Unlike the government, of course, the Red Sox organization is private and has every right to enact this measure. But, that doesn’t mean we should ignore the bad economics in action, especially since it contradicts the exact goal the organization is apparently pursuing.  By restricting the market for these seats in an attempt to make them cheaper, the Red Sox are only going to make them more expensive for most fans and increase the power of incumbent season ticket holders.

If you’re a Red Sox fan without season tickets, you had two choices: Buy a ticket the day of release (January 28) or purchase a ticket on StubHub. Both options got worse this year thanks to the new policy. Since buying the day of release was the only way to purchase $12 upper-bleacher seats, more people presumably lined up on January 28, so the odds of getting a cheap ticket were reduced.

Let’s say the tickets were sold out, and you go to StubHub to buy a ticket. The prices on StubHub will be higher, since the supply of tickets that can be resold has also been reduced. In one act the Red Sox have made it harder to buy the cheapest tickets and made the tickets available for resale more expensive. Neither of these measures helps the average fan.

Likewise, season ticket holders will now have more control over ticket distribution. In Fenway Park only a small portion of tickets are released for individual game sales. Under the model the Red Sox are promoting, these season-ticket holders will act as gatekeepers for ticket distribution. They are more likely to allocate them to close relatives or friends than individual-game ticket holders are. This will create a small group of elites with lots of tickets and make it harder for those tickets to be distributed more evenly.

In effect the Red Sox are promoting a form of a sports-ticket aristocracy. They’re nominating an elite class that gets to distribute a scarce resource by their own whims and desires in the name of public welfare. Sound vaguely familiar?

Occupy Fenway Park.

In his State of the Union address earlier this year, President Obama spoke of the need for the federal government to help boost the economy by making “investments” in a wide variety of areas, including construction jobs, high-speed rail, education, biomedical research, “clean energy” technology, and even high-speed wireless Internet access. But this “investment” is just a code word for more spending on pet programs. This will only lead to more economic stagnation, not economic recovery, because the wealth-consuming nature of public investment is fundamentally different from the wealth-creating nature of private investment. Taxpayers ignore this difference at their peril.

President Obama’s form of investment promises to “create countless new jobs for our people,” but he does not stop to ask from where the money to pay for all these new jobs will come. It must be taken from others “of our people,” either today, through tax increases, or tomorrow, through borrowing (which will harm the economy in the future and delay the ultimate recovery). Of course, taking money from taxpayers to fund these new jobs means there is less money left in the private sector to invest in new jobs and business growth.

The crucial difference between the public sector and the private sector is that the public sector cannot create wealth; it can only shift resources from one group of people to another (after skimming some off the top to placate special-interest campaign donors and support bureaucratic inefficiency, of course). In the private sector, job growth—and economic growth generally—occurs when firms create something that consumers value. In the public sector, government growth occurs whenever government can appropriate more money from the people, and these funds are directed to whatever politicians desire.

The government’s “investment” in green energy startup Solyndra Inc. is a case in point. Last May, President Obama visited the Fremont, California-based solar panel maker in a highly publicized photo-op to hail it as the kind of business in which he thinks the country should invest. And that’s just what the government did. In September 2009 the administration announced that it was awarding Solyndra $535 million in taxpayer-funded loans to finance the construction of a new solar-equipment factory. The following June, just one month after the President’s visit, the company cancelled its initial public offering, and its CEO quit the following month. In November 2010 the company announced it was abandoning its plans to expand its Fremont facility (and the planned hiring of a thousand workers) and would even have to close another factory in the East Bay, eliminating nearly 200 additional workers. That’s some investment.

Throwing Good Money after Bad

This episode did not prevent Obama from visiting another green-energy company two days after delivering his State of the Union address to tout the benefits that surely would come from investing in such technology. During his trip to renewable-energy firm Orion Energy Systems in Manitowoc, Wisconsin, Obama lamented that the United States was falling behind the investment of even more centrally planned economies: “China’s making these investments and they have already captured a big chunk of the solar market, partly because we fell down on the job. We weren’t moving as fast as we should have. Those are jobs that could be created right here that are getting shipped overseas.” While China has made great strides toward a more open economy in the past couple decades, the communist country is hardly a model for economic policy. China’s growth is due to its economic liberalization, not the arbitrary decisions of the ruling elite, yet these command-and-control elements of economic planning that remain in China seem to be Obama’s model of the ideal. This does not bode well for economic liberty and growth here in the United States.

Government has never been particularly good at picking economic winners. Consider, for example, the government “investments” in Amtrak, which has never turned a profit since it began service in 1971 and has lost about $35 billion in its 40 years of operation—or the U.S. Postal Service, which lost a record $8.5 billion last year alone and has projected an additional $6.4 billion loss this year.

The reason for this failure of government investment is not simply poor leadership (although this is certainly endemic and does not help matters) but rather an inability to determine value in the public sector. There is no market price system in government, so there is no measure of profit and loss. As Mises noted in Human Action, “There is no such thing as prices outside the market. Prices cannot be constructed synthetically, as it were.” In Bureaucracy he added, “Bureaucratic management is management of affairs which cannot be checked by economic calculation.”

Value

In a free market prices are determined by supply and demand, by changing consumer preferences, differing knowledge and evaluations of market information, and the risk-taking of entrepreneurs. A greater desire for a good or service will be reflected in consumers’ willingness to pay more for it and bid up the price.

In the political sphere “value”—such as how much to spend on a particular government program—is determined by the force and influence politicians, bureaucrats, and special interests can exert to extract money from taxpayers and divide it up as these elites please. There is rarely even any semblance of competition for the provision of these services and thus little incentive to maximize productivity and service quality or minimize costs. Since there are no price signals to reveal people’s preferences for one thing or another, there is no good mechanism to determine if programs are useful or satisfying constituent demands.

In the absence of a true market price mechanism, how do you tell if an investment is profitable? And where is the incentive to avoid unprofitable investments? If a government program is deemed successful, there are calls to provide more funding. If it is a failure, we are told we must double down on the spending in order to turn it into a successful program.

Private investment means putting your own money at risk in anticipation of realizing a gain later; public “investment” means taking and spending someone else’s money to support your idea of how you think they should live, or to satisfy the special interests that help get you reelected. Private investment requires putting off spending today so that you may (hopefully) earn more in the future; public “investment” is all about spending today.

Unfortunately, the federal government has not learned the lessons history has tried to teach us about subsidizing business and illusory job growth. This ignorance is especially on display when politicians react to the onset of a recession. The prescription made famous by economist John Maynard Keynes is to “stimulate” the economy through government spending and job creation (otherwise known as “make-work”). Never mind that this means fighting a problem of too much debt by incurring even more debt. As Freeman columnist Robert Higgs, senior fellow in political economy at the Independent Institute and author of Crisis and Leviathan, has said, “Every drunk understands this way of fighting depressions.”

Lost Decade

In the 1990s—and beyond, as it turned out—Japan faced a financial crisis as asset bubbles in the real estate and stock markets, stoked by the central bank’s expansionist monetary policy of the late 1980s, burst and prices came crashing down. The ensuing government response and policy errors paralyzed the economy and ultimately led to a series of economic recessions. Japan followed the Keynesian remedy—with disastrous results—and the country still has not recovered to this day. During the 1990s, Japan passed ten fiscal stimulus packages, focused largely on public works. When one construction plan did not work (meaning it did not return the economy to rapid growth), another was tried. Altogether the Japanese government spent about $6.3 trillion on construction-related projects between 1991 and 2008. Those plans did not revive the economy, but they did saddle the nation with a mountain of debt that postponed any recovery at all for many years, leading the period to be dubbed Japan’s “Lost Decade.”

The construction jobs for the government’s infrastructure projects were not sustainable and did not lead to systemic economic growth. Public debt skyrocketed, unemployment actually doubled, and the economy remained stagnant. (Does any of this sound familiar?) As Gavan McCormack, Pacific and Asian history professor at the Australian National University, noted in his book The Emptiness of Japanese Affluence, “The construction state is in some respects akin to the military-industrial complex in Cold War America (or the Soviet Union), sucking in the country’s wealth, consuming it inefficiently, growing like a cancer and bequeathing both fiscal crisis and environmental devastation.”

