Free Enterprise: Our Heritage, Our Wealth [5 ed.]
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Fifth Edition
A . PA U L B A L L A N T Y N E , P h . D . | J O H N B R O C K , P h . D . DA LE D B O E R, Ph.D. | T I M OT HY T RE GA R T HE N, Ph.D.
$$&&#SJOHTUIF&DPOPNJD8BZPGɩ JOLJOHUP $PMPSBEP5FBDIFSTBOEɩ FJS4UVEFOUT ɩ FOPOQSPmU$PMPSBEP$PVODJMGPS&DPOPNJD&EVDBUJPO $$&& XBTGPVOEFE JO BOEJTBOJOEFQFOEFOU MPDBMMZHPWFSOFE BċMJBUFPGUIFOBUJPOBM$PVODJM for Economic Education based in New York City. CCEE is the leading Colorado OPOQSPmUPSHBOJ[BUJPOEFEJDBUFEFYDMVTJWFMZUPQSPNPUJOHBCFUUFSVOEFSTUBOEJOH PGFDPOPNJDT PVSGSFFFOUFSQSJTFTZTUFN BOEQFSTPOBMmOBODJBMMJUFSBDZBNPOH Colorado teachers and by extension, their students. CCEE accomplishes this by presenting an ever-changing variety of accredited, graduate-level economics classes for teachers. During the past two decades, CCEE has played a key role in the adoption of legislation requiring the inclusion of economics, and later personal mOBODJBMMJUFSBDZ JOUIF$PMPSBEPBDBEFNJDTUBOEBSETXIJDIBSFSFRVJSFEUPCF taught in Colorado’s public schools at every K-12 grade level.
Tax-Deductible Contributions to CCEE ɩ F$PMPSBEP$PVODJMGPS&DPOPNJD&EVDBUJPOJTBO*34RVBMJmFE D OPUGPSQSPmU PSHBOJ[BUJPO UIBU JT TVQQPSUFE CZ GPVOEBUJPOT CVTJOFTTFT BOE JOEJWJEVBMT JOUFSFTUFE JO QSPNPUJOH FDPOPNJD BOE QFSTPOBM mOBODJBM MJUFSBDZ CCEE receives virtually all of its funding from private sources. Tax-deductible contributions are gratefully accepted and may be made online at www.ccee.net or mailed to the address shown on the back cover. Additional copies of Free Enterprise: Our Heritage, Our Wealth are available for purchase, please contact us for more information.
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free enterprise Our Heritage Our Wealth Fifth Edition
Authors: A. Paul Ballantyne John Brock Dale R. DeBoer Timothy Tregarthen
ɩ JTCPPLMFUXBTQSJOUFEXJUI support from a grant from the Bruni Foundation, Colorado Springs, Colorado. Copyright ©, 1993, 1995, 2004, 2005, 2012 by the Colorado Council for Economic EducaUJPO B$PMPSBEPOPUGPSQSPmUDPSQPSBUJPO"MMSJHIUTSFTFSWFE/PQBSUPGUIJTCPPLNBZCF reproduced in any manner whatsoever without written permission except in the case of brief quotations. Printed in the United States of America.
COLORADO COUNCIL FOR ECONOMIC EDUCATION
Authors
DR. A. PAUL BALLANTYNE
DR. JOHN BROCK
Dr. Ballantyne is Professor Emeritus of Economics at the University of Colorado, Colorado Springs. After teaching at UCCS for 44 years, Professor Ballantyne retired in June 2011. He holds a B.A. from the University of Southern California, an M.A. from the University of Iowa, and a Ph.D. from Stanford University. He taught at the University of Iowa, the U.S. Air Force Academy, Colorado College, and in the University of Pittsburgh Semester at Sea Program.
Dr. Brock is Director of the Center for Economic Education and a Senior Instructor of Economics at the University of Colorado, Colorado Springs. Prior to joining the University of Colorado in the mid-1990s, he was a Professor of Economics at the United States Air Force Academy.
Dr. Ballantyne received several teaching awards at the University of Colorado, including the Outstanding Teacher of the Year Award in 1994. He was recipient of the Chancellor’s Award given for outstanding teaching, research and service, and is listed in Who’s Who in America and also in American Men and Women in Science. For many years he consulted internationally with the Russian Academy of Economic Science in Moscow and with Sumy State University in Ukraine, which awarded him an Honorary Doctorate in 2004. He has written in the areas of monetary theory, economic development, economic education, and macroeconomics. ii
He received a B.S. in economics from the Air Force Academy, an M.B.A. from the University of Southern California, and a Ph.D. in economics from Cornell University. Dr. Brock was awarded the Air Force Academy’s Outstanding Educator Award in 1984 and the University of Colorado’s Outstanding Teacher of the Year Award in 2002. He has published articles as well as a handbook on using experimental economics in the classroom. Over the past 13 years, Dr. Brock has taught and advised economic educators in South Africa, Indonesia, and many countries in Latin America, the Middle East, and the post-Soviet region.
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
DR. DALE DĖBOER
DR. TIMOTHY TREGARTHEN
Dr. DeBoer is an Associate Professor and Chair of the Department of Economics at the University of Colorado, Colorado Springs. He received his B.A. degree in Philosophy from the University of Washington, and his M.A. and Ph.D. from the University of California, Davis.
Dr. Tregarthen is Professor Emeritus of Economics at the University of Colorado in Colorado Springs. He taught at the University from 1971 to 1996. He served as Chairman of the Department of Economics from 1974 to 1985. He received two University of Colorado Outstanding Teacher of the Year Awards and the Chancellor’s Award.
He is the recipient of four teaching awards including the University of Colorado’s Outstanding Teacher of theYear Award in 1999. Dr. DeBoer’s research focuses on the macroeconomic implications of computing and information technologies. He serves as a consultant to the hedge fund industry and to TFWFSBMOFXUFDIOPMPHZmSNT)FBMTPTFSWFE as a research consultant to the National Early Head Start Program.
Dr.Tregarthen completed his graduate work in economics at the University of California at Davis, where he was a Woodrow Wilson National Fellow and a Regents Fellow. He was student body president at California StateUniversity,Chicoandwherehereceived his B.A. in economics magna cum laude. He was Executive Editor of ɩF .BSHJO magazine from 1985 to 1994. He founded the freshman seminar program at UCCS in 1991. He has been a visiting professor at Colorado College and for the University of Colorado’s Semester at Sea program. He is the author of hundreds of articles on a wide range of economic issues. He has written two books and wrote a nationally syndicated humor column on economics from 1980 to 1985. iii
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Preface to the Fifth Edition 0OCFIBMGPGUIF#PBSEPG%JSFDUPST GBDVMUZBOETUBĊPGUIF$PMPSBEP$PVODJMGPS &DPOPNJD&EVDBUJPO $$&&
XFBSFQMFBTFEUPQSFTFOUUIJTmGUIFEJUJPOPGFree Enterprise: Our Heritage, Our Wealth"T64DJUJ[FOTBMMPGVTBSFCFOFmDJBSJFTPG BOFDPOPNJDTZTUFNUIBUJTEZOBNJDBOEWJCSBOUCVUXIJDIGSPNUJNFUPUJNFTVĊFST setbacks (see Chapter 7, “Economic Crisis and Promise”). Notwithstanding these setbacks, our free enterprise economy has generated historically unprecedented QFSDBQJUBJODPNFXIJDIJTOFBSMZGPVSUJNFTUIFBNPVOUOFDFTTBSZUPCFDMBTTJmFE by the World Bank as a “high-income” country (see Table 1, p.2). Although our free enterprise system has been very successful in creating a comparatively high standard of living, the fundamental economic principles on which it is based are not well understood by most Americans. As with the past editions, UIJTmGUIFEJUJPOJTPVSFĊPSUUPIFMQJTTPNFTNBMMXBZUPSFNFEZUIJTTJUVBUJPOCZ providing a succinct, engaging, and readable explanation of how a market economy actually works. In the words of Roger W. Ferguson, Jr., former Vice Chairman, Board of Governors of the Federal Reserve System, “By the time I graduated from junior high school, I had read the Constitution; not until much later did I study how prices are set in a market economy.” In today’s fast-paced, ever-changing, global economy we believe that students need to have a solid understanding of the economic principles that govern how free markets work before they leave high school. CCEE acknowledges and thanks A. Paul Ballantyne, Ph.D., Professor Emeritus, Department of Economics, University of Colorado at Colorado Springs (UCCS), for his leadership in creating Free EnterpriseBOEGPSIJTUIJSUZmWFZFBSTPGTFSWJDFUP the cause of economic education. New perspectives and insights, as well as updated FDPOPNJDTUBUJTUJDTGPSUIFmGUIBOEFBSMJFSFEJUJPOT IBWFCFFOQSPWJEFECZ+PIO Brock, Director of the UCCS Center for Economic Education and by Professor Dale %F#PFS $IBJSPGUIF6$$4%FQBSUNFOUPG&DPOPNJDTɩJTFEJUJPOGFBUVSFTBOFX BOEWFSZVTFGVMFYQMBOBUJPOPGUIFSFDFOUFDPOPNJDBOEmOBODJBMDSJTJTJO$IBQUFS “Economic Crisis and Promise”, primarily authored by Professor DeBoer. We extend our gratitude to CCEE Board member Jerry Bruni, and to the Bruni Foundation of $PMPSBEP4QSJOHT GPSNBLJOHQPTTJCMFUIFQVCMJDBUJPOPGUIJTmGUIFEJUJPO Robert L. Clinton, President Colorado Council for Economic Education June, 2012 iv
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Introduction to the First Edition Our economic system is like the air. We aren’t always conscious of it, but it touches virtually every aspect of our lives. Every day billions of economic decisions are coordinated in a system of voluntary exchange that provides us with an abundance of goods and services, creates jobs which provide us with the means to support ourselves and our families, and sustains a measure of prosperity and freedom unparalleled in human history. ɩFFWFOUTPGUIFUXFOUJFUIDFOUVSZQSPWJEFEFNQJSJDBMFWJEFODFUIBUiDBQJUBMJTN has been as unmistakable a success as socialism has been a failure” as ex-socialist economist Robert Heilbroner recently stated. It is abundantly clear that systems matter – economic systems as well as political systems. ɩF PSJHJOBM DPNNVOJTUT CFMJFWFE UIBU QPWFSUZ JODPNF JOFRVBMJUZ PQQSFTTJPO and man’s inhumanity to man were caused by a free enterprise economy. To save the world, they outlawed market forces. As a result, millions of people starved, priceless natural resources were squandered, the environment was ruined, sectarian violence was exacerbated, and squalid living conditions became the norm at a time when millions of people living in free enterprise economies were leaving this kind of grinding poverty behind. ɩFMFTTPOJTPCWJPVTɩ PTFXIPMBDLBCBTJDVOEFSTUBOEJOHPGUIFPQFSBUJPOPGB free enterprise economy often, with the best of intentions, promote policies that inhibit market operations and do more harm than good. People living in free enterprise economies unquestionably have more liberty, a better quality of life, more wealth, more concern for the environment, and a higher level of charitable giving than people living under any other form of economic organization. Ironically, teaching young Americans about our economic system has never received the attention in the curriculum of our schools commensurate with the importance of economic understanding. National polls indicate that most American students neither understand how a market economy functions nor grasp the most fundamental economic concepts underlying all economic systems. Our students must understand not just the role of our economic system in allowing UIFTUBOEBSEPGMJWJOHUIFZFOKPZ CVUBMTPJUTSPMFJOQSFTFSWJOHUIFJSGSFFEPNɩ F institutions of a free society and those of a free economy are inextricably linked. v
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If we value our freedom, it is our obligation to teach each new generation about the ideas underlying our economic system and our political system, and the relationship between the two. As Dr. Dwight Lee, O’Neil Chair of Global Markets & Freedom, $PY4DIPPMPG#VTJOFTT 4PVUIFSO.FUIPEJTU6OJWFSTJUZTBZT iɩ FNPTUQSFDJPVT thing provided by a market economy is not the abundance of material wealth, but GSFFEPNɩ PTFPGVTXIPIBWFIBEUIFHPPEGPSUVOFUPTQFOEPVSMJWFTJOFDPOPNJFT CBTFEPONBSLFUTIBWFEJċDVMUZBQQSFDJBUJOHPVSGSFFEPNGPSUIFTBNFSFBTPO JU JT BMXBZTEJċDVMU UP BQQSFDJBUF BEWBOUBHFT POFIBT OFWFS IBEUPEP XJUIPVU 'FXQFPQMFXIPCFOFmUGSPNNBSLFUTBOEGSFFEPNSFDPHOJ[FIPXQSFDJPVTUIFJS freedom is, and fewer still are aware of how crucially their freedom depends upon the institutions of the marketplace.” Anyone truly interested in preserving liberty, improving the lot of the disadvantaged, or promoting the wise use of natural resources must have a basic understanding of the principles underlying a free enterprise economy. Free Enterprise: Our Heritage, Our Wealth provides a lively and easily understood introduction to those principles BOEXJMMBNQMZSFXBSEUIFFĊPSUTPGUIPTFDPODFSOFEFOPVHIUPSFBEJU LaKay J. Schmidt, President 1976-1994 Colorado Council for Economic Education July 4, 1992
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FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Table of Contents
Chapter 6:
Authors .................................................... ii
Non-Enterprise: ɩ F"MUFSOBUJWF................................... 25
Preface to the Fifth Edition....................iv
Figure 4: Economic Freedom Relative to GDP/Capita............... 26
Introduction to the First Edition............v Chapter 1:
You’re Rich!............................................ 1 Table 1: International Income ɩ SFTIPMETBOE%BUBGSPN Select Countries .............................. 2 Chapter 2:
ɩ F8FBMUIPG/BUJPOT .................... 3 Chapter 3:
Free Enterprise: ɩ F,FZUP8FBMUI ............................. 7 Chapter 4:
Free Enterprise and Self-Interest ......................................... 11 Figure 1: 2010 Large Governmental Contributions to the International Red Cross/ Red Crescent ................................. 13 Chapter 5:
Free Enterprise: ɩ F&TTFOUJBMT ..................................... 15 Box 1: A Brief Discussion of Demand and Supply Basics.............................................. 19 Figure 2: Employee Compensation and Investment .............................. 23 Figure 3: Hourly Compensation Costs for Manufacturing Workers, 2009 ............................... 24
Figure 5: Wages, Income and Productivity in Eastern versus Western Germany ........................ 27 Figure 6: Percent of Households in Eastern Germany with Selected Amenities....................................... 28 Table 2: Economic Growth: U.S. and U.S.S.R. (1951-1990) .. 29 Chapter 7:
Economic Crisis and Promise ...... 33 'JHVSF/FU'JOBODJBM*OnPXT.... 35 'JHVSF&ĊFDUJWF'FEFSBM Funds Rate..................................... 35 Figure 9: Average 30-Year Mortgage Rate ............................... 36 Figure 10: U.S. Housing Price Index............................................... 38 Figure 11: U.S. Real GDP............ 39 Figure 12: U.S. Real Per Capita GDP................................... 39 Chapter 8:
Ten Myths About Free Enterprise ................................... 41 Figure 13: Share of Output Controlled by the Four Largest Firms, 2007 ...................... 42 Figure 14: Worker Share of Income ............................ 43 Figure 15: Share of the Population Living in Severe Poverty............... 44 Box 2: Tradable Pollution Permits........................................... 47
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viii
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Chapter 1:
you’re rich!
