Exercise solutions for questions in “Basic Economics” by Thomas Sowell

Part I: Prices and markets

1) Can there be a growing scarcity without a growing shortage—or a growing shortage without a growing scarcity? Explain with examples.

• Definitions

  • Shortage is a temporary situation where the quantity demanded of a good or service exceeds its quantity supplied at the current market price. This is usually caused by market conditions such as a sudden spike in demand, a disruption in supply, or government intervention (like price controls)

  • Scarcity refers to the basic economic problem that resources are limited while human wants are unlimited. It is a naturally occurring, permanent condition that exists because there is a finite amount of resources (like land, water, oil, or time) to meet infinite human needs and desires

Shortage and scarcity are independent of each other. There can be shortage without scarcity and vice-versa.

• Example of shortage without scarcity:

  When rent controls are placed in the housing markets a shortage occurs even though there might be enough physical housing space available for all the people to be accommodated (no scarcity).

  This is because at low prices demand increases. People who would on the face of rising prices be forced to share housing can now afford to keep the entire place to themselves. At the same time people on the search for housing find it extremely hard to find a place.

  Clearly, this is shortage not scarcity.

• Example of scarcity without shortage

  Consider the example given in the book of the San Francisco earthquake of fire of 1906. More than half the city’s houses were destroyed causing scarcity of housing. Yet, there was no shortage.

  This was because in the absence of rent controls, prices were allowed to rise and renters left without a home had incentives to use lesser space and those with space in their homes had incentives to take in people.

  Also, rising prices increase supply. In this case the rising prices also made building new houses feasible.

2) Can a decision be economic, if there is no money involved? Why or why not?

A decision can absolutely be economic even if no money is involved. Economics is fundamentally the study of how people make choices under conditions of scarcity, which means deciding how to allocate limited resources—such as time, effort, or opportunities—not just money

Recall the example, given in the book about a military medical team arriving on a battlefield to treat injured soldiers. The team is confronted with the classic economic problem of allocating scarce resources that have alternative uses.

There are seldom enough medical staff to treat all wounded soldiers. Some soldiers might have mild injuries that might self-heal even if they aren’t given immediate medical attention, others might survive if given immediate medical attention, still others unfortunately might not survive even if given the required medical attention. The medical staff has to thus decide how best to allocate the resources at its disposal.

3) Can there be surplus food in a society where people are hungry? Explain why or why not.

Yes. When the government sets floor prices for food items it guarantees that if market prices under supply and demand caused the food price to drop below the government set price, the government will buy up what the market is unwilling to.

When prices are high, supply increases and demand decreases. Due to the artificially enhanced food prices supply increases leading to a surplus. At the same time demand decreases since people in the poorest sections of society cannot afford to buy sufficient food at artificially high prices. This causes people to go hungry while the government buys up the unsold food items that went unsold in the market under the higher prices.

4) When a housing shortage suddenly disappears, within a time period too short for any new housing to have been built, and yet people no longer have any trouble finding a vacant home or apartment, what has probably happened? What will probably happen in the longer run? Explain.

Assume that rent control laws were applicable earlier that lead to the shortage in housing in the first place.

When rent control laws are ended, housing prices are no longer kept artificially low. The ensuing price rise causes the people who were occupying much larger apartments than they actually need to shift to smaller spaces or share their apartment with renters.

Without rent control laws in the long run assuming increasing demand, prices go up. Since, increased prices lead to increased supply building new houses becomes profitable. This was not the case under rent control laws as the artificially lowered prices decreased supply of new housing as well.

5) Which of the following are—or are not—affected by price controls that limit how high the product’s price can go: (a) the quantity supplied, (b) the quantity demanded, (c) the quality of the product, (d) a black market for the product, (e) hoarding of the product, (f) the supply of auxiliary services that usually go with the product, or (g) efficiency in the allocation of resources? Explain in each case.

• a) Do price ceilings affect quantity supplied?

  Yes. Price ceilings artificially lower prices. At lower prices supply decreases.

• b) Do price ceilings affect quantity demanded?

  Yes. At lower prices quantity demanded increases.

• c) Do price ceilings affect the quality of the product?

  Yes. Artificially lowered prices under price ceilings cause an increase in the quantity demanded and reduction in the quantity supplied.

  Some items that under free market conditions would be disposed as being low quality might be continued to be sold when price ceilings are implemented. This is because the shopkeepers know that the quantity demanded is high anyway and whichever price-controlled item is on the shelf will be sold anyway. Hence, they choose to not waste time (and money) sorting the quality of the price-controlled item and choose to use their time (scarce resource) somewhere else (alternative uses).

• d) Do price ceilings lead to black markets?

