Economics-Free Enterprise in Action

Economics—Free Enterprise in Action
by David E. O’Connor
(Orlando: Harcourt, Brace, Jovanovich), 1988, 594 pp.

Rating: D

General comments: This hardcover textbook was published in 1988 and, 10 years later, is still in its first edition. The book is attractively produced and the writing is neither too advanced nor too childish for high school students. However, the book is quite weak in training the student how to think like an economist. The author rarely works through economic issues in ways that get the student to think about results rather than intentions, to weigh all costs and benefits, to consider changes in incentives and other secondary consequences. Furthermore, the book often advocates solutions that contradict its subtitle, "Free Enterprise in Action."

Criterion 1: Costs and Prices—How Production is Determined

O’Connor starts out well with a broad definition of economics: "The study of the choices people make in an effort to satisfy their wants and needs is called economics" (p. 22). However, he does not elaborate upon this definition to show that economics helps to explain and predict a vast range of human decisions, not just matters commonly perceived as "economic." He then takes a wrong step when discussing the "Basic Questions" as aggregate rather than individual matters. For example, he writes that "the nation must determine who will receive what goods and services and in what amounts" (p. 27, italics added). But one of the most important teachings of economists from Adam Smith onward is that the basic questions of economics do not have to be decided at the national level and indeed should not be. The spontaneous order of the market will answer the questions of production and distribution. Unfortunately, the book, here and elsewhere, reinforces the notion that many economic decisions can only be decided collectively.

The book’s discussion of Adam Smith and the idea of the "invisible hand" is not clear. O’Connor writes, "Smith argued that the promotion of self-interest benefits all of society by helping the economy to grow. He attributed the growth to an invisible hand that leads individuals to unknowingly do what is best for all of society when they protect their own self-interests" (p. 30). This is somewhat misleading; it suggests that producing particular goods and services for profitable trade means doing what is "best for all of society." That is not exactly Smith’s point. Smith was saying that the overall wealth of a nation would rise if people were free to pursue their self-interest, since doing so would optimize the use of human energy, capital and resources.

The author’s presentation of basic market dynamics is good and shows how profits and losses work to direct resources in the economy. The major weakness of this section is the end-of-chapter discussion on defenders and critics of the price system. The student gets two paragraphs in defense of the price system, followed by a lengthy batch of criticisms (pp. 87-89). These criticisms have been often refuted, but they are allowed to stand without comment. For example, we hear the old "big business dominates" argument that is part of socialist folklore, but neither stands up to scrutiny nor, even if true, would constitute a reason for abandoning the price system in favor of some other rationing device. Also, while it is true that there can be negative externalities in a market economy, there can also be negative externalities in any other economic system. The market can deal with them better than other systems.

Finally, O’Connor commits an inexcusable error when he says that "Price controls are adopted because the price system is unable to reach equilibrium on its own" (p. 89). Markets always have a tendency toward equilibrium; the problem is that government often interferes with the market on behalf of people who don’t like the market’s results. We don’t have rent control, for example, because the rental housing market "can’t reach equilibrium," but because individuals who are either unable or unwilling to pay the market price for housing give their support to politicians who will pass such measures.

Criterion 2: Competition and Monopoly

The book’s discussion of various market structures from pure competition to monopoly is flawed—especially in the treatment of monopoly. The logic of monopolistic pricing and profit maximization is not raised, except to say that if prices are too high, buyers will buy less. Here, marginal cost and marginal revenue analysis would have simultaneously helped the student’s economic thinking and would have explained the point more clearly. Nor does the student learn that monopolies are inefficient suppliers.

Government monopolies are discussed in reverential tones. O’Connor writes, "Government monopolies exist in response to a public need the private sector

. . . has not met. Most enhance the general welfare rather than seek profits. For this reason, the public generally supports government monopolies" (p. 126). These assertions are entirely lacking in economic analysis. Government monopolies sometimes exist because the government has outlawed competition (the Post Office) and sometimes because government provision crowds out the possibility of private-sector action (e.g., unemployment insurance). Moreover, O’Connor never discusses the efficiency problems of government monopolies. Instead of learning economic thinking, the student is handed an almost indefensible platitude.

Antitrust enforcement is given a brief, non-analytical treatment. The student learns little except that the intent of antitrust is to protect competition and break up monopolies. O’Connor mentions only one case, the breakup of AT&T. He says nothing about the tendency of government regulators and some businessmen to bring antitrust suits that stifle competition; nor does the author discuss how hard it is to secure and maintain a monopoly without help from the government, AT&T being a good example. In many states, AT&T faced competing phone companies in the early 1900s, but managed to have them legislated out of business so it could enjoy a monopoly.