h
ow much income does your family earn each year? Whatever it is, divide it by six. If your income were $12,000 a year, dividing it by six would cut it to $2,000. If your income were $24,000 a year, it would be $4,000. If it were $96,000, it would be $16,000. Now imagine getting by on that lower income – an income just one-sixth as great as you now enjoy. One-sixth! Could you do it? Could you survive on such an income? People in countries rated as “middle-income” economies by the World Bank do – their incomes average roughly one-sixth the level in the United States (See ...incomes per person in the 5BCMF 4JODF UIF mHVSFT BSF BEKVTUFE GPS United States pack roughly QSJDFEJĊFSFODFTJOEJĊFSFOUDPVOUSJFT BWFSBHF six times the purchasing incomes per person in the United States pack power of incomes in the roughly six times the purchasing power of middle-income countries... incomes in the middle-income countries such BT&DVBEPS UIF1IJMJQQJOFT PSɩ BJMBOE Now consider incomes in the United States compared to those in countries SBUFEBTIBWJOHiMPXwJODPNFTTVDIBT.BMJPS-JCFSJBɩ FJSJODPNFT BGUFS BEKVTUJOHGPSDPTUPGMJWJOHEJĊFSFODFT BWFSBHFMFTTUIBOone-thirtieth of the U.S. mHVSF4VSWJWJOHPOBOJODPNFMJLFUIBUSFRVJSFTUIBUIBWJOHQSFWJPVTMZEJWJEFE your income by six, you now take less than one-quarter of that! Feeling rich? You should be. If you live in the United States, your income is several times greater than that received by more than three-fourths of the approximately seven billion people in the world. What about the “high-income” countries like Japan, Britain, Germany, and Mexico? Of the large industrialized countries, the U.S. is the wealthiest country in the world! According to the World Bank, income per person in the world’s other large industrialized countries BWFSBHFTBQQSPYJNBUFMZGPVSmGUITUIF64MFWFM 1
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Table 1:
INTERNATIONAL INCOME THRESHOLDS AND DATA FROM SELECT COUNTRIES Low-Income Countries Middle-Income Countries High-Income Countries Country
Per capita income less than $995 Per capita income between $996 and $12,195 Per capita income greater than $12,196 Per Capita Income (2009)
United States Germany United Kingdom Japan Mexico Ecuador ɩ BJMBOE Philippines Mali Liberia
$45,640 $36,850 $35,860 $33,440 $14,020 $8,100 $3,540 $1,190 $290
Income numbers are adjusted GPSEJĊFSFODFTJODPTUPGMJWJOH ɩ FSFGPSF JO-JCFSJBJT comparable to $290 in the United States. Source: World Bank. World Development Report, 2011.
Here is another way of gauging living standards – think about the highest wage you have ever earned. Was it as much as two dollars per hour? If it was, you were among the highest paid workers on Earth. If you worked 40 hours per week earning $2 per hour you would make an income greater than that received by most of the world’s population. All these calculations illustrate a simple point: we’re rich – you’re rich. Even the poorest people in the United States receive incomes many times greater than the average incomes of most of the people on Earth. What accounts for this great prosperity? Why are incomes in one country high and in another country low? Why is it that people in the United States have an annual gross national income per person of $45,640 while the people of Liberia, the poorest country on Earth, have an annual income per person of $290? In this booklet we will examine the sources of our nation’s great wealth and see how our economic system works to make us so prosperous. 2
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Chapter 2:
the wealth of nations
i
n 1776, the same year our nation declared its independence from England, a Scottish economist, Adam Smith, wrote a book that sought to answer the kinds of questions asked in the previous chapter. In fact, he called his book An Inquiry into the Nature and Causes of the Wealth of Nations. Smith examined the factors that cause one nation to be rich, another to be poor. Smith equated wealth with income. Today, we think of wealth in terms of the Today, we think of wealth in ability to generate income. A nation that can terms of ability to generate generate high levels of income is wealthy; one income. that is capable only of low levels of income is poor. What is it that allows a nation to create a high level of income? What is it that makes a nation wealthy?
Money? Does more money make a nation wealthy? Many of the people who lived JO4NJUITEBZUIPVHIUTP"OEJUJTOPUTPQSFQPTUFSPVTBOPUJPOɩ FHSFBU novelist F. Scott Fitzgerald is said to have remarked to his fellow writer Ernest )FNJOHXBZ i:PV LOPX &SOFTU UIF SJDI BSF EJĊFSFOU GSPN VTw 5P XIJDI )FNJOHXBZSFQMJFE i:FT *LOPXɩ FZIBWFNPSFNPOFZUIBOXFEPw But what is true for one person is not always true for a whole nation. Suppose the total amount of money in the United States were to double instantly. Suddenly, everyone would have twice as much money in his or her wallet, twice as much money in the bank, twice as much money squirreled away in the ashtray of the car – twice as much everywhere. Would we be richer? If you think about it for a moment, you will see that the answer is “no.” We would still have the same number of cars, the same number of houses, the same amount of food, the same 3
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OVNCFSPGTDIPPMTɩ FGBDUUIBUFWFSZPOFIBEUXJDFBTNVDINPOFZXPVMEOPU change the amount of goods and services available. What would happen is that the prices of these goods and services would go up, but we would not be any richer. We would not have created wealth by doubling the amount of money available. In considering whether more money makes a country wealthy, Adam 4NJUI IBE UIF CFOFmU PG IBWJOH PCTFSWFE UIF GPMMJFT PG UIF HSFBU DPMPOJBM powers in trying to get rich. Countries such as 1PSUVHBMBOE4QBJOJOWFTUFEFOPSNPVTFĊPSU More money makes for in acquiring gold from the New World based higher prices. It does not on the mistaken belief that having more money create wealth. would make them rich. But as they obtained more gold and minted it into coins – their form of money – they succeeded mainly in causing prices to go up. Portugal was one of the most successful looters of New World gold; it managed to force its prices up by 200 percent during the 16th century.1 More money makes for higherprices. It doesnot create wealth. Ifit did, ending poverty would be simple – print more money. Life in the real world is not so simple.
Natural Resources? Another possible source of wealth is a nation’s stock of natural resources. Surely the availability of such factors as fertile land, a good climate, mineral EFQPTJUT UJNCFSBOEPDFBOSFTPVSDFTNBLFBOBUJPOXFBMUIZɩJTQPTTJCJMJUZ is more realistic than using monetary growth as the sole source of wealth. But it too falls short as an explanation of wealth creation. Consider Japan and India. Japan is a very successful country; one that 60 years ago many people expected would play an increasingly dominant role in the world economy – as indeed it has. Yet Japan has very few natural resources. It must import virtually every raw material it uses from other, generally poorer, countries that do have natural resources available. On the other hand, India is blessed with great natural wealth. It has roughly four times as much arable land per person as Japan. Yet India is poor while Japan is rich. Income per person in Japan is $33,440, more than 10 times as great as per capita income in India. 1
See A. H. de Oliveria Marquez, History of Portugal, 1976, for a discussion of this problem.
4
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
For another example, compare incomes in North America with those in South America. South America possesses abundant natural resources. In Adam Smith’s day South America was considered by many to have the greater prospect for economic development. But Smith put his bet on the prospects of North America, particularly for what would become the United States. While they can be advantageous, natural resources are no guarantee of wealth.
People? What about a nation’s people? It would be nice to be able to pat ourselves on the back and say that our great wealth is a result of our own cleverness or skill. It would be nice to say that there is just something about us that sets us apart from the great majority of the world’s people – people who must live in conditions of desperate poverty. But if it is people who account for the wealth, how are we to account for cases in which the same people generate very unequal wealth? Consider Korea. After World War II, Korea was split into two parts: the Democratic People’s Republic of Korea (North Korea) and the Republic PG,PSFB 4PVUI,PSFB 1SJPSUPUIFTQMJU ,PSFBIBECFFOBVOJmFEOBUJPO %VSJOHUIFmSTUIBMGPGUIFUIDFOUVSZUIF+BQBOFTFDSVFMMZFYQMPJUFE,PSFB Its productive base was further decimated by UIFJOUFSOBMDPOnJDUPGUIF,PSFBO8BSɩ F How could the same people PVUDPNF PG UIJT DPOnJDU XBT B OPSUITPVUI produce such a markedly QBSUJUJPOPGUIFDPVOUSZɩ FTPVUIFSOIBMGHPU EJĊFSFOUPVUDPNF the short end of the resource stick – Korea’s natural wealth is located primarily in the north. But the people – north and south – were the same. Yet today, South Korea is rich with a per capita income of $27,240, while North Korea is poor with a per capita income of $1,800.2 )PXDPVMEUIFTBNFQFPQMFQSPEVDFTVDIBNBSLFEMZEJĊFSFOUPVUDPNF )POH,POHPĊFSTBOPUIFSTUSJLJOHFYBNQMFɩJTUJOZTQFDLPOUIFFEHF of China is inhabited mainly by ethnic Han Chinese – the same people who live across the border in the People’s Republic of China. Hong Kong has no natural resources, except for a good harbor. It was little more than a refugee 2
Data from the World Bank, World Development Report, 2011, except for North Korea from CIA 8PSME'BDUCPPL1SPmMF 5
COLORADO COUNCIL FOR ECONOMIC EDUCATION
camp as recently as 1950. But by 2011, Hong Kong ranked among the world’s highest income countries with per capita income of $44,450 per year – more than 6 times that of the People’s Republic of China’s $6,890. If money, natural resources, and special characteristics of people do not explain a nation’s wealth – its ability to produce income – what does? To answer this question, we must examine how it is that income is created. Waving a magic wand cannot create income in a nation. It can only be created through the production of goods and services. By producing something, we earn income. Take away the production and you take away the income. Of course, we could create income for some people by simply taking away income from someone else. But that would merely redistribute the existing income; it would not create more income for the nation as a whole. A nation must have people and access to resources to produce goods and services. But it is only when these resources are used for production that income is created. ɩFTPVSDFPGBOBUJPOT wealth lies in its ability to use If a nation fails to make good use of its natural resources and people, it will be poor. If it its resources productively. NBLFT FĊFDUJWF VTF PG UIFTF GBDUPST JU XJMM CFSJDIɩ FTPVSDFPGBOBUJPOTXFBMUIMJFTJOJUTBCJMJUZUPVTFJUTSFTPVSDFT productively. How does a nation accomplish this task?
6
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Chapter 3:
free enterprise: the key to wealth
a
XFBMUIZ OBUJPO JT POF UIBU VTFT JUT SFTPVSDFT QSPEVDUJWFMZ ɩ F NPSF productive a nation is, the wealthier it is. But what makes a nation productive? ...key to a productive – and thus a wealthy – nation lies in an economic system based on individual freedom.
Smith’s answer to this question was a simple one. He said that the key to a productive – and thus a wealthy – nation lies in an economic system based on individual freedom. It lies in a system of free enterprise.
A quick look around the world suggests the power of Smith’s insight. Countries with free enterprise systems are rich. Countries that lack free enterprise systems are poor. Writing in 1776, when America’s prospects for even becoming a Countries with free country were highly uncertain, Smith predicted enterprise systems are rich. that our nation would enjoy great wealth. Countries that lack free America would be a wealthy nation, he said, not enterprise systems are poor. because it had natural resources, not because of any peculiarity of its people, but because its people had the freedom of enterprise. What is it about a free enterprise system that fosters the creation of wealth? What does free enterprise have that other economic systems lack? We will answer those questions by examining the essential characteristics of a free enterprise system. Later we will contrast those with the essential characteristics of other systems.
