An Overview of Prices | Basic Economics by Thomas Sowell | Ch. 4

Continuing with our overview of Thomas Sowell's book, Basic Economics. We've already finished the first three chapters (Ch. 1 | Ch. 2 | Ch. 3), so now here is the fourth!

Note: Previous to this post, I had been (unknowingly) been using an older copy of the book. I am now using the fifth edition of Basic Economics.

Chapter Overview

While the title of the chapter is “An Overview of Prices”, which might seem redundant to some, in the fourth chapter, Sowell now endeavors to explain the methods and purposes of economics, namely, looking at the cause-and-effect relationships inside economies. While economics may have moral or philosophical applications, it isn't based on those principles. The application of economic principles can have a lot of consequences, and so we must take those head on.

Cause and Effect

There are many different ways causes and effects materialize in an economy.

Systemic causation poses an interesting dilemma. It is the idea that, within a system (i.e. society), there isn't just one simple cause that happens, but multiple, and even reciprocal causes. For example, buyers and sellers will adjust their demand and prices, depending on each other's supply or demand.

However, in economics, the concern is about outcome rather than intentions. For example, in many low-income neighborhoods, there are high costs for things like groceries, gas, and other store-bought goods. People often look at a situation like this, and blame 'greed' or 'capitalism' for exploiting people there. What they don't recognize is that, due to higher rates of crime and vandalism, the cost for doing business in low-income neighborhoods, including cost of insurance, security, and other legal issues, is much higher as well. If these businesses didn't charge the prices they did, they'd go bankrupt, and then move out of these neighborhoods.

So it isn't a good idea, or even true, to blame intentions like “greed” or “discrimination” for what we see in society. Instead, we need to understand economic principles and their effects, even if it doesn't feel as moral or have the same emotional hook.

Economic principles are not complicated. Even though consequences may be complex, the source can often be very basic or simple. For example, the climate, seasons, plant life, animal migration patterns, and even human psychology are all different and very complex things. Yet, each of these are inherently affected by the Earth's tilt towards the Sun—so much so that if the Earth were pointed straight “up”, we would have a completely different version of Earth. In the same way, easy-to-understand principles like supply and demand dictate how economies function, so that even if people were to put in things like price controls, these principles still apply.

Because of these cause and effect principles, there is rationality behind any given economic problem. Even decisions made by politicians and bureaucrats, whom many like to lambast as “stupid” or “ignorant”. This is primarily because incentives generally govern human behavior. And when different incentives exist between different institutions, a person who was successful in one area (e.g. business) may not necessarily be in another (e.g. politics).

A point brought up in an earlier chapter—Russia is one of the most resource-rich countries in the world. However, in the Soviet Era, many local Russian officials kept food from moving freely around their local boundaries, so as to keep food prices artificially low, and thus win political support for themselves. This resulted in rotting food surpluses in their locales, while other areas had massive food shortages. But these policies were implemented due to wrong incentive structures, not irrationality. In a free market, this wouldn't happen. As Sowell points out:

The difference is that one system involves each individual making choices for himself or herself, while the other system involves a small number of people making choices for millions of others.

Scarcity and Competition

Since everyone's desires can't be satisfied completely, competition is basically inevitable. Everyone must compete to get what they want, no matter what economic system is used. But, that system being used has a lot to say about what happens as everyone competes.

Even when we simply buy things at a grocery store, we're participating in a competition. But what prices often do is prevent this competition from being explicit. If two religious groups are wanting to build a sanctuary for worship, they are unlikely to think they are competing for the same resources through the prices with which they buy building materials. But if the government builds these sanctuaries, and then assigns them to various religious groups, that competition becomes obvious. This same idea applies to all areas of society.

In this way, prices actually empower conscious decision-making. When there is a personal cost, people will think before they act, whether what they're doing is a waste or not. Price controls, subsidies, and even luck or corruption don't actually remove cost. Instead, they allocate that cost to intangibles that still have real manifestations, like bread lines and wait lists.

We're often torn between two choices, and the comparative value between them. Even in politics, when a figure says they want to “set national priorities”, it actually tells us that the thing they are focusing on has more importance, and thus value, than other things. But a government's 'categorical priorities' have more power over individual ones. Each individual knows how much some action will cost them, but an overall authority (i.e. government) who spends taxpayer's money will not necessarily count these costs individuals must make. Thus, regulation often makes situations worse in the name of good intentions.

There lots of talk today about subsidies and special tax laws or deductions. But, as given from previous chapters, we understand that prices are a simple indication of value. When people or groups (like corporations) ask for these things, even if their motives are benevolent (e.g. humanitarian help), what they're actually asking for is a forced mislabeling of value (i.e. supply and demand). When politicians act to help special interest groups—even if they have benevolent intentions—their favoring of particular groups through changing prices will create a situation that often will benefit those who are far better off than the average person, since those particular people are the ones who can take advantage of subsidies and tax laws the most.

To understand this better, and in a sense 'bring it home', we need to understand what “costs” really are. Or aren't.

When politicians campaign on bringing costs down, they're often talking about bringing the prices that consumers pay for goods and services down. But by doing this, they're often neglecting the actual costs to provide the product or service. For example, bringing down the prices which people pay for medical care doesn't bring down the cost of training doctors and nurses, building hospitals and clinics, and the millions of dollars of research that goes into medication and other medical tools.

