“Basic” Economics
When having one-on-one meetings with senior leaders at our company, I always probe for book recommendations to broaden my perspective. One of these recommended books was “Basic Economics” by Thomas Sowell, which I really enjoyed reading and now want to share a bit with you. In the below paragraphs I will focus on my key takeaways, and comment on each one of them respectively. The structure is as follows:
What is the book about - and who is Thomas Sowell anyways?
Prices as a tool to allocate resources
The subtle difference between shortage and scarcity
Sowell being pro-government control?
Why it can be more efficient to buy new, than repair old
What is the book about?
Thomas Sowell wrote the book under the premise of explaining economics in a straightforward way. Straightforward but extensive (the book has more than 600 pages packed with content). The book touches on many different topics such as work & pay, the national and international economy, or industry and commerce. In the first chapter, Sowell lays the foundation of his further explanations by describing how the “economy” is a system that “determines the use and allocation of scarce resources that have alternative uses.” Prices and the free market are a tool of the economy to decide on how to allocate these scarce resources.
Who is Thomas Sowell anyways?
I must admit, I haven’t heard about Thomas Sowell before learning about the book. I’m not pretending to make an overly enthusiastic effort to give you a biography, but here are a few key facts for reference.
The man is really smart. Making a tour through most Ivy League Universities with a Ph.D. from the University of Chicago. He is so smart he did so despite the sentiment against African americans during the time of his rise (he’s still living at 91 years old at the time of writing).
Ideology wise, he leans towards libertarianism. He states: “I suspect that 'libertarian' would suit me better than many others, although I disagree with the libertarian movement on a number of things.“
REVIEW OF THE BOOK CONTENT
Prices as a tool to allocate resources
Sowell explains that different economic models (e.g. Feudalism, communism, capitalism) in essence present different ways of how to allocate scarce resources with alternative uses. Within a capitalistic society, the allocation decision is made with the use of “prices”. Goods and services have prices that need to be paid by each individual (or a company), and the individual decides whether or not he/she wants to purchase that specific good at that specific price. Thereby the consumer of the good makes the decision on where he puts his money. Resources are then being allocated in the direction where consumers purchase the goods the most.
In contrast to that, Sowell mentions soviet communism where state officials made most allocation decisions. He argues that through pushing the decision-making power towards the people also having to live with the consequences, the overall economy allocates resources more efficiently than under any centralized dictated allocation process.
The main advantages of using prices as a tool for allocating resources are that they:
make individuals self ration their consumption
enable individuals to account for their respective preferences (you might want to pay more for food, than for a large apartment)
enable efficient incremental substitution rather than priority substitution (how much you are willing to pay depends on how much you already have of a good. If you are thirsty, you would pay more for a liter of water compared to when you are not thirsty. Water is not always more important than everything else if you already have had enough of it)
My thoughts:
Not much to comment on from my side. Above is the simplest yet most effective way to think about what an “economy” does. Allocating resources. This explanation also accounts for many different economic models. Using prices as a tool to push the decision-making process close to the people having to live with the consequences makes sense to me as well. Even though there are limitations to that form of decision making, which we will touch upon in a later paragraph.
The subtle difference between shortage and scarcity
Sowell differentiates between scarcity (“fewer goods available relative to the population”) in contrast to shortages, which are a phenomenon of the economy (in the case of capitalism, a “price” phenomenon). He argues, these two phenomena do not necessarily need to occur at the same time. We can experience a “growing shortage without an increased scarcity” as well as a “growing scarcity without a shortage.” Sowell uses the example of rent control to illustrate his point (be aware, he is a big opponent of rent control) :
Rent control is a way of how the government changes the prices in the marketplace for housing.With forces outside the market, such as regulations, the government often lowers housing prices. This external price control then nudges the behavior of individuals in two ways:
People are not inclined to self-ration and do consume more than needed. A single person can now afford an apartment that could also house 2. The lack of self-rationing increases demand.