Free to Agree As its name suggests, a free enterprise system is based on freedom. But XIBUJTJUUIBUQFPQMFBSFGSFFUPEPVOEFSTVDIBTZTUFN ɩ FFTTFOUJBMBOTXFS 7
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JTUIBUUIFZBSFGSFFUPFOUFSJOUPWPMVOUBSZBHSFFNFOUTXJUIPOFBOPUIFSɩJT freedom, called the freedom of contract, lies at the heart of a free enterprise TZTUFNɩ FGSFFEPNPGDPOUSBDUJTBQPXFSGVMGSFFEPN POFUIBUNPTUPGUIF world’s people lack. To see its importance consider starting an imaginary business – a car wash. 0VSDBSXBTISFRVJSFTTFWFSBMWPMVOUBSZBHSFFNFOUT'JSTU XFIBWFUPmOEQFPQMF UPIFMQXJUIUIFXPSL5PHFUUIFNUPBHSFFUPIFMQ XFIBWFUPPĊFSUIFNB wage, or perhaps a share of the revenues. We have to get someone to provide us XJUIBOBSFBUPPQFSBUFɩBUQFSTPONJHIUBHSFFUPEPOBUFUIFTQBDFPSSFRVJSF VTUPQBZGPSJU JOFJUIFSDBTF UIFBHSFFNFOUJTWPMVOUBSZɩ FO PGDPVSTF XF have to get people to come to our car wash. We agree to wash customers’ cars if they will agree to pay the price of the wash. With all these agreements in hand, PVSDBSXBTIoPVSFOUFSQSJTFoJTPĊBOESVOOJOH 0VSDBSXBTIJTNBLJOHMPUTPGQFPQMFCFUUFSPĊ0VSXPSLFSTBSFCFUUFSPĊ that they agreed to work for us reveals that they value the opportunity to work for us and to earn money, more than they valued whatever activity they gave up XIFOUIFZDIPTFUPXPSLGPSVTɩ FQFSTPO Our business, if successful, XIPQSPWJEFEVTXJUIUIFTQBDFJTCFUUFSPĊ will make everyone the landlord chose to provide it because our use of the space is more valuable than whatever associated with it – use had been made of the space before. Our customers, workers, suppliers, and us –CFUUFSPĊ TVQQMJFSTBSFCFUUFSPĊ UIFZHBJOCZTFMMJOHVT rags, soap, polish, and other materials. Our DVTUPNFST BSF CFUUFS PĊ UIFZ XPVME OPU BHSFF UP QBZ GPS B DBS XBTI JG UIFZ did not think the service was worth even more than the price we are charging. "OEmOBMMZ XFBSFCFUUFSPĊ8FXPVMEOPUPQFSBUFUIFCVTJOFTTJGJUEJEOPU QSPWJEF VT NPSF CFOFmUT UIBO TPNF PUIFS BDUJWJUZ XF DPVME IBWF BUUFNQUFE Our business, if successful, will make everyone associated with it – customers, XPSLFST TVQQMJFST BOEVToCFUUFSPĊ
Failure Of course, things might not work out so well. We might not have enough customers. Our workers might think we aren’t paying enough and leave. We NBZUVSOPVUUPCFBOVJTBODFUPUIFQSPWJEFSPGUIFTQBDFBOECFPSEFSFEPĊ of the premises. We might lose money and decide to shut down the operation. 8
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
If failure comes, what is it we are failing to do? We are failing to make people CFUUFSPĊ If we do not attract enough customers, we are failing to make them CFUUFSPĊCZCVZJOHPVSDBSXBTIFT*GPVSXPSLFSTMFBWF JUNFBOTXFBSFOPU NBLJOHUIFNBTXFMMPĊBTUIFZDPVMECFJOTPNFPUIFSBDUJWJUZ*GXFBSFCPPUFE GSPNUIFQSFNJTFT JUJTCFDBVTFXFBSFOPUNBLJOHUIFMBOEMPSECFUUFSPĊ"OE if we are the ones who decide we must close up shop, it is because we are not NBLJOHPVSTFMWFTCFUUFSPĊ
Success ɩ FMFTTPOPGGBJMVSFTVHHFTUTBMFTTPOPGTVDDFTT*GPVSDBSXBTITVDDFFET JUJTCFDBVTFXFBSFNBLJOHQFPQMFBTTPDJBUFEXJUIJUCFUUFSPĊɩ BUJTBDSJUJDBM point about free enterprise. People succeed in a free enterprise system only to the FYUFOUUIBUUIFZNBLFUIFNTFMWFT"/%PUIFSQFPQMFCFUUFSPĊSince no coercion is involved, there is no other reason that these voluntary exchanges would otherwise occur. 0VS TVDDFTT JO NBLJOH PUIFS QFPQMF CFUUFS PĊ JT SFnFDUFE JO BOPUIFS accomplishment: we have created new wealth. We have increased the incomes of our workers and our suppliers. We have increased our own incomes. In some sense, we have increased the wealth – or at least the wellbeing – of our customers. We may have attracted them with a lower price or with a better product at a higher price. In either case, we allowed them to buy more with their money, thus increasing their purchasing power. With more purchasing power we, along with our workers, suppliers, and customers, will be able to buy more goods and services from other enterprises; this increases their incomes and their wealth.
Zero Sum? ɩ FJEFBUIBUTVDDFTTGVMFOUFSQSJTFDSFBUFTXFBMUIJTUPPPGUFOPWFSMPPLFE Some people might say that we did not create wealth, we merely took some business away from some other car wash. People who make this argument see economic activity as a ɩFJEFBUIBUTVDDFTTGVM game – like Monopoly® or poker – in which one enterprise creates wealth is person gains but another loses. Such games are too often overlooked. called zero-sum games; the gains of the winners are just balanced by the losses of the losers. People caught in zero-sum thinking miss the essence of a free enterprise economy, the creation of wealth through FOUFSQSJTFɩ F[FSPTVNFSSPSJTBDPNNPOPOFUIBUXFTIBMMDBSFGVMMZFYBNJOF 9
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It is surely true that we got some of our customers from competing car washes. But why? Why did some of our customers leave other car washes? It must be something about our car wash – our quality, our location, our price, or perhaps our winning attitude – that makes a car wash from us a better choice than one produced by our competitors. Our product is, for those customers who chose us, more valuable than those of our competitors. It is not simply a matter of having one less car washed at a competitor and one more washed at PVSFOUFSQSJTFɩ BUPVSDVTUPNFSTDIPTFVTNFBOTXFQSPEVDFBCFUUFSWBMVF for the customer. Our ability to do this suggests that we have created wealth and greater well-being. ɩ FXFBMUIXFDSFBUFXJMMCFQVUUPVTFFMTFXIFSFJOUIFFDPOPNZ4PNF PG PVS DVTUPNFST XJMM mOE PVS QSJDFT MPXFS UIFZ XJMM IBWF NPSF NPOFZ UP spend on other things. Some of them will now have more time to use in other activities. Our workers and suppliers will have more income to spend. And, if all goes well, we will have more income to spend and invest. All this additional activity creates still more wealth. Consider what it would mean if the “zero-summers” were right. Enterprise XPVME OPU DSFBUF XFBMUI UIF TVDDFTT PG POF FOUFSQSJTF XPVME CF PĊTFU CZ the failure of another. But if that were true, what would create wealth? We have already seen that some societies enjoy great wealth – how could this CF BDDPVOUFE GPS ɩF BOTXFS PG DPVSTF is that it could not be accounted for. ZeroɩFTFDSFUPGBXFBMUIZ sum thinkers are simply wrong. Successful nation, he argued, was an economic system that allowed enterprise creates wealth. And what creates TVDDFTTGVMFOUFSQSJTF 1FPQMF*UJTUIFFĊPSUT people to create wealth. of people that create a successful enterprise BOEDSFBUFXFBMUIɩ FTFFĊPSUTFOSJDIUIFQFPQMFXIPPSHBOJ[FUIFFOUFSQSJTF the people who work for the enterprise, the people who supply the enterprise, and the customers of the enterprise. Successful enterprise creates wealth and in so doing enriches all who are associated with the undertaking. Adam Smith insisted that this process of wealth creation would spring spontaneously from the minds and enterprise of individual people provided that they were allowed to do it.ɩ FTFDSFUPGBXFBMUIZOBUJPO IFBSHVFE XBTBOFDPOPNJDTZTUFNUIBU BMMPXFEQFPQMFUPDSFBUFXFBMUI"OFDPOPNJDTZTUFNUIBUTUJnFEDSFBUJWJUZ he warned, would be poor. 10
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Chapter 4:
free enterprise and self-interest
w
hy does a free enterprise system work so well to promote wealth? Adam Smith linked its success to what he argued was a basic tendency for people to make choices that serve their self-interest. It was one of Smith’s most important – and most misunderstood – observations.
%FmOJOH4FMG*OUFSFTU What is self-interest? Some people argue that self-interest is the same as HSFFEPSTFMmTIOFTT#VUXIFUIFSTFMGJOUFSFTU NFBOTTFMmTIOFTTEFQFOETPOUIFXBZTJOXIJDI Some people argue that selfpeople interpret and act on their perception of interest is the same as greed their self-interest. We can make some guesses PSTFMmTIOFTT about what people regard as their “self-interest” by observing their behavior. First, “self-interest” must include a regard for one’s family. Why else would XFTFFQBSFOUTNBLJOHTVDIFOPSNPVTTBDSJmDFTGPSUIFJSDIJMESFO Second, “self-interest” apparently includes a concern about one’s friends and neighbors. We can all think of cases in which friends and neighbors have helped us and in which we have helped them. ɩJSE iTFMGJOUFSFTUw NVTU JODMVEF B TVCTUBOUJBM JOUFSFTU JO UIF XFMGBSF of one’s fellow citizens. As evidence, consider that over one million people participated in the Komen Race for the Cure UPmHIUCSFBTUDBODFS FWFOUTJO 2010. What does their “self-interest” include? Observe the huge number of PSHBOJ[BUJPOTTUBĊFECZWPMVOUFFSFĊPSUT8IBUJTUIFiTFMGJOUFSFTUwPGUIFTF volunteers? 11
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Or consider the charitable activities of the Bill and Melinda Gates Foundation that has provided over $24 billion in grants since its inception. What is the “self-interest” of the Gates? $MFBSMZ XFEFmOFPVSPXOJOUFSFTUTJOBXBZUIBUJODMVEFTUIFXFMGBSFPG others. We run errands for a sick neighbor, Acting in one’s self-interest is deliver meals to shut-ins, contribute food for the hungry. Acting in one’s self-interest is not OPUUIFTBNFBTCFJOHTFMmTI the same as being TFMmTI #VU JG TFMGJOUFSFTU JT OPU TFMmTI OFJUIFS JT JU TFMnFTT 8F DFSUBJOMZ EP OPUFYQFDUQFPQMFUPEJTSFHBSEUIFJSPXOOFFETPSBEWBOUBHFTɩ F#JCMJDBM admonition is to love your neighbor as yourself. People who enjoy gardening, HBSEFOɩ PTFXIPMJLFUPTFX TFXɩ PTFXIPMJLFUPSVO SVO8FQVSTVF UIPTFBDUJWJUJFTUIBUHJWFVTQMFBTVSFBOETBUJTGBDUJPOɩBUJTXIBUTFMGJOUFSFTU is all about. ɩF mSTU NJTDPODFQUJPO BCPVU TFMGJOUFSFTU UIFO JT UP DPOGVTF JU XJUI TFMmTIOFTT8FBSFBMMHFOFSPVTUPWBSZJOHEFHSFFT CVUXFBSFHFOFSPVT8F GVMmMMUIBUHFOFSPTJUZPGTQJSJUXIJMFTFSWJOHPVSPXOJOUFSFTUT ɩ FTFDPOENJTDPODFQUJPOBCPVUTFMGJOUFSFTUDPODFSOTJUTSFMBUJPOTIJQUP free enterprise. As we shall see, free enterprise systems do such a good job of responding to individual interests that some people equate self-interest to free enterprise. It is only in a free enterprise system, they presume, that people pursue their self-interest. In some other economic system, people pursue …. what? 8IBUJOUFSFTUXPVMEQFPQMFQVSTVFPUIFSUIBOTFMGJOUFSFTU ɩ FJSOFJHICPST interest? But what would that interest be, if not the neighbor’s self-interest? And how would anyone other than one’s neighbor clearly know what that is? Of course people pursue their self-interest, as there is no other interest to pursue. People pursue their self-interest in a free enterprise system and in any other system in which ɩFQVSTVJUPGTFMGJOUFSFTU UIFZmOEUIFNTFMWFTɩ FQVSTVJUPGTFMGJOUFSFTU is fundamental to human is fundamental to human nature. It is not nature. the product of any particular economic system. 12
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
We can askwhicheconomicsystemdoesthebestjobofinstillingagenerosity of spirit intopeople’s concept of their own self-interest. We could ask, “In what system do people give most generously of their time and resources?” In what economies are resources most aggressively mobilized to come to the aid of victims of disaster? Some answers to this question are illustrated by examining past instances PGHJWJOH'PSJOTUBODF JOUIFGPVSMBSHFTUQSPWJEFSTPGmOBODJBMSFTPVSDFT to developing countries were the United States ($26.0 billion), Germany ($13.9 billion), the United Kingdom ($11.4 billion), and France ($10.9 billion).3 Notice that all of these countries have free enterprise economies. Examining the pattern of contributions to the International Red Cross and Red Crescent Movement provides additional evidence. In Figure 1, notice that the large sources of funding to this benevolent group come from free enterprise economies. It is worth noting that these governmental contributions account for 86 percent of all governmental funding received by the International Red Cross/Red Crescent and 70 percent of funding from all sources during 2010. Clearly it appears that it is in free enterprise systems that the pulse of generosity beats strongest. Figure 1:
Source: International Red Cross and Red Crescent Movement Annual Report, 2010. 3
U.S. Census Bureau. Statistical Abstract of the United States, 2011. 13
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Serving Self-Interest ɩ FHFOJVTPGBNBSLFUFDPOPNZJTJUTBCJMJUZUPHVJEFTFMGJOUFSFTU FWFOJO instances in which no generosity of behavior is intended, to the service of the general interest. Why might we have started – as was discussed in the previous chapter – a car wash business? Because of a humanitarian concern about people driving in dirty cars? No, it was surely the opportunity to further our own – and our family’s – interests that motivated our action. How did we entice people UPXPSLGPSVT 8FPĊFSFEBXBHFUIBUNBEFXPSLBUPVSDBSXBTITPNFUIJOH UIBUBQQFBMFEUPUIFJSTFMGJOUFSFTU)PXEJEXFBUUSBDUDVTUPNFST 8FPĊFSFE a better product, or a better price, or both, than they could get elsewhere. ɩ FBQQFBMJOBGSFFFOUFSQSJTFTZTUFNUPTFMGJOUFSFTUGPMMPXTEJSFDUMZGSPN its reliance on voluntary contract. People are free to choose; they can spend their money, and allocate their time, in whatever activities they want. If we want to persuade them to do something we want them to do, we must arrange for that act to be in their interest as well as our own. In the famous words of Adam Smith: It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves not to their humanity, but to their self-love, and never talk to them of our necessities, but of their advantages. 4 In a system based on voluntary choice, all attempts by individuals to enhance their own interests must further the interests of others. As we have already seen, it is only by serving the interests of others that we serve ourselves. A free enterprise economy encourages the creation of wealth as it frees individuals to pursue their own interests. In the next chapter, we turn to an examination of the ingredients that make a free enterprise system tick.
