For well over a hundred years, the economic world has been engaged in a great intellectual debate. On one side of this debate have been those philosophers and economists who advocate an economic system based on private property and free markets—or what one might call economic freedom. The key ingredients of economic freedom are personal choice, voluntary exchange, freedom to compete in markets, and protection of person and property. Institutions and policies are consistent with economic freedom when they allow voluntary exchange and protect individuals and their property. Governments can promote economic freedom by providing a legal structure and a law-enforcement system that protect the property rights of owners and enforce contracts in an evenhanded manner. However, economic freedom also requires governments to refrain from taking people’s property and from interfering with personal choice, voluntary exchange, and the freedom to enter and compete in labor and product markets. When governments substitute taxes, government expenditures, and regulations for personal choice, voluntary exchange, and market coordination, they reduce economic freedom. Restrictions that limit entry into occupations and business activities also reduce economic freedom. Adam Smith was one of the first economists to argue for a version of economic freedom, and he was followed by a distinguished line of thinkers that includes John Stuart Mill, Ludwig von Mises, Friedrich A. Hayek, and Milton Friedman, as well as economists such as Murray Rothbard. On the other side of this debate are people hostile to economic freedom who instead argue for an economic system characterized by centralized economic planning and state control of the means of production. Advocates of an expanded role for the state include Jean-Jacques Rousseau and Karl Marx and such twentieth-century advocates as Abba Lerner, John Kenneth Galbraith, Michael Harrington, and Robert Heilbroner. These scholars argue that free markets lead to monopolies, chronic economic crises, income inequality, and increasing degradation of the poor, and that centralized political control of people’s economic lives avoids these problems of the marketplace. They deem economic life simply too important to be left up to the decentralized decisions of individuals. In the early twentieth century, state control grew as communism and fascism spread. In the United States, the New Deal significantly expanded the role of the state in people’s economic lives. In the late 1970s and early 1980s, economic freedom staged a comeback, with deregulation, privatization, and tax cuts. Of course, the major increase in economic freedom came with the fall of the Soviet Union. Today, the advocates of freedom dominate the debate. In fact, one major socialist, the late Robert Heilbroner, believed that the advocates of freedom have won (see socialism). Substantial evidence has informed the debate. Indeed, the stark differences in the standards of living of people in economically freer systems compared with those in less-free systems have become more and more obvious: North versus South Korea, East versus West Germany, Estonia versus Finland, and Cubans living in Miami versus Cubans living in Cuba are examples. In each case, people in the freer economy have better lives, in virtually every way, than their counterparts in the less-free economies. Measuring Economic Freedom The above comparisons are suggestive. But is it possible to find a relationship between economic freedom and prosperity over a wider range of nations? In the 1980s, scholars began to measure and rate economies based on their degree of economic freedom. Organizations such as Freedom House, the Heritage Foundation, and the Fraser Institute, as well as individual scholars, published “economic freedom indexes” attempting to quantify economic freedom. They came up with an ambitious, and necessarily blunt, measure. In 1996, the Fraser Institute, along with a network of other think tanks, began publishing the Economic Freedom of the World (EFW) annual reports, which present an economic freedom index for more than 120 nations. Using data from the World Bank, International Monetary Fund, Global Competitiveness Report, International Country Risk Guide, PricewaterhouseCoopers, and others, the report rates countries on a zero-to-ten scale. Higher scores indicate greater economic freedom. The overall index is based on ratings in five broad areas. Counting the various subcomponents, the EFW index uses thirty-eight distinct pieces of data. Each subcomponent is placed on a scale from zero to ten that reflects the range of the underlying data. The component ratings within each area are averaged to derive ratings for each of the five areas. In turn, the summary rating is the average of the five area ratings. The five major areas are: • Size of government. To get high ratings in this area, governments must tax and spend modestly, and marginal tax rates must be relatively low. While governments are important in protecting property rights, enforcing contracts,

The distribution of income lies at the heart of an enduring issue in political economy—the extent to which government should redistribute income from those with more income to those with less. Whether government should redistribute income is a normative question, and each person’s answer will depend on his or her values. But for many people, answering the normative question requires understanding the facts about the current income distribution. The term “income distribution” is a statistical concept. No one person is distributing income. Rather, the income distribution arises from people’s decisions about work, saving, and investment as they interact through markets and are affected by the tax system. The 1990s and early 2000s witnessed the establishment of a growing body of work, increasingly precise, describing how the income distribution has changed. This work can be summarized in three points: • The distribution of pretax income in the United States today is highly unequal. The most careful studies suggest that the top 10 percent of households, with average income of about $200,000, received 42 percent of all pretax money income in the late 1990s. The top 1 percent of households, averaging $800,000 of income, received 15 percent of all pretax money income. • In the longer view, the path of income inequality over the twentieth century is marked by two main events: a sharp fall in inequality around the outbreak of World War II and an extended rise in inequality that began in the mid-1970s and accelerated in the 1980s. Income inequality today is about as large as it was in the 1920s. • Over multiple years, family income fluctuates, and so the distribution of multiyear income is moderately more equal than the distribution of single-year income. Trends in Inequality The most frequently cited statistics come from the U.S. Census Bureau’s Current Population Survey (CPS), the monthly household survey best known as the source of the official unemployment rate. Since 1948, the March edition of the CPS has collected household income information for the previous year, as well as the personal characteristics of household members—their age, education, occupation, and industry (if they work), and other data that help give insight into changing income patterns. Although this makes the CPS an indispensable statistical source, it has disadvantages as well. The CPS uses a restricted income definition: pretax money receipts excluding capital gains. This definition is further restricted by a “cap,” currently $999,999, imposed on reported annual earnings for reasons of confidentiality.1 Together, these problems mean that CPS estimates of inequality omit the effects of taxes, nonmoney income such as government and private health insurance, and the portion of individual earnings that exceeds the cap. A second source of inequality statistics is the U.S. Treasury’s Statistics of Income (SOI), which summarizes income reported on federal income tax returns. SOI data contain no personal data on taxpayers such as age or education, and they cannot describe the precise shape of the lower part of the income distribution.2 The strengths of SOI data are their ability to accurately describe the upper part of the distribution—SOI income data are not “capped”—and to extend this description back to 1917, thirty years before CPS statistics begin. Table 1 contains selected information on CPS measures of family and household income inequality since World War II.3 The upper panel describes income patterns across families: living units occupied by two or more related persons. The lower panel describes income patterns across households: all occupied living units including families, persons who live alone, unrelated roommates, and so on. To form each distribution, the sample of families (or households) is listed in order of increasing income. The Census then calculates the fraction of all family income going to the quintile (one-fifth) of families with the lowest incomes, the quintile of families with the second-lowest incomes, and so on, as well as the share going to the highest 5 percent of families (who also are included in the top quintile). The CPS data