

⁴Keep in mind that private-sector organizations can rely on charitable contributions and not just revenues from commercial sales. A pure market economy is perfectly consistent with soup kitchens, homeless shelters, and so forth. The crucial difference is that in a pure market economy, the owners of these institutions would need to solicit voluntary donations rather than receiving funding from the government, which ultimately was not derived in a purely voluntary manner.

⁵For example, there are situations where private enterprise may be deemed inappropriate, such as the provision of military defense. There are also situations where we can imagine a majority of people agreeing to be “forced” to contribute money to a certain cause, so long as everyone else is similarly forced. For example most residents of a city probably wouldn’t view it as “theft” if the local government took $10 a year from everyone in order to maintain “free” garbage cans (placed on busy street corners) and street lights. Because of these types of considerations, many economists who are aware of the flaws with government spending would nonetheless maintain that there is a scope for some government purchases.

⁶Actually the move to “flatten” the sales tax would probably bring in more total revenue, because more sales would occur at the lower rates, and because in the original scenario consumers would have shifted their purchases away from the 10%-taxed goods towards the 0%-taxed goods. Therefore, in the new situation (when all goods are taxed uniformly at 5%), the actual number of sales on taxable items would probably more than double relative to the original scenario, which would more than offset the halving of the sales tax rate. (Note that we are just discussing general tendencies; we could invent specific numerical examples where the “flat” 5% sales tax brought in less revenue than a particular 10% sales tax on half the items. For example, if the 10% tax rate originally applied to food and cigarettes, while the 0% tax rate originally applied to yachts and diamond earrings, then switching from that system to a flat 5% sales tax on everything would probably bring in less total tax revenue.)

⁷Note that the 20% rate applies only to the $90,000 in income falling in the second bracket’s range; the higher rate doesn’t apply to the whole $100,000 of income. This is why (under normal circumstances) you can’t actually see your take-home pay drop after a pay raise that “puts you into a higher tax bracket.”

⁸People often say the mortgage interest deduction gives an incentive to buy a home rather than to rent, but prices adjust to eliminate much of this impact. If an entrepreneur buys a house and then rents it to tenants, any interest on borrowed money is a business expense and hence tax deductible too. Competition among entrepreneurs in the housing rental market would tend to lower rents to tenants to reflect this feature of the tax code. At the same time, home prices are probably higher than they otherwise would be, if homeowners weren’t able to deduct their mortgage interest payments. So although people often assume that the mortgage deduction gives a huge bias toward homeownership versus renting, the distortion on this decision is not as severe as it may first seem.

LESSON 19

¹Of course, countries per se don’t import or export goods; people within a country do. But it is difficult to convey the essence of mercantilism without speaking of various countries as collective units regarding trade.

²For example, if France exported 100 gold ounces’ worth of wine to Great Britain, while it only imported 80 gold ounces’ worth of books from Great Britain, then (if these were the only transactions) there would be a net flow of 20 ounces of gold out of Britain and into France.

³If you are an advanced reader, we should make the technical point that a given country (such as the United States) can have a trade deficit with one country (such as China) while simultaneously running a trade surplus with another country (such as Australia). However, these deficits and surpluses need not cancel out, for any particular country. The United States, for example, runs a net trade deficit with the-rest-of-the-world. This is possible because people outside the United States can invest in American assets. For example, if a Japanese investor buys a corporate bond issued by IBM, this purchase “returns dollars to the U.S.” and helps balance out the net flow of dollars to Japan resulting from the trade deficit in goods and services. (Note that financial assets—such as stocks and bonds—do not form part of a country’s exports.)

⁴We added the qualifier “(on average)” because technically, imposing a trade barrier can make some people in a country better off—namely, the people who compete with the imports that are now being penalized. But as we’ll see in the next section in the text, the possible gains to the protected producers are more than offset by the losses to everyone else in the country.

⁵To be clear, we are here focusing on general economic arguments for and against free trade. If someone argues that, say, U.S. producers of ballistic missiles shouldn’t be allowed to trade with people living in North Korea, that is not a specifically economic argument, but rather a military claim. In the text we are dealing with the very popular—but misguided—belief that trade barriers make a country richer by stimulating the domestic economy.

⁶We are calling it the economic case for free trade to distinguish it from other types of arguments. For example, someone versed in natural law theory might claim that even if free trade made countries poorer, it would still be the correct policy because the government has no right to restrict how people use their private property.

⁷We have to add the qualifier “(per capita)” because in theory, we can imagine particular individuals being hurt by the removal of trade barriers. We know that if China pursued a free trade policy, total Chinese production and consumption would rise, meaning that on average people in China would benefit from the move. But if there were particular producers who benefited from the trade barriers and were put out of business by foreign imports, their individual losses as producers could conceivably be larger than their gains as consumers when they had far more options (and lower prices) in the stores. We stress this point mainly so that you better understand the economic case for free trade. In the real world, a complete move to free trade—rather than removing individual barriers one at a time—would probably make just about everyone better off, especially in the long run.