The Great Depression

Even during the Great Depression, often held up as a great example of government creating jobs to help get the nation out of an economic recession, President Roosevelt’s massive spending program, which actually had its roots in the Hoover administration, did not stimulate the economy. Despite all that spending and all those jobs programs, unemployment remained extremely high. Prior to the stock market crash in 1929, the unemployment rate stood at a little over 3 percent. By 1933, in the midst of massive spending and public-works projects, it had risen to 25 percent. Even after years of New Deal programs unemployment remained around 15 percent or higher through 1940. It was not until World War II that unemployment dropped back to the low single digits (and then only because millions were drafted into military service).

This led Henry Morgenthau, treasury secretary under Roosevelt, to make a startling admission in 1939:

We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong . . . somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises. . . . I say after eight years of this administration we have just as much unemployment as when we started. . . . And an enormous debt to boot! (Morgenthau Diary, Roosevelt Presidential Library)

The fact is that economic recessions—and even more serious depressions—need not be so severe or so long-lived. It is government policies that prevent the natural pressures and incentives of the market from purging bad investments and other economic decisions and returning to a path of stable growth. As Murray Rothbard wrote in the introduction to the third edition of his book, America’s Great Depression,

Before the massive government interventions of the 1930s, all recessions were short-lived. The severe depression of 1921 was over so rapidly, for example, that Secretary of Commerce [Herbert] Hoover, despite his interventionist inclinations, was not able to convince President Harding to intervene rapidly enough; by the time Harding was persuaded to intervene, the depression was already over, and prosperity had arrived. When the stock market crash arrived in October, 1929, Herbert Hoover, now the president, intervened so rapidly and so massively that the market-adjustment process was paralyzed, and the Hoover-Roosevelt New Deal policies managed to bring about a permanent and massive depression, from which we were only rescued by the advent of World War II. Laissez-faire—a strict policy of non-intervention by the government—is the only course that can assure a rapid recovery in any depression crisis.

After more than two and a half years and trillions of dollars worth of bank and auto industry bailouts, stimulus packages, and Federal Reserve interventions, the American economy remains sluggish and unemployment is still about 9 percent. According to Federal Reserve Chairman Ben Bernanke, it could take another four or five years for the labor market to “normalize fully.” Unless the government’s interventionist policies are abandoned and reversed, it appears that the United States is headed for its own Lost Decade.

The United States’ $14 trillion federal debt and annual deficits of over $1 trillion are reducing productivity and hindering economic growth. It is time we learned the repeated lessons of the past that government spending, particularly when used to try to stimulate an economy, is simply a bad investment.

As economists have long pointed out, anti-gouging laws are horrifically counterproductive for a variety of reasons. By capping prices at pre-disaster levels, the laws prevent prices from reflecting the increased scarcity of the goods in question. Prices, as I’ve discussed before, play two intertwined roles: They are knowledge wrapped in an incentive. Rising prices after a disaster provide important information to users of the good, indicating they should economize on their use of it and devote the now smaller supply (relative to the intensified demand) to only the most important uses. And those rising prices provide the incentive necessary to do so, by raising the cost of using the resource for less urgent purposes.

Signal to Suppliers

At least as important is the dynamic effect of rising prices. Higher prices signal to other suppliers of the good that it is more scarce, indicating that supplies need to move to the affected area. And this signal is wrapped in an incentive: The higher prices provide the profits to lead other suppliers to want to bring goods to the affected area. Coercively preventing sellers from raising prices only exacerbates the very shortage the distressed area is experiencing and eliminates the incentive for people to use the good for only the most important purposes.

But what is perhaps most interesting about gouging is that the charge is only selectively applied. Right now, just a week or two after the tornadoes in the South, carpenters, plumbers, electricians, roofers, and trash removal workers are seeing wages well above their pre-disaster levels since the demand for their services is extremely high. We saw the same thing after Hurricane Katrina, not to mention pretty much every major natural disaster you can think of. Yet not once has any of those workers been prosecuted for price gouging. In fact, you pretty much never even hear the accusation made against them.

No Difference

Economically there’s no difference between the two cases. The price of items like gas or water rises because demand for them increases after a disaster and because supply lines are often interrupted. The same is true of labor services: People demand them more and some number of local trades people will be injured, dead, or busy repairing their own property. The combination drives up the wages of those who remain in the market.

Just as economics would predict, the higher wages available to such workers act as beacon wrapped in an incentive to draw in skilled labor from other parts of the country, if not the world, to take advantage of the temporarily higher wages. The Gulf Coast saw a significant influx of Hispanic day laborers after Katrina for precisely this reason. The benefits here are clear: The additional competition from the new supply of skilled labor begins to drive wages back down to where they were before the disaster — again just as economics predicts.  The public also gets access to the much-needed skills as the supply of labor expands. There is not one difference between what happens in these markets and what happens in the markets for gas, generators, water, or any other good.

Immune from Accusation

So why is it that we never see trades people accused of gouging? I suspect that it is due to our prejudice against profits. Most people don’t object to an individual earning a higher wage during such a time, but when a business, especially a large corporation, earns higher profits in the short term, that raises moral objections. Again, economically there is no difference here: Both the higher wage and the higher profits arise from the same supply-and-demand process and, more important, have the same functional role in ensuring expanded supply.

Those who complain about “price gouging” (some of whom are probably receiving higher wages) need to be consistent. If raising prices during an emergency is morally objectionable, the complainers should be willing to apply anti-gouging laws to workers.  If that is morally objectionable, then the lack of any meaningful economic difference between higher wages and higher profits should lead them to do the right thing for both producers and consumers and call for an end to anti-gouging laws.

Pete’s quite correct to remind us that the most basic laws of economics hold no matter how hard we wish they didn’t.  And that particular law is one well worth remembering:  If we want less of something, make it more costly.  But it’s also important to understand that supply is just the flip side of demand and often gives us an alternative way to change the incentives people face.

Imagine an entrepreneur considering making tents out of canvas.  The price of canvas will be crucial to his ability to supply those tents.  But the price of canvas is in turn determined by the demand for other consumer goods made of canvas.  That is, the supply of tents depends on the demand for canvas sneakers, canvas drawing boards, and the like.  Should there be a public craze for canvas sneakers, driving up their price, sneaker producers will bid canvas away from alternative uses and increase the quantity of sneakers.  The higher price of canvas will in turn will reduce the supply of tents since our entrepreneur will face rising input costs.

Thus supply decisions are ultimately driven by demand for the alternative uses of the inputs.  Or to put it in more colloquial terms: If we want people to do more of something we like, we either have to increase the benefit of their doing so or increase the cost of alternatives that use the same inputs.  Because all supply is based on the demand for alternative uses of inputs, changing either the costs of one side or the benefits of the other will change the relative value of the two choices in the same direction, generating the same result.

Overlooked Strategy

People often overlook this point when trying to change the incentives facing others.  Even economists tend to think first and foremost of raising the costs of an observed bad behavior as a way to discourage it.  The problem is that sometimes raising other people’s costs also raises our own. In such situations we don’t think enough about how to increase the benefits of alternatives as a way to discourage the undesired behavior.  The problem is that what we dislike is in front of us, while the alternatives we’d like to reward require some imagination.

Consider a parenting example.  From the time my wife and I first started dating, we agreed that our children would never be like the out-of-control monsters we saw all too frequently in restaurants.  So how to make sure our kids behaved when we took them out to dinner?

One solution was to punish them for the misbehavior.  If they got out of their seats or made too much noise or threw things, we could reprimand them or, in the extreme, remove them from the restaurant.  This would certainly raise their costs, especially if it was connected with further punishment at home, such as taking away their favorite toys.  But this would be costly to us too, in terms of the scene it would make and the disruption of our dinner.  If one remembers, however, that supply is driven by the often unseen demand for alternatives, there is a solution.

Without a higher return alternative to misbehaving, that’s what we’d continue to get. But kids’ energy and time have alternative uses. So we would always bring a few of their favorite toys for them to play with while waiting for food.  (Restaurants understand this point: Many kid-friendly ones provide crayons and paper, though some kids might find those too boring.)  Bringing toys and engaging with them as they played increased the demand for good behavior and thereby reduced the supply of misbehavior.  Instead of just punishing the seen, we imagined an unseen alternative and rewarded it.

