Prices enable the producers to satisfy not just random wants and desires of consumers, but they show the entrepreneur which wants and desires are most urgent. They help consumers ration goods; they stop people from taking too much. They allow each of us to adjust our own personal plans and integrate them into the greater whole. All this is done without a central planner. No one person, computer, or government bureau can set and then constantly adjust prices better than the market. Additionally, the price is itself economical. It is just a single number. Yes, prices are truly amazing.

Perhaps the most important aspect of the price system is that it is the mechanism by which we are able to calculate efficiency. To make an economy function efficiently, we need to be able to compare the relative scarcities of all the different goods and services in an economy. Without such knowledge, we have economic chaos. Prices allow us a basis of comparison.

How do we measure the scarcity ratio between apples and oranges without a common denominator? In a barter economy with two goods, there is only one ratio that needs to be considered. In an economy with three goods, there are three ratios. With four goods, there are six ratios; and with five goods, there are ten ratios. In a complex economy like ours, there are too many ratios to count.

However, in an economy that uses money, all we have to do is compare prices. They quickly show us the relative scarcities. If the price increases, the item is becoming scarcer. Not only does the price tell us if the item is becoming more or less scarce, it also tells us by how much. A 1 percent change is different than a doubling of the price. Since each item’s relative scarcity is expressed as a price, no one has to know all the relative scarcities of the various inputs unless he wants to look. In a world of barter, I would need to keep in my head the relative scarcity ratio between my toothbrush and magnesium. In a world of prices, we don’t have to know the price of magnesium unless we want to know. By simply looking at prices and comparing costs, entrepreneurs are able to calculate economic efficiency.

Suppose an entrepreneur wants steel in his production process; he would have to bid it away from an already profitable use—its opportunity cost. When every factor of production is devoted to its most profitable use, the economy is running efficiently and consumers are getting the goods they value most highly. Suppose that an entrepreneur has an idea for a new business. He would then look to see if the price at which he could sell the good on the open market would exceed the costs. If it would and he could make a profit, then he’d start the business. However, if it looked as though he wouldn’t be able to cover the costs, then the market would be telling him that the resources were currently employed in a more efficient manner and that he shouldn’t divert them to his idea. If he did, the resources would be employed in producing goods consumers would find less useful. It is this mechanism of economic calculation that is too often overlooked, especially when it comes to matters of environmental economics.

Environmentalists say we need to take account of the true cost of driving. That is absolutely true. However, that means the full cost, which includes the unseen alternatives forgone. Durable goods yield services through time, and when considering the costs of such goods, we need to discount future values. This is necessary to get the true value of the good, because present goods are more valuable than future goods.

To explore this concept, I came up with a problem: calculating the true cost of a hybrid car. This is basically an annuity problem. You have a large upfront cost followed by a slow and steady stream of cash into the future. So the real question is, how long will it take for the savings from the hybrid’s fuel efficiency to make up for the upfront costs?

Let’s look at the popular 2007 Honda Civic Sedan Hybrid and compare it to the nonhybrid version. The Civic Sedan’s average price is $17,760; the hybrid’s average price is $22,600, a $4,840 difference. Next we need to check the miles per gallon claimed for each car. The Civic Sedan gets 35 mpg, the hybrid 50 mpg. If the average person drives 15,000 miles per year, then the savings is 128.57 gallons a year, or $424.28 a year (assuming gasoline at $3.30 per gallon). Before we discount for the future, we see that it will take over 11 years to make buying the hybrid worthwhile. When we include a reasonable discount of 3 percent, the number grows to 14.5 years.

How can this be? Is it a simple rigging of the numbers, or is this the case with all hybrids? I have compared these 2007 models: Honda Accord Sedan, Ford Escape, Toyota Camry, Toyota Highlander, Nissan Altima, Saturn Aura, Saturn Vue, Lexus GS Sedan, and Lexus RX 400h with their respective hybrids. Under the best assumptions of 15,000 miles a year, a discount rate of 3 percent, and gasoline prices of $3.30 per gallon, the best hybrid was the Saturn Aura, with five years till payoff, and the worst was the Lexus GS Sedan, with over 100 years. (See table.)

