Introductory Concepts and Supply and Demand (Chapters 1-9)
1. Introduction The Midnight
Economist
According to a famous definition: “Economics is the science which studies human behavior as a
relationship between ends and scarce means which have alternative uses.”
Some may gag a bit over reference to economics as a science. And some may sense
from the definition a lack of sex appeal, with economics appealing as a deadly dull, dry, and
dreary field of arcane doodling and diddling. In actuality, there is, in good economics, much of
feel and flair, of instinct and intuition: economic analysis is not a purely mechanical exercise of
grandly grinding out uninteresting answers to artificial problems. In any discipline of analytic
application to important matters, elegant tools and rigorous techniques of thought must be
supplemented with accumulated learning and developed wisdom in order to distinguish the
profound from the superficial, the appropriate from the inapt and the inept, and the feasible from
what cannot work well.
A world of scarcity is inherently a hard world. But with some civility and sense, we can
make our lives easier than they otherwise would be. How are we to organize ourselves as a
community, what ground rules and institutions can we evolve and adopt which will enable people,
with all their grasping grubbiness, to live together peacefully and productively?
By and large, people and their governmental leaders and masters have not answered
that central question well. History is not an impressive story of progressive sophistication in
formulating rules and procedures which enable the great bulk of the world’s people to live without
People usually have done as well in their personal affairs as they have been permitted to
do. How can they be permitted to do better? Much of what we do is “economic” in nature—what
we do and how we do it, that is, in allocating “scarce means which have alternative uses.” Much
of our misery has stemmed from dumb economics-inefficient institutions, inappropriate property
fights, wasteful processes, debilitating policies.
While people commonly are shrewd in handling their private business, they are not
accomplished economists in the broader context where their expertise and; experience are
necessarily limited. And they have been taught much mythology, including:
* a government budget deficit reflects failure to tax enough to finance needed government
services, and increasing tax collections will surely reduce a deficit;
* inflation is caused by greedy domestic monopolists and irrational consumers, and disruptive
international cartels;
* the optimal size of various key measures is invariably zero, e.g., zero budget deficit, zero
foreign trade balance, zero unemployment, zero pollution, zero crime, zero unwed mothers;
Questions for Thought and Discussion:
1. Frank Knight, a famous economist, was well-known for saying “It ain’t ignorance that does the
most damage; it’s knowing so derned much that ain’t so.” If the myths listed above are not, in fact,
true, what differences will it make in our understanding of public policy?
2. In a world of scarcity, can social problems be “solved” without causing problems elsewhere?
Which problems are therefore worth solving?
2. Understanding Adam Smith and the Economy The Midnight Economist
Mouse Karl was in one of his sophisticated moods of insightful sneering. “You and Professor
Allen,” he sneered to Mouse Adam in sophisticatedly insightful manner, “like to laud Adam Smith
as the great father figure of modern economics. But Smith was either extraordinarily naive or a
deliberate purveyor of capitalistic propaganda. And, in extolling Smith, you and Allen also are
either innocent of sense or guilty of little integrity.”
“Well!” exclaimed the amiable Adam. “What inspired that outburst? Adam Smith was
capable of error and inadequacy. Further, there have been giants in the history of economic
analysis both before and after Smith. Still, his influence on serious economic thought has been
enormous.”
“I confess that I am confused,” conceded Karl. “If businessmen are so grasping, so
willing to exploit, how could Smith promote an arrangement of private property and open markets,
thereby giving free play to the most unlovely characteristics of people?”
“Market processes, with efficient production and exchange,” answered Adam, “do not
require that we like one another and are inspired by purity of heart to cooperate with one another.
Market institutions and prices provide options and incentives to use our privately-owned
resources well. Our intention is to benefit ourselves. But we individually prosper by supplying
valuable goods and services to others, led as by ‘an invisible hand’ to coordinate our activities to
the benefit of all.”
Questions for Thought and Discussion:
1. If an analyst has made mistakes in one area, does that demonstrate whether his ideas in other
areas are either correct or incorrect? Why do you think people so often attack the analyst rather
than the analysis?
