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Tuesday, June 29, 2010

More Border-Picture Economics

I suggested in the May issue that an aerial photograph of the border between barren Haiti and the heavily forested Dominican Republic was a predictor of the recent Haitian earthquake devastation. Not the earthquake, mind you, but the devastation that followed.

The property-rights vacuum that encouraged Haitians to cut trees down  without replanting also motivated them to skimp on construction durability. When the “big one” came, buildings collapsed and tens of thousands died. Incentives mattered, big time.

A satellite photo of the Korean peninsula provides a similar border-economics lesson. Taken at night, the photo shows South Korea lit up like a Christmas tree. To the southeast, Japan is much the same and, to the north and west, China’s glowing, too. But North Korea has just one isolated dot of light. The message: In a vibrant region, North Korea is a failure, especially compared to its brethren just over the DMZ.

Economic statistics confirm the message. South Korea is the world’s 15th largest economy. North Korea is an economic coffin, at or near the bottom of all national economic rankings except misery. Things were not always this way, however. Some 60 years ago living standards were actually higher in the north.

What happened? The short answer is that the South Koreans accepted private property rights as an organizing principle for economic activity. The North Koreans shunned such rights, opting for the seeming sureness of top-down economic decision-making. Institutional choices trumped Koreans’ common cultural heritage and language to produce a disparity in living standards surely unimaginable to those who made the choices.

The Heritage Foundation publishes an Index of Economic Freedom, of which the security of private property is an important component. Of the 179 countries in the 2010 index, South Korea is 31st and North Korea is . . . you guessed it, 179th. Economic data for closed societies like North Korea are sketchy. Nevertheless, Heritage estimates South Koreans’ average income to be a double-digit multiple of that of their northern counterparts.

The contrast is sobering. But before we get too gushy about South Korean economic institutions, a note of caution is in order. South Korea has long pursued “crony capitalism,” where a number of chaebol—large industrial conglomerates, usually controlled by a single family—enjoy preferential status with the government. Samsung, Hyundai, and LG are three of the better-known chaebol. Among the special privileges of chaebol is access to government finance not open to others. The effect of such “privileges” is to limit entry of non-chaebol competitors. It also lets them deploy various tariffs and subsidies to keep imports—especially those from politically unpopular countries—artificially expensive.

Attempts at market closure are certainly not unique to South Korea, but it does make it difficult to label South Korea a wide-open, free-market economy. That South Korea has experienced prosperity in the presence of such impediments leads statist-types to assert that its government officials must have “picked the winners.” How myopic, risk-averse bureaucrats, largely immune from the consequences of their decisions, can have such insight goes unexplained.

Success Despite Cronyism

The more important point, however, is that the notion that market closure somehow promotes economic advancement is fatuous and at odds with all economic logic and evidence. The adage about correlation not implying causation certainly applies here. Market closure, with or without a miraculous ability to “pick winners,” stunts advance, reducing living standards below what they otherwise would be. South Koreans enjoy relatively high living standards despite their government’s crony capitalist practices, not because of the practices, though the families in charge of the chaebol and people pursuing lifetime employment as salarymen certainly get some extra benefits. Absent such practices, overall living standards would be even higher.

At the same time, the fact that the two Koreas are so far apart in economic institutions and economic outcomes is a useful reminder that living standards don’t just happen. The goods and services responsible for our survival and enjoyment of life must be produced. They don’t spontaneously appear like Old Testament manna or multiply like New Testament loaves and fishes.

The problem is that there’s not enough land, labor, and capital to produce everything people want. Consequently, every society must have processes that determine what gets produced and who produces it. The yardsticks for measuring the effectiveness of these processes are the extent to which people value what is produced and that this production occurs at minimum cost or sacrifice.

For example, raising beef cattle in downtown Boston for American Vegetarian Society conventions fails on both counts. Not only would the beef be of no value to its intended users, it would also be exceedingly costly in terms of other things that could have been produced on the Boston real estate. It would destroy wealth.
Raising cattle on, say, Montana ranches for National Football League training camps would be at the other end of the spectrum. Low opportunity cost and high consumption value translate into wealth creation.

Private property in a truly free market harnesses self-interested sellers and buyers to act as wealth creators not destroyers. First, such sellers will seek out the buyers who value their products most highly, since they will be willing to pay the most. Second, self-interested buyers will be drawn to lower-cost producers, since they will be most willing to sell at lower prices. The result is high consumption value at low cost—more wealth.

Smile Like You Mean It

Lest you think that this process begins and ends in self-interested behavior, note that self-interested sellers are also constrained to act as if they cared about buyers. To wit, they must offer buyers terms that benefit buyers. Otherwise, buyers don’t buy. Likewise, self-interested buyers must act as if they cared about sellers by offering terms that benefit sellers, or sellers don’t sell. Wealth accrues to people on both sides of the transaction.

My idealistic students tell me that acting as if you care about your counterparts in the marketplace isn’t good enough. It’s so shallow; we need to really care, say these students. Put differently, my students are telling me that economic actions should be grounded in benevolence and love. It’s a fair comment. What’s the answer?

Interestingly, Adam Smith noted in his 1776 masterpiece, The Wealth of Nations, that “In civilized society [man] stands at all times in need of the co-operation and assistance of great multitudes, while his whole life is scarce sufficient to gain the friendship of a few persons.” It’s not that benevolence and love are incapable of motivating our actions. It’s just that their operative range is limited by the extent we want to live in an economy with the high living standards that follow on a substantial division of labor and its accompanying anonymity.

So I tell my students that if they want to really care, join a commune. Not surprisingly, they take a rain check.

To think that top-down, czar-like government directives could even remotely approximate the market’s assignments of production tasks and consumption benefits is wrongheaded. There is no way so-called economic czars could ever command the millions upon millions upon millions of bits of information about buyer valuations and producer opportunity costs for countless numbers of goods and services. It simply cannot be done. And if a society tries? Lights out! Look again at that satellite photo.

Individual sellers and buyers in free markets have no need for information on such a cosmic scale. Readily observed prices provide each, individually, with the economic equivalent of green lights and red lights to guide their activities in wealth-creating directions. The lights flash green when selling prices rise relative to costs; they flash red when costs rise relative to selling prices.

Moreover, and this is key, each seller only needs to know the price of what he sells and his costs, just as each buyer only needs to know the price of what she buys relative to the value she places on the item. Do sellers have to know why prices are what they are, or why their costs are what they are? No. Do buyers have to know why prices are what they are, or why their consumption valuations are what they are? No.

Sellers and buyers responding individually to the green and red lights embodied in prices permit these millions of bits of information about potential sellers and buyers to get processed into market outcomes. Production assignments for a vast array of goods and services go to their lower-cost producers and the corresponding consumption benefits go to their higher-valued users. No one knows a lot, but lots of lights go on. Look at that photo again.

  • T. Norman Van Cott, professor of economics, received his Ph.D. from the University of Washington in 1969. Before joining Ball State in 1977, he taught at University of New Mexico (1968-1972) and West Georgia College (1972-1977). He was the department chairperson from 1985 to 1999. His fields of interest include microeconomic theory, public finance, and international economics. Van Cott's current research is the economics of constitutions.