Book SummaryBasic Economics, by Thomas Sowell

1-Page Summary1-Page Book Summary of Basic Economics

What is economics? Economics is the study of the use of scarce resources that have alternative uses, and how to allocate these resources to maximize output.

There has never been enough resources to satisfy everyone completely - tradeoffs must be made on an individual and societal level. The decisions around how to allocate these scarce resources to produce the best output is the central question of economics.

Economics is not about making moral judgments about what choices are morally better than others, just as mathematics doesn't explain love.

Prices Allocate Resources

How are scarce resources allocated across an economy?

The straightforward way is for a central authority to decide what to do. In a feudal economy, the lord tells people what to grow and how to sell it. The Soviet Union operated similarly, with the government determining how much steel to produce in Bulgaria and how much wheat to be grown in Ukraine.

The problem with this method is that economies are so complex, with many millions of products and services, that allocating resources optimally across millions of items is incredibly difficult. Counterproductive incentives also arise in these centralized systems, as we’ll discuss later.

Instead of a central authority, market economies use prices to allocate scarce resources. Prices allow individuals to bid higher for goods that have more value to them. Prices connect market participants in a complex network without a central coordinator.

Prices allow producers and consumers to ignore why things are getting cheaper or more expensive - they can simply make decisions based on prices alone.

Prices provide financial incentives - profits and losses - to affect behavior in the use of resources. Losses force the producers to stop producing what consumers don’t want, thus shifting resources from wasteful to more productive activities.

Profits are the cost to society for efficiency. If profits were counterproductive, you'd see nonprofits taking over for-profit industries, or socialism providing higher standards of living than capitalism - but in reality the reverse is more likely to happen.

When prices are artificially altered relative to their natural market price, inefficiencies result, causing market distortions.

• Rent control causes artificially low prices, causing undersupply and overconsumption of housing.
• Minimum wage laws cause artificially high prices, reducing employment and increasing discrimination (since they flatten a range of workers into a single price).

Businesses

Much is said about “outsized profits” earned by businesses. They seem like unnecessary arbitrary charges added onto the cost purely to benefit the owners. But this ignores the risks inherent in creating businesses. Half of all new businesses fail in 4 years, and most former titans (like Kodak) eventually go bankrupt as they fail to adapt to changing circumstances.

Profits provide incentives for businesses to produce goods that consumers most want at the lowest cost. Without these incentives, businesses would be less efficient, producing lower quality goods with less concern for cost, as in the Soviet Union.

Furthermore, there are natural limits to the profits that can be earned - high profits in one sector encourage competition, which reduces profits and increases quality. Without this competition for profits, businesses would have less incentive to adapt to changing conditions to maximize consumer value. Business profit is the price society pays for efficiency.

Work and Pay

Labor - people’s time, energy, knowledge, and skills - is a scarce resource. Paying for work provides incentives for people to work and provides a set of constraints on employers.

Just like any other resource, pricing labor allocates scarce resources that have alternative uses. Paying engineers higher salaries than artists shifts people’s time toward engineering, where their output to society may be larger.

What determines a person’s pay?

• On the demand side, the productivity that the person is able to produce to the employer is the upper limit. A worker who added $100,000 to...

Basic Economics Summary Chapter 1: What is Economics?

Economics is the study of the use of scarce resources that have alternative uses. Examples of resources include land, labor, natural resources, and capital.

There has never been enough resources to satisfy everyone completely - tradeoffs must be made on an individual and societal level. The decisions around how to allocate these scarce resources to produce the best output is the central question of...

Basic Economics Summary Part I: Prices and Markets | Chapter 2: Allocating Resources

How are scarce resources allocated across an economy?

The straightforward way is for a central authority to decide what to do. In a feudal economy, the lord tells people what to grow and how to sell it. The Soviet Union operated similarly, with the government determining how much steel to produce in Bulgaria and how much wheat to be grown in Ukraine.

The problem with this method is that economies are so complex, with many millions of products and services, that allocating resources optimally across millions of items is incredibly difficult. Counterproductive incentives also arise in these centralized systems, as we’ll discuss later.

Instead of a central authority, market economies use prices to allocate scarce resources.

On a micro-level, each consumer and producer makes transactions with other individuals on whatever terms they can agree on. The terms often consist of prices. Even though a market economy has millions of goods with millions of prices, each party in the transaction just needs to keep track of the few prices relevant to their own decision-making, not the entire economy’s prices.

For example, a camera lensmaker doesn’t need to know the...

Basic Economics Summary Chapter 3: Price Controls

In a repeated theme in Basic Economics, a good way to see why the principles are important is to see what happens when they are not functioning.