“Dust to Dust”

When comparing the environmental footprint of a hybrid with a nonhybrid vehicle, we need to look at the total picture, the footprint from “dust to dust.” The costs of the resources and the costs of disposal need to be compared to the benefit from the use of the vehicle. A hybrid car uses gasoline and an alternative power source, such as a battery. There are some nasty chemicals that go into making these fuel-efficient cars that also create some nasty waste byproducts. So the disposal of the batteries also needs to be taken into account; this phase is also a part of the total “ecological footprint.” While hybrids may be more fuel efficient in terms of gasoline consumption, there may be offsetting effects in the creation and disposal of the battery. And if we are considering a completely electric car, then we also need to consider the generation of the power to the outlet when we plug it in the wall.

When the full picture is examined, hybrids do not look quite as good as the environmental lobbyists would have us believe. According to the “Dust-to-Dust Automotive Energy Report” by CNW Research (http://tinyurl.com/2h976h), the average energy cost per mile for the top ten hybrids (2006 models) is $3.65. The average for the industry is $2.95. (I happily report that my Chevy Monte Carlo is $1.61 and my wife’s Saab 9-3 is at $1.64 per mile.) The Prius, Civic, Accord, and Escape hybrids are $2.87, $3.40, $3.42, and $3.54, respectively.

To efficiently use resources, we want the best combination of least-cost technology. Suppose a family is growing and badly needs a bigger vehicle. Surely a hybrid would be better than a minivan or SUV, right? Don’t run out to the hybrid dealer just yet. The average energy cost for upper-midrange SUVs like the Hummer H3, the Saab 9-7X, and the Range Rover Sport is $2.43 per mile, well below the hybrids, and the average for minivans is even better: $2.23 per mile. If we want to be good to the environment, we need to use resources wisely. The price system shows us how to act so we don’t waste resources. When people naturally minimize costs, they are conserving resources. No governmental interference is necessary.

Some of my students point out that a tax credit helps offset the price differential of a hybrid, thus lowering the cost to the owner. While true, the credit doesn’t negate the evasion of the economic-allocation problem. It merely masks it. Just because the consumer does not bear the burden of bidding resources away from more profitable uses doesn’t mean those resources aren’t being misdirected.

Environmental economics is a fascinating field. It attempts to assure that people confront the full costs of their decisions about what to produce and what to buy. Better than any government bureau, the price system communicates which methods of production are least costly. If we want to be environmentally friendly, all we need do is follow the market and compare total costs. The market abhors waste.

Individuals surely strive for efficiency; to the best of his knowledge, each person attempts to economize resources, time, and energy in the pursuit of goals, and each necessarily puts higher values before lower ones. As Israel Kirzner suggests, if all we wish to claim when we say the market is efficient is that it lets individuals coordinate with others in pursuit of their personal aims, then that claim is unobjectionable. The problem is that many economists, unrealistically assuming equilibrium and perfect knowledge, think there’s more to the claim. You can see this when they assert that the market directs resources to their best, or highest-valued, use.

To a methodological individualist this should be troubling. “Best” to whom? If I choose between using a quantity of gasoline to run my lawnmower and to drive to the park, it makes sense to say that my choice indicates my highest-valued use of the gasoline. At any given time, I have a scale of values that is revealed by what I do. If I drive to the park I demonstrate that, at the moment of choosing, I prefer that to a mown lawn.

But we can’t use this kind of analysis with more than one person. What’s a higher-valued use of the gasoline: my driving to the park or your mowing your lawn? There’s no answer to that question because more than one value scale is in the picture and no way exists to rank the two activities. If that’s true for two people, it’s no less true for 285 million people. There is no social value scale to consult. The idea that there is such a scale lies at the heart of collectivism.

