Economics: An Integrated Approach

Economics: An Integrated Approach
by Benjamin Davis
(Upper Saddle River, N. J.: Prentice Hall, 1997), 329 pp.

Rating: B-

General comments: This textbook is for the most part good at teaching students how to think economically and encouraging them to use the economist’s mental toolkit. It eschews photographs to concentrate on the material. The writing is engaging and often witty, but sometimes goes overboard in trying to sound chatty and "in tune" with students. The coverage of the main topics is uneven—sometimes very enlightening, but in other places very shallow. Some economic myths are slain, but others are reinforced. Davis sticks mainly to the economic issues and seldom tries to smuggle in normative conclusions under the guise of positive economics, but is not entirely free of that vice.

Criterion 1: Cost and Prices—How Production is Determined

Davis does a very good job explaining the fundamentals of economics. He begins with a broad definition and points out that virtually all of our decisions are economic in nature since they entail trying to satisfy our unlimited wants from scarce resources. He also writes that the study of economics develops a "new set of tools" with which to look at the world. That is exactly what a good economics textbook should do—train the student to use the mental toolkit of economic thinking.

The book is excellent in explaining scarcity and the explicit and implicit costs it imposes. The book also introduces early a vital axiom that few high school books cover: rational self-interest. As Davis writes, "Rational self-interest means that individuals weigh the costs and benefits as they perceive them and make decisions that will increase their welfare. This includes decisions to buy and sell, to invest or save, to take a job or retire, to spend on one’s self or give to charity" (p. 9). He also draws a useful distinction between self-interested behavior and selfish behavior.

Davis also includes a section on common fallacies. It is important to show students that apparently sound reasoning can actually be illogical and that they need to guard against it. Similarly, the book devotes a chapter to understanding graphs and charts.

The author’s explanations of the laws of supply and demand, equilibrium prices, shortages and surpluses and other fundamental concepts are very clear, and he makes the important point that the market makes its adjustments automatically: "No one has to set prices or determine how much should be produced or sold" (p. 79). Unless this is expressly stated, students may fail to grasp the spontaneous nature of the market order; Davis does so.

His discussion of the impact of price controls, working through agricultural price supports and rent controls as examples, put to work the student’s ability to think economically, and simultaneously demonstrate that good intentions do not lead to good results when you tamper with the market order.

The book is also good on the concepts of elasticity (incorporating a discussion of the impact of drug policy on supply and demand) and cost (including a good discussion of sunk costs).

Criterion 2: Competition and Monopoly

Davis juxtaposes perfect competition and monopoly in a chapter to show how decisions and behavior differ at the two extremes in market structure, but he cautions that "Every market, in reality, lies somewhere in between these two extremes" (p. 162). The discussion of monopoly is remarkably thorough, with the observation that the barriers to entry that protect monopolists from competition are frequently artificial (i.e., erected by government) and that without government help, it is very hard to achieve and maintain a monopoly or cartel. Davis also points out that monopolists still have to compete for scarce consumer dollars and cannot continually afford to raise prices without reducing sales and profitability.

The book’s discussion of mergers, however, is not as good. What is missing is a clear sense of the reasons why firms want to merge. Moreover, Davis argues that horizontal mergers lead to a decrease in competition, an analysis that many economists and antitrust scholars reject. Horizontal mergers decrease the number of competitors, but that is not necessarily the same as decreasing competition, the intensity of which could even be enhanced by some mergers. Also, Davis uses the term "economic power" in conjunction with mergers. Economic relations, however, are not based on "power" at all; they are based upon voluntary transactions for mutual benefit. All that any firm can do is to make offers to consumers, workers, and suppliers. Power is a term more accurately applied to government action, to which firms often turn for favors.

The book’s treatment of government’s means of dealing with monopoly is uneven. Antitrust is given just one short paragraph without much in the way of analysis at all, concluding with a flippant, "You decide whether that would be a good or bad thing" (p. 176). The discussion of price regulation is only slightly better; it ignores the various problems associated with regulation. Davis claims that it is inefficient for the government to own and operate monopolies, but he needs to say why. Finally, the author devotes the greatest amount of space to the laissez faire option of just living with whatever inefficiencies monopolies create. He writes, "Intervening in the market may reduce, not increase, the likelihood of competition, and the outcome might be to support the monopoly’s hold on the marketplace" (p. 177).