⁸A technical note: From the Japanese producers’ point of view, American demand for their cars has dropped. That is, at the same (Japanese) price of $10,000 per car, suddenly Americans don’t want to buy as many Japanese cars as they did the day before the tariff was erected. To keep things simple, we are assuming that this drop in U.S. demand for imported vehicles doesn’t lower the equilibrium price of $10,000 for Japanese cars in the world market. If you go on to study more advanced economics, you will learn that this subtlety can give rise to the theoretical possibility of there being an “optimal tariff” in which a large country such as the U.S. could conceivably gain (while hurting the rest of the world) through the strategic use of low tariffs. In practice this is a slippery argument, if for no other reason than that politicians couldn’t be trusted to stick to the “optimal” tariff structure. But if you are going on in economics, you should be aware of this technicality.

⁹The new tariff also hurts some other American producers, as we’ll see in the text.

¹⁰In practice, if the new tariff caused the (pre-tax) market price of Japanese cars to fall, then in a sense the payment of tariff revenues would be shared among American consumers and Japanese producers, because the out-of-pocket price of an import to Americans wouldn’t rise by the full tariff charge per car. Even here, though, it’s worth stressing that it is U.S. consumers who actually spend the money collected by the tariff.

¹¹The one possible exception to this rule is that the unemployment rate could drop. In other words, it’s possible for one industry to expand, while others maintain their original levels of employment, if the newly hired workers come from the ranks of the unemployed (or come from sectors which then replenish the lost workers from the ranks of the unemployed). In Lesson 23 we’ll explore the business cycle and see that this complication doesn’t change the conclusions in the text above.

¹²What about the $1,000 tariff payments sent to the U.S. government for every Japanese car that Americans still decide to purchase? Well, if the government spends that money, then this constitutes an additional distortion to the pure-market outcome, for the reasons outlined in Lesson 18. The best case for the protectionist is to assume that the government uses the tariff revenue to reduce other taxes on Americans. In the text we are ignoring this complication because we want to focus on the other distortions caused by the new tariff.

¹³We have added the qualifier “in the long run” because an individual household could run up its debt by consuming more than it produces, at least for a while. By the same token, a country as a whole can run a net trade deficit if foreigners are willing to invest in its financial assets (such as buying stocks or bonds from corporations in the country running the trade deficit). But even here, what is really happening is that the country running the trade deficit is effectively borrowing against its future production.

LESSON 20

¹As with our analysis of other types of government intervention, in this lesson we are interested in pragmatic arguments by looking at the consequences of drug prohibition. We ignore arguments (for or against) based on a specific code of morality, or a view of property rights and the proper scope of government action. These viewpoints are definitely important, but they lie outside the scope of a textbook on basic economics.

²We should clarify, the likelihood of a professional drug dealer being arrested is much higher than for one of his customers were it not for bribes (“protection money”) regularly paid to the police. We are trying to understand how drug prohibition alters the original market outcome, and then we will see the scope for corruption.

³See http://www.whitehousedrugpolicy.gov/drugfact/cocaine/cocaineff.html#extentofuse. Regarding marijuana, a survey conducted between 2006 and 2007 found that more than 10% of the U.S. respondents reported using the drug within the last year. See http://economix.blogs.nytimes.com/2009/08/11/drug-use-across-the-united-states-or-rhode-island-needs-more-rehab/.

⁴The Eighteenth Amendment was actually ratified in 1919, but alcohol Prohibition did not take effect until 1920.

⁵A loan shark refers to someone who makes short-term loans at very high interest rates (which may violate usury laws) and popularly resorts to physical punishments in order to ensure repayment.

⁶Indeed, if drug dealers could conduct major transactions using electronic payments routed through a universally respected third party, the number of violent drug deals “gone bad” would plummet. Rather than bringing suitcases of cash (along with heavily armed bodyguards) to parking garages in the dead of night, a cocaine retailer could deposit $1 million with a reputable financial institution, which would agree to transfer the funds to a Colombian wholesaler once the retailer had received his goods. (The process could unfold in stages if the Colombians wanted to make sure they weren’t double-crossed.) The reason drug dealers currently can’t operate in this fashion isn’t that they fear a bank will steal their money and then the drug dealers won’t be able to call the police. The first time that happened, nobody—even people unconnected with the drug trade—would use that bank again. In reality drug dealers can’t use the simple mechanism we’ve described because of the risk that the government would seize their funds as “drug money.” So we see that it is not government neglect, but government enforcement of drug laws, that makes violence more appealing in the drug trade.