in Table 1 trace a J-shaped evolution of post–World War II inequality. In 1947, the top quintile of families received $8.60 for every dollar of income received by the bottom quintile. This ratio fell gradually through the 1950s and 1960s until 1969, when it reached $7.25 to $1.00—the low point of inequality. Beginning in the late 1970s, the ratio began to rise again until, by 2002, it had increased to $11.36 to $1.00, significantly greater than in 1947. Household data tell a similar story. To make these trends more concrete, Table 1 includes the 1947, 1979, and 2001 income levels that divide each quintile from the next. Similar data are presented for households, and all income levels are expressed in 2003 dollars. Between 1947 and the mid-1970s, income grew rapidly at all points in the distribution, resulting in both rising living standards and moderating inequality. After the mid-1970s, average income grew much more slowly, and the growth that did occur was concentrated in the distributions’ upper half. Between 1979 and 2001, the income dividing the first and second family quintiles grew slightly, from $22,280 to $24,000 (7.7 percent), while the income dividing the fourth and fifth quintiles grew from $74,470 to $94,150 (26.4 percent). Now, as in the 1970s, a majority of families would describe themselves as middle class, but the “middle class” is now a larger, more diverse concept than it once was.4 Inequality estimates based on the U.S. Treasury’s SOI data expand on this picture. At the outset, SOI data do not “cap” high incomes, so household income inequality as reported in the SOI is significantly larger.5 Using “capped” statistics, the CPS reports that the top one-fifth of households receives 49 percent of all pretax money income. The SOI estimates, more accurately, that the top one-tenth of households, with average annual income of about $200,000, receives 42 percent of total pretax money income. The top 1 percent of households with average annual incomes of about $800,000 receives 15 percent of all pretax income. With their longer historical perspective, SOI statistics also show that inequality in the 1920s and 1930s was as high as it is today. Beginning in 1938, the income share of the top one-tenth of households fell from 43 percent to about 32 percent, where it remained until the deep blue-collar recession of the early 1980s. At that point, inequality began its return to the levels of the 1920s and early 1930s.6 Table 1 Family and Household Income Distributions (Census Definitions) *. Original table rearranged and bracketed headings added here for clarity. †. Data available only since 1967. A. Shape of the Family Income Distribution (share of all family income going to each one-fifth [quintile] of families) First Quintile (Lowest Income) Second Quintile Third Quintile Fourth Quintile Fifth Quintile (Highest Income) Top 5 percent (Contained in Fifth Quintile) Upper bound of Quintile (2003 dollars) Lower bound of top 5% [1st] [2nd] [3rd] [4th] [5th]* 1947 5.0 11.9 17.0 23.1 43.0 17.5 $11,088 $17,893 $24,263 $34,427 na. $56,506 1959 4.9 12.3 17.9 23.8 41.1 15.9 1969 5.6 12.4 17.7 23.7 40.6 15.6 1979 5.4 11.6 17.5 24.1 41.4 15.3 $23,171 $38,102 $53,979 $74,329 na. $119,243 1989 4.6 10.6 16.5 23.7 44.6 17.9 2001 4.2 9.7 15.4 22.9 47.7 21.0 $24,960 $42,772 $65,000 $97,916 na. $170,668 B. Shape of the Household Income Distribution (share of all households’ income going to each one-fifth [quintile] of households)† First Quintile (Lowest Income) Second Quintile Third Quintile Fourth Quintile Fifth Quintile (Highest Income) Top 5 percent (Contained in Fifth Quintile) Upper bound of Quintile (2003 dollars) Lower bound of top 5% [1st] [2nd] [3rd] [4th] [5th]* 1967 4.0 10.8 17.3 24.2 43.8 17.5 $14,002 $27,303 $38,766 $55,265 na. $88,678 1979 4.2 10.3 16.9 24.7 44.0 16.4 $16,457 $30,605 $47,018 $68,318 na. $111,445 1989 3.8 9.5 15.8 24.0 46.8 18.9 2001 3.5 8.7 14.6 23.0 50.1 22.4 $17,970 $33,314 $53,000 $83,500 na. $150,499 The Causes of Inequality In one sense, the growth of inequality in the last part of the twentieth century comes as a surprise. In the 1950s, the bottom part of the income distribution contained large concentrations of two kinds of families: farm families whose in-kind income was not counted in Census data, and elderly families, many of whom were ineligible for the new Social Security program. Over subsequent decades, farm families declined as a proportion of the population while increased Social Security benefits and an expanding private pension system lifted elderly incomes. Both trends favored greater income equality but were outweighed by four main factors. • Family structure. Over time, the two-parent, one-earner family was increasingly replaced by low-income single-parent families and higher-income two-parent, two-earner families. A part of the top quintile’s increased share of income reflects the fact that the average family or household in the top quintile contains almost three times as many workers as the average family or household in the bottom quintile. • Trade and technology. Trade and technology increasingly shifted demand away from less-educated and less-skilled workers toward workers with higher education or particular skills. The result was a growing earnings gap between more- and less-educated/skilled workers. • Expanded markets. With improved communications and transportation, people increasingly functioned in national, rather than local, markets. In these broader markets, persons with unique talents could command particularly high salaries. • Immigration. In 2002, immigrants who had entered the country since 1980 constituted nearly 11 percent of the labor force (see immigration). A relatively high proportion of these immigrants had low levels of education and increased the number of workers competing for low-paid work.7 These factors, however, can explain only part of the increase in inequality. One other factor that explains the particularly high incomes of the highest-paid people is that between 1982 and 2004, the ratio of pay of chief executive officers to pay of the average worker rose from 42:1 to 301:1, and pay of other high-level managers, lawyers, and people in other fields rose substantially also. Does Measurement Matter? As noted above, both CPS and SOI statistics measure pretax money income. These measurements are deficient for three reasons. First, increases in governmental aid to the poor have been concentrated in nonmoney benefits such as Medicaid and food stamps and through tax credits under the Earned Income Tax Credit (EITC). Nonmoney benefits are excluded from standard statistics, and EITC tax credits are typically underreported. Second, an increasing proportion of wage-earners’ total compensation goes to health insurance and pension benefits—which are not counted in standard statistics. Third, taxes themselves modify the income distribution. The U.S. Census has attempted to correct these definition problems for recent years by estimating the household income distribution under alternative income definitions. Table 2 shows the effect in 2001 of moving from the standard Census definition (pretax money excluding capital gains) to an adjusted definition that includes the estimated effects of capital gains, taxes, the EITC, and the monetary value of private and governmental nonmoney benefits. The result is a substantial reduction in inequality, with the ratio between incomes in the top and bottom quintiles falling from $14.31:$1.00 to $10.40:$1.00. Similar adjustments for selected earlier years indicate that better income measurement reduces inequality in any single year. Even under the adjusted definition, though, the trend toward increasing inequality in the 1980s and 1990s remains, but at a slower pace. Table 2 Shape of the Household Income Distribution Under Alternative Income Definitions for 2001 (share of income going to each quintile of households) *. Original table rearranged and bracketed headings added here for clarity. †. Standard Census Income is defined as pretax money income excluding capital gains. First Quintile (Lowest Income) Second Quintile Third Quintile Fourth Quintile Fifth Quintile (Highest Income) Upper bound of quintile (2003 dollars) [1st] [2nd] [3rd] [4th]* Standard Census income† 3.5 8.7 14.6 23 50.1 $18,618 $34,780 $55,105 $86,914 Adjusted Census income 4.5 10.3 15.6 22.6 47 $21,334 $35,485 $51,747 $75,195 Note: Adjusted Census Income is based on pretax money income including estimated capital gains, less all taxes paid plus the estimated receipt of the Earned Income Tax Credit plus the imputed value of in-kind income from employer-provided health insurance and government nonmoney benefits like food stamps, Medicare and Medicaid, and free school lunches. Table 3 Mobility Within the Family Income Distribution Quintile in 1998 First Quintile (Lowest Income) Second Quintile Third Quintile Fourth Quintile Fifth Quintile (Highest Income) First Quintile in 1988 53.30% 23.60% 12.40% 6.40% 4.30% Fifth Quintile in 1988 3.00% 5.70% 14.90% 23.20% 53.20% Source: Katherine Bradbury and Jane Katz, “Are Lifetime Incomes Growing More Unequal? New Evidence on Family Income Mobility,” Federal Reserve Bank of Boston Regional Review 12, no. 4 (2002). Inequality