  Price ceilings lead to shortages. Though it may be legally forbidden to purchase price-controlled items at a higher than set price, individuals may regardless still choose to do so since it is mutually beneficial (the seller gets to make more money while the buyer gets a way around the shortage to get the good they desire). The black market prices are usually more than the prices would have been in a free market since the legal risks also have to be compensated.

• e) Do price ceilings cause hoarding of the product?

  Price ceilings artificially lower the price of a product. This leads to increased demand and causes shortages. The shortages cause people to hoard the price-controlled stuff whenever they do come across it because of the uncertainty of getting the price-controlled good at a later point of time.

  Services usually cannot be hoarded. If barber rates were price controlled you would not cut your hair twice back-to-back so that you could go twice as long without having to visit a barber again.

  Hoarding also depends on the nature of the price-controlled good. Not all price controlled goods can be hoarded. If price controls were placed on strawberries, the shortage would be less acute since they cannot be hoarded as they are too perishable.

• f) Do price ceilings affect the supply of auxiliary services that usually go with the product

  Lower prices cause a dip in supply. Thus, when price ceilings are imposed there is a dip in the supply of auxiliary services usually attached with the product.

  For example, under rental price ceilings the maintenance and upkeep of rental properties is usually ignored because landlords no longer have to maintain the appearance of their rental properties owing to the increased demand at lower prices.

• g) Do price ceilings affect efficiency in the allocation of resources?

  Yes. Price ceilings keep prices artificially low. This means originally the demand is higher and in a free market the price would be further up than the ceiling price.

  Under the artificially lowered price, demand goes even further up and results in shortages. It might cause people with less urgent needs to consume more than they require while people with more urgent needs are left dealing with shortages.

  Consider the example given in the book where under the British government’s medical system a woman with cancer had her operation postponed so many times that the malignancy eventually became inoperable while a 12-year old girl was given a breast implant.

6) Building ordinary housing and building luxury housing involves using many of the same resources, such as bricks, pipes, and construction labor. How does the allocation of these resources between ordinary housing and luxury housing tend to change after rent control laws are passed?

Rent control laws artificially lower prices. At reduced prices demand increases and supply decreases.

Recovering the cost of building new rent controlled housing and making a profit becomes extremely hard. Hence, builders construct new properties that are exempt from rent control laws.

These are usually luxury housing and commercial buildings. Hence, even though ordinary housing and luxury housing use many of the same resources, under rent control laws building luxury housing is preferred by builders since they represent the best chance of recovering the costs of acquiring these resources and making a profit.

7) Are prices usually higher or lower in low–income neighborhoods? Why? Include among prices the interest rate on money borrowed and the cost of getting paychecks cashed.

A misunderstanding / non-understanding of the basic principles of economics leads people to characterize results of systemic causation as results of individual intention. Similar to attributing swaying of trees to an invisible spirit instead of the actual systemic cause i.e. variations in atmospheric pressure.

Prices are usually higher in low-income neighborhoods. This is not due to individual intentions (greed of people operating businesses in low-income areas). Rather, the cause in systemic.

• Higher prices in low-income neighborhoods:

  The interest rates charged by pawnbrokers and small finance companies in low income neighborhoods is higher than the rates charged by banks in middle-class communities. Check-cashing companies usually operating in low-income neighborhoods charge a fee while people in middle-class neighborhoods get their checks cashed in free of charge in their banks.

• Systemic causation for higher prices in low-income neighborhoods instead of attributing them to individual intentions:

  But instead of chalking these things up to individual greed of people keen on exploiting poor people, these must be chalked up to the simple systemic explanation - it often costs more to deliver goods and services in low-income neighborhoods.

  • Higher insurance costs and higher costs for various security precautions, due to higher rates of crime and vandalism.

  • Also, leaving aside these risk factors, even the cost of doing business per dollar in low-income neighborhoods is more. Consider a check cashing company operating in a low-income neighborhood. An armored car delivering money in small denominations to a neighborhood finance company or a small check-cashing agency in a low-income area costs just as much as an armored car delivering a hundred times as much value of money, in larger denominations of bills, to a bank in a suburban shopping mall.

• The risk of attributing higher prices in low-income areas to individual intentions (i.e. personal greed)

  Treating the causes of higher prices and higher interest rates in low-income neighborhoods as being personal greed or exploitation, and trying to remedy it by imposing price controls and interest rate ceilings only ensures that even less will be supplied to people living in low-income neighborhoods thereafter. This is a direct corollary of reduced prices resulting in reduced supply.

• Crime in low-income areas as the cause of higher prices rather than the greed of business owners

  The fraction of dishonest people in such neighborhoods are the real source of many of the higher costs behind the higher prices charged by businesses operating in those neighborhoods. But it is both intellectually and emotionally easier to blame high prices on those who collect them, rather than on those who cause them.