Pete Boettke is also fond of saying that all economics is the economics of relative prices.  It’s as true for kids in restaurants as it is for tents and sneakers.

To many, the Austrian and Chicago economists seem to be saying the same thing: markets are an efficient way of using scarce resources to best serve consumers; individuals know their own interests and circumstances better than government regulators and planners; political controls tend to distort supply and demand and the price system through which markets are kept in balance. In addition, members of both schools of thought have long warned that inflation and its negative consequences stem from government monetary mismanagement.

As a result, on the surface there seems not to be much difference between the two schools. Yet anyone fairly familiar with the Austrian and Chicago approaches knows that in fact they not only look at the world through significantly different conceptual lenses, they often are extremely critical of each other.

In his recent book, Vienna and Chicago: Friends or Foes?, Mark Skousen tries to explain the history of the Austrian and Chicago approaches, and critically evaluate their strengths and weaknesses. Skousen explains the beginnings of the Austrian school in the last decades of the nineteenth century, during which Carl Menger, Eugen von Böhm-Bawerk, and Friedrich von Wieser developed the theory of marginal utility and opportunity cost; formulated a theory of capital, investment, and interest; and undermined the foundations of Marxian economics. He then traces the contributions of such leading twentieth-century Austrians as Ludwig von Mises and F. A. Hayek in the areas of monetary and business-cycle theory, their insightful criticisms on socialist central planning, and their conception of the market as a dynamic competitive process.

The Chicago school developed later, in the 1920s and 1930s, out of the writings of Frank Knight, Jacob Viner, and Henry Simons, who were early critics of some aspects of Keynesian economics and of government planning. But the Chicago school only really flowered in the postwar era out of the contributions of Milton Friedman and George Stigler, who challenged, respectively, some of the rationales for macroeconomic and regulatory management of market activities.

For the remainder of the book, Skousen contrasts the two schools on a variety of topics, including methodology; inflation, business cycles and the monetary system; and government regulation and intervention. Somewhat irritatingly, Skousen concludes each section by declaring which school “wins the debate,” using the language of tennis: “advantage” Vienna or Chicago. While seeming to be a cute way to evaluate the two schools, it comes across as rather sophomoric. Also, it often seems that Skousen’s decision reflects his judgment about which school has been more influential among economists or in the policy arena. But the correctness of an idea is not measured, per se, by the number of its adherents. Alchemy and astrology have had wide followings, after all.

The core of the differences between the Austrian and Chicago schools is the question of how one tries to understand the world, including the market. Imagine that two objects are observed moving toward each other at a certain velocity. What can we predict about what will happen? Well, we can attempt to estimate their respective speeds and calculate when they are likely to collide, given the measured space between them.

There is nothing wrong with doing this. But if the two objects happen to be human beings, limiting the “facts” or “evidence” to these quantitative dimensions will leave out crucial features of the situation. For example, do these individuals view each other as friend or foe? The answer to that question alone will greatly influence what we predict as the likely sequence of events as they come closer to each other. (If foe, one of them might suddenly stop dead in his tracks and run in the oppose direction from fear.)

To analyze this situation requires the social scientist or economist to look beneath the quantitative surface to try to determine how the actors define the situation, including the meanings they see in their own actions and those of others with whom they may interact. A voluntary exchange and a coerced transfer may look the same to an observer. But they are certainly not the same when understood from the perspectives of the actors.

Unlike the Chicago-school economists, the Austrians have always insisted on emphasizing this “subjectivist” approach. This is partly due to the Chicagoans’ continuing belief (a subjective state of mind, for sure!) that “science” should be defined narrowly as the quantitatively measurable and predictable.

Skousen tries to reduce and ridicule the Austrian view by making it into a caricature of an “a priori deductive” approach that is both incorrect and unjust to the actual arguments that Austrians like Mises developed in great detail. Nor does Skousen do justice to the fact that Austrians, too, believe in “applied” economics, historical studies, and factual evidence. They just do “empirical” work differently from the Chicago economists—the Austrian approach tries not to forget that it is the course of human events that is being investigated.

He therefore too easily gives “advantage” to the Chicago school when comparing their contributions, for instance, in the area of government regulation. The Austrians focus on the entrepreneurial element of innovation and market coordination; they think of competition as a creative discovery procedure; and they view markets as processes of change and adjustment through time. To appreciate the power of the unregulated market, none of these aspects of the real “empirical” world can simply be reduced to econometric coefficients of correlation without losing essential qualities of the subject. It would be like trying to study man by looking only at the skeleton and ignoring the flesh, blood, muscles, nerve endings, and most especially, the mind that guides what the body does.

Skousen finds the most important Austrian contributions in the areas of money, inflation, the business cycle, and monetary institutions. This should not be surprising since these are the areas in which he has written the most over the years from an Austrian-oriented perspective. Friedman’s monetary contributions have basically followed in the Keynesian footsteps. While rejecting most of Keynes’s assumptions about the power of fiscal policy for stimulating the economy, Friedman accepted his “aggregate” approach of looking almost purely at money’s impact on prices, wages, and output in general.

The Austrians, on the other hand, have always focused on the more insidious effects of monetary expansion on relative prices and wages, and on demand, effects that can give a wrong twist to the entire economy.

Unfortunately, while an easy read and even entertaining in places, Vienna and Chicago fails to give the reader a fully balanced understanding of the Austrians or a sufficiently critical appreciation of the limits of the Chicago school.

Before exploring the errors of the political charges, we should first understand exactly what’s happening in the oil market. The simple explanation for high prices is: supply and demand. Global oil output has been roughly flat since 2005, while demand in developing economies such as China and India has been growing quickly. In a market the only way to reconcile these facts is for the price to rise; if China is consuming more barrels per day while producers aren’t churning out more product, that means other countries have to cut back their daily consumption. Rising prices do just that, without anyone consciously orchestrating the worldwide coordination involved.

To add nuance to the explanation, we should note that the sinking U.S. dollar has played a role. From June 2007 to June 2008, the price of oil—measured in dollars—more than doubled. Yet 15 percent of this rise can be attributed entirely to the sinking dollar, which fell 15.6 percent against the euro during the same interval. Because oil is a fungible commodity traded on a world market, changes in foreign-exchange rates translate immediately into changes in the price of oil (quoted in dollars).

If politicians want to “do something” about record oil prices, the answer is simple: Enact policies that boost supply and/or reduce demand—and this prescription indirectly includes policies that strengthen the dollar. For example, opening up the Arctic National Wildlife Refuge (ANWR) and the outer continental shelf (OCS) to drilling would boost (expected future) supplies of oil, causing producers with excess capacity today to ramp up current production. The feds could also start unloading the Strategic Petroleum Reserve, which currently has some 700 million barrels stockpiled. As the early Reagan experience showed, large marginal tax-rate reductions would boost the dollar on the foreign exchanges. And as far as reducing demand, foreign governments could stop subsidizing gasoline prices for their populations.

All these policies made sense even five years ago when oil was trading around $30 per barrel. Now that oil is flirting with $150 per barrel (as of this writing), such policies are imperative. Unfortunately, as we’ll now discuss, the suggested remedies coming from Washington will have the exact opposite impact.

Likely driven more by politics than sound economics, Republicans have increasingly endorsed expanded drilling on domestic land and in sea areas controlled by the federal government. For various reasons the standard Democratic response has been to dismiss these proposals as gimmicks that won’t solve America’s long-term “addiction” to fossil fuels. In this context the rhetorical lengths to which some politicians have gone are simply astounding.

The best (or worst) example concerns statistics on federal land-leasing that have served as talking points during the presidential campaign. The congressional Committee on Natural Resources prepared a report (http://resourcescommittee.house.gov/images/stories/Documents/truth_about_americas_energy.pdf) intended to derail the enthusiasm for more drilling by “Big Oil.” According to the report:

Even if increased domestic drilling activity could affect the price of gasoline, there is yet no justification to open additional federal lands. . . . Combined, oil and gas companies hold leases to nearly 68 million acres of federal land and waters that they are not producing oil and gas [from]. . . . Oil and gas companies would not buy leases to this land without believing oil and gas can be produced there, yet these same companies are not producing oil or gas from these areas already under their control.

If we extrapolate from today’s production rates on federal land and waters, we can estimate that the 68 million acres of leased but currently inactive federal land and waters could produce an additional 4.8 million barrels of oil and 44.7 billion cubic feet of natural gas each day.