and Mobility A second offset to estimated inequality is economic mobility. Because most family incomes increase as people’s careers develop, long-run incomes are more equal than standard single-year statistics suggest. Table 3 summarizes the results of one study of recent family income mobility.8 Among families in the bottom quintile in 1988, half were in the bottom quintile ten years later, a quarter had moved up to the second quintile, and a quarter had moved to the third or higher quintiles. Families in the fifth quintile (highest incomes) show a similar mobility over time. The Economic Case for Inequality of Wages and Incomes David R. Henderson Is inequality of wages and incomes bad? The question seems ludicrous. Of course inequality is bad, isn’t it? Actually, no. What matters crucially is how the inequality came about. Inequality of wages and incomes is clearly bad if it results from government privileges. Many people would find such an outcome unjust, but even more important to many economists is that such inequality sets up perverse incentives. Instead of producing valuable products and services for their fellow citizens, as people tend to do in free economies, people in societies based on government-granted privileges devote much of their effort to pleasing, or outright bribing, government officials. In many African countries, for example, such as Côte d’Ivoire, Ghana, and Zaire, there are stark inequalities because the government has the power to take a high percentage of the wealth of the already poor and give a large amount of it to government officials or their cronies. And in many Latin American countries, for many decades a few families have had most of the wealth and have used government power to cement their privileges. But inequality in wages and incomes in relatively free economies serves two important social functions. First, it gives people strong incentives to produce so as to make higher incomes and wages. Second, it gives people, and not just young people, strong incentives to get training or education that will allow them to perform well in higher-wage jobs. In his January 1999 Richard T. Ely lecture, economist Finis Welch put the point as follows: Wages play many roles in our economy; along with time worked, they determine labor income, but they also signal relative scarcity and abundance, and with malleable skills, wages provide incentives to render the services that are most highly valued. (Welch 1999, p. 1) Further Reading   Mbaku, John Mukum. “Bureaucratic Corruption in Africa: The Futility of Cleanups.” Cato Journal 16, no. 1 (1996): 99–118. Rothbard, Murray. “Egalitarianism as a Revolt against Nature.” Available online at: http://www.lewrockwell.com/rothbard/rothbard31.html. Welch, Finis. “In Defense of Inequality.” American Economic Review 89, no. 2 (1999): 1–17.   About the Author Frank Levy is the Daniel Rose Professor of Urban Economics in MIT’s Department of Urban Studies and Planning. Further Reading   Charles, Kerwin Kofi, and Erik Hurst. “Correlation of Wealth Across Generations.” Journal of Political Economy, 111, no. 6 (2003): 1155–1182. Fortin, Nicole M., and Thomas Lemeiux. “Institutional Changes and Rising Wage Inequality: Is There a Linkage?” Journal of Economic Perspectives 11, no. 2 (1997): 75–96. Gottschalk, Peter. “Inequality, Income Growth and Mobility: The Basic Facts.” Journal of Economic Perspectives 11, no. 2 (1997): 21–40. Johnson, George E. “Changes in Earnings Inequality: The Role of Demand Shifts.” Journal of Economic Perspectives, 11, no. 2 (1997): 41–54. Saez, Emmanuel. “Income and Wealth Concentration in a Historical and International Perspective.” In Alan J. Auerbach, David E. Card, and John M. Quigley, ed., Public Policy and the Income Distribution. New York: Russell Sage Foundation, 2006. Also available at http://emlab.berkeley.edu/users/saez/berkeleysympo2.pdf. Topel, Robert. “Factor Proportions and Relative Wages: The Supply Side Determinants of Wage Inequality.” Journal of Economic Perspectives 11, no. 2 (1997): 55–74.   Footnotes 1. That is, earnings greater than $999,999 are reported as $999,999.   2. SOI data are combined with national income accounts estimates of total personal income received in the economy to calculate the share of all personal income received by the top 1 percent of households, the top 10 percent of households, and so on. Because many lower-income households do not pay federal income taxes, the SOI cannot provide similar detail on, say, the share of income received by the 10 percent of households with the lowest incomes.   3. Household and family income data are available online at http://www.census.gov/hhes/income/histinc/histinctb.html.   4. The connection between “class” and the income distribution is complicated by the fact that the distribution includes families of all ages, ranging from married students to retirees, while our stereotype of a middle-class income is based on families in their prime earning years.   5. The SOI data are based on tax filing units, a concept that is reasonably close to the Census’s definition of household.   6. See Thomas Piketty and Emanuel Saez, “Income Inequality in the United States, 1913–1998,” Quarterly Journal of Economics 118, no. 1 (2003): 1–39.   7. See Robert Lerman, “U.S. Income Inequality Trends and Recent Immigration,” American Economic Review 89, no. 2 (1999): 23–38.   8. Katherine Bradbury and Jane Katz, “Are Lifetime Incomes Growing More Unequal? New Evidence on Family Income Mobility,” Federal Reserve Bank of Boston Regional Review 12, no. 4 (2002) 3–5.   (0 COMMENTS)

Defeated in battle and ravaged by bombing in the course of World War II, Germany and Japan nevertheless made postwar recoveries that startled the world. Within ten years these nations were once again considerable economic powers. A decade later, each had not only regained prosperity but had also economically overtaken, in important respects, some of the war’s victors. The surprising swiftness of recovery from disaster was also noted in previous eras. john stuart mill commented on what has so often excited wonder, the great rapidity with which countries recover from a state of devastation; the disappearance, in a short time, of all traces of the mischiefs done by earthquakes, floods, hurricanes, and the ravages of war. An enemy lays waste a country by fire and sword, and destroys or carries away nearly all the moveable wealth existing in it: all the inhabitants are ruined, and yet in a few years after, everything is much as it was before. (Mill 1896, book 1, chap. 5, para. I.5.19) Still, successful recovery is by no means universal. The ancient Cretan civilization may or may not have been destroyed by earthquake, and the Mayan civilization by disease, but neither recovered. Most famously, of course, the centuries-long Dark Ages followed the fall of Rome. Sociologists, psychologists, historians, and policy planners have extensively studied the nature, sources, and consequences of disaster and recovery, but the professional economic literature is distressingly sparse. As a telling example, the four thick volumes of The New Palgrave: A Dictionary of Economics (1987) omit these topics entirely. The words “disaster” and “recovery” do not even appear in the index of that encyclopedic work. Yet disasters are natural economic experiments; they parallel the tests to destruction from which engineers and physicists learn about the strength of materials and machines. Much light would be thrown on the normal everyday economy if we understood behavior under conditions of great stress. The Historical Record Although everyday small-scale tragedies like auto accidents and disabling illnesses are disastrous enough for those personally involved, our concern here is with events of larger magnitude. It is useful to distinguish between community-wide (middle-scale) calamities such as tornadoes, floods, or bombing raids, and society-wide (large-scale) catastrophes associated with widespread famine, destructive social revolution, or defeat and subjugation after total war. In community-wide disasters the fabric of the larger social order provides a safety net, whereas society-wide catastrophes threaten the very fabric itself. The former may involve hundreds or thousands of deaths; the latter, hundreds of thousands or millions. (As a special case, hyperinflations and great business depressions are society-wide events that do not directly generate massive casualties and yet still have calamitous consequences.) Middle-scale community-wide disasters are relatively frequent events, making empirical generalizations possible. In such disasters, it has been observed, individuals and communities adapt. Survivors are not helpless victims. Very soon after the shock they begin to help themselves and one another. In the immediate postimpact period community identification is strong, promoting cooperative and unselfish efforts aimed at rescue, relief, and repair. After the San Francisco earthquake of 1989, for example, inhabitants of a poor neighborhood spontaneously helped rescue motorists trapped by a freeway collapse. And after the