Criterion 3: Comparative Economic Systems

O’Connor’s discussion of comparative economic systems is very weak.

Under the "Origins of Socialism," he gives the long outdated view that in the Industrial Revolution "the quality of life for workers deteriorated" (p. 443). Using data on infant mortality, diet, life expectancy, and other measures, historians and economists now know that the quality of life rose for the working class. Life was indeed hard, but it had always been hard for workers and peasants; they had never enjoyed "adequate sanitation and medical facilities" before the Industrial Revolution, but many began to enjoy these things as a result of the rising productivity and incomes brought about by the Industrial Revolution.

O’Connor portrays Sweden in rosy terms as the "model" democratic socialist state. After a list of all the social programs of the welfare system, students are told that "The standard of living in Sweden is one of the highest in the world" (p. 444). This implies a cause and effect relationship. What is omitted from the text is Sweden’s stagnant GDP, crushing tax rates, and high rates of alcoholism and suicide. Many economists who have studied Sweden argue that its relative prosperity is not because of, but in spite of its welfare system. The author’s illusion about Sweden is hopelessly outdated and befuddled.

O’Connor then lavishes several pages on a history and description of communism. He fails to give an accurate picture of the mass starvation, terror and murder that were necessary for the Soviet and Chinese regimes to implement their programs. The main weakness here, however, is not in the history, but in the weak analysis of central economic planning. Students are told that "The process of creating annual economic plans is complex," (p. 452) but that is a far cry from explaining to the student how and why it is virtually impossible to make efficient use of resources in without a price system, profit motive, or private ownership.

Criterion 4: The Distribution of Income and Poverty

The book says little about the distribution of income, poverty, and the various programs to assist the poor.

O’Connor presents students with a list of some government programs, but he has no analysis of the effects of those programs—nothing to encourage economic thinking along the lines of costs, incentives, or alternatives. He seems to think that as long as the intentions of government are good, the outcome of its handiwork must be good too. This is not thinking like an economist.

The "case study" on Social Security is wholly inadequate (p. 184). It contains no analysis of the future financing problems, the negative effect on savings and work, the redistributive effects, or the incidence of the Social Security tax.

Two pages are devoted to government job-training programs (pp. 182-83), but the material is almost entirely descriptive and focuses on intentions, not results.

Criterion 5: The Role of Government

O’Connor’s book is very deficient in analyzing the economic effects of government action. Instead, he gives students what sounds like a sales pitch: "Despite fears by some Americans that governmental tampering with the free-enterprise system would be harmful, most government policies have met with success" (p. 189). Economists have filled libraries with volumes disputing this conclusion. Shouldn’t students be able to read some of this evidence in O’Connor’s text?

The author first tries to argue that government had to expand as population expanded. But he never explains why a growing population necessitates a larger and more intrusive state; nor does he explain (or observe) a much faster rate of growth for government spending than population. Second, O’Connor states that "disadvantaged groups" make up a larger percentage of the population now than in the past. Yet, many members of "disadvantaged groups" are very prosperous and today a smaller percentage of the population is below the official poverty line than 50 years ago. Third, O’Connor cites "changing attitudes." He writes that the government’s "success in ending the Depression" convinced many people that bigger government was desirable. While it may be true that there are people who believe that the government "ended the Depression," economists in increasing numbers are finding that the policies of Presidents Hoover and Roosevelt deepened and prolonged it. (This point is made in other reviews within this report). Putting that point aside, however, popular attitudes have almost nothing to do with the proposing and passing laws, as Public Choice economists have shown. Fourth, O’Connor says that national emergencies have led to the growth of government. If so, why does it continue to grow even when there is no emergency? O’Connor merely gives the students his opinions, not analysis.

On the functions of government, students are told that the government regulates economic activity and protects competition, workers, and consumers. O’Connor gives no economic analysis, however, of the effects of all those laws and regulations. He merely encourages the mistaken notion that intentions always square with results. There is no hint that regulations have costs, or that those costs could outweigh the benefits.

The book’s definition of public goods is also wrong. Economists do not define them as "goods and services that are provided for everyone by the government" (p. 179). National defense and highways are (or probably are) public goods because the market would under-provide them on its own. But many things the government provides are clearly private goods (e.g., job training, retirement income, passenger rail service). Having the government provide such goods and services has consequences for economic efficiency; consequences O’Connor fails to explore.