Why is it a big problem for pricing to be disrupted? In short, because it causes misallocations of resources. But why is that a big problem? If these are just internal transfers within a closed system, misallocations of resources may seem zero sum - money goes to sugar producers when it would otherwise have gone to pig farmers.

The real losses come from misallocation of scarce resources and a reduction in the total wealth of society.

Here are three situations where artificial prices arise - centrally set prices, artificial price ceilings, and artificial price floors.

Centrally Set Prices

In the Soviet Union, prices were set not by supply and demand, but by central planners. However, as we discussed earlier, it has been historically impossible for a central authority to have detailed knowledge across millions of goods, then to set pricing optimally.

In a market economy, individuals with the most knowledge of their situation bid for resources. Prices automatically calibrate to cause resources to flow to their most...

Basic Economics Summary Chapter 4: Myths about Prices

We’ll cover a number of myths about prices and their role in the economy.

Myth: High Prices are a Sign of Greed

Many people see prices as obstacles to getting what they want. Beach-front homes in Malibu are priced at millions of dollars, out of reach of most of the country. This can be labeled in the popular press as “greed is driving up the price of housing,” as though people are charging more than the product is worth.

However, this ignores the fact that the price becomes a reality only if others are willing to pay them and if a transaction happens. One could price her phone at $5,000,000, but no one would be willing to buy at that price. Therefore, greed has little impact on what others are actually willing to pay.

Thus, high prices are not a sign of “greed” on the part of homeowners - prices merely reflect the scarcity of beach-front homes, that there are not enough beach-front homes to satisfy all of us. Different economies ration these houses differently - in a feudal economy, the lord would ration the houses by fiat, giving houses to certain people. They could also be rationed by lottery. No matter the method, **the rationing would still have to...

Basic Economics Summary Part II: Industry and Commerce | Chapter 6: Profits and Losses in Businesses

(Shortform note: we’re presenting the chapters a little out of order, starting with business profits and losses, then combining the chapters on business operations in the next Shortform chapter.)

Much is said about “outsized profits” earned by businesses. They seem like unnecessary arbitrary charges added onto the cost purely to benefit the owners. But this ignores the risks inherent in creating businesses. Half of all new businesses fail in 4 years, and most former titans (like Kodak) eventually go bankrupt as they fail to adapt to changing circumstances.

Further, the average rate of return on corporate assets before taxes is between 4-12%, and after taxes between 2-8%. This is lower than what the average guess might be.

Profits provide incentives for businesses to produce goods that consumers most want at the lowest cost. Without these incentives, businesses would be less efficient, producing lower quality goods with less concern for cost, as in the Soviet Union.

Furthermore, there are natural limits to the profits that can be earned - high profits in one sector encourage competition, which reduces profits and increases quality. Without this competition for...

Basic Economics Summary Chapters 5-7-9: Business Operations

The book explains the economics behind a number of business operations, including the role of middlemen, the cost of inventory, and executive compensation.

Changes in Markets

Businesses need to respond to a variety of changes:

• Social changes
  • In the 19th century, the majority of people lived in small rural communities, with high cost of goods to small scattered stores. Montgomery Ward operated a mail order service, delivering products at lower costs than those charged by rural stores. But as urbanization happened in the 1920s, urban department stores became more efficient, leading to the rise of JC Penney.
  • Grocery chain A&P was dominant for decades, from the 1930-50s. Located in central cities, A&P stores had operational efficiency that allowed charging lower prices. However, the automobile led to suburbanization, which led to supermarkets and their advantages of scale (including lower delivery costs per unit, and larger transaction sizes with lower overhead per $).
• Economic changes
• Technological changes
  • Rockefeller produced new products from petroleum, extracting more value and reducing the price of its main product kerosene, instead...

Basic Economics Summary Chapter 8: Monopolies, Regulation and Anti-Trust Laws

What are monopolies? Why are they harmful to economies? How do regulations stifle monopolies? All will be answered here.

In short, a monopoly exists when a specific person or organization is the only supplier of a particular good or service. Monopolies face little economic competition to produce the good, have few substitutes that consumers can use instead, and are able to price well above what an efficient market would otherwise produce.

The Cost of Monopolies

In a competitive market, consumers can take prices for granted. They know that they are not being charged outlandish prices leading to high profits for businesses - if this were really the case, competitors will soon arrive who will compete the profits down to a rate of return similar elsewhere in the economy. Water finds its level.

However, monopolies, oligopolies, and cartels reduce competition, control prices, and thus distort markets. The monopolist would earn a rate of return necessary to attract the capital required, but no competition arises to drive down prices.