4
Adam Smith. An Inquiry into the Nature and Causes of the Wealth of Nations. New York: Modern Library Edition, p. 14. 14
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Chapter 5:
free enterprise: the essentials
w
e have already noted one ingredient of free enterprise; it is the freedom of contract. But it takes far more for free enterprise to work than that. Below the essential characteristics of a free enterprise economy are discussed.
Government It may come as a surprise to see government listed as a vital component of free enterprise – isn’t government the antithesis of free enterprise? In actuality, free enterprise could not exist without government.
...free enterprise could not exist without government.
ɩ FFYJTUFODFPGHPWFSONFOUJTBTTVNFEJOUIFWFSZOPUJPOPGUIFGSFFEPN to enter into contracts. Contracts are meaningless if they are not enforced. Inevitably it is governments that act to enforce contracts. Without government and the rule of law there could be no contracts. Consider again our car wash. We started the car wash because we thought that XFDPVMEFBSONPOFZ BQSPmU JOUIFFOUFSQSJTF#VUXIZTIPVMEXFFYQFDUUPCFBCMF UPSFUBJOUIFQSPmUTXFFBSO 8IBUJTUPQSFWFOUTPNFPOFFMTFGSPNTFJ[JOHUIFN ɩ FBOTXFS PGDPVSTF JTUIBUUIFHPWFSONFOUFOGPSDFTUIFSJHIUTUPFOKPZPVSQSPmUT But the actions of governments go further than this. Many governments QSPWJEF OBUJPOBM EFGFOTF QPMJDF BOE mSF QSPUFDUJPO FEVDBUJPO QBSLT BOE wilderness areas. Some argue that these actions go too far and begin to infringe on the ability of the free enterprise system to best function. Rather than enter the debate on the appropriate role and size of government, we prefer to highlight a core area of agreement – virtually everyone agrees that government must have some involvement with the economy. Further, this role is vital to the successful functioning of a free enterprise economy. 15
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Private Property ɩFFYDIBOHFPGQSJWBUFMZ held property lies at the heart of economic activity in a free enterprise system.
If individual choices are to be meaningful, people must have resources at their command. *OPUIFSXPSET UIFZNVTUIBWFQSPQFSUZɩ F exchangeofprivatelyheldpropertyliesattheheart of economic activity in a free enterprise system.
Consider the resources that you own. Probably the most important is your labor. In a free enterprise economy you may exchange your labor for income. You may also own a house or an automobile or a big screen television. In each case, you have the right to exchange these goods for income or for other goods. ɩ FQSJWBUFPXOFSTIJQPGPOFUZQFPGSFTPVSDFoDBQJUBMoHJWFTGSFFFOUFSQSJTF another name: capitalism. Capital includes the machinery, equipment, and CVJMEJOHTVTFEUPQSPEVDFHPPETBOETFSWJDFTɩ FQSJWBUFPXOFSTIJQPGDBQJUBM is one characteristic of a free enterprise, or capitalist, economic system. While we often think of ourselves as owning particular things, what we really own are the rights to use those things in certain ways. For example, the ownership of a baseball bat gives one the right to hit a ball with it but not to use it to attack the neighbor’s dog. Two of the rights that typically go with ownership are particularly important: they are the right of exclusion and the right of transferɩ FSJHIUPGFYDMVTJPO means that the owner of a particular thing has a right to exclude others from its VTFɩ BUNBZTPVOEIBSTI CVUJNBHJOFXIBUXPVMEIBQQFOJGXFEJEOPUIBWF this right. Suppose that the ownership of a car carried no right to exclude others from using the car. Anyone could use your car whenever he or she wanted. If that were true, would you bother to change the oil or to get regular tune-ups? It is unlikely that you would as your inability to exclude others from the use of the DBSXPVMENFBOUIBUZPVDPVMEOPUDMBJNUIFCFOFmUTPGZPVSFĊPSUTUPLFFQUIF car in good running condition. It would no longer be in your self-interest to take care of the car. ɩ FSJHIUUPUSBOTGFS PSUIFSJHIUUPTFMMUIFSJHIUTXFIBWF JTFRVBMMZJNQPSUBOU Suppose the ownership of a house carried with it no right of transfer. In other 16
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
XPSET ZPVDPVMEOPUTFMMJUɩ FBCTFODFPGUIFSJHIUPGUSBOTGFSXPVMETUSJQUIF marketplace of the mechanism through which assets such as houses are transferred to other users who place a greater value on the asset. It would be impossible for you to sell your house to someone who values it more than you. Stripped of this right to sell, you would have less incentive to maintain and improve your property. If there were no rights of transfer, resources would remain locked to their present users forever – even if they no longer had any desire to keep the property. An advantage of private property is seen in the formerly planned economies PGUIFQPTU4PWJFUSFHJPO4PNFPGUIFTFDPVOUSJFTIBWFFYQFSJFODFETJHOJmDBOU movements towards privatization of productive assets and been rewarded with TJHOJmDBOU HSPXUI 'PS JOTUBODF 1PMBOE IBT QSJWBUJ[FE OFBSMZ BMM PG JUT LFZ sectors and experienced growth of nearly 6.8 percent per year since 1990. On the other hand, Ukraine, with nearly 76 percent of its productive assets still in state hands, experienced contraction of nearly 10.8 percent per year during the 1990s.5 Fortunately, the Ukrainian economy has more recently experienced a rebound in growth that corresponds with its movement towards privatization of its productive assets.
Prices 1SJDFTBSFUIFOFSWPVTTZTUFNPGBGSFFFOUFSQSJTFFDPOPNZɩ FZDBSSZUIF signals that guide decisions and that move goods and services around in the economy. To get a sense of how well prices work, think about the things you buy during a typical Prices are the nervous system year. If you are like most people, you could list of a free enterprise economy. hundreds of different items. Do you worry about the availability of each of these items? For virtually everything you buy, the answer is surely “no.” Indeed, as we look around in the marketplace we see the appropriate quantities of nearly everything being made available every day. We do not see shortages, nor do we see surpluses. Prices make that happen. Prices CBMBODFUIFEFNBOEGPSHPPETXJUIUIFJSTVQQMZɩ FZBTTVSFUIBUUIFRVBOUJUZ DPOTVNFSTXBOUUPQVSDIBTFNBUDIFTUIFRVBOUJUZQSPEVDFSTXBOUUPTFMMɩ JT balance between supply and demand is no accident – prices make it happen. 5
World Bank. World Development Report, 8JOHɩ ZF8PP FUBMEconomies in Transition, 1998; and Zenonomics Research Report: Ukraine, 2009. 17
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To see how prices play this role, consider the market for a simple product, lettuce. Wherever you live and whatever the season of the year, it is likely fresh lettuce will always be available. But suppose that the lettuce crop was reduced this season because of a deep freeze. Suddenly, less of the product is available to sell. 8IBUIBQQFOT ɩ FBOTXFSJTTJNQMFoUIFQSJDF PGMFUUVDFJODSFBTFTɩ FIJHIFSQSJDFTFOETB ..the higher price induces the signal to consumers that lettuce is now relatively purchaser to naturally reduce more dear; therefore, the consumer is induced his or her consumption. to purchase less. Notice that no government announcement is needed, the buyer correctly interprets the signal – in this case, UIFIJHIFSQSJDFNFBOTUIBUMFTTJTBWBJMBCMFoBOEQVSDIBTFTMFTTɩ FSFGPSF EFTQJUF the freezing weather reducing the crop, stores continue to have lettuce to sell; it is just sold at a now higher price. A shortage does not arise because the higher price induces the purchaser to naturally reduce his or her consumption. To fully appreciate how well this system works, consider what happens when the price mechanism is not allowed to work. An example is provided by the market for electricity in California during the fall of 2000 when the state experienced particularly cold weather. Naturally people responded to this weather by turning up the heat and thereby using more electricity. Since people were using more electricity, a well-functioning price mechanism would signal this increased desire GPSBHPPECZSBJTJOHUIFQSJDFɩ FQSJDFUPUIFDPOTVNFSPGFMFDUSJDJUZTIPVME IBWFHPOFVQ#VUUIFHPWFSONFOUPG$BMJGPSOJBmYFEUIFQSJDFUISPVHISFHVMBUJPO In the short term, consumers might view this as a desirable outcome – more electricity at a constant price. But what happened on the supply side? Suppliers PGFMFDUSJDJUZXFSFOPUJOTVDIBGPSUVJUPVTQPTJUJPOɩ FZIBEUPQVSDIBTFUIFJS supplies in the open market. Since they needed more supplies to produce the EFNBOEFE FMFDUSJDJUZ UIF QSJDFPG UIPTFTVQQMJFTJODSFBTFE ɩ JT USBQQFEUIF QSPEVDFSTJOBOVOGPSUVOBUFTJUVBUJPOPGJODSFBTJOHDPTUTCVUmYFETFMMJOHQSJDFT Quickly they began losing money and the government of California, along with the federal government, had to begin subsidizing their operations to keep them in existence.6ɩ FTFTVCTJEJFTDPNFBUBDPTUoZPVQBZGPSUIFNXJUIZPVSUBYFT Notice that the whole problem could have been avoided if the price mechanism had been allowed to function. As consumers increased their demand, prices would JODSFBTF1SPEVDFSTXPVMECFBCMFUPBĊPSEUPQSPEVDFUIFFYUSBFMFDUSJDJUZ BT 6
ɩF&DPOPNJTU January 13, 2001, reported these losses as totaling $10 billion.
18
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Box 1: Basic demand and supply model
Brief Discussion of Demand and Supply Basics A free market for lettuce is depicted in Figure A P Figure A, with price (P) on the vertical S axis and quantity (Q) per time period on UIFIPSJ[POUBMɩFNBSLFUEFNBOEDVSWF P1 is denoted “D” and the market supply DVSWFi4wɩF%DVSWFUFMMTVTUIFRVBOUJUJFT of lettuce buyers are willing and able to D QVSDIBTFBUFBDIQSJDFɩF4DVSWFJOEJDBUFT the amounts of lettuce sellers desire to sell Q1 Q BUFBDIQSJDFɩF%DVSWFUZQJDBMMZIBT the downward slope shown in the Figure because as the quantity consumed rises, buyers often derive less satisfaction from each additional unit and are UIFSFGPSFXJMMJOHUPQBZMFTTGPSFBDITVCTFRVFOUVOJUɩF4DVSWFUZQJDBMMZ has the upward slope shown in the Figure because the cost of each additional unit tends to rise in the short run as greater quantities are produced. In a free market, the price and quantity of lettuce gravitate toward the intersection of the D and S curves, the market equilibrium denoted P1 and Q1 in Figure A. At P1 the quantity demanded is equal to the quantity supplied. However, at prices above (or below) P1 the quantity supplied will be greater (or less) than the quantity demanded and the resulting surplus (or shortage) will cause price to fall (or rise) toward P1. )PXEPFTBEFFQGSFF[FBĊFDUUIFNBSLFU for lettuce? Since the freeze reduces the available supply of lettuce, the S curve shifts leftward causing the price to rise to P2, as depicted in Figure B. While consumers may not even realize that a freeze occurred, the higher price has signaled that lettuce is now in greater scarcity and buyers reduce their quantity demanded, as shown by the movement along the demand curve from point A to point B in Figure B.
Figure B P
P2 P1
S2
S1
B A
D Q2 Q1
Q
19
COLORADO COUNCIL FOR ECONOMIC EDUCATION
the higher price being paid by consumers would allow them to cover their higher DPTUT8JUIPVUBOZUIPVHIUPSFĊPSUUIFQSPCMFNCSPVHIUPOCZUIFDPMEXFBUIFS would have been resolved – and without the risk of producers going out of business! Another example of government interference lies further back in history. In the former Soviet Union virtually all prices were set by a government agency, Gosplan. Imagine the complexity of coordinating the prices of thousands of individual goods. *NBHJOFUIFEJċDVMUZ PG LFFQJOHUIPTFQSJDFT BUUIFDPSSFDUMFWFMBTFDPOPNJD conditions evolve. It should be no surprise that the prices were not right. It is even less surprising Faced with the wrong prices, Soviet consumers were forced that Gosplan gave up the attempt to get them right. During one stretch from 1955 to 1966 to endure long lines … wholesale prices in the Soviet Union did not change at all, even though the population changed, climatic conditions changed, and incomes changed.7*UXBTFBTJFSGPSUIFBHFODZUPHJWFVQUIFFĊPSUUPDIBOHFQSJDFT than attempt to get them right. Faced with the wrong prices, Soviet consumers were forced to endure long lines to buy nearly everything they desired. Soviet sociologists estimated that the members of the average household in a Soviet city spent nearly 40 hours per week standing in line to buy – or more likely just attempting to buy – basic goods. You never see this failing where prices are allowed to work.