Last, O’Connor argues that another function of government is giving subsidies: "Each year governments grant subsidies totaling billions of dollars to private businesses and public agencies to ensure continued service or production of certain goods" (p. 181). But he never encourages the student to ask whether such subsidies are cost-effective, whether they are really needed to "ensure continued service," or what impact they have on the economy as a whole. The asking of such questions is the whole point of economics.

Criterion 6: Public Choice

O’Connor ignores public choice theory probably because he almost never doubts the ability of government to solve problems. Nowhere will the student read that government officials have personal goals that may and often do conflict with "the public interest." Of the standard public choice topics, only interest groups are treated at all. Even here, however, O’Connor never notes that interest groups lobbying for benefits have an advantage in the political arena over disorganized consumers and taxpayers who will bear highly diffused costs. Indeed, special interest groups are depicted as forces for good (e.g., AARP works "on behalf of the elderly" and Public Citizen works for "all consumers") without any suggestion that such groups might be promoting the interests of their own members at the expense of others. Accepting the motives of lobbyists at face value does little to teach students about economics.

Criterion 7: The Role of the Entrepreneur

Entrepreneurship is treated surprisingly well. There are several profiles of successful entrepreneurs throughout the book and the author even includes a good discussion of why venture capital is important. (Unfortunately, the fact that government policy has a dramatic impact on the availability of venture capital is omitted.) O’Connor includes an excellent feature on "The Entrepreneurial Explosion" (p. 119), which points out that entrepreneurs have created much of the wealth, employment, and progress in the U. S. in recent years. He also notes that entrepreneurship is risky, but fails to point out that people will accept high risks only if they think they can earn and keep high rewards.

Criterion 8: Taxation

The book’s section on taxation is all description and no analysis. Students learn about the kinds of taxes levied and that they enable the government to pay for its various outlays, but there is nothing on the costs and effects of taxation.

Taxation has its opportunity cost, namely foregone private-sector activities that generate wealth and employment. The author never brings out this fact, but does manage to get the student to worry about how much tax breaks "cost" the government (p. 203). The tax cuts of the 1920s, 1960s, and 1980s, however, actually generated more tax revenue by spurring entrepreneurs to invest in factories instead of hiding their income from the government in tax-exempt bonds. Also missing is any consideration of the costs of tax enforcement, compliance with tax laws, and how taxes alter incentives.

Finally, O’Connor never raises the problem of tax incidence. With respect to Social Security, the book reiterates the long-discredited idea that employers match employee "contributions." The "employer contribution" to Social Security actually comes out of the worker’s pay, but the student gets no inkling of that.

Criterion 9: The Business Cycle

The treatment of the business cycle and government policy to deal with it is extremely weak.

First, O’Connor ignores the debate between economists who believe that business cycles are inherent in a market economy and those who argue that they are induced by government policy that upsets an otherwise stable market. Only a single paragraph mentions the changes in the availability of money and credit, which many economists see as the key to economic fluctuations.

Second, the standard Keynesian theory of fluctuating aggregate demand is presented in glowing terms (Keynes’ General Theory is called a "monumental work" that "revolutionized economic thinking" [p. 360].) The heated economic controversy over the Keynesian theory is never discussed. Students read that "many economists" accept the Keynesian view, but never learn that many economists (including Nobel Prize winners) do not accept it.

O’Connor does describe a few of the difficulties involved in using fiscal policy to smooth out the business cycle (timing problems, the difficulty of economic forecasting, and political considerations). But the most serious drawback in the minds of many economists—that government spending and borrowing merely crowds out private spending and borrowing—never appears. O’Connor devotes a page to the "multiplier effect," but never asks, "If government spending has risen, but private-sector spending has fallen, how can there be any multiplication of income?"

The discussion of supply-side theory is both lengthy and misleading. For example, the author writes that "The first assumption of supply-side economics is that economists can identify where the economy is placed on the Laffer Curve" (p. 376). This is not true. The purpose of the Laffer Curve is not to locate the current state of the economy at any point on the Curve, but to illustrate a relationship between the level of taxation and the amount of revenue collected by the government. O’Connor says that supply-side policy was expected to produce sufficient new tax revenue to balance the budget, the implication being that supply-side economic theory didn’t pan out. He fails to give the other side of the argument: That tax cuts in the 1920s helped produce large budget surpluses during that decade, and that the tax cuts of the 1980s also produced huge windfalls of revenue—windfalls that were eaten up by a Congress that hiked spending far beyond what the extra revenue could buy.

