Economics by Design

Economics by Design
by Robert A. Collinge and Ronald M. Ayers
(Upper Saddle River, N. J.: Prentice Hall, 1997), 606 pp.

Rating: A-

General Comments: This book is an excellent teaching tool. On virtually every page, it illustrates the economic way of thinking and trains students to look below the surface to perceive economic effects they would otherwise miss. In helping the student to develop the mental toolkit of the economist, Economics by Design is wonderful. Moreover, the authors explore a wide array of topics: they show that economics is not just about production and trade, but extends to all purposeful human action. For example, they briefly discuss the economics of crime. The writing is engaging and clear. The only drawback to the book is that it is aimed at advanced high school students, and even college students.

Criterion 1: Costs and Prices—How Production is Determined

The authors begin with a masterly exposition of "the basics"—scarcity, choice, cost, the price system and the allocation of resources, and profit and loss. Their discussion is careful and thorough. The student who learns the early chapters will have a remarkably good grasp on the functioning of the market and the economic way of thinking.

Along the way, the authors introduce the reader to the uses of economic thinking on issues not usually perceived as "economic." They devote several pages, for example, to the effects of drug prohibition. They don’t make a normative judgment on whether prohibition is good or bad, but show how government policy changes prices and incentives. The great virtue of this and many other topics they cover is that the student learns to set aside preconceived value judgments and examine the real world trade-offs. Attentive readers will often find themselves thinking, "I never thought of that."

Where many books stop with basic price theory, this ones goes further, drawing out important implications. For example, the authors discuss how prices influence resource conservation, and the way black markets work as "safety valves" when government regulations have blocked the operation of the free market.

Criterion 2: Competition and Monopoly

The book’s treatment of competition and monopoly is very good. Monopolistic competition is not attacked for theoretical shortcomings, but instead as a market structure that very efficiently serves consumer desires. The allocative efficiency problem with monopoly is explained well, as is the logic of the monopolist’s decision-making. The authors also point out that successful collusion to eliminate competition in a free market is very difficult and that monopolies are hard to sustain.

Not much space is devoted to antitrust. The student learns what the objective of antitrust law is and that the wording of the statutes is so vague that it is often difficult to know beforehand whether various business actions will or will not be subject to legal attack. The book would have been stronger with a more thorough treatment of antitrust economics.

In their "current issues" section, the authors have several pages of solid analysis of the U. S. Postal Service and the feasibility of open competition in mail delivery.

Finally, the book gives the student an excellent discussion of mergers, leveraged buyouts and "junk" bonds, shedding light on these much misunderstood topics.

Criterion 3: Comparative Economic Systems

Economics by Design explains the differences between free market economies and those subject to central planning. The authors show that the choice between "the chaos of the market" and "the rationality of central planning" (as it is so often phrased) is a false choice. "Government planning is often disorderly and wasteful," they write (p. 555). As an example, they cite the Nigerian government’s foolish purchase of far more cement than could be unloaded at the port, which led to tremendous waste when the cement eventually hardened in the holds of ships.

The authors explain why it is hard to make rational decisions without a price system, and discuss many of the undesirable consequences of command and control economic systems. Their treatment would have been stronger, however, if they had explained the strong tendency for planners to allocate resources abundantly toward the production of goods and services that benefit the government and its apparatus.

Criterion 4: Income Inequality and Poverty

The issues of income inequality and poverty are dealt with rather briefly under the chapter on "Income from Labor and Human Capital." The authors present data showing changing shares of after-tax income earned by the various groupings between 1977 and 1992. The authors caution against leaping to the conclusion that "the richer are getting richer and the poor are getting poorer" by pointing out that there is considerable income mobility in the U. S. economy. "The poor" and "the rich" are not the same people over time. They also make the important point that the government’s income distribution figures do not take account of in-kind transfers.

The book says little about the impact of welfare programs, except that they have disincentive effects. Also, there is only a brief suggestion that some poor people are poor because of laws and regulations that get in the way of their earning ability. The authors should have developed this point at greater length. The discussion of the "wage gap" for working women and critique of "comparable worth" legislation, however, are excellent.

Criterion 5: The Role of Government

The book gives the student a good analysis of the role of government in dealing with instances of market failure. First, regarding the problem of public goods, the authors clearly explain the free rider problem. They also caution that just because a good has "publicness" qualities does not mean that government should be the provider. They write that entrepreneurs "may find ways to tie public goods to private goods that individuals or firms are willing to buy" (p. 322). A point they omit here, however, is that just as the market may be inefficient by under-providing the public good, so may government be inefficient by over-providing it, or doing so at low quality.

The authors have an enlightening discussion of the problem of externalities, with a detailed examination of the pros and cons of the various policy tools at the government’s disposal. A point they make strongly is that government regulators do not have to bear the cost when they create rules that produce high costs with almost no benefits.

Collinge and Ayers also include an interesting discussion on "merit goods" such as access for the handicapped. Instead of treating them as moral imperatives, they employ sound economic thinking to show that there are trade-offs. For example, government safety mandates may make the workplace marginally safer, but safety is not free. Workers will find that their compensation is reduced; if given the choice, they might have preferred somewhat higher pay to a somewhat safer work environment.

Criterion 6: Public Choice

One of the greatest virtues of this book is its full coverage of public choice theory.

Collinge and Ayers reject the naive view that government generally responds in "the public interest." Lest the student miss the key point, it is put in bold type: "rational ignorance means that politicians and bureaucrats can often safely follow their own personal agendas, even when those agendas conflict with what the public would want them to do" (p. 365). The rational ignorance of the public leads to several political maladies the authors discuss, including the "fiscal illusion"—the tendency of voters to fix their attention on the government spending that benefits them, while ignoring the fact that they are being taxed far more to pay for programs, projects and services that benefit others.