1SPmUT In a previous chapter we started a hypothetical new business, a car wash. ɩ JTOFXCVTJOFTTXBTFTUBCMJTIFEJOUIFIPQFUIBUPVSSFWFOVFTXPVMEFYDFFE PVSDPTUToMFBWJOHVTXJUIBQSPmU4PNFQFPQMFPCKFDUUPQSPmU1BSUPGUIJT PCKFDUJPOMJLFMZTUFNTGSPNBNJTDPODFQUJPOPWFSIPXMBSHFQSPmUTBSF0QJOJPO QPMMTTVHHFTUUIBUQFPQMFHFOFSBMMZCFMJFWFUIBUQSPmUTBDDPVOUGPSUPQFSDFOU PGUIFQSJDFTUIFZQBZGPSHPPETBOETFSWJDFT*GQSPmUTXFSFUIBUIJHI XFNJHIU agree that they were objectionable. However, we do not have to try to decide if UIFZBSFPCKFDUJPOBCMFɩ FBGUFSUBYQSPmUTFBSOFECZ64DPSQPSBUJPOT FYQSFTTFE relative to gross output) averaged only 6 percent since the end of World War II.8 )PXFWFS TVQQPTFUIBUQSPmUTJOBQBSUJDVMBSTFDUPSXFSFVOVTVBMMZIJHIo 20 or 30 percent. Rather than being concerned about this situation we should 7 8
Gregory, P. and Stuart, R. Comparative Economic Systems, 1992, 4th edition, p. 281. Average rate calculated from Bureau of Economic Analysis data for 1947 to 2010.
20
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
BQQSFDJBUFUIFJNQPSUBOUSPMFTVDIVOVTVBMMZIJHIQSPmUTQMBZ)JHIQSPmUTTJHOBM to other producers that a particular product line is highly desired by consumers. In response to this signal new producers will enter this line of business and begin QSPEVDJOHUIFQSPEVDUɩ JTOFXQSPEVDUJPOIBTUISFFPVUDPNFT'JSTU JUTBUJTmFT the consumer by making more of the highly desired product available. Second, it MPXFSTQSJDFTBTNPSFPGUIFJUFNXJMMCFBWBJMBCMFJOUIFNBSLFUɩ JSE BTUIFOFX DPNQFUJUJPOQVTIFTEPXOQSJDFTJUSFEVDFTUIFQSPmUTGSPNUIFJSVOVTVBMMZIJHI QPTJUJPO*OPUIFSXPSET UIFIJHIQSPmUTJOEVDFUIFDPNQFUJUJPOUIBULFFQTQSPmUT TPMPXoBOETPVOPCKFDUJPOBCMFɩ FGBMMJOQSJDFGSPNUIFFOUSZPGDPNQFUJUJPO (and just as importantly, from changes in technology) has clearly been seen in the information processing industry (i.e., computers, data processing, telephone, etc.) over the past thirty years. *UJTJNQPSUBOUUPSFDPHOJ[FUIBUQSPmUTBSFDSJUJDBMUPUIFFYJTUFODFPGFOUFSQSJTFT 8FSFJUOPUGPSUIFPQQPSUVOJUZUPFBSOBQSPmU GFXQFPQMFXPVMEFWFSFTUBCMJTIB OFXmSN8JUIPVUmSNTJUJTVOMJLFMZUIBUXFXPVMEIBWFUIFHPPETBOETFSWJDFT UPDPOTVNFUIBUXFTPIJHIMZWBMVF"mSNFBSOJOHBQSPmUTIPXTUIBUUIFmSNJT EPJOHBHPPEKPCPGCFOFmUJOHPUIFSQFPQMF*GJUXFSFOPU JUXPVMEMPTFNPOFZɩ JT potential for losses is another important characteristic of the free enterprise economy.
Losses -PTTFTUZQJDBMMZSFDFJWFMFTTBUUFOUJPOUIBOQSPmUT CVUUIFZQMBZBOFRVBMMZ JNQPSUBOUSPMFJOBGSFFFOUFSQSJTFFDPOPNZ+VTUBTIJHIQSPmUTTFOEBTJHOBM that more enterprises should begin providing a product, losses send a signal that UPPNBOZmSNTBSFQSPWJEJOHBQSPEVDUBOEUIBUTPNFTIPVMETIVUEPXO#PUI messages are important. 8IFOBmSNJTMPTJOHNPOFZ UIFDPTUTPGJUTFĊPSUTFYDFFEJUTSFWFOVFTɩ BU NFBOTUIBUTPNFPUIFSVTFPGUIFmSNTSFTPVSDFTTIPVMECFUSJFE-PTTFTQSPWJEF a powerful incentive to do just that! Losses and the failure they bring are a harsh penalty. However, recall what GBJMVSFNFBOT*UNFBOTUIBUUIFmSNJTGBJMJOHUPNBLFPUIFSQFPQMFCFUUFSPĊ#Z MFUUJOHUIFmSNGBJM XFBMMPXUIFSFTPVSDFTPGUIFmSNUPCFQVUUPPUIFSVTFTBOE UPCFNBOBHFECZPUIFSNBOBHFSTɩ PTFPUIFSNBOBHFSTXJMMCFTFFLJOHBQSPmU *GUIFZTVDDFFE UIFZXJMMNBLFQFPQMFCFUUFSPĊ*GUIFZGBJM UIFZUPPXJMMIBWFUP 21
COLORADO COUNCIL FOR ECONOMIC EDUCATION
leave the industry. It is only through failure that resources are redirected to better VTFTBOEUPCFUUFSVTFSTVTFTBOEVTFSTUIBUXJMMNBLFPUIFSQFPQMFCFUUFSPĊ ɩ FTUPSZPG)FOSZ'PSEJMMVTUSBUFTUIFJNQPSUBODFPGGBJMVSF'PSEUSJFEUISFF UJNFTUPHPJOUPUIFBVUPNPCJMFNBOVGBDUVSJOHCVTJOFTT)JTmSTUUXPFĊPSUT GBJMFE*UXBTJOUIFmSTUGBJMVSFT UIPVHI UIBUIFHPUUIFJEFBUIBUXPVMEUSBOTGPSN the industry and the country – that cars should not be expensive luxuries for the rich to race, but utilitarian vehicles for everyone. He put that notion to work in his third company, the Ford Motor Company. His personal success now seems OFBSMZUIFTUVĊPGMFHFOE But the importance of his success was and is experienced by us all – he increased the well-being of society by introducing the automobile to the average GBNJMZ)FTVDDFFEFEJONBLJOHTPDJFUZCFUUFSPĊUISPVHIIJTGSFFFOUFSQSJTF
Wages .PTUPGVTEPOPUIBWFUIFIFBEZFYQFSJFODFPGTFFLJOHBQSPmUBOESJTLJOH a loss. We work for the people who do, receiving a wage in return. Wages, ultimately, Wages, ultimately, are determined by our productivity and by the are determined by our productivity and by the value WBMVFPGXIBUXFQSPEVDF/PmSNXBOUTUPQBZ a wage that exceeds the value of what a worker of what we produce produces. Doing so would be a recipe for failure. 8IBULFFQTB mSNGSPNQBZJOH XPSLFSTMFTTUIBO UIFWBMVF PG XIBUUIFZ produce? Competition. If an additional worker can produce output valued at $20 per hour, and his or her employer is only paying $5 per hour, it is highly likely TPNFPUIFSmSNoPSNBOZPUIFSmSNToXJMMDPNFUPUIFXPSLFSBOEPĊFSBNVDI IJHIFSXBHF*OBDPNQFUJUJWFFDPOPNZ XBHFTSFnFDUUIFVOEFSMZJOHQSPEVDUJWJUZ of labor. Several factors determine this productivity; some of these factors are under the control of the worker, some are not. ɩ FNBJOJUFNUIBUBXPSLFSDBODPOUSPMJTIJTPSIFSTUPDLPGhuman capital. Human capital is just a fancy way of saying the set of skills and experience we bring to the workplace. We can increase our human capital by pursuing education or training. In general, the greater our human capital, the greater the wage we are paid. 22
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
0UIFSGBDUPSTBĊFDUQSPEVDUJWJUZBTXFMM0OFPGUIFNPTUJNQPSUBOUJTUIF stock of capital goods with which we can work. A carpenter with the latest power tools at his disposal will be more productive than one who has only a hammer and BTBXɩ BUHSFBUFSQSPEVDUJWJUZUSBOTMBUFTJOUPBIJHIFSXBHF ɩ JTTVHHFTUTBGVOEBNFOUBMFSSPSNBOZQFPQMFNBLF0GUFOQFPQMFTFFB struggle between the interests of owners of tools and equipment – the capitalists oBOEXPSLFSTɩ FZWJFXUIJTBTBDMBTTTUSVHHMFCFUXFFOHSPVQT BTUSVHHMFUIBU UIFZTFFBTDFOUSBMUPBDBQJUBMJTUPSGSFFFOUFSQSJTFFDPOPNZ#VUUIJTDPOnJDUJT OPUSFBM0XOFSTPGDBQJUBMFOIBODFUIFJSQSPmUTCZJOWFTUJOHJOOFXDBQJUBM#VU this same investment increases the productivity of workers and pushes up wages. In other words, by pursuing one’s own self-interest by increasing the capital stock, the capitalist also aids his or her employees by making them more productive, which leads to higher wages. A look at the movement of wages and productivity over the last century in the 64NBLFTUIJTQPJOURVJUFDMFBS8BHFT BEKVTUFEGPSJOnBUJPO IBWFNPWFEJO QBSBMMFMXJUIDIBOHFTJOQSPEVDUJWJUZBOEJOWFTUNFOU8IFOmSNTBSFJOWFTUJOH heavily, productivity rises and wages increase as shown in Figure 2. When JOWFTUNFOUGBMMTPĊ QSPEVDUJWJUZGBMMTPĊBOEXBHFTEFDMJOF Figure 2:
Source: Federal Reserve Bank of St. Louis.
23
COLORADO COUNCIL FOR ECONOMIC EDUCATION Figure 3:
Source: Bureau of Labor Statistics.
Now we can also see the reason wages in the United States are higher than those in many parts of the world (Figure 3). American workers receive high wages CFDBVTFUIFZBSFNPSFQSPEVDUJWFɩ FZBSFNPSFQSPEVDUJWFCFDBVTFPGUIFJSPXO IVNBODBQJUBMBOECFDBVTFPGUIFQIZTJDBMDBQJUBMXJUIXIJDIUIFZXPSLɩ BU QIZTJDBMDBQJUBMSFTVMUTGSPNJOWFTUNFOUCZQSPmUTFFLJOHDBQJUBMJTUT8IBUJTHPPE for the capitalist, in other words, is ultimately good for the worker.
Summing Up A free enterprise economic system is one in which individuals have the freedom to reach agreements with one another concerning the use of resources that they privately own. People in such a system are free to start their own business, to decide what company to work for, to decide what product to buy – they are free UPDIPPTFɩ FHSFBUCFBVUZPGTVDIBTZTUFNJTUIBUPOFQFSTPODBOBEWBODFIJT PSIFSPXOJOUFSFTUPOMZCZBEWBODJOHUIFJOUFSFTUTPGPUIFSQFPQMFɩ FHSFBUFS the success a person has, the greater the degree to which that person has made PUIFSQFPQMFCFUUFSPĊ 24
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Chapter 6:
non-enterprise: the alternative
w
hat is the alternative to a free enterprise system? It is a system in which people are not free to do the things we have discussed. It is a system in which people do not have the freedom to reach agreements with one another, in which people do not have the freedom to start their own businesses. It is a non-enterprise system. It is hard to imagine that non-enterprise systems would appeal to many people. ..the sad fact is that much of However, the sad fact is that much of the the world’s population lives in world’s population lives in non-enterprise non-enterprise economies. FDPOPNJFTɩ JTVOIBQQZTJUVBUJPOJTSFMBUFE to the observations we made earlier about the fact that much of the world’s people are terribly poor. Non-enterprise economies deliver poverty. ɩ FSFBSFUXPCSPBEGPSNTPGOPOFOUFSQSJTFFDPOPNJFT0OFJTTPDJBMJTN JOXIJDIUIFHPWFSONFOUBDUTBTUIFQSJNBSZPXOFSPGDBQJUBMɩ FPUIFSJT economic fascism. In economic fascism the capital may be privately owned, but extensive government regulation dictates how it will be used, the prices that will be charged, and the wages the workers will receive. Both systems have proven to be failures at delivering high living standards.