Many people believe that only government intervention prevents rampant discrimination in the private sector. Economic theory predicts the opposite: market mechanisms impose inescapable penalties on profits whenever for-profit enterprises discriminate against individuals on any basis other than productivity. Though bigoted managers may hold sway for a time, in the long run the profit penalty makes profit-seeking enterprises tenacious champions of fair treatment. To see how this works, suppose that male and female hot-dog salesmen are equally productive and that bigoted stadium concessionaires prefer to hire men. The bigger demand for male employees will raise men’s wages, meaning that the concessionaires will have to pay more to hire men than they would to hire equally productive women. The higher wages for men cause employers who insist on all-male workforces to be higher-cost producers. Unless customers are willing to pay more for a hot dog delivered by a man than by a woman, higher costs mean smaller profits. Concessionaires interested in maximizing their profits will forgo prejudice, hire women, reduce their costs, and increase their profits. Even if all concessionaires collude in refusing to hire women, new woman-owned firms can exploit their cost advantage by selling hot dogs for less, an effective way to take away customers. Unless government steps in to protect the bigots from competition, market conditions will end up forcing firms to choose between lower profits and hiring women. Though it may take decades, lower costs for female labor will result in the expansion of equal-opportunity employers. This will increase the demand for female labor and increase women’s wages. Some antiwomen owners may contrive to remain in business, but competition will make their taste for unfair discrimination expensive and will ensure that less of it will occur. An example of the effect of market penalties on prejudicial hiring occurred in South Africa in the early 1900s. In spite of penalties threatened by government and violence threatened by white workers, South African mine owners sought to increase profits by laying off high-priced white workers in order to hire lower-priced black workers. Higher-paying jobs were reserved for whites only after white workers successfully persuaded the government to place extreme restrictions on blacks’ ability to work (see apartheid). Market penalties for discrimination also mitigated the effects of prejudice in the McCarthy era when profit-maximizing producers defied the Motion Picture Academy’s blacklist and secretly hired blacklisted screenwriters. Although government intervention often blunts the market mechanisms that penalize bigotry, people who unequivocally support such intervention often do so because they believe that unfair discrimination exists whenever outcomes for a particular group differ from those of the population as a whole. Economist Thomas Sowell calls the idea that “various groups would be equally represented in institutions and occupations were it not for discrimination . . . the grand fallacy of our times.”1 People differ in their tastes, aptitudes, and childhood experiences, in the skills they acquire from their extended families, and in the geography they must adapt to. People who have lived in cities for generations are less likely to become farmers. Those whose families have spent generations in rural areas may

Compound Rates of Growth In the modern version of an old legend, an investment banker asks to be paid by placing one penny on the first square of a chessboard, two pennies on the second square, four on the third, etc. If the banker had asked that only the white squares be used, the initial penny would have doubled in value thirty-one times, leaving $21.5 million on the last square. Using both the black and the white squares would have made the penny grow to $92 million billion. People are reasonably good at forming estimates based on addition, but for operations such as compounding that depend on repeated multiplication, we systematically underestimate how quickly things grow. As a result, we often lose sight of how important the average rate of growth is for an economy. For an investment banker, the choice between a payment that doubles with every square on the chessboard and one that doubles with every other square is more important than any other part of the contract. Who cares whether the payment is in pennies, pounds, or pesos? For a nation, the choices that determine whether income doubles with every generation, or instead with every other generation, dwarf all other economic policy concerns. Growth in Income per Capita You can figure out how long it takes for something to double by dividing the growth rate into the number 72. In the twenty-five years between 1950 and 1975, income per capita in India grew at the rate of 1.8 percent per year. At this rate, income doubles every forty years because 72 divided by 1.8 equals 40. In the twenty-five years between 1975 and 2000, income per capita in China grew at almost 6 percent per year. At this rate, income doubles every twelve years. These differences in doubling times have huge effects for a nation, just as they do for our banker. In the same forty-year time span that it would take the Indian economy to double at its slower growth rate, income would double three times—to eight times its initial level—at China’s faster growth rate. From 1950 to 2000, growth in income per capita in the United States lay between these two extremes, averaging 2.3 percent per year. From 1950 to 1975, India, which started at a level of income per capita that was less than 7 percent of that in the United States, was falling even farther behind. Between 1975 and 2000, China, which started at an even lower level, was catching up. China grew so quickly partly because it started so far behind. Rapid growth could be achieved in large part by letting firms bring in ideas about how to create value that were already in use in the rest of the world. The interesting question is why India could not manage the same trick, at least between 1950 and 1975. Growth and Recipes Economic growth occurs whenever people take resources and rearrange them in ways that make them more valuable. A useful metaphor for production in an economy comes from the kitchen. To create valuable final products, we mix inexpensive ingredients together according to a recipe. The cooking one can do is limited by the supply of ingredients, and most cooking in the economy produces undesirable side effects. If economic growth could be achieved only by doing more and more of the same kind of cooking, we would eventually run out of raw materials and suffer from unacceptable levels of pollution and nuisance. Human history teaches us, however, that economic growth springs from better recipes, not just from more cooking. New recipes generally produce fewer unpleasant side effects and generate more economic value per unit of raw material (see natural resources). Take one small example. In most coffee shops, you can now use the same size lid for small, medium, and large cups of coffee. That was not true as recently as 1995. That small change in the geometry of the cups means that a coffee shop can serve customers at lower cost. Store owners need to manage the inventory for only one type of lid. Employees can replenish supplies more quickly throughout the day. Customers can get their coffee just a bit faster. Although big discoveries such as the transistor, antibiotics, and the electric motor attract most of the attention, it takes millions of little discoveries like the new design for the cup and lid to double a nation’s average income. Every generation has perceived the limits to growth that finite resources and undesirable side effects would pose if no new recipes or ideas were discovered. And every generation has underestimated the potential for finding new recipes and ideas. We consistently fail to grasp how many ideas remain to be discovered. The difficulty is the same one we have with compounding: possibilities do not merely add up; they multiply. In a branch of physical chemistry known as exploratory synthesis, chemists try mixing selected elements together at different temperatures and pressures to see what comes out. About a decade ago, one of the hundreds of compounds discovered this way—a mixture of copper, yttrium, barium, and oxygen—was found to be a superconductor at temperatures far higher than anyone had previously thought possible. This discovery may ultimately have far-reaching implications for the storage and transmission of electrical energy. To get some sense of how much scope there is for more such discoveries, we can calculate as follows. The periodic table contains about a hundred different types of atoms, which means that the number of combinations made up of four different elements is about 100 × 99 × 98 × 97 = 94,000,000. A list of numbers like 6, 2, 1, 7 can represent the proportions for using the four elements in a recipe. To keep things simple, assume that the numbers in the list must lie between 1 and 10, that no fractions are allowed, and that the smallest number must always be 1. Then there are about 3,500 different sets of proportions for each choice of four elements, and 3,500 × 94,000,000 (or 330,000,000,000) different recipes in total. If