The book has surprisingly little space on "monopolistic competition," and instead spends a great deal of time on oligopoly. Perhaps it is true that, as Davis writes, "Oligopoly does an even better job of describing the reality that businesses and consumers face today" (p. 183), but firm behavior under conditions where there are many competitors is worth some analysis. Another shortcoming here is Davis’ discussion of advertising, which was considered solely from the standpoint of sellers. The benefits that consumers derive from advertising are important, but not mentioned.

Criterion 3: Comparative Economic Systems

Davis compares market economies with the essential conditions of command, or socialist, economies. But in discussing the effects of socialism, Davis is rather weak. He does note that economic growth is slower under socialism, and concludes that "The key issue seems to be incentive" (p. 219). Incentive is indeed an important reason for the difference in economic performance between free markets and command-and-control economies, but it is not the only reason. This would have been the place for an analysis of the inherent problems of centralized decision-making and the absence of a price system to guide the allocation of resources. But Davis neglects these important issues. He does, however, note that the distribution of income is often as unequal or more so under socialism than under capitalism.

Criterion 4: The Distribution of Income and Poverty

The book devotes little space to income distribution. Davis includes the typical chart on income distribution by quintiles, but does not analyze the impact of government poverty programs. That is an unfortunate omission because analysis of such wealth-transfer programs help us hone the tools of economic thinking through examination of incentives, implicit marginal tax rates, costs, and alternatives. Davis says merely that government programs can have unintended results and may wind up helping the wealthy rather than the poor and for that reason we should carefully consider the impact of such programs.

Davis also needs to consider the impact of government regulations on economic opportunities for poorer people. For example, students ought to be thinking about the impact of the minimum wage, occupational licensure, and other laws that keep newcomers out of some jobs, and keep wages high for the people already in them.

Davis argues that discrimination is a major reason for differences in earnings between men and women. Oblivious to the persuasive evidence that earnings differences between men and women are mainly due to differing family roles, Davis repeats the frequent complaint that women earn only 70 percent as much as men do for equal work. Thomas Sowell and other economists have long pointed out that mere statistical differences do not prove discrimination. Davis’ one-sided treatment is not sound economic analysis.

Finally, the usually suggested remedy for discrimination—affirmative action laws—is hardly mentioned at all, except to say that such laws are "certainly worth a try." There has been a great deal of economic analysis of the effects of "affirmative action," with many economists concluding that they are counterproductive.

Criterion 5: The Role of Government

Davis begins with the problem of negative externalities, but he never explains exactly why economists view them as undesirable. Negative externalities pose an efficiency problem (too much production of goods where the producer does not bear all the costs), but this important insight is left out. The author lists and briefly explains four kinds of responses to pollution (elimination, regulation, negotiation and adjudication), but does not engage in any serious analysis or comparison of them.

Similarly, the book discusses the "public goods" problem without much detail. Davis explains the free rider problem and cautions against the mistake of thinking that every good provided by government is a "public good." But he never explains why government is an inefficient provider.

A third reason for government intervention discussed in the book is the common ownership problem. How do we prevent overuse of a resource when there are no clear property rights, such as in schools of fish in the ocean? Alas, Davis brushes over possible market responses, leaving the impression that either designating a single owner or imposing government regulation is the optimal response. He neglects to consider any problems that might arise from these solutions.

Criterion 6: Public Choice

The book does not address public choice analysis per se, but does offer the student some hints at various points that there are reasons to be skeptical about political solutions to economic problems.

For example, Davis notes that "Government decision makers do not bear the costs of their decisions (taxes are paid by the citizens) but do reap some benefits from their decisions. Politicians gain re-election and bureaucrats can count on job security. When people benefit from something but do not bear the costs, they are likely to do a lot of it whether or not it needs to be done" (p. 232). Saying that public decision-makers don’t directly bear the costs of their actions is a vital element in public choice analysis. But Davis should have developed this point in more detail.

On p. 60, Davis says this about special interest groups: "Because many people benefit a little while some are hurt a lot, those who do pay the high price tend to be ‘noisier’ than those who benefit a little, and democratic governments tend to respond to noise." This sentence refers to international trade, but it has widespread applicability to the problem of concentrated benefits and diffused costs. A coherent treatment of the various difficulties with public decision-making would have made for a much stronger book.

