One of the most important building blocks of economic analysis is the concept of demand. When economists refer to demand, they usually have in mind not just a single quantity demanded, but a demand curve, which traces the quantity of a good or service that is demanded at successively different prices. The most famous law in economics, and the one economists are most sure of, is the law of demand. On this law is built almost the whole edifice of economics. The law of demand states that when the price of a good rises, the amount demanded falls, and when the price falls, the amount demanded rises. Some of the modern evidence supporting the law of demand is from econometric studies which show that, all other things being equal, when the price of a good rises, the amount of it demanded decreases. How do we know

National defense is in many ways a public, or “collective,” good, which means two things. First, consumption of the good by one person does not reduce the amount available for others to consume. Thus, all people in a nation must “consume” the same amount of national defense (the defense policies implemented by the government), although different people may value that common defense policy differently. Second, the benefits that a given person derives from the provision of a collective good do not depend on that individual’s contribution to funding it. Everyone benefits, including those who pay little or no taxes. To say that everyone gains from defense is not to say that everyone gains from government expenditures that are labeled “defense.” There is no necessary connection between defense expenditures and actual improvements in protection from foreign threats. Some defense expenditures may not contribute to such security at all; some expenditures may contribute a great deal; and some expenditures may, by stirring up hornets’ nests, actually reduce security. National defense, like other public goods, has an important “free-rider” problem. That is, because people benefit whether or not they contribute toward defense, each person has an incentive to wait for others to provide the collective defense good, and thus hopes to get a “free ride.” Also, because a free rider’s consumption does not reduce the amount of defense available for others to consume, even those who pay have little incentive to prevent free riding by others. As a result of such free riding, individuals acting privately to provide national defense services would produce too little from the standpoint of society as a whole. Each person would provide defense until the incremental benefits to him equaled the incremental costs. But for society as a whole—that is, for all individuals collectively—the incremental benefits would exceed the incremental costs, precisely because once an individual provides some of the collective good, all people benefit from it and no one can be excluded. This free-rider behavior yields one of the important traditional arguments for government: By imposing taxes on all individuals and then providing collective