3. Economic Order: Big Brother Versus Mutual Bribery The Midnight Economist
We dream of a world in which no one has to work, where nature lavishes on us all the goods we
could desire. But this is not the kind of world in which we actually live. The means to satisfy
wants are scarce: we want more than we can have.
Scarcity gives rise to competition and conflict. And yet in a viable society we must live
together with coordinated activity. How can there be peaceful and efficient co-existence of
acquisitive and uncooperative people in a stingy world?
Common Benefit.”
One may reject violence as a mode of interpersonal relations and still be dissatisfied with
the Hobbesian resolution of the problem. Instead of state–imposed order, how about mutual
bribery? We tend to class as immoral all bribery. But is it immoral to induce people to do what
you wish by making them better off?
Let Adam Smith, the Scottish thinker of the 18th century, explain:
Man has almost constant occasion for the help of his brethren, and it is in
address ourselves not to their humanity but to their self–love.
We are confronted by scarcity. And so conflict does exist. Are we to adapt through
giving up our individual freedom and responsibility to Hobbesian central control or adapt through
mutually beneficial coordination of self-interested actions in a market system?
Questions for Thought and Discussion:
1. Are character traits, like honesty and compassion, scarce, in much the way that iron ore and
arable land are scarce? How does this scarcity affect how we organize society?
4. Needs and Preferences, Decrees and Market Bids The Midnight Economist
Marxists and poets speak of “needs.” But, in economics, “need” is a non-word. Economics can
say much which is useful about desires, preferences, and demands. But “need” presumably is a
moral, psychological, or physical imperative which brooks no compromise or adjustment–or
analysis. If we “need” something, we must have it: There is literally no alternative of either
substitution or abstinence.
But the assertion of absolute economic “need”–in contrast to desire, preference, and
demand–is nonsense. What do we do if I need” a certain amount of something and you also
compassion, and there will be a journalist who will protest that you lack humane values.
If distribution by central authority for the purpose of better satisfying “needs” were
desirable in the case of medical care or concert tickets, it is difficult to see why the same system
should not be used in distributing the entire social output, regardless of differing productivities of
workers and differing preferences of consumers. Few of our self-styled benefactors go that far
(Nor did the Russians ever go that far in practice). While they enthusiastically champion it case-
by-case, even the naive and the vicious recognize it in the aggregate as in some sense
ridiculous–both unfeasible and unappealing.
Obviously, the world is complicated and frustrating. To make do well, we must analyze
cogently and act effectively on the basis of the analysis. We must have intellectual guidance–-an
Questions for Thought and Discussion:
1. Why is talking in terms of needs not useful in analyzing people=s behavior? Why does
marginal analysis require analytical terms such as preferences and demands rather than
needs ?
2. If I argue that the government should provide me with something because I need it, is that
analytically any different from saying I want it, but I don t want to pay for it ?
5. Property Rights, Conflict, and Harmony The Midnight Economist
It is doubtful that Adam and Eve could have had a full measure of comprehension of the
implications of their indiscretion. The consequences have been more dire than they should have
been, for succeeding generations have not always adjusted shrewdly to the condition of scarcity
which was seductively introduced into the Garden.
How is a society to deal with the competitions and conflicts inevitably associated with
scarcity? We are forever cursed with sweaty brows in obtaining our daily bread and it behooves
These different approaches to living together in a stingy world are illustrated by
administration of large blocs of valuable land. As recounted by economists John Baden, Richard
Stroup and Dwight Lee, the Audubon Society owns the Rainey Wildlife Sanctuary in Louisiana.
The Sanctuary not only is home for much wildlife, it also contains natural gas deposits.
If the territory were owned by government–as is two-fifths of this nation–the Audubon
Society and the energy companies would be natural enemies. Each party, in single-minded self-
interest, would seek the jugular of the other through wielding political influence. But with private
ownership of the land, there is room and incentive for mutually useful negotiation. The Audubon
Questions for Thought and Discussion:
1. Was anything scarce in the Garden of Eden story? What?
2. Why would the Audubon Society develop natural gas deposits on its own wildlife sanctuary,
yet oppose similar development on government-owned land?