Equally important to understanding economics in politics is the role of interest groups. The authors show how the behavior of interest groups refutes the common view that democracy leads to government actions that are in the interest of the majority of the people. The wastefulness of the quest for government favors is brought home in the discussion "Rent Seeking—A National Pastime" (p. 367).

Finally, the authors show the student how the incentives of bureaucrats lead them to enlarge their budgets and fend off any cuts through tactics such as "The Washington Monument" strategy: threatening to curtail popular and even necessary public functions in order to save the unpopular and unnecessary ones.

Criterion 7: The Role of the Entrepreneur

Collinge and Ayers nicely define entrepreneurship and explain its importance. Entrepreneurs must take initiative and run risks if they are to succeed, and success comes only if they produce goods or services that fill an unmet need in the market. The authors write, "The common theme to the success stories of America’s modern entrepreneurs is insight into what the public likes to do and how they could do it better or more conveniently" (p. 41). This topic would have been stronger, however, with some discussion of how taxes and regulations affect entrepreneurship.

Criterion 8: Taxation

The discussion of taxation in the book is good, as far as it goes. The authors explain the different kinds of taxes levied and the importance of marginal tax rates. They also cover the subject of tax incidence. The student learns why it is misleading to talk about the employer’s "matching contribution" for Social Security and why the corporate income tax ultimately is borne by individuals. They also demonstrate that taxes alter people’s behavior.

The authors discuss several tax reform possibilities and suggest their probable economic effects. They also provide a good analysis of "sin taxes," and the tendency of politicians to shift the tax burden to vulnerable groups.

One thing the authors should have discussed at greater length is the overall cost of taxation. Students need to give serious attention to the burden that taxes and the tax system impose on the economy—compliance costs, enforcement costs, and avoidance costs.

Criterion 9: The Business Cycle

The discussion of the business cycle is one of the weaker parts of the book. They present the Keynesian aggregate demand explanation for the business cycle, but don’t analyze it well. Neither do they clarify the conflict between Keynes and J. B. Say (and his later defenders). The authors need to describe the debate between those economists who believe that a market economy is inherently unstable and requires frequent government intervention, and those who believe that a market economy is stable if left alone and suffers from instability because of needless government intervention.

What is missing from the book is the idea advanced by the Austrians and the Monetarists that the business cycle is not really a macroeconomic phenomenon, but a problem of many microeconomic adjustments that must be made because of government policy. Monetarism is only discussed in conjunction with monetary policy, not as an alternative explanation of the business cycle; Austrian theory is not mentioned at all.

Criterion 10: Wages, Unions, and Unemployment

The authors explain wages as a market phenomenon of supply and demand. But they should have made more clear the connection between wages and productivity.

The presentation on labor unions is too brief. The authors say it is hard to know how much difference unionization makes in wages, but go no further than saying that the difference is less than it appears to be if one looks only at raw wage data. The book, unfortunately, does not go into the questions surrounding the economic impact of unions on efficiency, productivity, prices, unemployment, and so on.

Collinge and Ayers explain the different types of unemployment and that there must always be some unemployment in a free economy (the "natural rate"of unemployment). They also cover how hard it is to accurately measure unemployment. They have a competent discussion of government programs aimed at unemployment, but they need to consider the economics of unemployment insurance.

Criterion 11: Trade and Tariffs

The book’s discussion of trade is very thorough, with clear explanations of the law of comparative advantage, balance of payments, and the foreign exchange market. The authors could have stressed more that "foreign trade" is economically no different from any other trade between human beings.

The treatment of the various arguments in favor of tariffs is excellent. Of the "lost jobs" argument, the authors write, "buying imported goods and services does not imply any reduction in aggregate employment. The reason is that dollars that are spent on products abroad bump up against the currency market and are immediately bounced back into the U.S. economy" (p. 173). The authors dispatch the "infant industry" argument after much analysis. They also cover the supposed harms of "dumping" and demonstrate that policies to prevent it do much more harm to consumers than dumping itself. They also cover "strategic trade initiatives" and the contention that government can bring about greater national prosperity by encouraging "the right" new industries. The authors note the "public choice" problem: that industries chosen for assistance would most likely be chosen on the grounds of political influence.

Finally, the book uses the case of bricks made in Mexico to show students how to analyze hidden protectionism in seemingly innocuous government mandates.

Criterion 12: Money and Banking

Collinge and Ayers explain the function of money and how it facilitates commerce better than barter. Money is a market phenomenon, not an invention of the state, and the authors could have made that point more explicitly. One of the few questionable statements in the book occurs when they say, "Paper money was more readily accepted if issued by government" (p. 49). Evidence from our monetary history often reveals just the opposite. Sometimes, privately issued paper notes circulated with great confidence and sometimes government paper money, as the expression goes, was "not worth a continental."

The book’s discussion of the banking system is good, with several important points brought out besides the nuts and bolts of bank operations. For example, the student learns about the tendency of federal deposit insurance to encourage lending institutions to make riskier loans than they would otherwise, and how the Glass-Steagall Act restricts competition in the financial services industry.

The role of the Federal Reserve in creating inflation is explained well, as is the point that inflation is actually another kind of tax. The authors connect monetary policy with interest rates and conclude, "Monetary policy cannot lower interest rates in the long run, except through lower inflation" (p. 483). The problem of hyperinflation is also handled well.

The authors briefly analyze the argument for reestablishing a gold standard, but unfortunately ignore the disadvantages of having a fiat money system subject to political manipulation by free-spending officials.