Now this is truly astounding. It’s hard to know what would be worse: Do the authors of this report—and the politicians who repeat the accusations—actually think this is how the oil industry works, or are they consciously throwing out ridiculous “facts” just to win votes?

If we are to believe the figures in the quotation above, oil companies have the ability to produce an extra 1.75 billion barrels of oil per year (4.8 million x 365), which at $140 a barrel would yield around $245 billion in extra annual revenues. It’s true, they would have to pay a lot more in wages and equipment costs, and the price of oil would certainly drop with that much additional production. Even so, it is ludicrous to think the oil companies are staring at that much money on the ground (or in the ground) and ignoring it.

In reality the situation is far less sinister. The oil and gas companies pay the federal government to lease some of the land where it is currently legal to do so, areas they believe are the best prospects for finding oil and gas deposits. Obviously they don’t know beforehand exactly where the best sites will be; they have to lease the land and explore. After doing so, they begin drilling in the areas with the most promise. With record-high oil prices, the companies are naturally going to cast a wide net (insofar as the feds give them legal permission to do so), and so the proportion of leased land that actually ends up being classified as “producing” will be much lower than 100 percent.

Ironically, the higher the fraction of leased land that is producing oil, the more suspicious we should be that the oil companies are purposely holding back. After all, assuming they found oil, why would they pay the government to lease lands on which they didn’t plan to drill?

Contradictions from Big Oil’s Critics

Here we run into yet another nonsensical aspect of the official story from Big Oil’s critics. Let’s suppose for the sake of argument that the accusations are correct and that opening up ANWR and other federal lands wouldn’t lead to more drilling. Then what in the world is stopping the politicians from accepting the oil companies’ money? In these hard times, why not take billions from ExxonMobil and all the rest? If they don’t end up drilling—as the harshest critics allege—then people in Alaska, Florida, and California don’t need to worry about their coastlines being soaked in crude spills, now do they?

Things get worse. It’s not merely that the conspiracy-charging politicians deny companies access to federal lands that have the potential of major oil and gas discoveries. They want to swing the pendulum in the other direction with so-called “Use It or Lose It” legislation, which would penalize energy companies that lease federal land if they don’t begin producing within a specified time.

Putting aside the arrogance of politicians telling oil-industry experts how to run their businesses, such legislation would merely present an additional risk to domestic exploration efforts. As it is, an oil company runs the risk of paying to lease a certain area and finding nothing. The proposed legislation would increase the hazards, causing companies to become more conservative in where they explore.

This sorry episode underscores the flaws with government ownership of land. There are legitimate concerns over environmental quality, just as there are obvious concerns over high gasoline prices. But the political process is a terrible way to settle disputes. If the federal government auctioned off its massive landholdings to the private sector, oil companies and conservation groups alike could make bids and channel resources into appropriate ends, guided by the price system.

As it is, we have the worst of both worlds, where valuable oil and natural-gas deposits are arbitrarily placed off-limits and where oil companies are given rights to develop in certain areas without local owners exercising oversight to ensure that the mineral extraction occurs with the appropriate level of attention to long-run resource and environmental value. The “use it or lose it” mentality already prevails when politicians sell access rights to the vast lands they temporarily control—though economists know that this mentality is conducive to economically inefficient exploitation, rather than the wise husbandry that would develop under truly private ownership.

Besides large oil companies, the other popular villains are financial-market speculators. According to the official story, oil prices are as much as $70 higher per barrel than the “fundamentals” justify. Hedge funds, pensions, and other institutional investors have flooded the futures markets, looking for a piece of the action. These investors have gambled on rising oil prices by increasing their holdings of oil futures contracts. The result (we are told) is a self-fulfilling prophecy, where institutional purchases push up futures prices, which in turn drive up spot prices. The speculators get richer while the average motorist pays at the pump for their fat profits.

There is so much wrong with this story that it’s hard to know where to begin. As always, when people accuse market participants of making profits through “manipulation” we can ask: What took them so long? Why was oil $30 back in 2003? Were investors back then more altruistic than they are today?

To unpeel the issues in oil speculation, we need to first review the mechanics of the futures market. Futures contracts allow producers and consumers to hedge against the risk of price movements. Oil producers can sell futures contracts—which are promises to deliver physical barrels of oil at a future date, for a pre-specified amount of money—while major consumers, such as airlines, can buy futures contracts to lock in a guaranteed price for the massive quantities of oil they will need for operations in the coming years. Futures markets thus promote efficiency, as producers and consumers can concentrate on their core businesses and make investments that would be far too risky if they were completely exposed to volatile spot prices.

The True Effects of Speculation

Contrary to popular belief, futures markets do their job much better in the presence of savvy speculators. When successful, speculators speed price adjustments, and actually make prices less volatile than they otherwise would be. After all, the speculator buys low and sells high (or shorts high and buys back low). These very actions are countercyclical, and keep prices within a narrower band than if the speculators had stayed on the sidelines.

In this environment, large institutional investors provide liquidity to the physical hedgers. It is ironic that while the government takes steps to prop up Fannie Mae and Freddie Mac—whose investors certainly don’t plan on living in the houses they finance—politicians and commentators wail about the evil investors who buy oil futures even though they don’t ever plan on taking delivery of physical barrels. With large investors willing to pick up the slack, as it were, the traditional hedgers in the oil futures markets can use these contracts more liberally, because they can unload them in a more liquid market.

Markets and Speculation

Up till now we have seen the benefits of speculation. It is true that if speculators are wrong, they can distort markets—the housing bubble is a prime example. (There were government policies that encouraged speculation in real estate, but that is another story.) But the market has a handy way of enforcing discipline on speculation. If speculators guess prices will rise, but instead they fall, then the speculators lose money in exact proportion to how wrong their forecasts were. There is no need for government to tack on additional penalties, so long as contracts are enforced and the losers are made to bear the full brunt of their mistakes. The irony is that there is no hard evidence that speculators have been driving up oil prices. Thus we have been defending speculators for a “crime” that they don’t seem to have even committed.

If it were really the case that the “sustainable” market price of oil that balanced the fundamentals of supply and demand was $80, while speculators had driven the price up to a bubbly $150, we would see a large surplus. Even though supply and demand in the oil market are notoriously inelastic, surely the growth in quantity supplied, and the drop in quantity demanded, from a $70 price hike—especially one that was years in the making—would show up in a sizable excess of crude hitting the market.

This would make perfect economic sense, incidentally. For example, if certain speculators became convinced that an attack on Iran would drive oil to $400 per barrel in the coming months, they would rush to buy futures contracts. This would push up the futures price such that refiners and others with the requisite know-how would find it profitable to sell futures contracts (at the sky-high prices) and buy oil on the spot market. They would literally warehouse the oil for a few months, then unload it when the futures contracts matured.

The Stockpiling Story

Although those stockpiling oil would be doing so for personal gain, the Invisible Hand would ensure that everyone else benefited. Their purchases of spot oil would drive up spot prices, leading to conservation in the present. And of course, when war with Iran interrupted imports, the stockpiled oil would be a blessing.

However, this story doesn’t seem to be playing out when we look at the data. The “yield curve” on oil has been in backwardation—where spot prices exceed futures prices—for large portions of oil’s record price run-up, making it difficult to see how investors in futures contracts are pulling up spot prices. Moreover, official inventory data don’t show any stockpiling occurring in the last few years.

Now there are ever more convoluted stories that certain economists are spinning to explain away this lack of evidence. For example, it’s possible that investors pushed up futures prices, which in turn led Saudi Arabia to scale back its output. This drop in supply then led to rises in spot prices, which explains the lack of massive contango (where spot prices are below futures prices) during the last year. Further, we see no stockpiling in inventory data, because the Saudis are stockpiling the oil under the sand by not pumping.

Even here, the data do not really fit such a story, though admittedly OPEC figures are not as trustworthy as those issued by privately held companies. The Energy Information Administration estimates that OPEC output did drop from 2005 through the first quarter of 2007. But since then it has been steadily rising, reaching all-time highs in the first quarter of 2008. If we’re trying to explain the doubling of crude prices over the last year, a complicated story involving speculators and OPEC restrictions gets ever harder to square with the facts.