The real harm of monopolies is not consumers paying more for goods - within an economy, this is simple redistribution of wealth....

Basic Economics Summary Part III: Work and Pay | Chapter 10: Productivity and Pay

Labor - people’s time, energy, knowledge, and skills - is a scarce resource.

Paying for work provides incentives for people to work and provides a set of constraints on employers.

Just like any other resource, pricing labor allocates scarce resources that have alternative uses.

• Paying engineers higher salaries than artists shifts people’s time toward engineering, where their output to society may be larger.
• Increasing compensation may extend the time before retirement, when the labor would have been spent on leisure instead.

What determines a person’s pay?

• On the demand side, the productivity that the person is able to produce to the employer is the upper limit.
  • A worker who added $100,000 to a company but asked for $150,000 in salary would not be hired. This would be unprofitable for the company.
• On the supply side, the pay other people with similar output are willing to accept is the lower limit.
  • That same worker would not be able to get a salary of $80,000, if there are other comparable workers willing to work for $60,000.

**Productivity depends not just on the worker’s internal abilities but also the worker’s...

Basic Economics Summary Chapter 11: Distortions in Labor Markets

We’ve learned that human labor is a resource like any other, and that markets price resources efficiently without the need for central control.

However, there are artificial changes to labor prices in the form of artificial floors. Minimum wage laws, mandatory benefits, job security, working conditions, collective bargaining and occupational licensing all have the same effect - they artificially increase the price of labor above what they would be in free competition. This causes a surplus of supply and less demand for labor.

Minimum Wage Laws

Even though minimum wage laws are meant to benefit workers, they can lead to increased unemployment. The real minimum wage is always zero. With artificially higher wages, employers tend to use more capital as a resource. Rather than hiring extra people, employers get more mileage through existing workers through overtime or by investing in technology to make workers more efficient.

Countries with no minimum wage laws like Switzerland and Singapore tend to have lower unemployment rates of 2-3%. Furthermore, countries with no minimum wage laws and fewer mandatory benefits tend to have shorter periods of unemployment and...

Basic Economics Summary Chapter 12: Other Problems in Labor Markets

Unemployment Statistics

Unemployment rate is usually defined as the percentage of people who are looking for jobs who are unemployed.

If the base - the number of people who are looking for jobs - decreases due to giving up or going back to school or retiring, then the unemployment rate can decrease even if the number of people without jobs increases.

Furthermore, comparisons across countries and cultures can be problematic. Countries with more generous...

Basic Economics Summary Part IV: Time and Risk | Chapter 13: Financial Investments

This part of Basic Economics deals with valuing risk and time, particularly around investments.

Investment is the sacrificing of money, goods, and services today to have more valuable money, goods, and services in the future.

Because the future is unknown, investments necessarily involve risks, which must be compensated to make it worthwhile for people to undertake the investments. This chapter covers financial investments, while the next covers other vehicles dealing with risk and time, like insurance.

Financial Investments

Examples of financial investments include bonds and corporate stock. You give money today to earn more money later.

Investments pool resources from many stakeholders to finance large projects that would not be possible with few investors. Think of a government bank selling bonds to build a hydroelectric plant, or a company raising funds to broaden access to its product. Countries without financial institutions cannot mobilize capital from a mass of individuals to make large investments, and they tend to be poorer.

Profits from banking and investments have been decried as “unearned income,” merely skimming profits off of hard labor. This...

Basic Economics Summary Chapters 14-15: Insurance, Human Capital, Natural Resources

This chapter considers other vehicles dealing with risk and time, such as insurance and human capital.

Insurance

Like speculators, insurers take on risk from individuals because they can weather individual risks by pooling large numbers.

Insurers also seek to reduce risk, charging lower prices to safe drivers and reducing premiums for losing weight. Higher prices for more risk conveys to people the costs created by their chosen activity or behavior and incentivizes them to reduce risk.

From the individual’s perspective, insurance also reduces risk - the cost of insurance has to be less than the cost of uninsured risk, otherwise the transaction wouldn’t happen. Without insurance, the higher cost must be priced into the product - thus, the cost of an insured product is lower than the cost of an uninsured product.

Insurers take money from premiums and invest - approximately 66% of life insurance companies’ income comes from premiums, and 25% from earnings on investments. Insurers aren’t just making outsized profits - competition reduces the cost of premiums to a market equilibrium.

When an entity becomes large enough, they can self-insure at cheaper rates....

Basic Economics Summary Part V: The National Economy | Chapter 16: National Output

The basic economic principles that apply to specific markets for goods also apply to national economies as a whole. The supply and demand for a nation’s output can fluctuate, just like supply and demand for a single good fluctuate.