As investors try to maximize their yield on investments, the housing market will less likely be chosen for future investments. That leads to a stagnating supply, which cannot keep up with the increased demand. The profitability of renting can even turn negative, making it “cheaper” for an investor to not rent out. In that case, supply would decrease and not only stagnate.
The changed behavior leads to a shortage of housing, even though there isn’t necessarily an increased “scarcity” in housing.
My thoughts:
I think of this difference from an angle of resource availability vs. resource allocation.
There are situations, where we cannot allocate enough resources to the demand because there aren’t enough resources available. In that case, we have a shortage and a scarcity.
We can have a situation, where we cannot allocate enough resources to the demand, but there would be enough resources available. In that case, we have a shortage but no scarcity.
And we can also have a situation, where we can allocate enough resources to the demand, despite a lower availability of the underlying resource. This can e.g. happen when we find new creative ways of using the available resources. We have no shortage, but a scarcity.
This is a valuable point because it gives us a framework to ask questions when we hear about shortages. Figuring out if we have a resource availability or a resource allocation problem is key for deciding what to do about it. If we don’t have affordable living and all current available housing is full, the way out is to build more housing, not artificially lowering prices. If we don’t have affordable living and have empty houses, then we need to look into how the economy (pricing) can allocate the available resources more efficiently.
Sowell being pro-government control?
Even though Sowell is classified as a ‘libertarian’, he is pro-government control to regulate external costs and benefits. External costs and benefits occur when the individuals (or company) who create the cost or benefit, do not face the full consequences of their actions. If your actions put costs onto the society that you do not have to pay in full, these should be regulated by the government (e.g. pollution of water sources by factories). The concept of “self-regulation” breaks in these cases. On the same token, if your actions create benefits that you do not get to enjoy in full, it should be managed by the government as well (e.g. the military, that creates “safety” as a service but is in itself as an enterprise ridiculous unprofitable).
There are many examples where the government and the market can complement each other though. Safety minimums are one of these. The government can mandate that e.g. every car needs to have seatbelts, but then let the marketplace determine how these standards are being met.
My thoughts:
Even though this point comes late in the book, I believe that this is one of the most crucial discussions to have in economics. What goods and services are best provided by the government and which ones by the marketplace? And which ones are best provided in conjunction? The answers to that question vary immensely. Compared to the US, a lot of Europeans think a certain minimum health care and transportation create external benefits and therefore should be provided by the government. Ultimately the good thing is, there is no need for a black and white solution.
Why it can be more efficient to buy new than repair old
The idea that we should be more environmentally friendly and repair old, rather than buy new is a compelling narrative. Without a doubt, that would improve the state of the environment. But can we achieve this solely by government regulation? Sowell is reserved, pointing out that we (as an industrialized world) have not yet found a way to automate repairing as we have production. He makes the case, that we have not yet found a way to recycle as efficiently as we can repair, and therefore it is more efficient, from a resource allocation perspective, to build new rather than repair old.
Let’s assume it costs one person to produce one item $100, and to repair one item it costs him/her $150 (costs are labor costs, raw materials, capital, etc.). The cost of repairing is 50% higher as opposed to producing new. If the economy now does its job and allocates resources the most efficient way, it nudges the person to build rather than repair.
My thoughts:
There is value in this straightforward explanation. Let’s leave the “save the environment” emotion aside for a moment and think about this. Government regulations are in place (and are constantly adapted), making sure that external costs to nature caused by companies are limited. Certainly not all costs, but a lot. Now the question is: if we want to be more environmentally considerate, how do we make the economy (read: market forces) nudge individuals and companies, to repair old rather than build new?
We need to work on changing the cost calculation. If it costs a person only 99$ to repair, market forces would immediately shift to repairing rather than building. The sustainable solution here is not to make the building cost $151 (e.g. with taxes etc.), but to make repairing cheaper! If we want to sustainably improve how we treat the environment, that is the way to move forward.