In any event, whether or not speculators are responsible for rising oil prices, we can confidently state that proposed regulations to restrict pension and other institutional investors from participating in the oil futures market would do nothing but harm the average American. If millionaires want to bet on rising oil prices, they will still be able to do so, either through hedge funds or in foreign markets. But schoolteachers and assembly-line workers typically do not have the money or savvy for such strategies. Instead, the only way they can hedge themselves against skyrocketing gasoline prices is for their pension- or mutual-fund managers to gain exposure to oil prices. Yet this is precisely what some members of Congress want to crack down on.

Americans are understandably becoming furious over record oil and gasoline prices. In response, the politicians have pointed fingers and proposed fixes that are based on faulty economics. If these odious measures pass, the result will be higher and more volatile oil prices and more exposed consumers. The truly sad thing is that even if this all comes to pass, most voters won’t understand what happened, and will believe the politicians when they blame $200 oil on anybody but themselves.

It is certainly true that China’s economy is expanding dramatically—10 percent last year. The Chinese build factories like crazy to pump out the inexpensive exports we Americans love to buy. To do that, Chinese producers have to purchase oil, steel, and lots of other commodities. The new demand drives prices up.

And as the Chinese and other people get richer, they improve their diets and eat more meat, putting pressure on world food prices.

So media handwringers suggest we should worry about the poor becoming rich.

Actually, we shouldn’t. It would be a sad world if one person’s economic success depended on another’s failure.

Hazlitt’s Lesson

More of us would understand this if we learned what the great economics writer Henry Hazlitt preached in his classic book, Economics in One Lesson: “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy.”

In the short run, richer Chinese and Indians bid up the prices of things. But that’s just the beginning of the story. Increased demand and higher prices create opportunities for entrepreneurs.

When the price of, say, oil goes up, entrepreneurs and inventors have a strong incentive to: 1) find more, 2) find alternatives, and 3) find ways to use oil more efficiently. You and I cannot foresee what they will invent, but that means nothing. Predictions about the end of progress have been issued countless times. There is no reason to think they will be right this time. Assuming government stays out of the way.

Our current “leaders” are full of promises about “protecting” workers and industries, creating new “green” industries, and starting worker-retraining programs. For example, Hillary Clinton promises government support for “research (to) stimulate the development of new technologies and life-saving medicines.” Former presidential candidate Mitt Romney wanted “to initiate a bold, far-reaching research initiative—an Energy Revolution, if you will. It will be our generation’s equivalent of the Manhattan Project or the mission to the moon.”

The media lap it up, apparently believing that no one will produce unless our wise leaders create an inducement. Nonsense.

The market would deliver the goods if government doesn’t impose crippling regulations and tax away everyone’s capital to fund its coercive utopian schemes. I like what Henry David Thoreau once said: “This government never furthered any enterprise but by the alacrity with which it got out of the way.”

George Mason University economist Alexander Tabarrok has another way to demonstrate the benefits of spreading prosperity. Tabarrok wrote in Forbes recently that the bigger the market, the more worthwhile it is for companies to make products that require costly research and development, such as medicines and chemicals. As the Chinese and Indians become more able to buy things, businesses everywhere will find it profitable to make products that yesterday weren’t profitable enough. The result will be cures for diseases and other products that make our lives better.

Tabarrok takes this a step further: “Amazingly, there are only about 6 million scientists and engineers in the entire world, nearly a quarter of whom are in the U.S. Poverty means that millions of potentially world-class scientists today spend their lives trying to eke out a subsistence living, rather than leading mankind’s charge into the future. But if the world as a whole were as wealthy as the U.S. and were devoting the same share of population to research and development, there would be more than five times as many scientists and engineers worldwide.”

When it comes to being wealthy, the more the merrier.

How can positive science (consisting entirely of “is” statements) be translated into “ought” statements within the framework of economic understanding? In the first part of this series we drew attention to some of the paradoxes surrounding economic advice. In particular we drew puzzled attention to the passionate advocacy by Ludwig von Mises of free-market arrangements—the same Ludwig von Mises who insisted on an attitude of purest, disinterested wertfreiheit (“value-freedom”) on the part of all social scientists. In the present article, as a step toward clarifying these paradoxes and puzzles, we discuss the nature of the strictly positive central propositions of economics. We shall find that a careful appreciation for the manner in which economic science accounts for the existence of chains of economic cause and effect can help us see how knowledge of these chains can sustain very definite ways of providing advice and guidance to economic policymakers. Statements describing chains of cause and effect are “is” statements. But, as we shall see, these statements can, in a carefully defined sense, generate the “ought” statements of which economic advice consists.

Cause and Effect in Economic Affairs

Economic science was established as a branch of knowledge in the eighteenth century, when the classical economists recognized that there exist systematic chains of cause and effect in economic phenomena (just as they exist in regard to physical phenomena). Although subsequent progress in economic theorizing radically altered the way in which economics understands economic cause and effect, it was the classical economists who, by establishing the idea of systematic chains of cause and effect, established the scientific discipline of economics.

The very perception of a scientific discipline of economics (or “political economy,” as it was called by the classical economists of the late eighteenth and early nineteenth centuries) carries revolutionary implications for public policy. As Mises emphasized again and again, the discovery of regularities in economic phenomena means that statesmen concerned with public policy can no longer treat the economy as putty that they are free to mold into whatever shape they believe best for society. Every political act, every legislative constraint over economic activity, and every public subsidy must now be recognized as entailing specific consequences. Before instituting any tariff, before granting any right of monopoly, before printing any money, before imposing any kind of price control, those responsible for state policy must ask themselves whether they have fully taken into account all the consequences that are likely to follow from these actions. There are, the classical economists had shown, “laws” of economics that must be respected and taken into account if economic disaster is to be avoided.

But how can such “laws” possibly exist? Surely an intuitive impossibility blocks any conceivable “laws” from existing. It is one thing to observe and understand regularities and causal or functional relationships in physical phenomena. But to expect such regularities and relationships in economic phenomena (which represent the outcome of the independently made decisions and actions of millions of freely choosing individual agents) seems to be glaringly counterintuitive. There seems to be no way of ensuring that freely choosing agents “obey” the regularities that a science might declare to be determinative.

This intuitive difficulty is the fundamental reason why both economic theorists and philosophers have, during the past two centuries, puzzled and argued over the very possibility of an economic science, and over its epistemological character. The present series of papers (and this one in particular) are informed by the insights and philosophical framework identified with the Austrian School of Economics, and especially with the thought of its leading twentieth-century representatives, Mises and F. A. Hayek.

In this framework the focus of attention is on the purposefulness of human beings, and on the way in which the expectations and knowledge of these human beings are systematically modified by economic experience. Changing economic experience alters the terms on which individual agents in fact find themselves able to choose; that experience also teaches agents where they had over-optimistically or over-pessimistically misjudged the terms on which others were prepared to trade with them; that experience also alerts individual agents to opportunities for the future that had hitherto not existed or that have until now not been noticed. Economic theory is able, in this analytical framework, to provide understanding of how exogenous changes in resource availabilities, technical knowledge, and consumer preferences may systematically change market phenomena, and thus determine the course of production and the patterns of resource allocation. To illustrate this approach to economic reasoning, let us take perhaps the most basic of the “regularities” in the market economy, the “law” of supply and demand.

The “Law” of Supply and Demand

This basic understanding of the behavior of market prices identifies the nature and the direction of the forces operating in the market for each product and for each resource. This understanding sees the market for any given item, be it a product for human consumption (such as milk or the services of an opera singer), or a resource (such as farmland for growing crops or the services of an engineering instructor for the training of engineers), as being continually modified by market experience in systematic fashion. At any given time “too much” or “too little” of the given item may be offered for sale (or sought to be bought). (“Too much” being offered for sale means that, at current prices, more of an item is being offered for sale than is being bought. “Too little” being offered for sale means that, at current prices, more of the item is being sought to be bought than sellers wish to sell.) The “law” of supply and demand focuses attention on the existence of spontaneous market forces tending to “correct” these imbalances.