6. Unhappiness and Uncleared Markets The Midnight
Economist
If Karl had been a chicken instead of a mouse, he would have been in a fowl mood. “I’m sick of
hearing you economist types talk about market equilibrium,” he snarled at his fellow mouse,
Adam. “You seem to want equilibrium at any price and suppose that that will solve all our
problems.”
“I’m sorry to learn of your sickness,” soothed Adam. “But you may be sick for wrong
reasons. We don’t want equilibrium at any price; rather we want a price at which there is
equilibrium. And we want an equilibrium price, not because that will solve all problems, but
“A price which is market-clearing is at an equilibrium level,” Adam explained. “At that
unique price, the amount of the good demanders are willing to buy is just equal to the amount
suppliers are willing to sell, and the price stays where it is. No one is frustrated because he
cannot buy or sell more at that price. Avoiding that particular frustration is not everything, to be
sure. Whatever is the market mechanism or the bureaucratic procedure of determining prices, it
will still be a world of scarcity.”
Questions for Thought and Discussion:
1. Is the quantity traded at the equilibrium price greater or less than if the government imposed a
higher minimum price or a lower maximum price?
7. Scarcity, Shortage, and Policy The Midnight Economist
Ever since the serpent seduced Eve and Eve seduced Adam, we have been cursed with scarcity.
No matter how much, how hard, and how well we work, we cannot produce all of everything we
want. It is not likely that grubby people will soon stop wanting so much; it is no more likely that
the supply of manna from heaven will appreciably increase. So it behooves us to be efficient,
squeezing as much as possible of those things we want most out of the limited resources we
Curtailment of oil can be a major difficulty. With current and prospective oil supplies
reduced, it is not surprising that the valuation of oil would rise. There is nothing nefarious or
subversive in gasoline prices going up when supply goes down.
But an increase in the price of a commodity as conspicuous as gasoline brings out the
demagogic craziness of Senator Snort and his little friends, who love to snarl darkly about
“gouging” by Daddy Warbucks. Even when the boys try to be terribly analytic, they make hash of
good sense. A single story in the Los Angeles Times refers ten–count them, ten–times to oil and
fuel shortages when what was meant was simply reduced supply.
If supply of oil is reduced, of course price rises. And the rise of price serves a purpose:
Questions for Thought and Discussion:
1. Does a dramatic reduction in the supply of a product result in a shortage? Does a dramatic
increase in the supply of a product result in a surplus?
2. If there is a sharp reduction in the supply of a good, how does imposing a price ceiling cause
the output available to fall even more than it would have otherwise?
8. The Moving Forces Behind Market Prices The Midnight Economist
Some economic fallacies don’t die easily. Take the belief that the only determinant of a market
price is the cost of producing the particular good. When a price rises or falls, it is commonly
assumed that the item’s cost of production must have gone up or down. And there is a tendency
to condemn price increases which are not apparently due to higher production costs.
But market prices are not mere reflectors of production costs. To see the real driving
force behind market prices, consider rental rates on trucks between Houston and Detroit. The
There are thus two factors which determine a market price: consumers’ demand and the
available supply. Either or both can change without any change in the cost of production. The
early 1980s decline in the auto industry induced more people to migrate from Detroit to other
areas, such as Houston. The demand for rental trucks in Detroit jumped. Inventories dropped.
Rental rates soared in order to apportion existing truck supplies among competing renters.
Someone who wanted to move from Detroit to Houston, therefore, had to pay a higher rental fee
because increased consumer demand and consequent dwindling inventories made rental trucks
scarcer in Detroit. Meanwhile, in Houston, competition for trucks was much smaller, and the
available supply of trucks increased as people arrived from depressed areas, such as Detroit.
Both factors–a smaller demand and a larger supply–kept rental rates in Houston much lower.
The lesson is clear. Prices move up or down in order to ration the existing supply among
Questions for Thought and Discussion:
I. What happens to the opportunity cost of renting a truck, an apartment, etc., when more people
want it than before? When fewer people want it than before?
