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End of chapter 1:

The American versions of democracy and free markets are sweeping the world. Most of us have a reasonable understanding of how democracy works, but we are nowhere as comfortable in explaining how self-interest is essential in enabling free markets to function.

In Wealth of Nations, Adam Smith describes self-interest as "bettering our condition, a desire which...comes with us from the womb, and never leaves us till we go into the grave." "It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest." To portray how the self-interests of the baker and butcher are transformed into getting food on our table at a reasonable cost, Adam Smith invented a wonderful image, an "invisible hand." Its workings are the subject of the next chapter.




The "Invisible Hand" coined by Adam Smith is competition.

* (NCEE concept) Markets and Prices develop from competition. For

example, bread prices result from competition among bakers.

Competition among buyers leads to different prices for various

cuts of meat.

Prices for items relate to the costs to produce them.

Branded items like Oreos will sell for more.

Milk and sugar are high priced in the US because of laws.



One of the most memorable metaphors in all of economics, Adam Smith's Invisible Hand still intrigues us today. It projects an aura of mystery because its workings are so quiet and beneficial - almost like a good spirit watching over us.

As presented by Smith, the "invisible hand" is the mechanism by which "the private interests and passions of men" are channeled into the direction "which is most agreeable to the interest of the whole society." At its basic level, the Invisible Hand is competition. Society gets what it wants at reasonable prices because of the competition among sellers (and also competition among buyers and among workers).



Let's start with Adam Smith's baker in a gathering food for our dinner. That baker and all other food producers work primarily to make money for their families, not to keep the public well fed. Selfishly, bakers would like to charge a lot for bread, but competition from other bakeries keeps prices reasonable. When you go to the store for a loaf, you can choose among a variety of brands and types. You compare prices, size of loaves, and apparent quality when making your selection. Loaves that are higher priced but not of higher quality will not all be purchased. Bakers of these loaves will quickly get the message that they have to lower their prices or raise quality to get all their bread sold. If they do not, those bakers will lose money, and eventually they will go out of business.

This process of giving information on what's wanted to bakers and then forcing those who don't listen out of business is an invisible one. There are no officials telling bakers what they must or must not do. They act out of their own self-interest.



Next, let's consider how the butcher contributes to our dinner. When we buy meat, we notice that there are big differences in prices of the various cuts available. The tender or desirable parts (as breasts in chicken) cost more. The butcher knows he can get a higher price per pound for them. This is not surprising, but have you ever wondered how prices for varying cuts of meat are set? Would you believe that meat sellers do not determine the prices? You do! You, and the many other buyers competing to obtain meat, establish the butchers' prices.

Here's how it works. There is a fixed assortment of cuts that come from every slaughtered animal (always two drumsticks per chicken, for example). The butcher wants to sell all the cuts. He will lower prices on the least popular parts as much as necessary to get them sold. He sets a higher price on the more desirable cuts. If he doesn't set them high enough, you and other buyers will quickly snap up all the desirable parts available, leaving unsold some of the other cuts of meat. Smart butchers get the message, and next time they raise the prices of chicken breasts or beef tenderloin. If butchers raise the prices too high, you the consumer will again give them the corrective message. Your competition with other buyers acts as an Invisible Hand that guides the butchers into the prices that society wants to pay for all the various cuts of meat.



Let's continue to see how the Invisible Hand gets us other parts of our dinner. The market for fresh vegetables is one that remains almost as free as in Adam Smith's time. There are many individual farmers independently bringing produce to markets, often on a daily basis. Brand names are absent or mean little to the millions of buyers; instead, consumers primarily look for signs of freshness and quality in choosing vegetables.

In some areas there are Farmers' Markets, where we can actually still buy from the individual growers of food. Farmers are free to set the prices they want; there is no middleman involved. We are free to compare and choose the vegetables we want to buy. In checking prices, we notice that some vegetables like mushrooms always seem to be much more expensive than others like carrots. This seems funny because many people prefer eating carrots to mushrooms. Both vegetables are common ingredients in stews or pot pies. The reason for the price difference, especially in favor of mushrooms, seems hard to figure out. The mystery starts to clear up when we realize that you can't easily grow mushrooms (at least the edible kind) in a backyard garden, as you can grow carrots. It takes special care to grow edible mushrooms. If you were to visit a mushroom farm, you would quickly see that there is much more involved than planting some seeds. Mushrooms are grown in dark indoor buildings, require a special soil, and have to be harvested carefully by hand. All these steps are more costly than the commercial growing and machine picking of carrots.

The growers of both carrots and mushrooms price their products to be a little higher than their costs to grow them. They would like to charge a lot more, but competition from other growers keeps them from doing so. As with all products in free markets, vegetable prices are determined by the buyers and sellers, each trying to get a good deal, each asking "What's in it for me?"

Although an individual grower has little control over food prices, he has a lot of control over his cost to produce the vegetables or on the decision of what crops to raise. A farmer's income is greatly affected by his ability to manage costs. Weather is a factor he can't control, but in general the most efficient growers make the most money. The Invisible Hand of competition not only assures we get our carrots and mushrooms at a fair price, it also distributes money fairly to the farmers who grow them (rewarding efficiency and quality).