Where “too much” has been offered for sale, falling prices (for the relevant item) tend to encourage some (“marginal”) sellers to cut back on its production and to encourage potential buyers to seek additional quantities for purchase. Where “too little” has been offered for sale, rising prices for the relevant item tend to encourage potential sellers to increase production (and thus the quantities they will offer for sale) and to discourage some (“marginal”) buyers from continuing to buy. Were this process of adjustment in a given market to be permitted to continue indefinitely (that is, were the costs and techniques of production for the relevant item, on the one hand, and the preferences of the consumers, on the other, to remain indefinitely unchanged while market adjustments continued), the market for that item might be imagined to attain “equilibrium.” Market equilibrium corresponds to the imaginary state of affairs in which neither “too much” nor “too little” of an item is being offered for sale. In such an imagined state of equilibrium there would be no scope for market forces to be set into motion. Prices and quantities offered for sale and sought to be bought are, in such an imagined state of equilibrium, such that no tendencies are set in motion for any of them to change.

Contrary to what many students of economics have been taught to believe, the “law” of supply and demand does not (when it is properly understood) declare that each market is at or near equilibrium at each moment. Nor does it declare (the less-objectionable form of the above) that markets tend rapidly to achieve equilibrium. Rather the “law” declares that, to the extent that a market, at any given moment, is not at equilibrium, this will itself set into motion forces predominantly pushing the market in the direction of equilibrium.

However, it should be understood and emphasized, the continual changes in the relevant exogenous variables (for example, the costs of production, the availability of resources, and the patterns of consumer preferences) will almost inevitably ensure that the equilibrium position for a market at any given moment is different from what that position was at any earlier moment. So the market forces unleashed by the disequilibrium conditions at one moment will almost certainly not ensure the attainment of equilibrium at any subsequent moment.

Nonetheless, it is reasonable to point out, the more gross imbalances present in the market at any given moment will, according to the “law” of supply and demand, tend to be corrected. An “oversupply” places pressure on prices to fall, discouraging marginal sellers from some production and encouraging additional purchases, and thus tending to eliminate the imbalance. A “shortage” operates in the reverse, but equally benign, direction. Let us examine why the elimination of these “imbalances” can legitimately be described as “benign.” In the final article of this series, this will help us to understand the sense in which economic theory can, in scientifically objective fashion, promote sound economic-policy advice.

Market Imbalance—Why Is It Regrettable?

Let us consider the case of “overproduction” in a particular market (a market seen as isolated and insulated from other markets). Due to miscalculation or other error, the decisions of producers in this market have overestimated the eagerness of buyers to buy. The amounts offered for sale, and the prices expected and asked by potential sellers, are not matched by the decisions of potential buyers (and thus by the prices at which potential buyers expect to be able to buy, and at which they are willing to buy). This imbalance corresponds to decisions that have turned out to have been disappointing, and to decisions that turn out to have been regrettable. Some potential sellers (who might otherwise have offered to sell for lower prices, but who mistakenly held out for higher prices) are disappointed in that their plans to sell at higher prices cannot be successfully carried out. Those sellers may also regret their refusal to offer to sell at lower prices, or they may regret their decisions to produce in the first place. The failure of the decisions of some of the potential sellers to dovetail with corresponding decisions of potential buyers reveals the “error” of all of those decisions and is the source of both disappointment and regret.

A different, more accurate pattern of decisions, by both potential buyers and potential sellers, might have permitted them to achieve more successful fulfillment of plans than has in fact occurred. When a pair of market participants might have engaged in voluntary exchange to mutual advantage (for example, at a lower price), their failure to have done so (due to “error”) seems, at least at first glance, to have been unambiguously unfortunate—for everybody. Nobody, it seems at first glance, has gained anything by the fact that potential steps to mutual advantage were not taken.

So, if we are correct in this judgment, the market process, which according to our “law” of supply and demand initiates continual market tendencies toward the correction of such imbalances, would appear to be benign. It tends to discover and to correct “erroneous” market decisions—that is, decisions which operate to frustrate the exploitation of potentially mutually gainful exchanges.

Although we have been careful to express this approving judgment (for the outcome of the “law” of supply and demand) strictly in tentative terms, we shall find that it in fact holds more robustly than we have suggested. As we shall see in the final article of this series, it tends to hold even when we drop the special assumptions made in this section. There is a definite sense in which the “positive” theory of supply and demand leads ineluctably to an understanding of its socially benign character (that is, of its “normative” implications). We have in fact glimpsed here the basis for scientifically based economic advice. But the present article has not yet completed its exposition of the “positive” operation of the “law” of supply and demand. Before proceeding further we must explore more carefully exactly how this “law” achieves its magic—its tendency to correct market imbalance. We shall find that the “normative” discussion of this section can help us understand the “positive” operation of the competitive market process.

How the Market Works*

As we have seen, market imbalance reflects and expresses decisions that have been made in error. Market participants have been disappointingly left with unsold goods. Had they known this previously, they might have produced fewer units of these goods; they might even have gone into entirely different lines of production; or they might have been happy to have sold for lower prices (the only reason for their having failed to do so being their erroneous conviction that they could obtain higher prices).

Notice that this understanding of market imbalance refers, in effect, to two distinct kinds of error. One kind of error made by participants in the market we have considered is that mutually gainful exchange opportunities have simply not been taken advantage of. (Thus when market prices have been “too high,” generating offers to sell that have been rejected, this is likely to mean that mutually gainful sales could, in principle, have occurred at lower prices.) A second kind of error has meant that some market participants have been led to believe (quite erroneously) that (nonexistent) opportunities for mutually gainful exchange really did exist. The first of these two kinds of error is thus to fail to recognize existing opportunities. The second kind of error is to “see” opportunities which in fact do not exist. One might describe the first kind of error as one of undue pessimism (failure to see opportunities really staring one in the face); the second kind of error might be described as one of undue and unjustified over-optimism. This insight can help us understand the process of market adjustment, the operation of the “law” of supply and demand.

Let us consider the errors of over-optimism. Whenever such an error occurs, it is discovered (and thus presumably corrected) almost inevitably. One’s market experience reveals where one has been over-optimistic; the opportunities that one had over-optimistically expected to encounter simply do not happen. Such chastening experience tends, almost inevitably, to rein in over-optimistic market anticipations. Such experience “teaches” where and how more realistic expectations are in order. Where over-optimistic would-be sellers had, for example, refused to sell for lower prices (confidently, but erroneously, expecting to sell at higher prices), their disappointing experience in the market tends to teach them to lower their asking prices.

But the other kind of error (that expressing undue pessimism) does not seem capable of “automatic” correction in any similar way. An opportunity (for mutually beneficial exchange) that was not seen today by the relevant parties (and therefore not taken advantage of) may not be seen tomorrow either (even if it still exists tomorrow). Let us take an example. If different prices for “the same” item have been prevailing in different parts of “the same” market, this is a scenario in which potentially mutually advantageous trading opportunities have existed, but have been missed. After all, in any market in which buyers have been buying at higher prices while some sellers have been selling at lower prices, we have a situation where these buyers and these sellers could obviously have benefited by trading with each other at some price lower than those higher prices at which the buyers have been buying, but higher than those lower prices at which the sellers have been selling. Clearly these market participants were simply unaware of what was going on elsewhere in this same market. But there seems no obvious manner in which such unawareness might be spontaneously replaced by superior market information. There seems no obvious way through which the market might tend to replace widely divergent market prices with less divergent prices.

It is here that the spontaneous market process depends on entrepreneurial alertness for one of the most fundamental (and widely recognized) tendencies in free, competitive markets: that prices for the same item do move toward a single price throughout the market.

Entrepreneurial Alertness

One of the less obvious, but nonetheless most powerful elements acting in markets is entrepreneurial alertness—the propensity of human beings to notice that which it is in their interest to notice. Sooner or later buyers paying unnecessarily high prices do tend to discover where they can obtain comparable goods at significantly lower prices. Sellers selling for unnecessarily low prices do tend to discover where they can find buyers willing to pay higher prices. Moreover, sooner or later entrepreneurs will discover that they can grasp pure profit simply by buying at the lower prices and selling at the higher prices. We do feel convinced that widely diverging prices in the same market for a given product or resource will give way in this fashion to competitive forces tending to push these diverging prices toward each other. Errors of undue pessimism do tend to be corrected in this way—as a result of entrepreneurial alertness.