The price system won’t get us out of this difficulty. If you outbid me for the gasoline, requiring me to forgo the park and enabling you to mow, we cannot say that you value the mowing more than I value the recreation. Why not? Because there is no unit with which to measure value, or utility, and thus no basis for comparing such things between individuals. What we can say is that I prefer whatever else I plan to buy with the money to time in the park, and you prefer a mown lawn to whatever else you could have spent the money on. (We could both discover we’re mistaken.) But those are separate intra-personal value comparisons and so do not violate methodological individualism.

We can also say that rising prices for resources tend to encourage individuals to postpone or cancel their (personal) low-priority projects, which frees the resources for other individuals’ (personal) high-priority projects. That may be mistaken for a shift to socially “higher valued” uses, but it isn’t the same thing.

(For more, see Roy Cordato, “Free Markets and ‘Highest Valued Use,’” Ideas on Liberty, May 2000, online at www.fee.org/vnews.php?nid=4623.)

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So much bad public policy comes out of the belief that the needs of the individual and the needs of the community clash. Nonsense, writes Arthur Foulkes.

It’s tough being unemployed, but that’s no reason to portray oneself as a victim and capitalism as the victimizer. Gary McGath explains why.

The war in Iraq brought calls for a resumption of the military draft. Aeon Skoble demonstrates why that would be a big mistake.

It’s a popular notion—and there are clichés to prove it—that those on the money side of a transaction are superior to those on the goods and services side. Gene Callahan exposes the faulty economics in that thinking.

A town in Denmark is a textbook model at turning industrial waste into valuable resources—and government planners had nothing to do with it. Pierre Desrochers has the details.

There’s a population problem after all. But it’s not the one the environmental lobby has warned of for the last 30 years. Jim Peron spells it out.

Thanks to government, we have reformulated gasoline. Michael Heberling wants to know how many more gifts like this we can stand.

Students of the Austrian, or subjectivist, approach to economics know that a precursor to that approach was developed by the School of Salamanca in late-sixteenth and early-seventeenth-century Spain. Norman Barry reports on the passing of an eminent scholar of the School of Salamanca.

As the success of America demonstrates, private property, though much disparaged, is indispensable to freedom. The late congressman Howard Buffett knew this well, as he shows in a classic reprint from 1956.

Here’s what our columns cover this month: President Richard Ebeling demonstrates that FEE is needed more than ever. Donald Boudreaux discourses on free trade. Burton Folsom documents President Andrew Johnson’s respect for the Constitution. Charles Baird draws lessons from the Washington, D.C., teachers-union scandal. And Shikha Dalmia, after mulling over the claim that culture needs taxpayer subsidies, remonstrates, “It Just Ain’t So!”

Coming under scrutiny in our book-review department are volumes on the Great Depression, the Jews in Germany, cities, and the “common good.”

—Sheldon Richman

This criticism is unwarranted, though understandable. Efficiency is a tricky concept. Once it is understood what economists mean when they refer to efficiency, it becomes clear that it is a much broader, and more desirable, goal than many people realize.

Technical versus Economic Efficiency

People often think of efficiency as an objective ratio of inputs to outputs. For example, they sometimes argue that the internal-combustion engine is inefficient because only a small percentage of the energy in the gasoline is converted into motion. Furthermore, the argument continues, it is possible to build engines that convert a larger percentage of gasoline energy into motion. But such objective measures of technical efficiency are meaningless by themselves because they leave out the relative values people place on things, values that are necessarily subjective. Even the argument that the internal-combustion engine is inefficient depends on valuing motion, which people do. But motion is not the only thing they value. For example, much of the energy in gasoline is converted into heat, some of which can be channeled inside the car. So even if all the energy in gasoline could be converted into automotive motion (which it can’t), people in cold climates would be willing to sacrifice some of this technical efficiency to heat their cars. This reduction in technical efficiency would increase economic efficiency, which involves making marginal sacrifices of one thing (motion) to obtain marginal increases in something people value more (heat).

One might argue that we should make engines as technologically efficient as possible since, even if we did, there would still be enough heat generated to warm a car. But this ignores the subjective value people place on lots of things that must be sacrificed to increase technical efficiency. Sure, new engines might convert more of the energy in gasoline into motion, but doing so would require diverting resources away from producing other things of value. Long before technical efficiency was maximized, the marginal cost of improving that efficiency would exceed the marginal value. This would reduce economic efficiency because it requires sacrificing more value (marginal cost) than is realized (marginal value).