Criterion 7: The Role of the Entrepreneur

Entrepreneurship is briefly discussed, but not explored in any depth. Davis explains that "Entrepreneurs are people with vision who can see an opportunity, accept the risk, and try something different" (p. 8). He stresses the riskiness of entrepreneurship again in his discussion of profits. Unfortunately, the book has no case studies of entrepreneurs to put some meat on the theoretical bones. Nor does Davis convey the vital role entrepreneurs play in economic progress, or the damage government policy can do to their endeavors.

Criterion 8: Taxation

The discussion of taxation is one of the best parts of this book. Davis notes the different kinds of taxes, but rather than wasting space on merely descriptive matters, he devotes pages to good economic analysis.

Tax incidence is a good example. The common assumption is that businesses pay taxes (and probably ought to pay a lot more), but Davis meets this headlong: "YOU pay taxes. Not businesses, not landlords, not any organization, but the individual" (p. 232). The Social Security tax is analyzed briefly, but Davis would have aided his readers far more if he had engaged in a more thorough discussion of where the employer’s "contribution" comes from than simply writing, "guess where it comes from!"

Davis also shows that imposing taxes can have unintended consequences. He cites the 1990 luxury tax that was supposed to raise lots of money from millionaires, but instead wound up costing a lot of ordinary workers their jobs. Taxes, he explains, cause people to change their behavior at the margin. That way, Davis causes students to think of the impact of taxes dynamically.

The book also reminds students that there is an opportunity cost to collecting taxes. Funds taxed away from individuals would have been put to some purpose of their choosing. Davis writes, "These monies have been earned in the private sector and would have been spent in the private sector where market signals of price and profit, supply and demand would direct them toward their optimal uses" (p. 235). Moreover, the process of taxation itself uses up resources through the cost of enforcement of tax laws and in what citizens expend to avoid paying taxes.

The only real weakness in the book’s treatment of taxation is the implied notion that business taxes are invariably "passed on" to consumers. Whether sales and corporate income taxes are ultimately borne by consumers, or by stockholders, or each in some degree is more complicated than the book indicates.

Criterion 9: The Business Cycle

Davis’s treatment of the business cycle is very brief. He lists a number of theories, but evaluates none of them. Among those he lists is the "erratic government policy theory." As Davis writes, "Certainly governments have caused business cycles by creating too much money and causing expansions or by restricting the supply of money and causing a recession" (p. 280). Here he is on the right track, but is derailed with this sentence: "However, the major cause of the business cycle is believed to be aggregate demand, in particular consumer spending." While there are some economists who hold to the Keynesian view that fluctuations in aggregate demand drive the business cycle, many others hold that the cause lies elsewhere. For most students, Davis’ analysis will be confusing.

To the author’s credit, he does not dwell upon the Keynesian counter-cyclical policy, sparing the student the silly "multiplier" exercises that were common in economics textbooks a generation ago. Instead, he provides a synopsis of the major schools of macroeconomic thought: classical, Keynesian, monetarist, and rational expectations (but he neglects the Austrian). The students do not learn very much about any of them, but at least they are not led to believe that all economists believe in macroeconomic "fine tuning" by the federal government.

Criterion 10: Wages, Unions and Unemployment

The book’s discussion of market determination of wages is excellent. Davis explains that firms have a demand for workers solely because they help produce goods consumers will buy. Firms try to combine inputs, including labor, to produce those goods as efficiently as possible. Workers in turn supply labor, searching for the best offers. The result: wages that bring supply and demand into balance.

Davis also devotes much space to labor unions. After lengthy definitions, he turns to the effect of unions on wages and states, "Labor unions cannot force higher wages on an employer. No ifs, no ands, no buts" (p. 134). He soon modifies this extremely strong statement by saying, "they cannot force employers to pay higher wages without pretty severe consequences on the union and its members." Such equivocation may confuse students.