So the “law” of supply and demand explains chains of economic causation along each of two distinct dimensions. First, as we have seen earlier, it operates toward the correction of market imbalances for given items. Second, it operates to correct such imbalances at the same time as it corrects the phenomenon of divergent prices for each such item. The forces of supply and demand operate to correct “wrong” decisions that are unduly optimistic, at the same time as it operates to correct “wrong” decisions that are over-pessimistic.

The Broad Scope of Our Analysis

Our discussion thus far has been extremely simple both in its assumptions and its substance. We have talked of the market for a “given item” while assuming this market to be isolated and insulated from all other markets. When one broadens one’s analytical perspective to include the markets for innumerable products and resources that may be bought and sold, and to include not only simple buying and selling decisions but also decisions on what to produce and how to produce, it might appear that we are now in a world of mind-boggling complexity, for which our simple analysis has little relevance. But this is not the case. The insights of the previous sections do have immediate relevance even for the most complicated of interlocking markets.

Consider, for example, a market in which a particular item C is produced by combining input A with input B, in accordance with some production recipe. Imagine that such production is highly profitable. The combined costs of inputs A and B are, at a given level of output, significantly lower than the revenue obtainable from selling C in the consumer-goods market. This scenario may seem fairly complicated (in comparison with the scenarios discussed earlier). But we should notice that this scenario is one in which buyers are paying higher prices than necessary, and sellers are selling at lower prices than necessary—exactly as in the single-item market discussed in the preceding section. Thus those selling A and B at prices summing to less than the price being paid for C could, in principle, have produced C and sold it for the higher price (since only A and B are needed to produce C). The profitability of this line of production results from a (disguised) divergence of prices “for the same item” in the same market (that is, it results from the circumstances that everything needed to produce C can be bought for less than the market price for C). Thus this profitability can be expected (unless we postulate monopolistic control of access to resources A and B) to tend to attract competitive entrepreneurial attention. This will tend to eliminate the profitability of this line of production (by pushing the price of C and the sum of the prices of A and B closer together).

Although this is not the place to do so, similar analysis can demonstrate the broad relevance of our earlier discussion of the “law” of supply and demand to key aspects, at the very least, of complex market scenarios.

Cause and Effect in Economic Affairs

Our discussion has illustrated the way in which simple economic theory accounts for the existence of definite and systematic chains of cause and effect in economic affairs. There do exist definite ways in which economic decisions made in any one period tend to take systematic account of the other decisions being made in the same markets. In this way decisions do mold each other in systematic fashion. And we have seen how the manner in which such “molding” tends to occur appears, at least at first glance, to deserve being called “benign.” This simple analysis will help us understand, in principle, how economic theory can lead toward making judgments on the “goodness” of specific policy initiatives through an understanding of the likely consequences of such initiatives.

We are now ready to tackle, in the final article in this series, the question posed at the beginning of the first article: Can positive economic understanding be translated into scientifically objective and valid economic advice?

*Much of the material in this article, and especially the material in this section, is covered in greater detail in my monograph How Markets Work: Disequilibrium, Entrepreneurship and Discovery (London:  Institute of Economic Affairs, 1997).

Government officials all across the country joined the expanding chorus. President Bush led the way early in the disaster’s aftermath calling for “zero tolerance” for looters, scammers, and price gougers” at the gasoline pump.”³ Other politicians echoed his message.

None of this is surprising. Even before Katrina knocked out half the Gulf of Mexico’s oil production (sending gas prices soaring to over $3 per gallon Labor Day weekend), politicians and “consumer advocates” were calling for investigations into gasoline prices, which had been rising for about two years, reaching $2.64 per gallon by last August 30.⁴ Indeed, this has become commonplace; since 1973 the government has investigated the oil industry about once every two years.⁵ A 2002 Senate investigation into the oil industry purported to have discovered oil companies “manipulating the market.” However, the report, sponsored by Senator Carl Levin of Michigan, was in the words of economist William Anderson “an exercise in economic illiteracy.”⁶

There is no mystery about recent rising gas prices. Strong economic growth in China, along with improved growth in the United States, has been pushing on the demand side of the gasoline market for some time. Meanwhile, political unrest in Venezuela and Iraq along with strict environmental restrictions and regulations in the United States have helped keep the supply side anemic and uncertain. The result is unsurprising—strong new demand with insufficient new supply (coupled with uncertainty) means higher prices at the pump.

Environmental regulations are often blamed for the fact that no new refineries have been built in the United States since 1976; however, the Cato Institute’s Jerry Taylor and Peter Van Doren point to other reasons. They write that “meager” profits in the refining business over the past 30 years, cheaper imports, and the fact that it is less expensive to add capacity to an existing refinery than to build a brand new one have all kept the number of refineries from rising. They note further that while there are fewer refineries than 30 years ago, “[d]ramatic improvements in the operational efficiency of oil refineries” have actually permitted domestic gasoline production to increase “by 20 percent since the last oil refinery was built.”⁷

Hurricane Katrina merely made the prevailing situation worse. Oil prices peaked at over $70 per barrel shortly after the storm, while average U.S. gasoline prices peaked at $3.07 in early September, “just a nickel shy of the inflation-adjusted record of $3.12 averaged over March 1981.”⁸ Prices fell significantly after that, before creeping up again as the winter came on. The public was nervous and angry; politicians were quick to respond.

No one likes paying more for gasoline (except maybe folks who have always resented America’s relatively cheap gasoline, its SUVs, and other signs of bourgeois opulence), but government-imposed price restrictions would only make matters worse. By interfering in the market’s pricing mechanism, price controls simply hinder the ability of entrepreneurs and investors to provide the goods and services consumers desire most.

Much of the support for price controls stems from a lack of understanding of where prices come from. Many politicians and other critics of markets believe that market prices (or at least “fair” market prices) can be calculated using production costs. For example, they believe it is evidence of gouging if a gas station raises its pump price on news of higher oil prices—even if the gas sitting in the station’s fuel tanks was purchased days or weeks earlier at a lower price. This thinking is mistaken on at least two counts.

First, “production costs” (themselves actually impossible to calculate since they are, in reality, subjective opportunity costs) don’t determine a good’s current market price. While it is true an entrepreneur will use his estimated accounting costs of production when deciding whether to produce a good or service, the actual market price of the finished good is a result of consumer desire to obtain the particular good as well as the ability and willingness of sellers to provide it. In other words, price is a function of supply and demand.

Second (and along the same lines), prices for final goods do not have to wait for immediate input prices to rise before they can change. The fact that retail gas prices skyrocketed on the news of Katrina’s devastation to the Gulf’s oil production—long before new, more expensive gasoline from the Gulf reached those stations—is no proof of any wrongdoing. On the contrary, it is a blessing that the price system can work so quickly.

News of increased demand for housing in a community (say, a new factory is coming to town with 10,000 employees) would immediately drive up the price of housing there. Housing prices might double or triple in a month, regardless of how much people paid for their houses. In a free market these higher prices would rapidly signal producers to redirect scarce resources—lumber, labor, cement mixers, and soon—from places where they are less urgently sought to where housing prices are rising. Likewise, if a plant closing in a community meant there would soon be a housing glut, home prices would immediately fall, discouraging the investment (and waste) of scarce resources. Because these prices change quickly, regardless of production costs, resources are redirected to more urgently desired areas more quickly than would otherwise be the case. Thus rapidly changing gasoline prices are a blessing because they send a clear signal early in a supply disruption, before things become much worse.

Emergent Phenomena

Politicians and others are undoubtedly frustrated by the teachings of economics because they more often than not tell political leaders what they cannot or should not do, not what they can do to change reality. In a recent essay Freeman columnist Russell Roberts wrote of the human desire to control what he calls “emergent phenomena,” which he defines as things that are the result of human action but not subject to human design or control. Such phenomena include language and market prices. Efforts to control emergent phenomena, Roberts writes, confuse engineering problems (which are subject to human design) with economic problems (which are not). “[T]he engineering way of thinking doesn’t work with emergent phenomena. Trying to change emergent results is inherently more complex than building a bridge or expanding your kitchen or even putting a man on the moon. Understanding the challenge involved is to begin to answer the old question that asks why we can put a man on the moon but we can’t eliminate poverty.”⁹

Despite talk of inelastic markets for retail gasoline, higher fuel prices over the past two years have started to have their anticipated effect on both supply and demand. The world’s largest oil producers have recently and significantly increased their spending on oil exploration in response to higher prices, while consumers have started to move away from SUVs and large trucks to more fuel-efficient autos.¹⁰

Left unregulated and unsubsidized, markets would lead human beings to cooperate and prosper in ways unimaginable by interventionist-minded government officials and politicians. And prices play a central role, acting as signals that help direct diverse and disconnected people into activities that serve other people’s most urgently felt wants and needs. Entrepreneurs also play a critical role by directing scarce resources toward ends most valued by consumers. If an endeavor proves mistaken, an entrepreneur fails and tries something else. All the while, consumers are likewise seeking out the most “profitable” (in a psychic sense) goods and services they can find. Thus a free market is in a never ending flux, constantly shifting resources from less-valued to more highly valued uses. This is not a process that can be improved on by political means.