And so, we understand that cost and prices are actually not the same thing, even when if is sold to us as such. Instead, once again, prices convey information about value, without requiring someone to know everything about the good or service they are trying to buy. As Sowell explains:

The most valuable economic role of prices is in conveying information about an underlying reality—while at the same time providing incentives to respond to that reality. Prices, in a sense, can summarize the end results of a complex reality in a simple number.

My Thoughts

I think a lot of this chapter explains itself quite well, so I won't have too much to say about it.

Competition is Key

In this chapter, Sowell again impresses on the reader how important the concept of scarcity is. I have previously redefined it to “limited access”, which I still stand behind. Here, it's primarily because I don't believe that the inability for everyone's desire to be fulfilled, which Sowell professes, is a problem of lack of resources. Rather, it seems to me to be a more spiritual malady. After all, there certainly are people who require very little of the world, and are perfectly content to live with much less than the plethora of material possessions most of us are used to. So it seems this is a trait of will, rather than a lack of resources.

Regardless of that change, it seems that both ideas result in the same outcome—namely that both scarcity and limited access result in competition. And here, at the end of the first part of the book, Sowell makes an extremely strong case against centralized control over an economy. I would even say that the ultimate conclusion being drawn is that a free market is the only real choice for an ever functioning economy.

A lot of people may balk at this. What about people and their labor being exploited? Isn't this the result of capitalism and free markets? Aren't monopolies inevitable if a market is completely free because of corporate greed?

Actually, if we sit back and think about it, this combination of ideas (i.e. free market capitalism partnered with exploitation and monopolies) may be a result of media and cultural association or expectation rather than fact. We've all seen movies, or heard of stories, like the Wolf of Wall Street or the Big Short. A lot of people walk away from these works believing that corporate greed (which is what is often explicitly shown) is what drove people to be exploited or monopolies to continue to have power over the world.

What people don't see, and what the movies don't often show, is the centralized government acts that allowed such things to happen. For example, the Big Short (one of my favorite movies of all time, by the way) is a movie about the 2008 financial disaster that led to a global recession that is still being felt today. It lays the blame on the banks and conniving real estate agents that gamed the mortgage system to earn money, while taking advantage of the average person.

But what they don't show you is the laws which incentivized such behavior. Prior to 2007, there were several laws enacted in the United States that incentivized banks and real estate agents to give out loans to people who did not show the ability to pay back these loans. These laws were proposed on the basis of helping poor and low-income people, without recognizing their inability to repay those loans. But, because the government encouraged and even gave benefits to companies and banks to do this, it was almost inevitable that they did so. And thus, the mortgage crisis happened.

Even when we look at things like slavery, we recognize that it was a problem of central governments, not the economy. Now understood by almost all economists, slavery in the United States was actually a prohibitively costly thing. Buying and selling slaves had to be balanced with the feeding and treatment of the same, in addition to whether they could or would work well. But it because the government allowed and even incentivized such practices that this immoral tradition continued on for so long.

Market Decentralization and Crypto

It's difficult to read this chapter and not think about crypto. After all, the very principles of free market and lack of price controls is what cryptocurrency (namely Bitcoin) was founded upon. The lack of need to have any central authority in order to transact is a valuable thing which we shouldn't take for granted.

Yet, there is a worry here. While the crypto markets are still growing, there seems to be a lack of awareness of centralization of another kind—whales.

In crypto, the term “whales” is used to refer to entities which have large portions of a certain currency. Because these whales have such a large portion of it, they can influence the price of those currencies through their selling or buying. This has led the entire crypto market to become almost completely correlated to one another. If Bitcoin goes up, so goes the rest of the market. When it goes down, again, so goes the rest of the market.

This is dangerous territory, and one in which I don't know how to really fix. Do we really want banks and financial institutions to step in? After all, if they do, they'll just become the new whales. Do we want federal regulations to come in? But, as demonstrated above, governments and centralized authorities are horrible at this.

The only way that this can be fixed that I can see is through DeFi stablecoin, like DAI and Kava's USDX. The price of these coins is pegged to the US Dollar, and so aren't as subservient to the buying and selling of whales. And in DeFi, these stablecoins are often the ones with the greatest interest rates across time (at least so far). But, of course, they are still pegged to a certain asset, one in which is in the control of a central government.

Thus, it may be required that there are several different kinds of stablecoins. For example, there will be those that are pegged to fiat, those that are pegged to precious metals, and those that are pegged to securities, among others. In this way, the prices of those assets are what determine the prices of the coins.

But there is another danger here. Namely, that it is easier to create a coin pegged to an asset, than it is to obtain it. There may be a scenario where many groups create coins that are pegged to the price of gold, even more than there would be gold available for people to buy. In these cases, how would this all go down?

I predict it would mean that those pegs would be diminished, just as DAI's peg, currently, has been hovering above the US Dollar for a while now (since March, actually). So this may be a tentative solution.

One thing I do know, as given by this brilliant chapter from Thomas Sowell, is that government intervention (i.e. price controls) is not the answer.