2. If costs borne in producing an item determines its value, should smarter students get lower
grades if they learned the material more quickly or easily? Should shorter people get more points
if they make a shot in basketball?
9. The Law of Demand and the Message of the Market The Midnight Economist
Occasionally, I have occasion to go from here to there. With time constraints which are severe, I
go by big, iron bird, despite the fact that travel in the cattle-car section of the plane is pretty
The Law of Demand says that the price of a good and the amount people are willing to buy
are inversely related. Starting with today‘s price, the price can be raised enough to induce people
to buy less; and price can be lowered enough to increase the amount demanded.
The Law of Demand holds for labor services as well as for airline travel. Does anyone really
suppose that employers will hire as many workers at a higher wage per hour as they would at a
lower wage? Surely not. And yet, a majority of Congress voted to increase the minimum wage,
with the President s support, while insisting that employment would not be affected.
The Law of Demand holds for gasoline. During the OPEC cartel shenanigans of the 1970’s,
many people with a public forum asserted that letting gas prices rise would not induce the
Questions for Thought and Discussion:
1. If you choose cattle-car airline seating on a flight to save $200, what does that indicate about
the added value to you of better seats?
2. Why must we be careful not to generalize from the statement would not fly to Detroit more
often at a price of $150 than at a price of $350″ to the statement people will not fly to Detroit
more often at a price of $150 than at a price of $350 ?
10. Liquidity Crisis The Midnight
Economist
Water is a liquid asset. And it is scarce: we don’t have all we want. For many, scarcity means
shortage. So we are told that we must now act appropriately or gasoline shortages of yesteryear
will pale in comparison with future shortages of water. Drought, population growth, industrial
expansion, pollution, increasingly thirsty appliances–all supposedly are disastrously gulping our
limited fresh water.
If we are not to go far in increasing water supply, perhaps we can cut water consumption
and improve the efficiency of use of the water we have. Some want water police to implement
controls and decrees, prohibiting ornamental and golf course use of water, unrequested serving
of water in restaurants, use of hoses in cleaning driveways and automobiles, and dampening
construction sites to keep down dust.
We need not surrender to officious officials the right to choose acceptable uses of water.
Freedom of individual choice is compatible with–and, indeed, required for—socially efficient use of
economically feasible to grow monsoon crops in a virtual desert. We cannot afford federal and
local laws which make it illegal for some areas to sell excess water to other areas which want to
buy it. We cannot afford, in short, to perpetuate a staggering subsidization of waste.
If California’s farmers used just 10 percent less water, enough additional water would be
available to everyone else,” says The New York Times, “for decades of urban growth with some
left over to restore the plundered salmon streams and wetlands.”
Questions for Thought and Discussion:
1. Why don t more farms in hot weather climates water at night, when evaporation is less, use
more water-saving drip watering systems or switch to less water intensive crops?
2. If there was a water market, why wouldn t the current large difference in what agricultural
users and urban users pay for water persist?
11. How Do We Ration a Pie Too Small? The Midnight
Economist
We have a rationing problem. We have had a rationing problem ever since a disgusted Deity
sent Adam and Eve packing. All of the currently produced pie of aggregate output is divided
among the members of the community, but everyone would like a bigger slice.
If the markets for the many goods are cleared, everyone can buy as much as he is willing to
buy at going prices. But we all still want more. So how about forcing down prices? However, if
we decree lower prices, we induce greater quantities demanded of the various goods and smaller
quantities supplied of most of them. Inflicting shortages through price controls will not magically
return us to the Garden of Eden.
In a purported spirit of “fairness” and a striving for “equity,” we sometimes stipulate
maximum prices, making it illegal to buy or sell an item above the ceiling price. Such stipulation
does not eliminate scarcity, and thus it does not eliminate competition. Rather, it simply curtails
one form of competition, so alternative forms must now be used. If people cannot buy as much
as they want at market prices, how else can they compete? In what other ways can the
necessary rationing be done?