Fortunately, market prices provide the information and motivation required to achieve economic efficiency. For example, engine producers increase profits by improving the technical efficiency of engines until the marginal revenue from the improvement declines to the marginal cost. Since marginal revenue tends to reflect how much consumers value additional improvement, and the marginal cost reflects the value of the goods and services sacrificed to make additional improvement (since input prices reflect their value in alternative uses), engine producers increase their profits by improving engines only as long as they add more value than is sacrificed. That’s not technically efficient, but it is economically efficient because it increases the total value realized from scarce resources.

Our discussion of economic efficiency should provide comfort to those who worry that we are wasting resources by using more than we need. We do use more of some resources than we need, but that is not wasteful if it allows us to create more value. In the engine example, using additional gas in technically inefficient engines frees resources to create more value than the gas is worth. This is not fundamentally different from leaving a light on in the bathroom because I am watching an exciting golf match on TV, something many would say is wasteful. But it’s not! Sure, I’m using more electricity than I need, but by doing so I’m using my time for something I value more than the electricity I could save. (If not I would have left the program and turned off the light.)

Electricity provides another good example of increasing economic efficiency by doing something easily seen as wasteful. Almost 20 percent of the hydroelectricity used in the United States is produced by pump-storage, the use of electricity to pump water uphill into a reservoir so the water can be released to generate electricity. It takes significantly more electricity to pump the water uphill than is generated when the water runs back downhill, so pump-storage is clearly not technically efficient. But pump-storage is widely used because it increases economic efficiency and avoids waste. The value of a kilowatt of electricity depends on when it is available. Late at night, additional electricity is worth much less than it is during the day and into the early evening. So electricity can be used to pump water uphill from midnight until early morning with little value sacrificed. That lost value is more than made up by the value of the electricity produced by releasing the water during the day when electricity is very valuable. Pump-storage reduces the amount of electricity available to consumers, but it increases economic efficiency and reduces waste by shifting availability from periods when it is worth less to periods when it is worth more.

Freedom and Efficiency

People often argue that wide-ranging government restrictions on our freedom are necessary to promote efficiency. But economic efficiency is impossible without freedom because it is not the narrow concept many accuse it of being. It is about increasing value as determined by the diverse and subjective preferences of hundreds of millions of individuals. The only way people can effectively communicate information about their values to those best able to respond is through the freedom to engage in market transactions for whatever and with whomever they choose. This freedom, for example, allows a person to take what seems to be a less-productive (and lower-paying) job than he could have because he enjoys the work, or prefers the location, or feels a duty to care for elderly parents, or numerous other reasons that can be fully known only to those faced with the particular tradeoffs involved. The freedom to take the lower-paying job, and to make any other choice in a free market, is essential for economic efficiency because value is determined by far more than just money and narrow material considerations.

Law and economics, or the economic analysis of law, is a relatively new discipline. It was launched in the late 1950s and early 1960s and has grown in importance and in the number of its practitioners ever since. It uses key principles of economics—such as self-interest, rationality, efficiency, and externalities—to predict the intended and unintended effects of different legal rules and to explain why we have the particular legal rules we do and why some legal rules might be considered better than others. Aaron Director and Ronald Coase, to whom the book is dedicated, and Judge Richard Posner, to whom the author refers in several chapters, have been major contributors to the field.

David Friedman is an economist and a professor of law at the University of Santa Clara School of Law. This book is one of his best efforts. His style makes it great fun to read, and it is filled with intriguing insights. Because of its comprehensive scope, it could easily be used as a text in an introductory course in law and economics. For example, it includes a chapter on antitrust law that I wish Joel Klein and Judge Thomas Penfield Jackson had read before they proceeded to punish Microsoft for being too effective a competitor.