Government officials may wish to magically or legally make gasoline more plentiful or less expensive, but they cannot change the forces of supply and demand. Indeed, their tampering only makes matters worse. The gas lines, shortages, and occasional violence that accompanied gasoline price caps in the 1970s should serve as an effective reminder. Politicians should he lessons of history and sound economics. To be sure, end all privileges for the oil companies, but leave gasoline prices alone.

1. See Robert Higgs, Crisis and Leviathan(Oxford University Press: NewYork, Oxford, 1987).
2. In the words of University of Chicago economist Austan Goolsbee, “States tend to make their anti-gouging laws purposely vgue, forbidding ‘unconscionable profiteering’ during a state of emergency or the like.” ” Pump It Up,” Slate, September 7, 2005, www.slate.com/id/2125814/.
3. Nedra Pickler, “Bush: Rebuilding Must Address Inequality,” Associated Press, September 16, 2005, www.newsmax.com/archives/articles/2005/9/16/134806.shtml.
4. “What Not to Do About Rising Energy Prices,” Research Reports, American Institute for Economic Research, September 12, 2005.
5. Rob Bradley, “Gasoline Prices: Still Good News,” Cato Institute Daily Dispatch, April 13, 2002, www.cato.org/dailys/04-13- 02.html.
6. William Anderson, “Congress and Oil Prices: The Outrage Mises.org Daily Article, May 6, 2002, www.mises.org/story/951.
7. “High Pump-Price Fairy Tales,” National review.com, June 3, 2005, www.nationalreview.com/nrof_comment/taylor_van_doren200506030857.asp.
8. Figures provided by the U.S. Energy Information Administration, Department of Energy, http://tonto.eia.doe.gov./oog/info/twip/twip.asp.
9. Russell Roberts, “The Reality of Markets,” Library of Economics and Liberty, September 5, 2005, www.econlib.org/library/Columns/y2005/Robertsmarkets.html.
10. Carola Hoyos and Javier Bias in London, “Search for Oil Stepped up as Price Rises,” Financial Times, September 12, 2005; Amy Lee and Brett Canton, “Gas Costs Stall Used Truck Sales,” Detroit News, July 11, 2005.

While reading this article might have a zero price, it most assuredly doesn’t have a zero cost. To reinforce the idea that price is not the full measure of cost, imagine that you live in St. Louis. The barber who cuts your hair charges $20. Suppose I told you that a barber in Charleston, S.C., would charge you $5 for an identical haircut, would you consider the Charleston haircut cheaper? While it has a lower price, it has a much greater cost.You’d have to sacrifice much more in terms of time, travel, and other expenses to get the Charleston haircut.

People often erroneously think of costs as only material things, but that which is sacrificed when a particular choice is made can include clean air, leisure, morality, tranquility, domestic bliss, safety, or any other thing of value. For example, a possible cost of a night out with the boys might be the sacrifice of domestic bliss.

Costs affect our choices in many ways, and for the purposes of this discussion we’re going to assume that all the costs associated with a given choice are borne by the chooser.

Just about the most important generalization that we can make about human behavior is that the higher the cost of a particular choice the less of it will be chosen and the lower the cost the more of it will be chosen. This generalization underlies the law of demand. For simplicity let’s assume price measures cost while we hold everything else influencing choice constant. The law of demand can be expressed several ways: the lower the price of something, the more will be taken; and the opposite is true of the higher price. We can also say there exists a price whereby one can be induced to take more or less of something. Finally, there’s an inverse (reverse) relationship between the price of a good and the quantity demanded.

Why do people behave this way? The answer in a word or two is that people try to be as happy as they can. For example, if, when the price of oil rose, people simply ignored the price increase, they’d have less to spend on other things and be less happy. If they sought substitutes for the higher priced oil, they’d have more money left over and they’d be happier. That’s why higher oil prices give people incentive to purchase more insulation, buy better windows, wear sweaters, and maybe move to a warmer climate. These choices, and many more, are substitutes allowing you to use less oil.

When people say a certain amount of one thing or other is an absolute must, that’s like saying the law of demand doesn’t exist and there are no substitutes. That’s untrue—consider a diabetic. Can he do without 50 units of insulin a day? The law of demand says that at some price, say at a $1,000 a unit, he can. There’s always at least one substitute for any good: doing without the good all together. In the diabetic’s case, no insulin. While going without insulin has unpleasant consequences, it’s a likely substitute at $1,000 a unit. You say, “Williams, that kind of economic analysis is cruel!” It’s no more cruel than the law of gravity that predicts that if you jump off a skyscraper you’re going to die. Both outcomes are unattractive, but it’s reality. Indeed, tragically millions of our fellow men around the globe are forced to endure the unpleasant substitute for insulin.

There’s a complexity to the law of demand that states: the lower the price the more people will take of something and the higher the price less will be taken. It’s crucial to recognize that it’s relative prices that determine choices, not absolute prices. Relative price is one price in terms of another price. Here’s an example; actually it’s a trick I pull on freshman students. Suppose your company offered to double your salary if you’d relocate to their Fairbanks, Alaska, office. Would you consider it a good deal and accept the offer? Some students thoughtlessly answer yes. Then I ask what if, on arrival, you find out that rents are more than double what you’re paying now and the prices of food, clothing, gasoline, and other items are three and four times more expensive. The end result is that while your absolute salary has doubled, your salary, relative to other prices, has fallen.

A bit trickier example of how it’s relative prices, not absolute prices, that influence behavior comes with the observation that married couples with young children who can’t be left alone tend to choose more expensive dates than married couples without children. The couple’s income and tastes have little to do with their decision; it’s relative prices. Keeping the numbers small, say an expensive date, dinner and concert, has a $50 price tag and a cheap date, a movie, $20. The choice of the $50 dinner and concert requires that the married couple without children sacrifice two and a half movies that they could have otherwise enjoyed.

The married couple with children must pay a babysitter $10 whether they go on the expensive or cheap date. With the cost of the babysitter figured in, the dinner and concert will cost them $60 and the movie $30. In choosing the dinner and concert, they sacrifice only two movies. That date is therefore relatively cheaper for the married couple with children. Since it’s cheaper we can expect to observe married couples with children taking more expensive dates when they go out. It doesn’t take economic analysis to come up with this. A husband might suggest, “Honey, let’s hire a babysitter and take in a movie.” The wife explains, “That doesn’t make sense. Since we have to pay $10 for a babysitter, whether we go on a cheap or expensive date, why not get our money’s worth and take in a dinner and concert?”

Rising Coffee Prices

How about another example of relative prices? Suppose today’s coffee price is $1 a pound and you typically purchase two pounds per week. You hear news that a freeze in Brazil destroyed much of its coffee crop and coffee prices are expected to soon rise. What would you do and why? I’m guessing you’d make larger coffee purchases now, but why? The average person would answer, to save money. That’s an okay answer, but it doesn’t tell the whole story. Once again it’s the law of demand working. If coffee prices are expected to rise next week, that means coffee prices this week have fallen relative to those next week, and the law of demand says that when a price of a good falls people will take a larger quantity. It works in reverse as well. If coffee prices are expected to fall next week, you’d buy less coffee this week. Why? Coffee prices have risen this week relative to next week.

You might be tempted to ho-hum this coffee analysis as oversimplification, but it is the basic principle underlying the complexities of futures markets such as the Chicago Mercantile Exchange, where people, as speculators, become rich, sometimes poorer, guessing the future prices of commodities.

Our next lecture will see what the law of demand says about discrimination and other choices we make.