One perfectly splendid way is to wait in line: first-come-first-served--with those at the end of
There is much to be said for the impersonality of the open market. Money is simply money,
and mine is no better than yours. If market competition is to be conducted in terms of beauty,
grace and charm, a few of us will do alright. But most of you will be in big trouble.
Questions for Thought and Discussion:
I. How can price ceilings, designed to ease the burden of scarcity in terms of money prices,
make goods still more scarce and costly?
2. Why is it in the joint interest of both buyers and sellers to convert non-money costs into money
prices?
12. The Hurricane After Hugo The Midnight
Economist
“It s disgraceful how some mice take advantage of others‘ misfortune,” complained Mouse KarI.
“After hurricane Hugo smashed the east coast, sellers increased prices of ice, plywood, chain
saws and other goods. Fortunately, government blocked the gouging by making it unlawful to
raise prices after the hurricane.”
“But the hurricane did temporarily increase the scarcity of many products,” answered Mouse
Adam. “Supplies of many items fell at the same time demands for them rose. There were not
enough products to satisfy all of every mouse’s increased wants, so somehow these items had to
“But price controls are not an effective means for helping the poor,” admonished Adam.
“Remember, price controls create shortages and cause rationing by waiting in line. Is it not cruel
to imply that a poor, elderly mouse in ill health cannot receive immediate relief because she does
not have as much endurance as others to wait in line?”
Rationing by waiting in line does not guarantee poor mice a greater share of the pie,”
continued Adam. “Indeed, many mice will pay others to wait for them. If public officials were
sensibly concerned about assuring the poor minimal access to goods in the marketplace, they
would give the poor cash to supplement their buying power. Then, the entire community–not just
suppliers of the purchased goods–would bear the cost of the subsidy.”
“Well, government price controls do keep goods cheaper during the emergency,” remarked
Karl.
Questions for Thought and Discussion:
1. How can government price ceiling hold down prices of goods but increase their opportunity
cost?
2. Why will price ceilings imposed after a disaster make recovery slower than it would otherwise
have been?
13. Safety Policies and Indirect Costs The Midnight
Economist
Sometimes things are not what they seem. And sometimes the illusion is more satisfying than
the reality. That is why cosmetics and foundation garments sell so well. But in the world of
economics, being led astray can be costly. And we often mislead ourselves. We can easily
mislead ourselves by stopping the thought process too quickly, noting only immediate
characteristics of problems and effects of policies, overlooking indirect implications and
consequences.
Safety is good. Granted, some extraordinarily silly things have been said in support of zero
tolerance of risk in a world of substantial inherent risk. But it can be prudent to promote reduction
of risk at reasonable cost.
Now, is that the appropriate end of the analysis? We like safety; infant safety seats can be
protective; so we should make such seats mandatory. Economists Richard B. McKenzie and
Dwight R. Lee suggest that we go further.
First, note the very modest gain in safety which would be achieved. Research in the
Department of Transportation indicates that mandatory safety seats could have prevented just
one infant death in the 12 years 1978-90. There were additional child fatalities in that period, to
be sure, but they occurred in sections of planes where no one survived.
Second, demanders respond to changes in prices. If the expenses of airline travel rise,
Questions for Thought and Discussion:
1. Could mandating $5000 of added safety equipment on all new cars result in more automobile
deaths and injuries than would otherwise have occurred? (hint: how long would you keep your old
car?)
2. How can making cars safer increase the number of pedestrian deaths from car accidents?
14. Private Property and Pollution The Midnight Economist
Everyone who is sensitive, cultured and very anxious to do good knows that the free–market
economists have sold out to Big Business, and that Big Business, in turn, delights in pillaging and
raping the landscape, the seascape, and the atmosphere in its frenetic search for an extra buck.
But Professor Dwight Lee provides quite a different--and vastly more sophisticated—picture.
The problem of environmental pollution, Professor Lee explains, is fundamentally an
economic problem, that is, a problem of scarcity. Pollution is a cost of living and producing;
worth of goods not only to their owners, but also to others in the market.