Socialism Socialist systems have been around for a very long time. Indeed, the very mSTU&VSPQFBOTFUUMFSTPG"NFSJDBFTUBCMJTIFETVDIBTZTUFNɩ FZBHSFFEUP hold their productive resources in common, to work for the common good and UPTIBSFUIFQSPEVDUTPGUIFJSMBCPSFRVBMMZɩJTTPDJBMJTUJEFBMWBOJTIFEXJUI the collapse of the community. With the fruits of each person’s labor shared equally, people did not work hard enough to maintain the existence of the 25
COLORADO COUNCIL FOR ECONOMIC EDUCATION
DPNNVOJUZɩ FGPVOEFSTPGUIFTVCTFRVFOUDPNNVOJUJFTEJEOPUSFQFBUUIF MFTTPOPGGBJMVSFGSPNUIFmSTUDPNNVOJUJFTɩ FZFTUBCMJTIFEUIFJSDPNNVOJUJFT on the basis of private property, freedom of contract, and free enterprise. Our TPDJFUZJTUFTUBNFOUUPUIFTVDDFTTPGUIFTFFĊPSUT If only the modern practitioners of socialism had seen their failure as quickly! Leaders of the former Soviet Union, having installed a system of monopoly government ownership of capital in their own country, succeeded in exporting their ideas to Eastern Europe, China, and scattered outposts in "GSJDB BOE -BUJO "NFSJDB ɩ FTF FYQFSJNFOUT JO OPOFOUFSQSJTF FDPOPNJD systems have proven to be failures. In Figure 4, we use the Index of Economic Freedom as a way to assess the degree to which an economy can be considered free enterprise (or conversely, OPOFOUFSQSJTF ɩ FJOEFYSBUFTDPVOUSJFTBSPVOEUIFHMPCFBDDPSEJOH to their degree of freedom of enterprise, accounting for such things as the extent of business regulation, the amount of government interference in markets, tax levels, restrictions on international trade, and the degree of private property Figure 4:
Index of Economic Freedom (higher values indicate greater economic freedom) Source: Heritage Foundation and the Dow Jones and Company, Inc. Index of Human Freedom, 2010.
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FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
rights protection. Consistent with the discussion of the past chapters, the greater the degree of economic freedom a country permits, the greater the amount of income per person it tends to generate over time. Another striking indication of the failure of socialism is in the former country of East ...the greater the degree of Germany. Following the tragedy of World economic freedom a country War II, East and West Germany followed permits, the greater the TIBSQMZEJĊFSFOUQBUITɩ F4PWJFU#MPD XIJDI amount of income per person installed a socialist economic system, absorbed it tends to generate over time. UIFFBTUɩ FXFTUFTUBCMJTIFEBGSFFFOUFSQSJTF economy. While East and West Germany started at the same level with much in common – the same people, the same language, the same heritage – over nearly 60 years the two separate economic systems generated vastly divergent outcomes. At the time of the collapse of communism in the early 1990s, East Germany found itself in economic ruins with income per person running at only about one-third of that of West Germany. As Figure 5 shows, enormous strides IBWFCFFONBEFTJODFVOJmDBUJPO XJUIFBTUFSO(FSNBOZOPXHFOFSBUJOHBWFSBHF wages that are 78% (up from 49%) of that in western Germany. Finally, Figure Q SFnFDUTUIFIJHIFSTUBOEBSEPGMJWJOHJOFBTUFSO(FSNBOZJMMVTUSBUFECZ the dramatic increase in the availability of hot water, central heating, telephone TFSWJDFBOEPUIFSBNFOJUJFTUIBUPDDVSSFEJOUIFmSTUZFBSTBGUFSVOJmDBUJPO Figure 5:
Source: Easterlin, R. and Plangol, A. “Life satisfaction and economic conditions in East and West Germany.” Journal of Economic Behavior and Organization, 68, 2008, pp. 433-444.
27
COLORADO COUNCIL FOR ECONOMIC EDUCATION Figure 6:
Source: The Economist. September 30, 2000, pp. 25-38.
Finally, we see in Table 2 that the former Soviet Union was unable to sustain economic growth over time. Its growth rate declined substantially in the 1980s, prior to its collapse. Since World War II, the former Soviet economy was unable to keep pace with economic growth in the U.S. economy. It is easy to see why socialism failed. With the government owning FWFSZUIJOH XIP IBE UIF JODFOUJWF UP mOE OFX BOE CFUUFS XBZT UP QSPEVDF HPPETPSUPQSPEVDFBOZHPPETBUBMM "MMXPSLFSTXFSFTUBUFFNQMPZFFTɩ F government set all prices. None of the keys to free enterprise success existed; failure was inevitable.
Economic Fascism Economic fascism is even more widespread than socialism. Many of the economies of Latin America and Africa adopted this economic system. To see how economic fascism operates, consider again our car wash. If we wanted to start a car wash in a fascist system, we would begin by getting government approval – lots of government approval.
28
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH Table 2:
Economic Growth: U.S. and U.S.S.R. (1951-1990) Time Period 1951-60 1961-1965 1966-70 1971-75 1976-80 1981-85 1986-90
Average Annual Growth Rate (%) U.S.S.R. U.S. 7.2 3.5 4.4 5.0 4.1 3.4 3.2 2.7 1.0 3.7 0.6 3.1 -4.1 3.2
Source: Robert C. Stuart and Paul A. Gregory. ɩ F3VTTJBO&DPOPNZ Past Present and Future, Harper Collins College Publishers, 1995, p. 35, and Bureau of Economic Analysis. Survey of Current Business, August 2000.
Hernando de Soto, the great Peruvian political economist, has written about what it takes to start a business in his own heavily regulated country. A myriad of permits must be obtained; bribes must be paid. He estimated that it cost more than $1,200 – at that time, roughly the equivalent of two years wages for the average Peruvian worker – to obtain permission to start a small business. De Soto compares this to the requirements just across the border JO$IJMF XIJDITIJGUFEUPBGSFFFOUFSQSJTFTZTUFNJOUIFFBSMZTɩ FSF starting a new business required a permit costing $10; the process of getting government approval took only about a week.9 It is easy to see that in a system PGFDPOPNJDGBTDJTNPVSDBSXBTIXPVMECFVOMJLFMZUPFWFSHFUPĊUIFHSPVOE 5PVOEFSTUBOEXIZTPNFDPVOUSJFTDIPPTFUPTUJnFDPNQFUJUJPO XFNVTU see how self-interest works in a system of extensive government involvement in the economy. Suppose you owned an established car wash in an economy in which everyone was accustomed to extensive government regulation. You XPVMEIBWFBIFBMUIZBQQSFDJBUJPOPGQSPmUToZPVSPXOQSPmUTJOQBSUJDVMBS 9
de Soto, H. ɩ F0UIFS1BUI 1989, Basic Books, NY. 29
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To protect your profits, it would be sensible to arrange to have the HPWFSONFOUNBLFJUEJċDVMUGPSBOZOFXDBS washes to get started. You would lobby for ...it is competition that MFHJTMBUJPO NBLJOH JU EJċDVMU GPS OFX mSNT LFFQTQSPmUTMPX to enter. You might even bribe government PċDJBMT XIP JO B IJHIMZ SFHVMBUFE TZTUFN DPVME TBZ iZFTw PS iOPw UP OFX FOUFSQSJTFT"GUFSBMM JUJTDPNQFUJUJPOUIBULFFQTQSPmUTMPX,FFQJOHPVU DPNQFUJUJPOXJMMLFFQZPVSQSPmUTIJHI 0G DPVSTF ZPV XPVMEOU DPVDI ZPVS FĊPSUT JO TVDI UFSNT :PV XPVME speak of the need to have an orderly marketplace to protect the public from VOTDSVQVMPVTDPNQFUJUPST:PVNJHIUFWFOQFSDFJWFZPVSFĊPSUTJOUIPTFUFSNT #VUUIFSFTVMUPGZPVSQBSUOFSTIJQXJUIHPWFSONFOUPċDJBMTXPVMECFUPCMPDL DPNQFUJUJPOBOECPPTUZPVSPXOQSPmUT ɩ BUJTUIFUSBHFEZPGFDPOPNJDGBTDJTN A system of extensive government controls A system of extensive XPSLTUPJOTVMBUFBIBOEGVMPGFTUBCMJTIFEmSNT government controls works from competition. Freed of the discipline of to insulate a handful of competition, firms charge high prices, pay FTUBCMJTIFEmSNTGSPN MPX XBHFT BOE FBSO FOPSNPVT QSPmUT 'PS competition. the handful at the top, this is an enormously lucrative system. For the rest of the population, it is a sentence of grinding poverty.
ɩ F&OEPG/PO&OUFSQSJTF ɩ F MBTU TFWFSBM EFDBEFT IBT TPVOEFE XIBU NBZ CF UIF EFBUI LOFMM GPS non-enterprise economies. People all over the world are beginning to realize that Adam Smith was right. Free enterprise creates wealth. Non-enterprise assures poverty. People who were forced to live under socialism scrapped it when given the freedom to do so. Virtually every nation that had been socialist before 1990 has discarded socialism and is functioning as a market economy. Cuba and North Korea appear to be the only pure socialist nations standing against this tide; but in the recent past even these stalwarts have made movements towards liberalization. 30
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
In Latin America, the recognition is growing that economic fascism is a GBJMVSFɩ FPMEFYDVTF UIBU-BUJO"NFSJDBJTQPPSCFDBVTFUIF6OJUFE4UBUFT is rich, has been thoroughly discredited by the dazzling success of small, once poor, free enterprise economies such as Hong Kong, Taiwan, Singapore, and South Korea. First Chile and now Brazil are leading the way in Latin America in casting aside the bureaucratic controls of economic fascism. ɩ FTUSVHHMFGPSGSFFFOUFSQSJTFJTBEJċDVMUPOF/POFOUFSQSJTFJTBGBJMVSF – except possibly for the people who happen to be part of the ruling elite. For UIFN JUJTBDPNGPSUBCMFTPVSDFPGHSFBUXFBMUIBOEUIFZXJMMmHIUUPNBJOUBJO it. But it is a struggle that the ruling elites of non-enterprise economies are sure to lose. People cannot be held down in needless poverty forever. Imagine, for a moment, a world of free enterprise. It is a world in which people advance their wealth only by serving the interests of others – not by seizing the fruits of other people’s labor. It is a world in which everyone stands to gain by the advancement of everyone else. It is a world in which war as a policy tool no longer makes sense. It is a world of unprecedented prosperity for ordinary people. And it is a world we can achieve!
31
COLORADO COUNCIL FOR ECONOMIC EDUCATION
32
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Chapter 7:
economic crisis and promise
a
OZPOFXIPSFBEUIFOFXTQBQFSPSUSJFEUPmOEBKPCEVSJOHUIF(SFBU Recession of 2008 – 2009 or during its aftermath, recognized that the HMPCBMFDPOPNZXBTVOEFSHSFBUTUSFTTɩJTBDLOPXMFEHFNFOUSVOTDPVOUFS to the ideas presented in this monograph. If free enterprise is such a superior FDPOPNJDTZTUFN IPXDBOJUHFOFSBUFTVDIBQPPSPVUDPNF ɩ FSFBSFNBOZ possible responses, from denial that the outcome resulted from an imperfection in the free enterprise system, to placement of the blame squarely on politicians. 0VSBQQSPBDIJTEJĊFSFOU8FSFDPHOJ[FUIBUUIFGSFFEPNJOIFSFOUJOBGSFF enterprise system opens the door for periodic crises and downturns. To some EFHSFF UIF(SFBU3FDFTTJPOSFnFDUTUIJTMJNJUBUJPOPGBGSFFFOUFSQSJTFTZTUFN Does this mean that the system should be rejected? Not in our opinion. ɩ FGSFFFOUFSQSJTFTZTUFNJTOPUQFSGFDUɩ FTZTUFNTPVUDPNFJTBOFYQSFTTJPO of human desires and needs. Sometimes in the pursuit of those ends people make mistakes. No individual or group of people is infallible. Most of the time those mistakes do not compound into widespread crisis. Investor Bob may buy BiTVSFCFUwTUPDLUIBUCFDPNFTXPSUIMFTTUXPEBZTMBUFSɩJTIBSNT#PC CVU the damage applies mainly to Bob. Manager Anna may buy materials just as EFNBOEGPSIFSQSPEVDUQMVNNFUT"OOBTmSNGBJMT IFSFNQMPZFFTCFDPNF unemployed, but the economy does not collapse. Unfortunately, at other times harm does compound. Homeowner Sally may buy a Unfortunately, if the timing house right before home prices crash. Her is wrong, individual bad loss when added to the losses of many others decisions can compound and in similar situations spirals into a loss for spiral into global problems. builders, bankers, and the stock market. Almost everyone is harmed. Unfortunately, if the timing is wrong, individual bad decisions can compound and spiral into global problems. A free enterprise system does not preclude this spiraling aggregate harm. 33
COLORADO COUNCIL FOR ECONOMIC EDUCATION
Isn’t this an argument for some other system? No. Every economic system is prone to human-based failings – all economic systems are human-based systems. As long as people make mistakes, economic systems will occasionally experience Economic crises occur in free crisis. As evidence, consider the collapse enterprise systems and every of the planned Soviet economic system or other economic system. the currently failing planned North Korean economy. Economic crises occur in free enterprise systems and every other economic system. However, from the evidence linking economic freedom to QFS DBQJUB JODPNF XF LOPX UIBU PUIFS TZTUFNT PĊFS UIF SJTL PG DSJTJT XIJMF QSPNJTJOH MPXFS MFWFMT PG QFS DBQJUB JODPNF ɩJT NBLFT UIF DIPJDF FJUIFS to accept a free enterprise system with the promise of high living standards and the occasional risk of system failure, or to accept another system with UIFTBNFSJTLPGGBJMVSFCVUUIFSFBMJUZPGNVDIMPXFSMJWJOHTUBOEBSETɩJT is not much of a choice. While not perfect, the promise of the free enterprise system is better than the promise of other systems. It seems that the free enterprise system is the worst economic system “except for all other forms that have been tried from time to time” (with apologies to Winston Churchill).