⁷Death statistics and Will Rogers quotation from Mark Thornton, “Alcohol Prohibition Was a Failure,” Cato Institute Policy Analysis No. 157, July 17, 1991, at: http://www.cato.org/pubs/pas/pal57.pdf.

LESSON 21

¹Some economists would say that the term inflation refers to an expansion of the amount of money and credit in the economy. This is a very technical issue having to do with the fact that banks are legally allowed to grant more loans than they actually have cash in the vault. This arrangement is described as a fractional reserve banking system. We will ignore this complication.

²Throughout this chapter, we will use the term stock of money rather than the more usual money supply, in order to avoid confusion. When people are comparing money to prices, they almost always mean how many actual units of money are in the economy; they are not referring to the “supply curve of money,” a concept that would actually be difficult to even define in modern economies where the government has intervened so heavily in the area of money.

³If you are a math whiz, we point out that we have calculated the average compounded annualized growth rates. In other words we didn’t simply take the total percentage growth and divide by 5, but rather we accounted for the exponential growth involved (multiplying percentages by percentages).

⁴Note that even without debasement, gold coins would not be pure gold, because they would be too malleable. Some amount of baser metal would be added to keep the coins durable and useful as money.

⁵The history of gold and silver legislation in the early United States is quite complicated and lies outside the scope of this introductory book. The important point is that even before the Constitution was written, the colonists were using gold and silver coins as money. Americans began using pieces of paper connected to the U.S. government only because originally these were claim tickets on the preexisting commodity monies.

⁶Strictly speaking, the U.S. government and the Federal Reserve don’t have complete control over the quantity of U.S. dollars, if we include checking account balances as part of the total. The willingness of commercial banks to grant loans, and of private individuals to borrow money, plays a role here as well. But for all practical purposes, the U.S. government and its agency, the Federal Reserve, control the “dollar supply curve.”

⁷Even here, the “collapse” of the gold money would be a mixed blessing, not an unmitigated disaster. It’s true that it would be very disruptive to the world economy if its money—gold—all of a sudden saw its value fall quite sharply because of the alchemists’ discovery. On the other hand, it would be wonderful if the alchemists made such a discovery, because of all the new gold. Besides the fall in prices for beautiful jewelry, consumers would benefit from much cheaper dental work (gold fillings etc.) and arthritis treatments (which inject gold into the body), as well as the industrial applications. Unlike a fiat currency, a market-based commodity money is actually useful for reasons other than its status as a medium of exchange, and so sudden increases in supply are beneficial in that respect.

⁸We should point out that technically, economists have imagined a fiat money even in a pure market economy, and have written books and articles describing the mechanics of such a system. In the text above we will ignore this complication and assume that fiat money is always the result of government intervention in the market economy. Whether this is true even in theory is a controversial issue among economists, but the connection between governments and fiat money is certainly correct in practice.

⁹Things became so absurd in Zimbabwe that its central bank eventually issued 100 trillion dollar bills. At a conference in the spring of 2010, someone humorously gave the author of this textbook a “tip” which was a “FIFTY TRILLION DOLLARS” note issued by the Reserve Bank of Zimbabwe. The jokester had acquired this piece of currency—which has a “5” followed by 13 zeroes printed on it—very cheaply on eBay. According to Steve Hanke, by November 2008 Zimbabwe was suffering from a monthly price inflation rate of 79.6 billion %. At this inconceivable rate, prices in Zimbabwe were doubling every 25 hours! (See http://www.cato.org/zimbabwe)

¹⁰Keep in mind that the government’s injection of new money might prop up prices that would otherwise have fallen. For example, the government might print up new money and buy goods for which the (private sector) demand had fallen. In this case, the monetary inflation still causes price inflation, but from a lower starting point, as it were. Thus the observed prices might not rise, but it would be wrong to conclude that the monetary inflation had no effect on prices.

ADVANCED LESSON 22

¹The finances of the U.S. federal government are usually recorded by fiscal years, which do not coincide with calendar years. For example, Fiscal Year 1990 ran from October 1, 1989 through September 30,1990. The $221 billion deficit thus refers to the mismatch between federal receipts and expenditures during these two dates.

²There are different items that could be included in this figure, which would make the “federal debt” greater or smaller. For example, a smaller figure of the debt might refer exclusively to the actual bonds issued by the U.S. Treasury. A much broader figure would include not just the bonds, but also the federal government’s expected future liabilities in programs such as Social Security, in which the expected payouts will at some point exceed the “contributions” from workers and will thus constitute a drain on general tax revenue, contributing to the government’s overall indebtedness.