laboratories around the world evaluated one thousand recipes each day, it would take nearly a million years to go through them all. (If you like these combinatorial calculations, try to figure out how many different coffee drinks it is possible to order at your local shop. Instead of moving around stacks of cup lids, baristas now spend their time tailoring drinks to individual palates.) In fact, the previous calculation vastly underestimates the amount of exploration that remains to be done because mixtures can be made of more than four elements, fractional proportions can be selected, and a wide variety of pressures and temperatures can be used during mixing. Even after correcting for these additional factors, this kind of calculation only begins to suggest the range of possibilities. Instead of just mixing elements together in a disorganized fashion, we can use chemical reactions to combine elements such as hydrogen and carbon into ordered structures like polymers or proteins. To see how far this kind of process can take us, imagine the ideal chemical refinery. It would convert abundant, renewable resources into a product that humans value. It would be smaller than a car, mobile so that it could search out its own inputs, capable of maintaining the temperature necessary for its reactions within narrow bounds, and able to automatically heal most system failures. It would build replicas of itself for use after it wears out, and it would do all of this with little human supervision. All we would have to do is get it to stay still periodically so that we could hook up some pipes and drain off the final product. This refinery already exists. It is the milk cow. And if nature can produce this structured collection of hydrogen, carbon, and miscellaneous other atoms by meandering along one particular evolutionary path of trial and error (albeit one that took hundreds of millions of years), there must be an unimaginably large number of valuable structures and recipes for combining atoms that we have yet to discover. Objects and Ideas Thinking about ideas and recipes changes how one thinks about economic policy (and cows). A traditional explanation for the persistent poverty of many less-developed countries is that they lack objects such as natural resources or capital goods. But Taiwan started with little of either and still grew rapidly. Something else must be involved. Increasingly, emphasis is shifting to the notion that it is ideas, not objects, that poor countries lack. The knowledge needed to provide citizens of the poorest countries with a vastly improved standard of living already exists in the advanced countries (see standards of livingand modern economic growth). If a poor nation invests in education and does not destroy the incentives for its citizens to acquire ideas from the rest of the world, it can rapidly take advantage of the publicly available part of the worldwide stock of knowledge. If, in addition, it offers incentives for privately held ideas to be put to use within its borders—for example, by protecting foreign patents, copyrights, and licenses; by permitting direct investment by foreign firms; by protecting property rights; and by avoiding heavy regulation and high marginal tax rates—its citizens can soon work in state-of-the-art productive activities. Some ideas such as insights about public health are rapidly adopted by less-developed countries. As a result, life expectancy in poor countries is catching up with that in the leaders faster than income per capita. Yet governments in poor countries continue to impede the flow of many other ideas, especially those with commercial value. Automobile producers in North America clearly recognize that they can learn from ideas developed in the rest of the world. But for decades, car firms in India operated in a government-created protective time warp. The Hillman and Austin cars produced in England in the 1950s continued to roll off production lines in India through the 1980s. After independence, India’s commitment to closing itself off and striving for self-sufficiency was as strong as Taiwan’s commitment to acquiring foreign ideas and participating fully in world markets. The outcomes—grinding poverty in India and opulence in Taiwan—could hardly be more disparate. A poor country like India can achieve enormous increases in standards of living merely by letting in the ideas held by companies from industrialized nations. With a series of economic reforms that started in the 1980s and deepened in the early 1990s, India has begun to open itself up to these opportunities. For some of its citizens, such as the software developers who now work for firms located in the rest of the world, these improvements in standards of living have become a reality. This same type of opening up is causing a spectacular transformation of life in China. Its growth in the last twenty-five years of the twentieth century was driven to a very large extent by foreign investment by multinational firms. Leading countries like the United States, Canada, and the members of the European Union cannot stay ahead merely by adopting ideas developed elsewhere. They must offer strong incentives for discovering new ideas at home, and this is not easy to do. The same characteristic that makes an idea so valuable—everybody can use it at the same time—also means that it is hard to earn an appropriate rate of return on investments in ideas. The many people who benefit from a new idea can too easily free ride on the efforts of others. After the transistor was invented at Bell Laboratories, many applied ideas had to be developed before this basic science discovery yielded any commercial value. By now, private firms have developed improved recipes that have brought the cost of a transistor down to less than a millionth of its former level. Yet most of the benefits from those discoveries have been reaped not by the innovating firms, but by the users of the transistors. In 1985, I paid a thousand dollars per million transistors for memory in my computer. In 2005, I paid less than ten dollars per million, and yet I did nothing to deserve or help pay for this windfall. If the government confiscated most of the oil from major discoveries and gave it to consumers, oil companies would do much less exploration. Some oil would still be found serendipitously, but many promising opportunities for exploration would be bypassed. Both oil companies and consumers would be worse off. The leakage of benefits such as those from improvements in the transistor acts just like this kind of confiscatory tax and has the same effect on incentives for exploration. For this reason, most economists support government funding for basic scientific research. They also recognize, however, that basic research grants by themselves will not provide the incentives to discover the many small applied ideas needed to transform basic ideas such as the transistor or Web search into valuable products and services. It takes more than scientists in universities to generate progress and growth. Such seemingly mundane forms of discovery as product and process engineering or the development of new business models can have huge benefits for society as a whole. There are, to be sure, some benefits for the firms that make these discoveries, but not enough to generate innovation at the ideal rate. Giving firms tighter patents and copyrights over new ideas would increase the incentives to make new discoveries, but might also make it much more expensive to build on previous discoveries. Tighter intellectual property rights could therefore be counterproductive and might slow growth. The one safe measure governments have used to great advantage has been subsidies for education to increase the supply of talented young scientists and engineers. They are the basic input into the discovery process, the fuel that fires the innovation engine. No one can know where newly trained young people will end up working, but nations that are willing to educate more of them and let them follow their instincts can be confident that they will accomplish amazing things. Meta-ideas Perhaps the most important ideas of all are meta-ideas—ideas about how to support the production and transmission of other ideas. In the seventeenth century, the British invented the modern concept of a patent that protects an invention. North Americans invented the modern research university and the agricultural extension service in the nineteenth century, and peer-reviewed competitive grants for basic research in the twentieth. The challenge now facing all of the industrialized countries is to invent new institutions that encourage a higher level of applied, commercially relevant research and development in the private sector. As national markets for talent and education merge into unified global markets, opportunities for important policy innovation will surely emerge. In basic research, the United States is still the undisputed leader, but in key areas of education, other countries are surging ahead. Many of them have already discovered how to train a larger fraction of their young people as scientists and engineers. We do not know what the next major idea about how to support ideas will