To justify his original statement, Davis shows the effects of pushing wages above their market equilibrium—a surplus of workers, i.e., unemployment. He concludes that "It is not in the union’s best interest to force wages up, and self-interest is the motivating factor in economics" (p. 135). While this is true sometimes, it is not always true. Much depends on the elasticity of demand for labor. If the firm’s demand is inelastic, the gains for the majority of workers who keep their jobs will exceed the losses to those who eventually or immediately lose theirs. Unions often find it in their self-interest to push for gains for some at the expense of others. While Davis is right to be skeptical of the ability of unions to increase wages generally, his treatment of the issue is too thin to show students how economists think about their effects.

Finally, the book is weak on the subject of unemployment. The author does not give the standard classifications of unemployment (such as frictional and cyclical) and devotes his space to merely descriptive rather than analytical points. He writes, for example, "Why unemployment rates vary is the key question, and one with which we must all concern ourselves" (p. 40). Unfortunately, he drops the matter there, doing nothing to help the reader answer the question.

Criterion 11: Trade and Tariffs

Davis begins his discussion of trade with the crucial observation that trade occurs only when people find it mutually beneficial. Unfortunately, some careless writing then implies that international trade is a government, not an individual action: "Has the United States taken advantage of its trading partners in the Third World? Yes. Did those countries benefit from the trade? Yes" (p. 61). But the United States does not engage in trade; individuals and firms do. And the "taken advantage of" language is misleading and polemical.

Next, the book explains comparative advantage and specialization; then it analyzes artificial trade barriers. Davis explains that when governments erect artificial barriers, "both nations suffer because of it" (p. 61). It would be better to eliminate the reference to the abstraction "nation" and examine the effects of trade and restrictions on individuals. Many individuals lose when tariffs or quotas cause prices to rise (as Davis subsequently notes), but some benefit. A more complete analysis of the effects of trade barriers would have made for a stronger book. Davis does show, however, how people and firms will act creatively to find ways around trade barriers. He cites as an example the re-engineering of Japanese motorcycle engines to fall just below the tariff on engines of more than 700 cc.

Davis also covers non-tariff trade barriers, suggesting that students should look skeptically at supposedly pro-consumer regulations that are, in fact, subtle forms of protectionism.

When it comes to the standard arguments in favor of trade restrictions, the book deals with only two—national defense and infant industry. He notes that the danger in the former is that "it is almost impossible to know where to draw the line" (p. 62). True, but Davis doesn’t really convey the danger in opening the door to special interests. Even if economists could tell where to "draw the line," there is little chance that politicians and bureaucrats would stick to it.

On the infant industry argument, Davis says, "Used appropriately in a limited way for a very short period of time, the infant industry argument can, however, be quite beneficial to the developing economy" (p. 63). This is a weak conclusion and Davis needs evidence for such a statement. Economic development flows optimally in the free market without any government "help" in picking certain industries for growth. Central economic planning has a poor historical record in creating successful industries.

Criterion 12: Money and Banking

The book is good on the functions and benefits of money, but does not clearly convey the idea that money is a natural market phenomenon. Davis writes that, "For whatever reason, people like gold and have been willing to accept it in exchange. . . ." (p. 268). Unfortunately, he completely fails to explain why the characteristics of gold made it the world’s top choice as a medium of exchange.

The analysis of the supply of and demand for money is correct and does get the reader thinking of money as subject to the standard tools of economic thinking. However, Davis errs in saying that gold (or other commodity money) is troublesome because "the amount of money in circulation is controlled by an outside factor that is not linked to the economy itself" (p. 268). This is badly mistaken. The production of gold is directly linked to the economy. Supply and demand operate to increase the price of gold when there is deflation. At times of inflation, the economy signals a need for more money by decreasing the price and production of gold. The author says that, "Clearly, control over the currency needs to extend beyond merely linking it to some external standard." This is a common belief, but shows that he has not done his homework in this area.

Davis says nothing about the origins of the Federal Reserve System, but seems to believe that government control of the monetary system is inevitable. His discussion of the operation of the Fed is adequate, but idealized. He gives the often-criticized view that the Fed is independent of political pressure and neglects to mention the Fed’s role in the Great Depression and subsequent economic downturns.

Davis provides an adequate explanation of business of banking and interest rates. The student, however, does not get much understanding of why banks are important in our economy, or why capital markets are essential to economic growth and prosperity. Moreover, he neglects the problems of federal deposit insurance; as in many other texts reviewed in this report, the S&L bailout is mentioned without saying anything about the role of government regulation in the debacle.