Exploring the Current Crisis Even though we do not conclude that the recent crisis should lead to a rejection of the free enterprise system, it is still worthwhile exploring the sources PGUIJTDSJTJTɩJTFYQMPSBUJPONBZIFMQUIFSFBEFSVOEFSTUBOEUIFDPNQMFY nature of economic relationships that drive modern economic functioning. While this brief discussion cannot explore all possible causes of recent economic problems, this discussion highlights several main contributors.10 5P CFHJO JU NVTU CF VOEFSTUPPE UIBU B IPVTF OPU POMZ TBUJTmFT NBOZ consumer wants, but it is also the primary store of wealth for most households. "TXJUIBOZmOBODJBMBTTFU UIFTPVSDFTBWBJMBCMFUPGVOEUIFQVSDIBTFPGBO asset are a driving force behind purchases. During the years leading to the surge in housing prices, the cost and availability of funds for purchases dramatically changed. Primary to these changes were the increases in global liquidity driven by Federal Reserve actions and economic growth in Asia. With the rapid growth 10
ɩ PTFXJTIJOHBGVMMFSFYQPTJUJPOBSFFODPVSBHFEUPSFBE%F#PFS %ɩ F(FOFTJTPGB$SJTJT 2008 (available for download at http://www.ccee.net/newsletters.htm). For a much more extensive discussion, please see the government’sɩ F'JOBODJBM$SJTJT*ORVJSZ3FQPSU(available for download at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/content-detail.html). 34
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH Figure 7:
Source: Federal Reserve Bank of St. Louis
of China and other Asian economies during the past decades came markedly higher levels of personal income and savings – savings in search of a secure outlet. Asian economies found safe haven in developed western economies, resulting in UIFSBQJEJODSFBTFPGmOBODJBMnPXTJOUPUIF6OJUFE4UBUFTEFQJDUFEJO'JHVSF 7. Compounding this expansion in liquidity from foreign savings, the Federal 3FTFSWFJOUIF6OJUFE4UBUFTGVSUIFSFYQBOEFEMJRVJEJUZUPPĊTFUUIFFĊFDUTPG UIF%PUDPNSFDFTTJPOPG TFF'JHVSF ɩ FDPNCJOBUJPOPGIJHIHMPCBM Figure 8:
Source: Federal Reserve Bank of St. Louis
35
COLORADO COUNCIL FOR ECONOMIC EDUCATION Figure 9:
Source: Federal Reserve Bank of St. Louis
savings and loose Federal Reserve monetary policy acted to lower the average 30-year mortgage rate by more than two percentage points from 2000 to 2005 (see Figure 9). By itself this would tend to drive up the demand for housing. Compounding the effect of high levels of liquidity in the mortgage market, the environment constraining lending decisions changed markedly from 1995 to 2005. First, government policy surrounding mortgage lending changed. Revisions to the Community Reinvestment Act in 1995 and 1999 allowed and encouraged the government sponsored enterprises Freddie Mac and Fannie Mae to invest in the secondary market for subprime mortgages. Second, as the government was encouraging more lending at the risky end PGUIFNPSUHBHFNBSLFU UIFmOBODJBMTFDUPSTBXBOFYQMPTJPOJOTPQIJTUJDBUFE mortgage-backed financial derivatives. The key to these new financial instruments is that they were an outgrowth of the computing and information technology revolution of the 1990s. Prior to the late-1990s, the inexpensive computing power required to bring mortgage-backed derivative securities to UIFUFSUJBSZmOBODJBMNBSLFUTEJEOPUFYJTU8JUIGBMMJOHQSJDFTGPSDPNQVUJOH QPXFS OFX mOBODJBM JOTUSVNFOUT XIPTF SJTL XBT QPPSMZ VOEFSTUPPE XFSF brought to market. In hindsight, it is clear that these instruments were NJTQSJDFE CVUJUXBTPOMZUIFMFTTPOTUBVHIUCZUIFmOBODJBMDSJTJTUIBUNBEF UIJTBQQBSFOU4JNQMZQVU UIFmOBODJBMTFDUPSNBEFTJHOJmDBOUNJTUBLFTBSPVOE new, technology-driven products. 36
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
'JOBMMZ SFHVMBUPSZQSBDUJDFTDIBOHFEEVSJOHUIJTFSBPGOFXmOBODJBMQSPEVDUT Partially, the deregulatory ethos that drove airline travel deregulation (to mostly HPPE FĊFDUT EVSJOH UIF $BSUFS BENJOJTUSBUJPO DPOUJOVFE JOUP EFSFHVMBUPSZ FĊPSUTPWFSUIFmOBODJBMTFDUPSEVSJOHUIFBENJOJTUSBUJPOTPG#JMM$MJOUPOBOE George W. Bush. Compounding this systemic movement towards deregulation, UIFOFXUFDIOPMPHZESJWFOmOBODJBMEFSJWBUJWFQSPEVDUTXFSFQPPSMZVOEFSTUPPE CZSFHVMBUPSTɩ BUXIJDIUIFZEJEOPUVOEFSTUBOE UIFZDPVMEOPUSFHVMBUF )FODF UIF mSTU TUFQ UPXBSET UIF SFDFOU DSJTJT XBT ESJWFO CZ HSPXUI JO liquidity. Building on this, the price surge changed individual behavior. Rising IPNFQSJDFTESFXTQFDVMBUPSTUPUIFNBSLFUTPUIFZDPVMEinJQwBIPVTFɩJT speculative behavior was not new, but the scale of the activity was. How could TPNBOZOFXQMBZFSTFOUFSUIJTNBSLFU ɩ F easy answer is that growth in liquidity allowed ɩFmSTUTUFQUPXBSETUIF GPS TJHOJmDBOUMZ HSFBUFS TQFDVMBUJWF BDUJWJUZ recent crisis was driven by than the markets had traditionally seen. growth in liquidity. Beyond this, non-speculator homeowners also DIBOHFEUIFJSCFIBWJPSɩ FSFXBTBESBNBUJDTVSHFJODBTIPVUSFmOBODJOH In other words, as home prices surged homeowners borrowed against their SJTJOHFRVJUZɩJTQPTFTOPQSPCMFms while home prices are rising, but turns against homeowners when prices fall. When the housing price bubble burst in late 2006 (Figure 10, p. 38), many homeowners found that they owed more on their mortgage than their homes were worth. By summer 2011 almost onequarter of all mortgages were “underwater,” with loan balances greater than home market value.11ɩ FTFDIBOHFTJOUIFIPVTJOHNBSLFUGPSNFEUIFTFDPOE step in the crisis. ɩ F mOBM TUFQ DBNF XIFO UIF NBSLFU GPS UIF OFX TPQIJTUJDBUFE IJHIMZ leveraged derivative mortgage-backed products, which had become so widely owned throughout the financial industry, collapsed. Why did so many individuals and institutions buy these products? Because the risk of a housing NBSLFUDPMMBQTFXBTVOEFSFTUJNBUFE BIVNBONJTUBLF
UIFQSPmUTQSPWFEUPP attractive to ignore. Additionally, the government provided another push by revising the 1933 Glass-Steagall Act to allow commercial bank and investment bank activities to become intertwined. With this change coming only in 1999, UIFmOBODJBMTFDUPSBOEJUTSFHVMBUPSTTJNQMZEJEOPUIBWFTVċDJFOUUJNFUPBEKVTU 37
COLORADO COUNCIL FOR ECONOMIC EDUCATION Figure 10:
Source: Federal Reserve Bank of St. Louis
their behavior to the new market conditions prior to the rapid fall in housing prices. As housing prices declined and the mortgage-backed securities market QMVNNFUFEBTXFMM mOBODJBMJOEVTUSZMPTTFTTQJSBMFEPVUPGDPOUSPM BOEMFOEFST – both commercial and investment – became increasingly averse to making new loans. As lending activity dried up, liquidity contracted, reversing the process PGFYVCFSBOUFYQBOTJPOBOEUIFFDPOPNZFYQFSJFODFEQBJOGVMDPOUSBDUJPOɩ JT makes the recent recession the fault of rapidly changing government policy compounding human mistakes that were fueled by high levels of market liquidity. "OVOMJLFMZDPOnVFODFPGFWFOUTUIBUXFXFSFVOGPSUVOBUFUPFYQFSJFODF Because of the extent and nature of the contraction (see Figure 11), the recovery was slower than past recessions. Worse, the economy currently faces challenges from many sources ranging from retiring baby-boomers to domestic budgetary DSJTFTUPQPMJUJDBMVODFSUBJOUZJO&VSPQFɩ JTNBLFTBOZBUUFNQUUPQVTIUIF FDPOPNZUPXBSESBQJEFYQBOTJPOVOMJLFMZUPCFTVDDFTTGVMJOUIFOFBSUFSNɩ F recent crisis and the sluggish economic recovery show all indications of being the start of long-term economic challenges.
11
CoreLogic. Q1 Negative Equity Report, 2011.
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FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Fortunately, the Great Recession came at a time when the U.S. economy enjoyed one of the highest per capita income levels in the world and at a time XIFO64JODPNFMFWFMTXFSFDMPTFUPBOBMMUJNFIJHI TFF'JHVSF ɩ FTF strengths come thanks to the economic system under which we live – the free FOUFSQSJTFTZTUFNɩJTTZTUFNJTOPUJNNVOFGSPNUIFCVTJOFTTDZDMF CVUJTB TZTUFNXIJDIPQFOTUIFEPPSGPSTJHOJmDBOUXFBMUIBOEJODPNFDSFBUJPO Figure 11:
Source: Federal Reserve Bank of St. Louis
Figure 12:
Source: Federal Reserve Bank of St. Louis
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FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Chapter 8:
ten myths about free enterprise
t
he theoretical appeal of free enterprise seems so great that it is hard to believe anyone would reject it. When you compare it to non-enterprise, JU CFDPNFT NPSF EJċDVMU TUJMM :FU NBOZ QFPQMF SFNBJO VOFBTZ BCPVU GSFF FOUFSQSJTF ɩBU EJTDPNGPSU NBZ TUFN GSPN TPNF CBTJD NZUIT BCPVU GSFF enterprise systems. Here are ten of the most common.
Myth 1: Free Enterprise is Based on Greed ɩ FSFBSF BTXFIBWFTFFO UXPUIJOHTXSPOHIFSF'JSTU TFMGJOUFSFTUOFFE not be greedy. Second, self-interest is an inherent character trait of human CFJOHTɩ FWJSUVFPGGSFFFOUFSQSJTFJTUIBUJUDIBOOFMTTFMGJOUFSFTUJOUPUIF service of others. Pope John Paul II , in his encyclical on free enterprise systems, accepted self-interest as a basic fact of human nature, and argued that an economic system must respond to it: ɩFTPDJBMPSEFSXJMMCFBMMUIFNPSFTUBCMF UIFNPSFJUUBLFTUIJTGBDUJOUP account and does not place in opposition personal interest and the society as a whole, but rather seeks ways to bring them into fruitful harmony. 12
Myth 2: Adam Smith is Irrelevant to Today’s World People often accept Smith’s logic of a competitive economy in which prices channel self-interest to the service of everyone’s interests. But then they add something like, “Of course, that was just true of the 18th century. Today, the FDPOPNZJTEPNJOBUFECZMBSHFmSNT BOEUIFDPNQFUJUJPOPOXIJDI4NJUIT logic relies does not now exist.” 12
Ninth Encyclical. Centesimus Annus, May 1991. 41
COLORADO COUNCIL FOR ECONOMIC EDUCATION
/POTFOTF ɩ F XPSME UPEBZ JT DMPTFS UP TBUJTGZJOH UIF SFRVJSFNFOUT PG Smith’s competitive ideal than it was when Smith was writing. Extraordinary advances in transportation and communication have transformed the world into a global economy, one in which new competitors can pop up literally from any corner of the globe. It is a mistake to look back to the 18th century world PGTNBMMmSNTBOEFRVBUFUIBUUPBDPNQFUJUJWFFOWJSPONFOU3FNFNCFSUIF WJMMBHFCMBDLTNJUI ɩ FQISBTFJTBMXBZTTUBUFEJOUIFTJOHVMBSoOPUiWJMMBHF CMBDLTNJUITwɩ FSFBTPOJTUIBUNPTUWJMMBHFTIBEPOMZPOFCMBDLTNJUI)F was a monopolist; high transportation costs to the next village blocked his competition. Today industrial giants like U.S. Steel have replaced the village blacksmith. It faces far more competition than the village blacksmith ever dreamed of – from companies large and small in the United States and from companies in Germany, China, Japan, Russia, India, South Korea and Brazil, Japan, South ,PSFBoWJSUVBMMZFWFSZXIFSFɩ FXPSMEJTGBSNPSFDPNQFUJUJWFUPEBZUIBO it ever was. Figure 13:
Source: U.S. Census Bureau. Economic Census of the United States, 2011. 42
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
.ZUI1SPmUTJO'SFF&OUFSQSJTF$PNFBUUIF Expense of Wages ɩF TBNF JOWFTUNFOU UIBU JODSFBTFT QSPmUT BMTP JODSFBTFT QSPEVDUJWJUZ and therefore increases wages. To think otherwise is to be guilty of zeroTVNUIJOLJOHoUIBUPOFNPSFEPMMBSPGQSPmUNFBOTPOFMFTTEPMMBSPGXBHFT Successful enterprise creates new opportunity and new wealth. It creates more EPMMBSTPGQSPmUBOENPSFEPMMBSTPGXBHFT Karl Marx was perhaps the most famous person to commit this error. He UIPVHIUUIBUQSPmUTDBNFBUUIFFYQFOTFPGXBHFTBOEUIBU PWFSUJNF DBQJUBMJTUT would receive a larger and larger share of income. It would come at the expense of wages, so workers would receive a smaller and smaller share. History has proven Marx wrong. A century ago, workers received two-thirds of total income while owners received one-third. As Figure 14 shows, the ratio of labor income UPUPUBMJODPNFIBTSFNBJOFEDMPTFUPUIJTWBMVFPWFSBMPOHQFSJPEPGUJNFɩBU is, as the economy grew over time the total compensation of workers and the total income of capital owners grew at almost exactly the same rate. Figure 14:
Source: U.S. Census Bureau. Economic Census of the United States, 2011.