be. Nor do we know where it will emerge. There are, however, two safe predictions. First, the country that takes the lead in the twenty-first century will be the one that implements an innovation that more effectively supports the production of new ideas in the private sector. Second, new meta-ideas of this kind will be found. Only a failure of imagination—the same failure that leads the man on the street to suppose that everything has already been invented—leads us to believe that all of the relevant institutions have been designed and all of the policy levers have been found. For social scientists, every bit as much as for physical scientists, there are vast regions to explore and wonderful surprises to discover. About the Author Paul M. Romer is the STANCO 25 Professor of Economics in the Graduate School of Business at Stanford University and a senior fellow at the Hoover Institution. He also founded Aplia, a publisher of Web-based teaching tools that is changing how college students learn economics. Further Reading   Easterly, William. The Elusive Quest for Growth. Cambridge: MIT Press, 2002. Helpman, Elhanan. The Mystery of Economic Growth. Cambridge: Harvard University Press, 2004. North, Douglass C. Institutions, Institutional Change, and Economic Performance. Cambridge: Cambridge University Press, 1990. Olson, Mancur. “Big Bills Left on the Sidewalk: Why Some Nations Are Rich, and Others Poor.” Journal of Economic Perspectives 10, no. 2 (1996): 3–23. Rosenberg, Nathan. Inside the Black Box: Technology and Economics. Cambridge: Cambridge University Press, 1982. Romer, Paul. “Endogenous Technological Change.” Journal of Political Economy 98, no. 5 (1990): S71–S102.   (0 COMMENTS)

One of the most important building blocks of economic analysis is the concept of demand. When economists refer to demand, they usually have in mind not just a single quantity demanded, but a demand curve, which traces the quantity of a good or service that is demanded at successively different prices. The most famous law in economics, and the one economists are most sure of, is the law of demand. On this law is built almost the whole edifice of economics. The law of demand states that when the price of a good rises, the amount demanded falls, and when the price falls, the amount demanded rises. Some of the modern evidence supporting the law of demand is from econometric studies which show that, all other things being equal, when the price of a good rises, the amount of it demanded decreases. How do we know

National defense is in many ways a public, or “collective,” good, which means two things. First, consumption of the good by one person does not reduce the amount available for others to consume. Thus, all people in a nation must “consume” the same amount of national defense (the defense policies implemented by the government), although different people may value that common defense policy differently. Second, the benefits that a given person derives from the provision of a collective good do not depend on that individual’s contribution to funding it. Everyone benefits, including those who pay little or no taxes. To say that everyone gains from defense is not to say that everyone gains from government expenditures that are labeled “defense.” There is no necessary connection between defense expenditures and actual improvements in protection from foreign threats. Some defense expenditures may not contribute to such security at all; some expenditures may contribute a great deal; and some expenditures may, by stirring up hornets’ nests, actually reduce security. National defense, like other public goods, has an important “free-rider” problem. That is, because people benefit whether or not they contribute toward defense, each person has an incentive to wait for others to provide the collective defense good, and thus hopes to get a “free ride.” Also, because a free rider’s consumption does not reduce the amount of defense available for others to consume, even those who pay have little incentive to prevent free riding by others. As a result of such free riding, individuals acting privately to provide national defense services would produce too little from the standpoint of society as a whole. Each person would provide defense until the incremental benefits to him equaled the incremental costs. But for society as a whole—that is, for all individuals collectively—the incremental benefits would exceed the incremental costs, precisely because once an individual provides some of the collective good, all people benefit from it and no one can be excluded. This free-rider behavior yields one of the important traditional arguments for government: By imposing taxes on all individuals and then providing collective

Most nations, including the United States, have used military drafts at various times. Regardless of one’s views on military or defense policy, a draft has many economic aspects that are inherently unfair (and inefficient) and unacceptable to most economists. Hence, the question of whether to have a draft is really a question of whether any expected benefits outweigh those inequities. A military draft forces people to serve in the military—something they would not necessarily choose to do. With a draft in place, the military can pay lower wages than it would take to attract a force of willing volunteers of the same size, skills, and quality. This reduction in pay is properly viewed as a tax on military personnel. The amount of the tax is simply the difference between actual pay and the pay necessary to induce individuals to serve voluntarily. If, for example, pay would have to be twenty thousand dollars per year to attract sufficient volunteers, but these volunteers are instead drafted at twelve thousand dollars per year, the draftees each pay a tax of eight thousand dollars per year. Before the United States abolished the draft in 1973, some of its supporters argued that an all-volunteer force (AVF) would be too expensive because the military would have to pay much higher wages to attract enlistees. But the draft does not really reduce the cost of national defense. It merely shifts part of the cost from the general public to junior military personnel (career personnel are not typically drafted). This tax is especially regressive because it falls on low-paid junior personnel, who are least able to pay. Moreover, not just draftees pay the tax; so do those who still volunteer despite the lower pay. In other words, the draft is a tax on military service, the very act of patriotism that a draft is sometimes said to encourage. The President’s Commission on an All-Volunteer Force estimated that the draft tax during the Vietnam War was more than eight billion dollars per year in 2003 dollars. Every time a draft has been imposed, the result has been lower military pay. But even in the unlikely event that military pay is not reduced, a draft would force some unwilling people to serve in order to achieve “representativeness” or “equity.” In recent years, for example, some have advocated a return to conscription because today’s AVF supposedly has too few college graduates or too many African Americans. How to decide which of today’s volunteers to turn away is never addressed. The unwilling conscripts who replace the willing volunteers would bear a tax that no one bears in an AVF. And because these conscripts do not necessarily perform better than the volunteers they displace, this tax yields no “revenue.” Because the conscripts are part of society, the tax they pay is simply a waste to the country as a whole. And some who are qualified and would like to enlist are denied and forced into jobs for which they are less well suited or that offer less opportunity. A draft also encourages the government to misuse resources. Because draftees and other junior personnel seem cheaper than they actually are, the government may “buy” more national defense than it should, and will certainly use people, especially high-skilled individuals and junior personnel, in greater numbers than is efficient. This means that a given amount of national defense is more costly to the country than it need be. In 1988, for example, the U.S. General Accounting Office (GAO) studied the effects of reinstituting conscription and concluded that an equally effective force under a draft would be more costly, even in a narrow budget sense, than the existing force. With a draft, a larger total force would be needed because draftees serve a shorter initial enlistment period than today’s volunteers. Therefore, a larger fraction of the force would be involved in overhead activities such as training, supervising less-experienced personnel, and traveling to a first assignment. The GAO estimated that these activities would add more than four billion dollars per year (in 2003 dollars) to the defense budget. A draft also forces some of the wrong people into the military—people who are more productive in other jobs or who have a strong distaste for military service. That has other serious consequences for the country. A draft, especially one with exemptions, causes wasteful avoidance behavior such as the unwanted schooling, emigration, early marriages, and distorted career choices of the 1950s