Criterion 10: Wages, Unions and Unemployment

"Supply and demand interact to determine wages just as they determine prices," O’Connor writes (p. 148). Alas, after this good beginning, the rest of the treatment of employment issues is flawed.

For example, the book defends the minimum wage and "comparable worth" issues with superficial arguments. On the minimum wage, O’Connor says nothing about its historical tendency to price low-skilled workers out of the labor market.

The book takes a brief look at affirmative action, saying that this policy "has been established to overcome past injustices to women and minorities" (p. 147). Whether it is possible to overcome past injustices through "affirmative action" in the present is a matter much in the public debate today, but O’Connor never says so. Far later in the book, at the end of the chapter on the business cycle, he includes a page from Thomas Sowell’s Markets and Minorities in which Sowell observes that discrimination imposes costs upon those who practice it. (p. 335). This sheds some light on labor market discrimination, but why is it not placed where it is most relevant?

The book’s treatment of unions covers their history, their professed objectives, and their work in passing labor laws. But we never get to the key economic questions: To what extent, if any, are unions able to increase worker compensation above the market level? If so, under what conditions? What impact do unions have on productivity? If union workers gain, does that come at the expense of others?

Criterion 11: Trade and Tariffs

O’Connor begins well in discussing international trade. He explains it as a micro phenomenon: "International trade is the voluntary exchange of goods and services between people in different nations" (p. 386). But when he proceeds to explain the law of comparative advantage, he lapses into macro language ("A nation determines its areas of comparative advantage. . . .") Students should be encouraged to think about how individuals and firms find their own areas of comparative advantage.

Next, the author discusses "Balancing Payments and Trade." The trouble is that he does not correct the common misconception that if the balance of trade or payments is "unfavorable," the economy must somehow suffer for it—and the government should take action. A good economics text should straighten out the old mercantilistic notion that aggregate trade statistics correlate with national wealth.

Arguments in favor of trade restrictions are presented in a cursory "Some say this, but others say that" fashion. O’Connor never teaches the student to think analytically.

The worst part of this section is the "case study" on MITI (p. 391), which is not a study at all, since it (and industrial policy in general) is subjected to no critical analysis. Many economists have pointed out that some of the major Japanese success stories have occurred where MITI’s advice was ignored. Honda, for example, went ahead and built cars despite MITI’s contrary advice. More generally, economists have attacked the idea that government policy-makers have any special ability to predict the future direction of the market. Entrepreneurs and capitalists, who have their own resources at stake, have more reason to invest thoughtfully. But O’Connor makes central economic planning seem entirely beneficial and non-controversial: "Many nations are using MITI as a model for similar agencies in their nations," (p. 391) he writes.

Criterion 12: Money and Banking

The book is good at explaining the functions of money, but not at how it evolved on the market. Moreover, the student reads very little discussion of the pros and cons of commodity money versus fiat money. O’Connor says that the gold standard "failed to provide for an efficient way to regulate the amount of money circulating in the economy" (p. 228). That is a conclusion rejected by many economists, who note that inflation was lower and the business cycle more stable while the gold standard was in effect.

O’Connor discusses banks and other financial institutions at some length (pp. 230-31), but the student does not learn much about the problems that have beset the banking industry. Continental Illinois did suffer a "near collapse" in 1984, but the student who wonders why will have to look elsewhere. The role of government regulation, especially deposit insurance, in promoting risky lending is never mentioned. The "case study" on the S&L crisis gives no hint of the government’s role in making possible the huge losses and taxpayer liabilities.

The structure and operation of the Federal Reserve are presented well, and the book includes a brief treatment of the debate between those economists who favor a discretionary monetary policy and those who favor fixed rules. There is a brief allusion to the Fed’s responsibility for the Depression, but no in-depth analysis.

When O’Connor discusses inflation, he argues that "Profit-push inflation occurs when producers raise prices in order to raise their profits" (p. 317). This is illogical. Producers always desire to maximize profits and search for the prices that do so. Once they are charging those profit-maximizing prices, raising them further in search of higher profits is counter-productive. That’s what "profit maximization" means. If most or all producers raise prices together, how can consumers with limited incomes afford to buy as much? Many economists have thoroughly criticized the profit-push explanation for inflation, but readers of this book would never know that.