8) When a government institution or program produces counterproductive results, is that necessarily a sign of irrationality or incompetence on the part of those who run that particular institution or program? Explain with examples.

In the last answer we discussed about the tendency to explain things having systemic causes as things being caused due to individual intentions. The specific example of this was the tendency to attribute higher prices being charged by businesses in low-income neighborhoods to the greed of businesses operating in these areas.

But this tendency to blame individual intentions for systemic causes extends beyond greed.

For example, bureaucrats are admonished for their stupidity / incompetence when government policies go wrong. However, a closer look often shows us that these bureaucrats are in fact not incompetent. Rather, the choices they are making are quite rational in the fact of the incentives they have and the constraints they face.

For example, blaming shortages caused due to price ceilings could easily be blamed on bureaucrats tasked by politicians to handle the implementation. However, it is not the incompetence of bureaucrats that caused the shortages. It is the policy itself that caused it. There was no way another “competent” bureaucrat could have implemented price controls with differing outcomes.

9) We all consider some things more important than others. Why then can there be a problem when some official government policy establishes “national priorities”?

When an official government policy establishes “national priorities” it is saying that thing A is categorically more important than thing B. However, this is the direct opposite of incremental substitution where we recognize that both A and B are important but the amount we need of A depends on the amount of B we are willing to forego. It also depends on the amount of A and B we currently have. Incremental substitutions tend to produce more beneficial results than categorical priorities.

A price coordinated economy facilitates incremental substitution but political decision making tends towards categorical priorities.

For example, one may believe that health is more important than entertainment. But the point to consider is how much more important (incremental thinking) and not that health is categorically more important than entertainment. If it were categorically the case then having a 20 year’s worth of band-aids would have higher priority than going to a movie.

Another example is the effect of increased bureaucracy on companies. It is appreciable from a government standpoint that it wants to pass as many laws as possible to safeguard the employees from any possible risk. But at some point the costs outweigh the benefits. In this case, the companies are under more and more pressure to factor into their decision making the different legalities which can trip them for every decision they take. Here, the question is not which is categorically more important - employee safety or ease of doing business. Rather, the question should be on incremental terms. How far can a government go to ensure employee safety before the business owners feel suffocated.

10) We tend to think of costs as the money we pay for things. But does that mean that there would be no costs in a primitive society that did not yet use money or in a modern cooperative community, where people collectively produce the goods and services they use and do not charge each other for them?

• Costs in a market economy with money

  Scarce resources have alternative uses. The value placed on one of these uses by an individual or company sets the cost that has to be paid by others that want to bid some of these resources away for their own use. For a societal standpoint, this ensures resources tend to flow to their most valued uses when there is price competition in the market place.

  This does not make one good categorically more important than others. Adjustments are on the other hand, incremental. Only that amount of milk as valuable to ice cream consumers as to it is to cheese purchasers will be used to make ice cream or yogurt.

  Prices convey an underlying reality. The price of a good basically states what someone else is willing to offer for the product and what you would have to pay to bid away this product from the competitor.

• Costs without the concept of money

  From a societal standpoint, the costs of anything is the value that is has in alternative uses.

  In a market economy with money, the price that one is willing to pay for a good becomes the cost that others are forced to pay in order to get a share of the same scarce resources or the products made from these resources.

  But irrespective of the economic system used by a society or whether or not money is the medium of value exchange, the “real cost” is defined as follows: the real cost of anything is its value in alternative uses.

  The real cost of building a bridge is whatever else could have been built with that same labor and material. This is also true at the level of a given individual. The cost of watching a television sitcom or soap opera is the value of the other things that could have been done with that same time.

11) How does rent control affect the average number of persons per apartment and the average amount of time that the same persons stay in the same apartment?

Rent control causes rent to be artificially cheaper than market rates. This means even though other people are willing to bid higher prices to get these resources they are maintained at artificially lower prices.

At lower prices, demand increases and supply decreases.

Hence, the average number of persons per apartment in apartments under rent control is very less (1 or so) because people can afford the low rents even if they do not necessarily need the extra space at hand. Rent control also incentivizes low housing turnover rates since the single person living in a 2 bedroom apartment doesn’t really have any incentive to vacate the apartment due to the artificially lower prices.

12) Back in the days of the Soviet Union, the government owned and operated most of the enterprises in the economy. Most prices were set by central planners, rather than by supply and demand, and the success or failure of Soviet enterprises was judged primarily by how well they met the numerical targets for production, which were set by the central planners. Specify five ways in which this arrangement produced different economic end results from those in market economies.