Friedman’s early chapters explain basic economic concepts vital to understanding law. A transition chapter explains the structure of the American legal system, and the later chapters apply economics to the analysis of such things as criminal law, tort law, contract law, and marriage, sex, and babies. One especially interesting chapter is devoted to a law-and-economics analysis of three alternative legal systems—saga-period Iceland, eighteenth-century England, and Shasta County, California.

Law’s Order is more than an introductory text, however. For example, in Chapter 5 Friedman goes far beyond the usual exposition of the Coase Theorem. He illuminates the differences between property rights and liability rights and how the choice of efficient rules depends on such things as the free-rider problem among joint buyers and holdouts among joint sellers. A reader is well advised to read this chapter carefully, with pencil and paper at hand since it is basic to much that comes later.

Friedman introduces each new concept with an actual or hypothetical example that puts the reader in the center of the issue. Frequently, he comes to what seems a reasonable conclusion and in the very next paragraph he explains why it is wrong. In one case, the issue of whether, on efficiency grounds, we need criminal law at all, he goes through seven rounds of arguments changing his answer each time. He offers this “as evidence of how risky it is to go from the existence of an argument for the efficiency of some particular rule to the conclusion that the rule is in fact efficient.” It is also an effective expository device because it engages the reader. I tried to anticipate the arguments in each round before I read them. I was often wrong, but I learned something useful every time.

Judge Posner is famous for his conjecture that the common law, which develops over time through judicial precedents and decisions, consists of legal rules that are, for the most part, economically efficient. Friedman gives many examples—for example, the negligence doctrine in torts—consistent with Posner’s conjecture, but he also gives a few—such as product liability rules—that aren’t. Posner’s great contribution, according to Friedman, has been to direct attention to the question of economic efficiency in the law. “We do not know whether the law is efficient. We do know that the question ‘What is the efficient legal rule?’ converts the study of law from a body of disparate doctrines into a single unified problem.”

The book is filled with elegant, instructive arguments. Consider just one. Burglary, Friedman argues, should be a tort rather than a crime, and denting a fender should be a crime rather than a tort. The basis of those startling assertions is the incentive for potential victims to undertake efficient preventative measures. In tort law, successful plaintiffs are made whole through compensatory damages. In criminal law, victims do not receive compensation. If the penalty is a fine, it is the state that receives the money, not the victim. If the penalty is imprisonment, the victim suffers an additional loss in taxes to pay for the incarceration. Therefore, potential victims of crimes are more likely to undertake efficient prevention measures than are potential victims of torts. Preventative measures are more effective for dented fenders than burglaries. Under the general rule that incentives should be placed where they do the most good, denting a fender should be a crime, and burglary a tort.

Finally, the book has no footnotes and very few references. Friedman and his publisher have set up a Web site for his readers to obtain the missing information online. Friedman chose this option to make the book more user-friendly for the intelligent layman who will read it for general information and entertainment rather than as an academic resource. Icons in the margins of the hard copy point to corresponding online icons. I think this bit of entrepreneurship will pay off and thus become widely imitated.

Charles Baird, a professor of economics and the director of the Smith Center for Private Enterprise Studies at California State University at Haywood, is a quarterly columnist for Ideas on Liberty.

The political benefits of federalism as a mechanism for dispersing and restraining governmental power are well understood by students of public policy. Often overlooked, however, are the economic benefits.

Take the federal government’s Community Oriented Policing Services (COPS) program. The COPS program has been the subject of much criticism since its inception in 1994. This criticism, recently repeated in a front-page Wall Street Journal story, usually focuses on the questionable claim that the program will add 100,000 new officers to the streets and the dubious proposition that communities will retain the newly created police positions as the federal government phases out its financial support. The efficacy of the program is indeed questionable, but the quibbling over the precise number of police officers added by COPS ignores the fundamental issue of whether the program should have been created in the first place. Critics seem to have overlooked the fact that COPS misallocates scarce resources that communities or individuals could have put to more highly valued uses.