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Myth 4: Free Enterprise Creates Poverty ɩJTTVSFMZRVBMJmFTBTUIFNPTUQSFQPTUFSPVTPGUIFGSFFFOUFSQSJTFNZUIT Poverty has been the norm throughout the history of mankind. It was the emergence of free enterprise that succeeded in largely eliminating poverty in the countries that chose free enterprise. Of course, poverty continues to exist even in free enterprise economies. Ability, enterprise, luck, and health are not distributed equally among people, nor are incomes. Some people, therefore, have not done as well and will continue to do less well than others. However, research by David Dollar and Aart Kraay demonstrates that a primary force in alleviating the most severe global poverty BOE JUT BUUFOEBOU TVĊFSJOH JT FDPOPNJD HSPXUI "OE UIF TZTUFN UIBU CFTU generates growth is the free enterprise system. Most people agree that those who do well should help those who do less XFMMɩ FSFTVMUJTUIBUJOBMMGSFFFOUFSQSJTFFDPOPNJFTCPUIQVCMJDBOEQSJWBUF FĊPSUTFYJTUUPIFMQUIFQPPS1PWFSUZJTBQSPCMFNJOBMMFDPOPNJFT CVUJUJTB vastly smaller problem in free enterprise economies. Figure 15:
Share of the Population Living in Severe Poverty (Less than $1 per day) 80 70 60 50 40 30 20 10 0 2
3 4 5 6 Economic Freedom Index (1 least free, 10 most free)
7
Source: Economic Freedom of the World, 2000, and Human Development Report, 2000. 44
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Myth 5: Consumers in Free Enterprise are Manipulated by Wasteful Advertising ɩJT JT BDUVBMMZ UXP NZUIT JO POF 'JSTU UIBU BEWFSUJTJOH JT XBTUFGVM Second, that consumers are manipulated by it. If advertising is wasteful, it does not waste very much of U.S. income. While advertising expenditures in the various media were just over 2 percent of our nation’s total output in recent decades, it is interesting to note that the fraction of output devoted to advertising is lower now than in earlier periods. Sellers spent well in excess of 3 percent of total output in the early 1900s.13 Is that small share spent on advertising a waste? Imagine an economy XJUIPVUBEWFSUJTJOH$PVMEOFXmSNTFOUFSJOUPDPNQFUJUJPO $PVMEXFIBWF started our car wash? How, except through advertising could we have informed potential customers of our existence? Clearly without advertising there would CFGFXFSOFXmSNTBOEGFXFSOFXQSPEVDUT ɩJOL PG UIF NBKPS OFX DPOTVNFS QSPEVDUT ...without advertising there of the last decades: personal computers, XPVMECFGFXFSOFXmSNT microwave ovens, or digital video disc players. and fewer new products. Would any of these products have been introduced without advertising being available to let us know of their existence? Advertising may seem excessive to us at times, but it is what makes markets more competitive than they otherwise would be. Comparisons of markets with and without advertising have consistently shown that it results in lower prices to consumers because it promotes competition.14 As for the proposition that consumers are manipulated by advertising, we NVTUBTLIPXUIFTFFĊFDUTTIPXVQJOUIFNBSLFUQMBDF*GDPOTVNFSTBSFDPFSDFE into buying things, does it mean that they are somehow forced to spend more of their income on consumption than they otherwise would? If that is what manipulation means, then it clearly does not exist. Consumers spend about 90 percent of their after-tax income on consumer goods and services, just as they did a century ago, long before television and radio changed the face of advertising. 13
Walters, S. Enterprise. Government and the Public. NY: McGraw-Hill, 1993, pp 304-5. For example, Lee Benham reports that he found eyeglass prices were 25–30 percent higher in TUBUFTXJUIUPUBMBEWFSUJTJOHCBOTUIBOJOTUBUFTXJUIOPSFTUSJDUJPOTPSPOMZXFBLSFTUSJDUJPOT iɩ F &ĊFDUPG"EWFSUJTJOHPOUIF1SJDFPG&ZFHMBTTFT wJournal of Law and Economics, October 1972). 14
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COLORADO COUNCIL FOR ECONOMIC EDUCATION
If the manipulation argument means we are forced by advertising to buy QBSUJDVMBSQSPEVDUT JUJTEJċDVMUUPJNBHJOFIPXUIBUXPVMEXPSLɩ FSFJTOP FWJEFODFUIBUBEWFSUJTJOHPGBQBSUJDVMBSQSPEVDU TVDIBTCFFS IBTBOZFĊFDUPO total consumption of beer. It is clear that advertising can get us to try a particular brand of beer. Suppose it convinces us to try it and we don’t like it. Could BEWFSUJTJOHQFSTVBEFVTUPSFNBJOMPZBMDPOTVNFST ɩ BUTFFNTIJHIMZVOMJLFMZ Do you continue to buy products you regard as inferior just because they are advertised? If that were the case, we would still see Studebakers being sold.
Myth 6 - Free Enterprise Destroys the Environment We see lots of environmental damage in free enterprise systems, but if you SFBMMZXBOUUPTFFFOWJSPONFOUBMEBNBHF WJTJUBOPOFOUFSQSJTFFDPOPNZɩ F air in some cities in Eastern Europe was dirtier under non-enterprise economic systems than the air in any other cities on Earth. ɩ FDFOUSBMQSPCMFNXJUIFOWJSPONFOUBMSFTPVSDFTJTUIBUJUJTEJċDVMUUP assign property rights to them. Who owns the air? Who owns the ocean? 8IPPXOTUIFDMJNBUF #FDBVTFPXOFSTIJQDBOOPUCFFBTJMZEFmOFE JUNBZ prove difficult for private markets to solve environmental problems. But, as brief ly ɩFDFOUSBMQSPCMFNXJUI described in Box 2, the government’s creation environmental resources is of property rights to pollute has shown rather UIBUJUJTEJċDVMUUPBTTJHO QSPNJTJOHSFTVMUTJOEFBMJOHXJUIUIJTEJċDVMU property rights to them. problem.
Myth 7: Free Enterprise Economies Exploit the Less Developed Nations If an economy is less developed, it is probably not a free enterprise economy. Its poverty is not the result of the choice of others to be free enterprise economies, but because of its own choice not to be a free enterprise economy. ɩ FCFTUUFTUPGUIJTQSPQPTJUJPOJTUPMPPLBUUIFDPVOUSJFTUIBUIBWFFYQFSJFODFE UIFHSFBUFTUJODPNFHBJOTJOUIFMBTUZFBSTɩ FDPNNPODIBSBDUFSJTUJDPG these rapidly growing economies – Taiwan, South Korea, China, India – is that they opened themselves to international trade; primarily this trade was XJUIXFBMUIZGSFFFOUFSQSJTFFDPOPNJFTMJLFUIF6OJUFE4UBUFTɩ FZHSFXBT 46
FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH Box 2:
Tradable Pollution Permits Several alternative government policies for dealing with pollution exist, CVUPOFBQQSPBDIUIBUJTOPXXJEFMZWJFXFEBTBDPTUFĊFDUJWFXBZUP keep the environment clean is the use of tradable pollution permits. We can apply our simple demand and supply diagram from Chapter 5 to see how this method might work. In the Figure below, the Environmental Protection Agency (EPA ) sets a quantity of pollution by issuing a chosen number of pollution permits – each permit authorizing a given amount of pollution per time period. In this case, the supply curve for pollution SJHIUTJTWFSUJDBMBUUIFRVBOUJUZPGQFSNJUTJTTVFECZUIF&1"ɩ FMFWFMPG demand (and position of the demand curve) now determines the price of a QPMMVUJPOQFSNJU BTEFQJDUFEJOUIF'JHVSF)FODF mSNTOFFEJOHQPMMVUJPO permits in order to produce their product must pay price P for each unit of pollution required. Since businesses are interested in increasing their QSPmU UIFZBSFBMXBZTPOUIFMPPLPVUGPSDIFBQFSXBZTUPQSPEVDFUIFJS product. If a new technology becomes available that allows production XJUIMPXFSMFWFMTPGQPMMVUJPO BmSNDBOSFEVDFJUTEFNBOEGPSQPMMVUJPO permits (assuming the new pollution reduction technology is a cheaper alternative than buying the required number of permits). As the demand declines over time, the demand curve shifts left and the price of pollution permits falls. In the next year, the EPA can then reduce the supply of permits issued, moving the supply curve leftward and again raising the QSJDFPGQPMMVUJPOɩJTIJHIFSQSJDFUIFONPUJWBUFTCVTJOFTTFTUPmOE XBZTUPSFEVDFQPMMVUJPONPSFFċDJFOUMZ Price of Pollution
Supply of Pollution Permits
P
Demand for Pollution rights Q
Quantity of Pollution 47
COLORADO COUNCIL FOR ECONOMIC EDUCATION
a result of these connections. Non-enterprise economies that avoided these interconnections remained mired in poverty. One need only think back to the example of North Korea to prove this point.
Myth 8: Free Enterprise Economies Promote Materialism Free enterprise systems certainly enhance material wealth. Does that lead to an obsession with material goods? Sabina Muller, an art teacher and mother of two children in the former East Germany, made an interesting comment about this claim. You know, we were raised in the G.D.R. (East Germany) to think that Westerners are evil capitalist materialists. But the truth is, people in the East are the real materialists. When your shops are always empty, when you have to stand in line for an orange, when you wait ten years for a lousy car, you spend your life obsessed with things. 15 Materialism is always a danger, whether in free or non-enterprise economies. *UJTBTQJSJUVBMCBUUMFUIBUXFBMMNVTUmHIU CVUJUJTIBSEMZUIFSFTVMUPGGSFF enterprise.
.ZUI$BQJUBMJTUT3FDFJWF1SPmUT CVU Don’t Produce Anything We became imaginary capitalists when we went into the car wash business. 4VQQPTFXFXFSFTVDDFTTGVM%PZPVSFBMMZUIJOLUIBUPVSFĊPSUTJOUIJOLJOHPG the idea of starting a car wash, organizing the workers, securing the location, mOEJOHUIFDVTUPNFST SVOOJOHUIFCVTJOFTT SJTLJOHGBJMVSFXFSFXPSUIMFTT 8FSFXFNFSFQBSBTJUFT MJWJOHPĊUIFIBSEXPSLPGPVSFNQMPZFFT ɩ FOPUJPOUIBUUIFPSHBOJ[FSTPGBCVTJOFTT UIFPXOFSTPGJUTSFTPVSDFT contribute nothing to its well-being is silly. Suppose all the capitalists got up and MFGUoBMPOHXJUIBMMPGUIFJSDBQJUBM8PVMEXFCFCFUUFSPĊ 8PVMEXPSLFST be more productive? Would wages rise? 15
ɩ F.BSHJO, November/December 1990, pp. 58-9.
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FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Myth 10: A Better Middle Way Exists ɩ JTOPUJPOPGBiNJEEMFXBZwJTPOFPGUIFNPTUEFTUSVDUJWFNZUIT*UBMMPXT JUTQSPQPOFOUTUPmOEUIJOHTUIFZEPOPUMJLFBCPVUGSFFFOUFSQSJTFBOEUPUIFO BTTVSFVTUIBUTPNFPUIFSVOEFmOFEFDPOPNJDTZTUFNXPVMEQFSGPSNCFUUFS Having done that, they reject free enterprise. But what would such a middle way be? Should we seek a “less-enterprise system?” One in which people are enterprising, but not so enterprising as in free enterprise? ɩ FSFBSFNBOZWBSJBUJPOTPOUIJTUIFNFɩ FFDPOPNJFTPG+BQBO 4XFEFO Germany, Canada, and the United States all have their own special features. But they share in common a system of free enterprise, a system in which individuals are free to make choices with their privately owned resources. *UJTFBTZUPmOEUIJOHTXFEPOPUMJLFBCPVUPVSGSFFFOUFSQSJTFFDPOPNZ and it is only proper that we should strive to make those things better. But, before we dismiss our system, we should do two things. First, we should identify what alternative we prefer. Is there a non-enterprise system somewhere that appeals? Where is it? What are its strengths and weaknesses? Simply saying that one does not like our current free enterprise system accomplishes nothing. We must specify what would be better and why. Finally, we must be able to show that it would work. To the present, this has not been done. Second, we should reflect on what free enterprise has meant to us, personally. How has it made us richer? Not just richer in material wealth, but in the satisfaction we receive from our lives and our families. In doing this, we must not make the mistake of thinking that we are not rich because we do not have as much money as William Gates III , the founder of Microsoft®. We must take a global perspective. In that perspective, nearly everyone in the United States is rich, and we have free enterprise to thank for this wealth. How lucky we are that those early Pilgrims recognized the error of a non-enterprise system. How lucky we are that generations of Americans have resisted the appeals of economic fascism. How lucky we are that our economic freedoms, as well as our political freedoms, have been preserved.
How lucky we are that our economic freedoms, as well as out political freedoms, have been preserved. 49
COLORADO COUNCIL FOR ECONOMIC EDUCATION
Our free enterprise system is not some idle abstraction. It is an essential part of our heritage as Americans – in much the same way as our civil rights BSFQBSUPGPVSIFSJUBHFɩJTIFSJUBHFCMFTTFTVTXJUIVOQSFDFEFOUFEXFBMUI ɩ FGSFFEPNJUHJWFTVOMPDLTPVSDSFBUJWFFĊPSUTJOUIFTFSWJDFPGPUIFST"T the rest of the world catches on to this simple truth, it is just as important that we understand it as well. It is one of our most precious assets – a heritage that is ours to enjoy and ours to protect.
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FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
CCEE’s Economics and Personal Finance Education Services for Teachers and Students •
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“A splendid booklet which states in very clear and eloquent terms the case for free enterprise.” —Milton Friedman, Nobel Laureate Economics
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