1. In the Soviet Union the central planners were responsible for estimating supply and demand for millions of products and allocating resources accordingly. This task was too much to take on by a select group of people for the rest of the population.

   On the other hand, in market economies, people only need to track prices of the handful of products that they use in their everyday life. The demand and supply experience in the market drives prices up or down for various products. If demand for leather bags is falling but demand for leather shoes is increasing, the prices for leather shoes will increase. Producers wanting to cash in on the potential profits will reallocate leather meant to product bags to now produce shoes.

   In the soviet union the leather could be reallocated from bags to shoes when the central planning committee said so.

2. In market economies, companies have to bid resources away from other companies that have alternative uses for the same resource. This forces companies to economize and only order those many resources that are really required.

   In USSR, the number of resources a company acquired depended on how much it was able to convince the central planning committee. These companies were not bidding resources away from competitors. Hence, they were not forced to economize. This lead to a massive drop in the quality of life for the people of USSR even though with the amount of resources and the technology which they had they could have easily lead more affluent lives under a price coordinated market economy.

3. In market economies losses play just an important a role as profits. Losses tell producers that the resources they are using to produce their goods have more valuable uses elsewhere.

   In USSR companies and the central planning committee could continue to make mistakes until the problem of shortage of some other good that could have been produced using the same resources become acute and very noticeable. There could be millions of trouser buttons when they are barely any trousers for people to wear.

4. Socialist economies introduce more bureaucracy even for seemingly simple decisions that make the system less efficient. There is always a chain of command that things need to be run by. In a price coordinated market economy things are more dynamic, there is more competition and hence, a solution is arrived at sooner.

13) How can the price of baseball bats be affected by the demand for paper or the price of catchers’ mitts be affected by the demand for cheese?

Central point: The price which one producer is willing to pay for any given ingredient becomes the price that other producers are forced to pay for that same ingredient.

1. Catcher’s mitts and Cheese

   For example, we have cheese producers, ice-cream producers and yogurt producers. All of these products require the raw material called milk. If customer demand for cheese explodes, the price of cheese shoots up. Cheese producers will have more money to bid away milk from ice-cream and yogurt producers. So they do just that.

   Cheese producers place a higher price on milk. Now the ice-cream and yogurt producers need to match this price in order to get their own share of milk. Assume ice-cream customers are not bothered to a large extent while Jogurt customers do not want to buy Jogurt at these higher prices. Then, more of the milk meant for Jogurt will go towards cheese production than the milk meant for ice-cream production.

   Cheese producers, facing higher price and demand, bid away milk from ice-cream and yogurt producers. Then, between ice-cream and yogurt producers, those less sensitive to price changes (ice-cream customers) can match higher milk prices, while those more sensitive (yogurt customers) cannot, leading to milk being allocated more to cheese and ice-cream.

   Now, as the price of milk rises, dairy farms have stronger incentives to not slaughter cows. Rather, they are allowed to grow to maturity. Because of this, there is less cow hide available. This causes an increase in the price of baseball mitts. This is because the producers of baseball mitts have to bid higher prices to get cow hide and this translates as increased costs to produce the baseball mitts and is passed on to the end customer.

2. Baseball bats and paper

   Baseball bats and paper both require the same raw material wood pulp. If demand for paper increases, paper manufacturers can bid away wood pulp from baseball bat manufacturers. This means, baseball bat manufacturers will have to match these higher prices of wood pulp to be able to continue manufacturing the bats. This in turn means that the prices of baseball bats also rise to accommodate the higher prices of wood pulp and to leave the bat manufacturer with a profit at the end of it.

14) Why are price controls likely to cause more of a shortage of gasoline than of strawberries?

When prices are kept artificially cheaper via price controls, demand increases. This is because demand increases when prices are low.

This means, that shortages will be caused. This prompts people to hoard up the price controlled good whenever they come across it. Hence, price controlled gasoline is hoarded up.

The same logic would apply to strawberry but since strawberries are highly perishable they cannot be hoarded. Hence, a shortage also is mostly not caused.

15) How does rent control affect the quality of housing and the average age of housing? (pages 41–42)

Supply of apartments declines under rent control laws. Prices are kept artificially low and at low prices, supply declines.

Hence, even though office buildings, commercial buildings and premium housing buildings might be constructed because they are not included under rent control laws, apartment building construction declines rapidly since they are just not profitable for builders to pursue.

Also, the supply of existing apartments declines under rent control laws. The landlords no longer find it necessary to maintain apartments appropriately in order to attract tenants. This is because there is already a shortage experienced by tenants under rent control. Also, even if landlords wanted to appropriately maintain apartments, they might not be able to without themselves facing a loss. The artificially low apartment prices mean that landlords would incur a loss when they try to maintain apartments well.