and 1960s. A draft also weakens the military because the presence of unwilling conscripts increases turnover (conscripts reenlist at lower rates than volunteers), lowers morale, and causes discipline problems. U.S. experience since the end of the draft in 1973 is consistent with the above reasoning. Today’s military personnel are the highest quality in the nation’s history. Recruits are better educated and score higher on enlistment tests than their draft-era counterparts. In 2001, 94 percent of new recruits were high school graduates, compared with about 70 percent in the draft era. More than 99 percent scored average or above on the Armed Forces Qualification Test, compared with 80 percent during the draft era. Because of that and because service members are all volunteers, the military has far fewer discipline problems, greater experience (because of less turnover), and hence more capability. So, for example, discipline rates—nonjudicial punishment and courts-martial—were down from 184 per 1,000 in 1972 to just 64 per 1,000 in 2002. And more than half of today’s force are careerists—people with more than five years’ experience—as compared with only about one-third in the 1950s and 1960s. Based on this experience, almost all U.S. military leaders believe that a return to the draft could only weaken the armed forces. Nor, as mentioned, would a draft reduce the budgetary costs of the military. For these same reasons, many countries in Europe recently have adopted an AVF or are actively considering doing so. Like the United States, the United Kingdom has had an AVF for decades. And three other large NATO countries—Spain, Italy, and, notably, France, where Napoleon invented modern conscription—recently have chosen to end conscription. Several smaller NATO members also have adopted an AVF or are considering doing so. In Germany, conscription is seen as blocking any return to twentieth-century militarism, and it provides “cheap” labor for many civilian social service agencies as well as the military. Yet some members of Germany’s governing coalition also favor adopting an AVF. And of the ten Eastern European countries that have recently become members of NATO, six—Bulgaria, the Czech Republic, Hungary, Latvia, Slovakia, and Slovenia—plan to end conscription before 2010; and two—Romania and Lithuania—are seriously considering doing so. These countries have elected to end conscription in part because of political pressure growing out of conscription’s inequities. And in most cases they recognize as well that an AVF will lead to a more effective and, ultimately, less costly military force. While it is too soon to pronounce conscription dead in Europe, there is clearly a strong trend toward voluntarism. In short, an all-volunteer force is both fairer and more efficient than conscription. The U.S. decision to adopt an all-volunteer force was one of the most sensible public policy changes of the last half of the twentieth century. Soldiers as Capital The reluctance to view a man as capital is especially ruinous of mankind in wartime; here capital is protected, but not man, and in time of war we have no hesitation in sacrificing one hundred men in the bloom of their years to save one cannon. In a hundred men at least twenty times as much capital is lost as is lost in one cannon. But the production of the cannon is the cause of an expenditure of the state treasury, while human beings are again available for nothing by means of a simple conscription order. . . . When the statement was made to Napoleon, the founder of the conscription system, that a planned operation would cost too many men, he replied: “That is nothing. The women produce more of them than I can use.” —German economist Johann Heinrich von Thünen, in Isolated State, 1850. About the Author Christopher Jehn is vice president for government programs at Cray Inc. He served as the assistant secretary of defense for force management and personnel from 1989 to 1993, and was assistant director for national security of the Congressional Budget Office from 1998 to 2001. He was formerly director of the Marine Corps Operations Analysis Group at the Center for Naval Analyses in Alexandria, Virginia. Further Reading   Anderson, Martin, and Valerie Bloom, eds. Conscription: A Select and Annotated Bibliography. Stanford, Calif.: Hoover Institution Press, 1976. Rostker, Bernard D. I Want You!: The Evolution of the All-Volunteer Armed Force. Santa Monica, Calif.: RAND Corporation, 2006. General Accounting Office. Military Draft: Potential Impacts and Other Issues, Washington, D.C.: The Office, 1988. Jehn, Christopher, and Zachary Selden. “The End of Conscription in Europe?” Contemporary Economic Policy 20 (Winter 2002): 101–110. The Report of the President’s Commission on an All-Volunteer Armed Force. New York: Collier Books, 1970.   Related Links Economic Freedom, from the Concise Encyclopedia of Economics. Joshua C. Hall, The Worldwide Decline in Conscription: A Victory for Economics? October 2011. David R. Henderson, Would a Return to Conscription Substantially Reduce the Probability of War? September 2015. Fred S. McChesney, Volunteers of America: Lessons from the New Contract Army. July 2005. (0 COMMENTS)

Some of the most significant tax changes in recent years have concerned the taxation of capital income. In 2003, Congress cut the top tax rate on dividends to 15 percent—significantly greater than the zero dividend tax that President George W. Bush wanted, but far below the 40 percent many high-income individuals paid in 2000. The 2003 tax bill also reduced the top capital gains tax from 20 percent to 15 percent. As always, political discussions of the tax cuts focused largely on who would reap the tax savings. The political wrangling obscured the real issues underlying a question that has occupied economists and tax experts for many years—whether individuals should pay any taxes at all on capital income. Strange as it may sound, most economists would agree that having zero taxes on capital income is theoretically the best thing to do. But many reject putting this theory into practice because they think that too much of the benefit would go to the “wrong” people, namely high-income households and the wealthy.

Economic competition takes place in markets—meeting grounds of intending suppliers and buyers.1 Typically, a few sellers compete to attract favorable offers from prospective buyers. Similarly, intending buyers compete to obtain good offers from suppliers. When a contract is concluded, the buyer and seller exchange property rights in a good, service, or asset. Everyone interacts voluntarily, motivated by self-interest. In the process of such interactions, much information is signaled through prices (see austrian school of economics). Keen sellers cut prices to attract buyers, and buyers reveal their preferences by raising their offers to outcompete other buyers. When a deal is done, no one may be entirely happy with the agreed price, but both contract partners feel better off. If prices exceed costs, sellers make a profit, an inducement to supply more. When other competitors learn what actions lead to profits, they may emulate the original supplier. Conversely, losses tell suppliers what to abandon or modify. Such profit-loss signals coordinate millions of sellers and buyers in the complex, evolving modern economy. The “dollar democracy” of the market ensures that buyers get more of what they want and expend fewer resources on what they do not want. Competitive prices thus work like radio signals; they are easy to perceive, and we do not need to know where they came from. There is no need to analyze all possible causes of the latest energy crisis to learn that we should scrap gas guzzlers and save electricity; and oil companies need to know only that petroleum is getting more expensive to start drilling new wells or to experiment with extracting fuel from oil shale or tar sands. Price competition informs millions of independent people in millions of markets, coordinating them effectively—as if by “an invisible hand,” as Adam Smith, the father of economics, once put it. Suppliers also engage in nonprice competition. They try to improve their products to gain a competitive advantage over their rivals. To this end, they incur the costs and risks of product innovation. This type of competition has inspired innumerable evolutionary steps—between the Wright brothers’ first fence hopper and the latest Boeing 747, for example. Such competition has driven unprecedented material progress since the industrial revolution. Differentiated products may give pioneering suppliers a “market niche.” Such a niche is never entirely secure, however, since other competitors will strive to improve their own products, keeping all suppliers in a state of “creative unease.” Another tool of competition is process innovation to lower costs, which allows producers to undercut competitors on price. This kind of competitive action has given us ubiquitous two-dollar pocket calculators only a generation after the first calculators sold for three hundred times that price! A third instrument to outcompete one’s rivals is advertising to bring one’s wares to buyers’ attention. Suppliers also compete