The cost of production is not the only reason why vegetables (or other items) vary in price. Typically a store will sell other root vegetables like turnips or parsnips at higher prices than carrots. Most root vegetables are grown similarly to carrots, and have about the same production costs. But people like and buy carrots in much greater numbers. As a high volume staple, carrots are grown by many farmers and are often featured in store ads. If suddenly turnips became more popular, more farmers would grow them, and the increased competition would bring turnip prices down closer to that of carrots.

How about some fruit and cookies for dessert? At the store we notice that the price per pound of apples is much lower than that of raspberries or blackberries. Yet berries are easy to raise. In many parts of the country, wild blackberries grow in profusion along streambeds. They are free for the picking. But if you've ever picked blackberries, you know it can be a prickly business. Picking a pound of berries takes a lot, lot longer than picking a pound of apples. It shouldn't be surprising that the price of berries is high, when the grower has to pay for lots of labor time to get a pound of them picked. Also, berries crush easily and spoil quickly. These factors add to the expense of bringing berries to market and lead their higher price.



Cookies turn out to be one of the more expensive items we buy for our dinner. This seems odd when we consider that the main ingredients for cookies are cheap (flour, sugar and vegetable oil). Some of the cookie price goes to pay for the cost of operating the factory, including workers' pay. The same is true for the bread we bought, yet cookie prices per pound are typically several times that of bread. How can the makers charge so much?

Unlike all the other items we bought for dinner, cookies have brand name labels that are very important to us. We usually don't want just a cookie or even a chocolate cookie, we want an Oreo. Since only one company makes Oreos, there is not the same kind of market competition that exists for the other items in our meal. Bread often comes with a brand label, but that label typically is not very important to us; one standard white loaf is about the same as another. But an Oreo is an Oreo - and woe to the parent who tries to get their kids to switch to a cheaper brand!

Lacking direct competition, the makers of Oreos are able to get a high price for their product. In their self-interest, they try to set a price that will maximize profits on Oreos. That price can't be too high, or buyers will turn to other types of cookies. If the price is too low, buyers will be encouraged to purchase lots of Oreos, but the company wouldn't make much profit. The company also finds that it is profitable to encourage sales by doing some advertising. Taking all these factors into account, the company finds its maximum profit on Oreos is at a price level that is higher than it would be in a classic free market. If other manufacturers were allowed make the same cookie recipe and print the Oreo label on the result, there would be true competition and the market price for Oreos would drop,

So why isn't that competition allowed? Wouldn't we consumers be better off with a lower price on Oreos and on other popular branded products? The answer is no, because manufacturers would lose their incentive to develop new, high quality products for us. It takes a lot of money to design, test, and promote a new product. Even experienced companies like Oreo's RJR/Nabisco find that the great majority of new products they try out lose money. If they could not charge a high price on the few products that are a commercial success, those companies would not be able to pay for experimenting with the many new product ideas that don't win acceptance in the marketplace.

Unfortunately, nobody can predict in advance which new items will be a success. If brands like Oreo or Tide were not protected from unauthorized copying, we consumers would eventually be left with only generic chocolate cookies or detergent on supermarket shelves. There would be very few interesting new products for us to try. Most of us would rather have the alternative of lots of choices, including paying more for a real Oreo.



Finally, let's get some milk to wash down the cookies. At different stores, we notice that milk is usually the same price and that there are never any big discounts on it. Milk is an item on which there are laws that set "fair" or minimum prices. Milk cannot legally be sold in stores below a certain minimum price. Periodically, the US Department of Agriculture and state organizations revise those legal minimums. If fewer people buy milk than expected or a store's refrigeration system goes out for a time, the store must simply dump its milk with a short shelf life. The store cannot lower milk prices (as it can with fresh fruit that is ripening fast) to get the excess sold. We all lose out when milk has to be thrown out, except for the dairy farmers, who got the law passed. Fortunately, with most other items a store manager can put up a sign "Reduced for Quick Sale" instead of throwing out food.

In addition to minimum price laws, the government has other restrictions that increase the prices on some foods we buy. Some of these laws are aimed at cheaper goods coming in from foreign countries. Sugar is a major example where there is a quota or limit on the amount of an item that can be imported into the US. With reduced competition from abroad, the protected US producers can charge more than the world price for sugar. Because sugar is a major ingredient in many of the processed foods we eat, like soft drinks and breakfast cereals, its high price adds to our overall food bill in many ways.

American sugar and milk producers have taken self-interest beyond what Adam Smith recommended. Other farm groups have convinced Congress to pass federal price support programs for crops like wheat, corn, and peanuts. If the world market price for a protected crop falls below a set level, Congress sends taxpayer money to those farmers. Special interest groups of all types regularly lobby legislators to pass laws that would help their industry, such as limiting imports of Japanese cars. All such laws are deviations from true free markets, and almost always the consumer ends up paying more.

The Invisible Hand of competition works most efficiently when buyers and sellers are free from restrictions. Laws, traditions, even the fear of violence can all make markets less free. Restricted markets always end up with higher prices for us than what truly free competition would bring. Sometimes, as in the case of protecting Oreo's brand name, the consumer is better off even with a higher price. In other cases, like milk and sugar price protection laws, the consumer is hurt. Even though there are many more consumers of milk and sugar than there are farmers raising these items, the strong self-interest of those farmers has come out ahead. They have done this skillfully using political pressure, the subject of a later chapter.

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