Traditionally, municipal policing has been a local issue, with state and federal assistance limited to purposes such as capturing criminals in interjurisdictional flight and specialized forensics, like DNA testing. That is, policing is primarily the domain of city and county officials who levy local taxes to finance it. Placing the responsibility for local policing on local officials is sensible because they are more aware of crime conditions than state or federal officials and are better able to judge their constituents’ willingness to pay for additional police protection. Local officials have an incentive to compare the improvement in community safety from additional officers to the cost of financing them through local taxes.

Hence, federalism, by providing for a division of labor among different levels of government, serves to enhance economic efficiency because local officials have better knowledge of their constituents’ willingness to pay for policing or other services than do state or federal officials.

COPS, however, weakens the link between hiring additional officers and local willingness to levy taxes to pay for them. A community’s cost of hiring an additional police officer is greatly reduced because three-fourths of the program is funded from federal revenues. Consequently, even if a community has what it considers to be an adequate police force, COPS induces it to hire an additional officer at only one-fourth the usual cost. It is a bitter irony that this affront to federalism, which moves Congress yet another step closer to becoming, in the words of Bloomington, Minnesota, police chief Bob Lutz, “the gigantic city council of the United States,” is foisted on the public under the name “Community Oriented Policing Services.”

Since no community solves or prevents all its crimes, communities might benefit from obtaining the additional police officer since that officer might deter or solve crimes that otherwise would have occurred or gone unsolved. This, however, does not mean that the benefit of the additional officer outweighs his cost. Since the community does not bear the full cost of the officer, it may add an officer to handle low-priority items like jaywalking and traffic enforcement. This results in the misallocation of society’s resources: Local officials choose not to hire an officer if they must pay his entire salary and expenses, but they do hire the officer when they have to pay only 25 percent of his cost. Since communities bear such a small share of the cost of an officer, even an officer assigned to low-priority duties might be considered worthwhile by local officials.

Consider Floyd County, Georgia, the home of Berry College. Floyd County has nine federally funded officers and receives a grant in excess of $600,000 over three years. While these officers have undoubtedly captured some real criminals and deterred other would-be criminals, the Floyd County “C.O.P.S. Unit 1998 Annual Report” touts the following accomplishments:

• Conducted 37 training programs in local schools, contacting 3,515 students.
• Participated in eight church events involving 128 people and providing security for a crusade held at the local civic center.
• Assisted 11 local charity events for, among others, the Special Olympics and Muscular Dystrophy Association.
• Sponsored a youth baseball team, the “Bullets.” (This politically incorrect name must drive gun-control advocates nuts.)
• Established the Floyd County Police Youth Boxing League.

Local citizens might consider these worthwhile, perhaps even high-priority, policing activities. But if that’s the case, then the local officials should have ample political support for locally funding the additional officers.

Can’t Raise Taxes?

This reveals another possible argument for federal funding of local police: Local communities need additional police officers, but for some reason local officials are either politically unable to raise taxes to fund such officers or too ignorant to realize that the benefit of additional officers would outweigh their expense. Putting aside the rank paternalism present in this line of reasoning, it is apparent that this contention is false. Local officials, at least those in Floyd County, have not seemed constrained in raising taxes to pay for questionable things such as subsidizing a hotel construction project or building a municipal golf course. It strains credulity, especially given the public’s near hysteria about crime in recent years, to believe that local officials are politically able to raise taxes for such projects but are unable to pay for local policing.

Rather than alleviating a dearth of police officers, COPS causes local police departments to proclaim how desperately “underfunded” they are, thereby creating an artificially high demand for police officers. That local requests for COPS grants exceeded available funds, as COPS Director Joseph Brann boasted in a 1997 letter to the General Accounting Office, does nothing to prove that local communities are somehow politically constrained from directly funding community policing. It simply indicates—no surprise here—that communities will queue up to receive free money from Uncle Sam.

While some local officials would no doubt argue that they are just trying to get back what their communities paid in federal taxes, this argument is specious because if all communities got back what they paid in federal taxes there would be no point in sending the funds to Washington in the first place. And since the contention that communities are only getting back what they paid disregards the bureaucratic overhead and the stipulations requiring communities to use the grants to hire unnecessary police officers, it overlooks the real means by which COPS squanders society’s resources.