by offering warranties and after-sales services. This is common with complicated, durable products such as cars. It reduces the buyer’s transaction costs and strengthens the supplier’s competitive position. Competition thus obliges people to remain alert and incur costs. Before one can compete effectively in a market, one needs the relevant knowledge. Buyers need to ask themselves what their requirements are, what products are available, what they can afford, and how various products compare, taking prices into account. This imposes search costs—think of the time and effort involved in buying a house, for example. Suppliers have to find out where the demand is, what technical attributes people want in their product, where to obtain the many inputs and components, how to train workers, how to distribute their wares, how to improve products and processes, how competitors will react, and much more. Such efforts—in research, development, and marketing—may be very costly and may still come to naught. For every market bonanza, there are many disappointments. And other costs arise as sellers and buyers negotiate contract details and monitor and enforce delivery. In a dynamic, specialized economy, the costs of searching for knowledge and carrying out exchanges (called “transaction costs”) tend to be high. Therefore, it is not surprising that market participants are keen to reduce transaction costs and associated risks. One method is to agree on set rules (called “institutions”) that help them to economize on knowledge acquisition costs. Markets fulfill people’s aspirations more effectively when there are enforced and expedient rules. Another transaction cost–saving device is to agree on open-ended, long-term relationships, such as employment contracts. Yet another is advertising, a means for sellers to inform buyers and save them some search costs. Deal making is also facilitated by intermediaries—market experts such as brokers, realtors and auctioneers. Despite these methods of reducing transaction costs, competition is uncomfortable and costly to competitors. Some entrepreneurs enjoy the market rivalry per se. But most people are ambivalent about competition in a particular way; they would like to avoid competing on their own side of the market, but welcome competition among those they buy from or sell to. In a free society, people are, of course, entitled to rest on their laurels by not competing, but they will lose market share, and their assets will probably lose value. To escape the competitive discipline, suppliers may try to conclude a “competitive truce,” forming cartels, particularly in markets with few suppliers or suppliers who need large lumps of capital to start operating. For example, the world’s airlines once formed the International Air Transport Association (IATA) cartel, which fixed airfares, schedules, and even such petty details as meal services. Cartels normally fail when a cartel member cheats on the agreed price (see cartels and opec) or when a firm not in the cartel competes by price or product innovation and established suppliers lose market share. For consumers and for the market as a whole, this cheating on cartel agreements is a boon. The only way for cartels or monopolies to avoid competition over the long term is to obtain government protection. All too often, politicians and bureaucrats readily oblige by imposing coercive regulations. They tend to hide behind all sorts of excuses—safeguarding jobs, ensuring public health and safety, or protecting nationals from foreign competitors. Yet, in reality, inhibiting competition is most often rewarding for regulators, who obtain moral or financial support for the next election campaign or secure lucrative consultancies. Economists call this “rent seeking” and point out that it is invariably at the expense of the many buyers, who are often unaware of the costs inflicted by political interference. Interventions may offer comfort to a few suppliers, but they harm the wealth of nations, which benefits the many. Most economists, therefore, consider untrammeled competition a public good that governments should protect and cultivate. This conclusion has, for example, inspired political attempts to control mergers, monopolies, union power, and cartels through internal competition policy; and the creation of the World Trade Organization, which was formed to protect international competition from opportunistic governments. Competition works well only if private property rights are protected and people are free to make contracts under the rule of law. Who would incur high knowledge-exploration costs knowing that the hoped-for gains might be expropriated, or that subsequent contracts to market a discovery are prohibited by regulation? That is why secure property rights, the freedom of contract, and the rule of law—in short, economic freedom—make for rapid economic growth, low unemployment, and diminishing poverty. International surveys invariably show that none of the poorest economies in the world is free, and that none of the world’s freest and most competitive economies is poor. From a society-wide viewpoint, lively market competition fulfills three vital functions: Discovery. Human well-being can always be improved by new knowledge. Competitive rivalry among suppliers and buyers is a powerful incentive to search for knowledge. Self-interest motivates ceaseless, widespread, and often costly efforts to make the best use of one’s property and skills. Central planning by government and government provision are sometimes advocated as a better means of discovering new products and processes. However, experience has shown that central committees are not sufficiently motivated and simply cannot marshal all the complex, often petty, and widely dispersed knowledge needed for broad-based progress. Selection and peaceful coordination. Competitive “dollar voting” selects what people really want and exposes errors through the “reprimand of red ink,” in the process dispersing useful knowledge. Since innovators cannot keep their discoveries secret, others see what is profitable and may emulate success. Despite occasional unsettling surprises and changing opportunities, competition fosters orderly evolution, distributing unavoidable adjustment burdens and coordinating divergent expectations. Competing and trading educates people in practicing a “commercial ethic”: pragmatism in problem solving and keeping peace to get on with the job. A competitive market order thus inspires confidence, social optimism, and a can-do spirit. Control of power. Supplier competition empowers consumers; competing employers empower workers. While some may try rent seeking, it is important that wealthy people remain exposed to competitive rivalry. Only then will they reinvest their wealth and talents in further knowledge searches, to the benefit of humankind. They will not always remain successful. Virtually none of the big American fortunes that existed in 1950 is still intact today. Competition tames concentrations of economic power and redistributes wealth. One may indeed go further and say that capitalism is legitimized by competition—the readiness of citizens of property to shoulder the costs of socially beneficial knowledge search. Socialists, with their slogan “Property is theft,” will gain followers only where competition is absent or politically distorted. Competition, as discussed here, hardly figures in standard, neoclassical economics since so-called perfect competition unrealistically assumes perfect knowledge. Yet, in reality, most economic activity is about finding and exploiting knowledge and motivating reluctant people with wealth and talents to do the same. Senator Henry Clay was right when he told the U.S. Senate in 1832, “Of all human powers operating on the affairs of mankind, none is greater than that of competition.” Indeed, competing is part and parcel of the pursuit of happiness. About the Author Wolfgang Kasper is an emeritus professor of economics at the University of New South Wales, Australia. Further Reading   Gwartney, J., and R. Lawson. Economic Freedom of the World. Vancouver: Fraser Institute, published annually. Hayek, F. A. “Competition as a Discovery Procedure.” In F. A. Hayek, New Studies in Philosophy, Politics, Economics and the History of Ideas. London: Routledge and Kegan Paul, 1978. Pp. 179–190. Kasper, W., and M. E. Streit. Institutional Economics: Social Orderand Public Policy. Cheltenham, U.K.: Edward Elgar, 1998. Especially chap. 8. Kirzner, I. M. How Markets Work. London: Institute of Economic Affairs, 1997.   Footnotes 1. We are not concerned here with other forms of competition, such as in sport, among political parties and interest groups, or among states in federations. Related Links Frederic Bastiat, “Competition,” in Economic Harmonies. Timothy Taylor, The Blurry Line Between Competition and Cooperation. February, 2015. Michael Munger, Rent Seek and You Will Find. July, 2006. Ross Emmett. A Century of Risk, Uncertainty, and Profit. December 2018. Arnold Kling, What Makes Capitalism Tick? April, 2018. Russell Roberts, Where Do Prices Come From? June, 2007. Buccholz on Competition, Stress, and the Rat Race. EconTalk, June 2011.   (0 COMMENTS)