National Output

The national output is what is produced during the current year. It is distinct from a country’s total wealth, which is accumulated across time and can be used to allow a country to live beyond its current production.

The most common measure of national output is Gross Domestic Product (GDP), the sum of everything produced within a nation’s borders.

Much is made of comparisons of GDP - how it’s changing over time, how one nation compares to another. But comparing GDP across any dimension has complications:

GDP comparisons across time have issues of changing composition of the output.

• Cars in 1950 are far less advanced than cars in the 2000, so merely comparing number of cars is misleading.
• Work compensation increasingly comes in benefits, rather than direct wages, so just comparing wages is misleading.
• Work that had previously gone...

Basic Economics Summary Chapter 17: Money, Banking, and Inflation

Money facilitates the production and distribution of wealth.

Barter of goods and services is awkward - if you make a chair, you may not want enough apples for the value of a chair, nor will the apples retain value for long. If you do accept apples, you may then need to spend time finding someone else who will trade for apples. You might also produce fewer chairs, knowing it’s difficult to get paid for your chairs.

Money allows chairs and apples to be exchanged for an intermediary thing, which can be subdivided into very small units. When people agree on what will be used as the intermediary of exchange, that becomes money. To an individual, money is equivalent to wealth only because it can be exchanged for real goods and services.

Banking

What purpose do banks serve? First, they guard money, for which they have economies of scale compared to individual businesses.

More importantly, banks supply businesses with money and lines of credit to bridge them over unpredictable drops in income and allow them to undertake large investments. Here banks also have economies of scale and risk pooling, reducing lending costs below those of their customers. In...

Basic Economics Summary Chapter 18: Government Functions

The government provides a number of functions that are highly relevant to the economy’s function.

Law and Order

Market transactions occur within a framework of rules, and those rules must be enforced for efficient economies to arise.

Economies with an unreliable legal framework, where application of the law is mercurial, increases investment risk and thus decreases the amount of investing relative to a reliable market economy. The laws don’t necessarily have to be fair - they just need to be reliable to reduce risk.

Economies with an unreliable legal framework are more likely to be corrupt, causing drag on the economy by increasing the cost of doing business and allowing bureaucrats to delay businesses. For instance, it takes fewer than ten days to start a business in Singapore, compared to 155 days in the Congo. Companies and talented people leave the country for a more hospitable place, and foreign companies are loath to hire local workers who may be dishonest.

Social Order

**Business transactions among strangers are required for successful mass economies. If people don’t trust each other, transactions don’t happen, and the cost of business increases....

Basic Economics Summary Chapter 19: Government Finance

Governments must collect resources to pay for their expenditures - the US government spent $3.5 trillion in 2013. If revenues exceed spending, then there is a budget surplus; otherwise, there is a deficit, which can add up over time to the national debt.

Government Bonds and National Debt

The national debt tends to grow with inflation, population growth, and national income growth.

The debt is better considered not as an absolute number but rather a percentage of GDP.

In some cases, a high national debt is secondary to other concerns, such as fighting World War II. However, a high peacetime national debt is troubling, since there is no reduction in spending in sight as there is in the end of war.

Generally, to pay for current benefits like the military and civilian personnel, governments use tax revenues, allowing those benefited to pay. For investment projects like highways and schools, governments sell bonds, go into debt, and essentially push the cost onto future generations who will benefit from the investment.

When these purposes are confused - **when the government goes into debt to fund current expenditures - this is as sensible as an...

Basic Economics Summary Chapter 20: The Incentives of Government

Why do politicians seem to adopt policies that seem so bad for citizens? This seems to occur regardless of the politician’s party or positions.

Here are a bevy of reasons.

In a popularly elected government, the incentive is to do what is popular and garners votes, even if the consequences are worse than those of doing nothing.

Even worse, politicians are spending taxpayer money, not their own, so frivolous spending hurts them little.

Contrast political elections with the marketplace. In the marketplace, decisions can be made 1) instantaneously 2) for individual goods and services 3) that are wholly finished. In contrast, in politics, candidates 1) are chosen only once every several years, 2) come as a “package deal” - all their stances must be accepted or rejected in whole, 3) can only convey promises, not finished accomplishments, and thus constitute speculation.

No politician wants to be smeared as being against something that people generally value, like being accused of being “soft on crime” or against child safety. However, this can lead to categorical thinking, where certain things are considered absolutely bad and must be stamped out, regardless of the...

Basic Economics Summary Part VI: The International Economy | Chapter 21: International Trade

International trade is not a zero-sum game, where one country is a winner and another is a loser. Both sides must gain, or it makes no sense to trade.