³The U.S. Treasury is the financial arm of the federal government. The Treasury collects taxes and disburses funds. When the federal government runs a deficit, it borrows money from lenders by having the Treasury sell bonds.

⁴In the text we are restricting our attention to “zero coupon” bonds, which apply to Treasury debt that is one year or shorter in maturity. If the government (or another entity) issues long-term debt, it will often involve periodic interest payments (“coupons”). In this case, the lender hands over the full face amount of the bond upfront, because the interest earnings are handled separately. (But for bonds that carry no coupon payments, the investor must earn his interest through a discount initially paid for the bond.)

⁵If interest rates fall then the government could enjoy lower interest payments even as its debt grows.

⁶It’s true that investors will take this dynamic into account when lending money to the government; they will insist on a higher yield (interest rate) knowing that the purchasing power of the dollar will likely fall over time. Even so, it is still true that when the Federal Reserve causes inflation, it makes it easier for the federal government to service its pre-existing debt. If the Federal Reserve were to suddenly stop inflating altogether, it would be harder for the government to service its debt compared to the expected scenario.

⁷If you are a sharp reader you might think that this isn’t truly printing up new money just to close a budget shortfall, because the federal government still owes interest and the return of principal to the holder of the bonds it issued. But guess what? The Federal Reserve is the recipient of these payments (since the Federal Reserve bought the bonds from the private dealers), and as standard operating procedure the Federal Reserve remits all of its excess earnings back to the Treasury. In other words, after the Federal Reserve pays it electric bill, employees, and so forth, any extra money it has, it sends back to the Treasury. So even though technically speaking the Treasury didn’t get those new dollars with no strings attached, for all practical purposes it did, since its interest payments on the debt held by the Federal Reserve will (largely) come right back to the Treasury, and because the Federal Reserve will likely roll over the principal on its outstanding holdings of Treasury debt. For an analogy, if you could always borrow money from your parents (at a contractual interest rate) when you spent more than your job’s paycheck, and if you knew you never had to pay back the principal, and if you knew your parents would always increase your birthday and Christmas gifts to give you all the “interest payments” on these loans right back to you, then the process of signing a loan contract with them would be a farce. You would spend with reckless abandon, which is exactly what the D.C. politicians have done and continue to do.

⁸Things get more complicated if we consider that foreign investors might be the ones financing the U.S. government’s debt. In that case, present Americans would indeed be living above their means and in the process force future Americans to live below their means. But if we take “the present generation” to mean all humans, and “future generations” to mean all future humans, then we’re back to the analysis in the text above.

⁹Some economists would argue that in the grand scheme, government deficits are largely irrelevant, because rational taxpayers will realize that they need to set aside more money to pay for future debt service. In other words, these economists say that when the government shifts out the demand for loanable funds, people in the private sector rationally respond by shifting out the supply curve as well. Thus the market interest rate stays the same, and what the government hands out to taxpayers with its right hand, it borrows back from them with its left hand. However, in practice this view can’t be right, because otherwise deficit spending wouldn’t be as popular as it is.

¹⁰Recall our thought experiment from Lesson 18: If the government enacted ridiculously high income and sales tax rates, virtually all economic activity would go underground and the government would take in virtually no tax revenue. But clearly these policies would be very harmful to the economy, despite the apparently low “burden” as measured by tax receipts. This principle explains how the true damage of an extra $100 billion in taxes (needed to pay down the government debt) is greater than the simple extraction of that amount of money from taxpayers.

ADVANCED LESSON 23

¹In this common analogy, the economy is likened to an engine, where “overheating” means high price inflation and apparently irrational increases in stock prices and other assets.

²If you are curious in reading further, we are here presenting the basics of the so-called “Austrian business cycle theory,” developed by economist Ludwig von Mises and elaborated by Friedrich Hayek.

³In terms of diagrams, the supply curve of loanable funds shifts to the right, pushing down the equilibrium interest rate.

⁴Strictly speaking, if the false boom allows for an increase in consumption, then total investment—correctly measured—must drop, since the printing press doesn’t give society the ability to create more goods and services. However, “total investment” is a subtle concept that requires market prices to be calculated. During the artificial and unsustainable boom, the producers of many types of capital goods can see their output increase, even though the economy as a whole is not investing enough in its capital structure to offset depreciation. For example, a factory owner may defer his normal practice of stopping production every month in order to lubricate the machinery etc., because “on paper” he is making more profits by cranking out orders for his customers. Yet in a few months, when his equipment is worn down from the hard usage and he needs to buy replacement units, he finds to his shock that equipment prices have skyrocketed. Up until that point, the factory owner would have thought he was increasing his wealth and hence his “stock of capital,” but in reality he was consuming capital because his increased output of capital goods (the product of his factory) wasn’t enough to offset his failure to engage in maintenance on his equipment.