Automobiles are private property, as are the gasoline and maintenance services which keep
them rolling. People rationally buy and sell such assets. But operating a car creates pollutants
which are emptied into the air–and air is not privately owned. Small wonder that we accept the
gains of automobile transportation but ignore the pollution costs. We weigh the costs of the car,
the gas and the maintenance against their benefit, but we do not have to buy the air, so we treat
pollution as being free.
In the absence of saleable property rights, there are no markets and no prices to induce
and guide efficient use of resources. The costs of pollution aren=t fully weighed, and individually
rational activity in a defective institutional arrangement results in excessive pollution.
Questions for Thought and Discussion:
1. Would it be possible to have zero pollution by any means?
15. Property Rights and Pollution The Midnight
Economist
“A sell-out to big business!” fumed Mouse Karl.
“What’s raising your blood pressure now?” wondered Mouse Adam.
grant rights to pollute,” gasped Karl. “In Southern California, the Air Quality
Management District is considering a plan to trash its regulatory procedures for curbing smog.
Instead, the agency would set an overall level of allowable air pollution, divide the total allowance
into shares, and then distribute the shares among local firms. The total allowance would decline
“As a remedy,” countered Karl, “governments have regulatory standards.”
pollute. Eliminating all pollution would mean prohibitive sacrifices by the community. So
government regulation, like the proposal you scorn, gives mice the right to put some dirt and
toxins into the air.”
“Maybe,” conceded Karl. “But at least regulation doesn’t let mice profit by selling their right
to pollute. With old-fashioned regulation, government just orders businesses to limit pollution by
telling them how to change their activities and technologies.”
Questions for Thought and Discussion:
1. Why do current pollution standards amount to rights to pollute?
2. Why would tradable pollution rights tend to lower the costs of a given degree of pollution
reduction?
16. Congress, Ethics, and Rules The Midnight Economist
“The rich are very different from you and me.” “Yes,” wrote Ernest Hemingway, “they have
more money.”
But what of public officials? Are they different from you and me? Many believe that
government types, unlike the rest of us, should always put the community’s interest before their
own.
So when government representatives do not act altruistically, a lack of ethics is often
blamed. Ethical behavior is no less important in personal and commercial relationships than in
But people are not angels. Unethical behavior stains the marketplace, as it blemishes
personal relationships and government. Compared with the marketplace, however, government
lacks effective rules of the game to direct self-interest to the common benefit.
These rules are absent or weak for a number of reasons. First, government officials are
often unable to identify community preferences. The community cannot easily communicate to
government. Most voters rationally remain ignorant about particular issues, for becoming well
informed is a costly process with only the small benefit of casting a vote more intelligently–and
the vote is for a candidate who represents a large package of diverse issues.
Second, government people typically lack effective incentive to satisfy community
preferences, for, unlike producers in the market, they do not increase their own wealth by
Questions for Thought and Discussion:
1. Does a rich person have more or less power to harm you than a congressman?
2. In a market system, if someone, whether rich or poor, wants to get richer, will he help or hurt
others in the process? Does someone who wants to get richer through government activity help
or hurt others in the process?
17. Education, Sex, and Character The Midnight
Economist
We do not live in a gentle and genteel age. Typically, behavior is neither decorous nor
disciplined. Conduct evinces general lack of pride and common rejection of erstwhile
conventional proprieties. And irresponsibility has its costs.
providing contraceptives and abortions have had the highest rates of premarital teenage
pregnancy.
Sexual activity is not a function of sex education alone. Such activity is reduced by family
stability, represented by both parents being in the home. It is reduced even more by frequent
church attendance.
Economics can contribute critically to analysis of teenage promiscuity and pregnancy and
to policy implications. Still, the problem is ultimately one of character and cultivation and
commitment. When social opprobrium of loutish behavior is severely diluted, when the
community has largely succumbed to coarseness, there can be no very satisfying and effective
answers. The best we can do in our degenerate condition is to fight a losing rearguard action in
trying simply to minimize losses and delay final disaster.
Questions for Thought and Discussion:
2. Why could the two consequences of sex education discussed above either raise or lower the
number of teenage pregnancies that result?