The same concepts that apply to transactions within a single nation also apply between nations. Freer trade allows scarce global resources to go towards their most valuable uses.

This may mean a loss of jobs in one sector with creation of jobs in another, but the economy is overall more efficient and the population at large benefits. Just as relaxing of interstate trucking restrictions in the US decreased jobs in railroads but created jobs in trucking in the same country, trade with manufacturers in Asia may lead to loss of manufacturing jobs but an increase in engineering or marketing jobs in the US.

There is no fixed number of jobs for countries to fight over - when countries become more prosperous, they all tend to create more jobs.

There are three primary reasons countries gain from international trade: absolute advantage, comparative advantage, and economies of scale.

Absolute Advantage

Some countries are simply more efficient at creating a good or service - due to climate, geography, or skills. Prices...

Basic Economics Summary Chapter 22: International Transfers of Wealth

Transfers of wealth between countries take several forms:

• Direct investment through stock and bond investment
• Putting money in a country’s banks, which will then issue loans domestically
• Remittances from outside workers back in to family
• Imperialists transferring wealth from nations they conquered (now more obsolete)
• Foreign aid

International Investments

Capital flows from where it is abundant and cheap (in terms of interest rates) to where it is in short supply (which can offer higher rates of return).

From a social equity point of view, ideally wealthy nations would invest much in poorer nations. However, rich countries tend to invest in other rich countries - out of $21 trillion in international bank loans, only $2.5 trillion went to poor countries. (This contradicts the claim that multinationals are exploiting Third World workers - if it were such a great deal, then American investments wouldn’t be primarily investing in other rich countries.)

In practice, poorer countries discourage investments due to high risk from unstable governments and risk of confiscation, corruption, and inadequate financial infrastructure.

Trade Deficits...

Basic Economics Summary Chapter 23: International Disparities in Wealth

The vast differences in wealth between people living in different countries can be emotionally troubling. However, Thomas Sowell argues that given the vast differences in factors underlying economies (geography, natural resources, culture), as well as the complex interaction of such factors, it is impossible to expect economic equality across the world.

Places with inherent advantages had more opportunities to develop urban industrial, commercial, and financial skills than disadvantaged areas. These advantages can kick off virtuous cycles that widen the gap.

Quick note: one study claimed that inequality is rising, because the ratio of the incomes of the top 20 vs lowest 20 nations increased from 23:1 in 1960 to 36:1 in 2000. However, this is misleading because the identity of the nations had changed - when comparing the same 20 countries in 2000, the ratio had declined to 10:1.

Relevant factors that differ between nations include:

Geography

Agriculture

• Land differs in fertility.
  • Fertile mollisols are found in the American midwest and Eurasia. They are seldom found in the tropics or sub-Saharan Africa.
• Rainfall, and even different...

Basic Economics Summary Chapters 24-25: Myths about Markets

Many misconceptions have been addressed above. We’ll summarize important ones here for good measure.

Myth: The Market as a Thing, Not as Humans

A market is just humans engaging in transactions among themselves. When it’s treated instead as a depersonified, third-party entity, rhetoric is allowed that takes away freedom from humans to transact on mutually agreeable terms.

Instead, restricting markets should be treated as subjecting humans to the will of third parties. (Shortform example: for instance, wage control laws may be seen as “preventing landlords and tenants from exchanging on the natural market price, thus leading to undersupply and increasing homelessness.”)

Myth: Profits as Gratuitious

Profits have been seen, at different times throughout history, as gratuitous overpayment beyond costs that restrict standard of living of people at large. Implicit in this is the assumption that whatever profits entrepreneurs and investors earn exceed the value they contributed.

However, it’s clear that without private property rights and financial incentives, as in the Soviet Union, living standards simply worsen. **People simply do better jobs when they have a...

Basic Economics Summary Chapter 26: A Brief History of Economics

The book ends with a brief history of how economic thinking developed over the centuries.

• 1600s-1700s: mercantilists argued that a nation should export more than it imports, causing a net inflow of gold. They equated gold with wealth. They were preoccupied with transfers of wealth and increasing the power of their own nations relative to that of other nations, not creating wealth for people at large. This supported policies like repressing wages to lower export costs.
• 1776: Adam Smith published The Wealth of Nations, conceiving of economic activity as creating wealth and non-zero-sum. He saw wealth as the goods and services that determine the standard of living, not as the amount of gold. He rejected government intervention to help merchants, believing individuals could sort out interactions with each other just fine. This built the foundation of classical economics.
• 1817: David Ricardo published Principles of Political Economy, adding rigor...