Most nations, including the United States, have used military drafts at various times. Regardless of one’s views on military or defense policy, a draft has many economic aspects that are inherently unfair (and inefficient) and unacceptable to most economists. Hence, the question of whether to have a draft is really a question of whether any expected benefits outweigh those inequities. A military draft forces people to serve in the military—something they would not necessarily choose to do. With a draft in place, the military can pay lower wages than it would take to attract a force of willing volunteers of the same size, skills, and quality. This reduction in pay is properly viewed as a tax on military personnel. The amount of the tax is simply the difference between actual pay and the pay necessary to induce individuals to serve voluntarily. If, for example, pay would have to be twenty thousand dollars per year to attract sufficient volunteers, but these volunteers are instead drafted at twelve thousand dollars per year, the draftees each pay a tax of eight thousand dollars per year. Before the United States abolished the draft in 1973, some of its supporters argued that an all-volunteer force (AVF) would be too expensive because the military would have to pay much higher wages to attract enlistees. But the draft does not really reduce the cost of national defense. It merely shifts part of the cost from the general public to junior military personnel (career personnel are not typically drafted). This tax is especially regressive because it falls on low-paid junior personnel, who are least able to pay. Moreover, not just draftees pay the tax; so do those who still volunteer despite the lower pay. In other words, the draft is a tax on military service, the very act of patriotism that a draft is sometimes said to encourage. The President’s Commission on an All-Volunteer Force estimated that the draft tax during the Vietnam War was more than eight billion dollars per year in 2003 dollars. Every time a draft has been imposed, the result has been lower military pay. But even in the unlikely event that military pay is not reduced, a draft would force some unwilling people to serve in order to achieve “representativeness” or “equity.” In recent years, for example, some have advocated a return to conscription because today’s AVF supposedly has too few college graduates or too many African Americans. How to decide which of today’s volunteers to turn away is never addressed. The unwilling conscripts who replace the willing volunteers would bear a tax that no one bears in an AVF. And because these conscripts do not necessarily perform better than the volunteers they displace, this tax yields no “revenue.” Because the conscripts are part of society, the tax they pay is simply a waste to the country as a whole. And some who are qualified and would like to enlist are denied and forced into jobs for which they are less well suited or that offer less opportunity. A draft also encourages the government to misuse resources. Because draftees and other junior personnel seem cheaper than they actually are, the government may “buy” more national defense than it should, and will certainly use people, especially high-skilled individuals and junior personnel, in greater numbers than is efficient. This means that a given amount of national defense is more costly to the country than it need be. In 1988, for example, the U.S. General Accounting Office (GAO) studied the effects of reinstituting conscription and concluded that an equally effective force under a draft would be more costly, even in a narrow budget sense, than the existing force. With a draft, a larger total force would be needed because draftees serve a shorter initial enlistment period than today’s volunteers. Therefore, a larger fraction of the force would be involved in overhead activities such as training, supervising less-experienced personnel, and traveling to a first assignment. The GAO estimated that these activities would add more than four billion dollars per year (in 2003 dollars) to the defense budget. A draft also forces some of the wrong people into the military—people who are more productive in other jobs or who have a strong distaste for military service. That has other serious consequences for the country. A draft, especially one with exemptions, causes wasteful avoidance behavior such as the unwanted schooling, emigration, early marriages, and distorted career choices of the 1950s and 1960s. A draft also weakens the military because the presence of unwilling conscripts increases turnover (conscripts reenlist at lower rates than volunteers), lowers morale, and causes discipline problems. U.S. experience since the end of the draft in 1973 is consistent with the above reasoning. Today’s military personnel are the highest quality in the nation’s history. Recruits are better educated and score higher on enlistment tests than their draft-era counterparts. In 2001, 94 percent of new recruits were high school graduates, compared with about 70 percent in the draft era. More than 99 percent scored average or above on the Armed Forces Qualification Test, compared with 80 percent during the draft era. Because of that and because service members are all volunteers, the military has far fewer discipline problems, greater experience (because of less turnover), and hence more capability. So, for example, discipline rates—nonjudicial punishment and courts-martial—were down from 184 per 1,000 in 1972 to just 64 per 1,000 in 2002. And more than half of today’s force are careerists—people with more than five years’ experience—as compared with only about one-third in the 1950s and 1960s. Based on this experience, almost all U.S. military leaders believe that a return to the draft could only weaken the armed forces. Nor, as mentioned, would a draft reduce the budgetary costs of the military. For these same reasons, many countries in Europe recently have adopted an AVF or are actively considering doing so. Like the United States, the United Kingdom has had an AVF for decades. And three other large NATO countries—Spain, Italy, and, notably, France, where Napoleon invented modern conscription—recently have chosen to end conscription. Several smaller NATO members also have adopted an AVF or are considering doing so. In Germany, conscription is seen as blocking any return to twentieth-century militarism, and it provides “cheap” labor for many civilian social service agencies as well as the military. Yet some members of Germany’s governing coalition also favor adopting an AVF. And of the ten Eastern European countries that have recently become members of NATO, six—Bulgaria, the Czech Republic, Hungary, Latvia, Slovakia, and Slovenia—plan to end conscription before 2010; and two—Romania and Lithuania—are seriously considering doing so. These countries have elected to end conscription in part because of political pressure growing out of conscription’s inequities. And in most cases they recognize as well that an AVF will lead to a more effective and, ultimately, less costly military force. While it is too soon to pronounce conscription dead in Europe, there is clearly a strong trend toward voluntarism. In short, an all-volunteer force is both fairer and more efficient than conscription. The U.S. decision to adopt an all-volunteer force was one of the most sensible public policy changes of the last half of the twentieth century. Soldiers as Capital The reluctance to view a man as capital is especially ruinous of mankind in wartime; here capital is protected, but not man, and in time of war we have no hesitation in sacrificing one hundred men in the bloom of their years to save one cannon. In a hundred men at least twenty times as much capital is lost as is lost in one cannon. But the production of the cannon is the cause of an expenditure of the state treasury, while human beings are again available for nothing by means of a simple conscription order. . . . When the statement was made to Napoleon, the founder of the conscription system, that a planned operation would cost too many men, he replied: “That is nothing. The women produce more of them than I can use.” —German economist Johann Heinrich von Thünen, in Isolated State, 1850. About the Author Christopher Jehn is vice president for government programs at Cray Inc. He served as the assistant secretary of defense for force management and personnel from 1989 to 1993, and was assistant director for national security of the Congressional Budget Office from 1998 to 2001. He was formerly director of the Marine Corps Operations Analysis Group at the Center for Naval Analyses in Alexandria, Virginia. Further Reading   Anderson, Martin, and Valerie Bloom, eds. Conscription: A Select and Annotated Bibliography. Stanford, Calif.: Hoover Institution Press, 1976. Rostker, Bernard D. I Want You!: The Evolution of the All-Volunteer Armed Force. Santa Monica, Calif.: RAND Corporation, 2006. General Accounting Office. Military Draft: Potential Impacts and Other Issues, Washington, D.C.: The Office, 1988. Jehn, Christopher, and Zachary Selden. “The End of Conscription in Europe?” Contemporary Economic Policy 20 (Winter 2002): 101–110. The Report of the President’s Commission on an All-Volunteer Armed Force. New York: Collier Books, 1970.   Related Links Economic Freedom, from the Concise Encyclopedia of Economics. Joshua C. Hall, The Worldwide Decline in Conscription: A Victory for Economics? October 2011. David R. Henderson, Would a Return to Conscription Substantially Reduce the Probability of War? September 2015. Fred S. McChesney, Volunteers of America: Lessons from the New Contract Army. July 2005. (0 COMMENTS)

Some of the most significant tax changes in recent years have concerned the taxation of capital income. In 2003, Congress cut the top tax rate on dividends to 15 percent—significantly greater than the zero dividend tax that President George W. Bush wanted, but far below the 40 percent many high-income individuals paid in 2000. The 2003 tax bill also reduced the top capital gains tax from 20 percent to 15 percent. As always, political discussions of the tax cuts focused largely on who would reap the tax savings. The political wrangling obscured the real issues underlying a question that has occupied economists and tax experts for many years—whether individuals should pay any taxes at all on capital income. Strange as it may sound, most economists would agree that having zero taxes on capital income is theoretically the best thing to do. But many reject putting this theory into practice because they think that too much of the benefit would go to the “wrong” people, namely high-income households and the wealthy.

Economic competition takes place in markets—meeting grounds of intending suppliers and buyers.1 Typically, a few sellers compete to attract favorable offers from prospective buyers. Similarly, intending buyers compete to obtain good offers from suppliers. When a contract is concluded, the buyer and seller exchange property rights in a good, service, or asset. Everyone interacts voluntarily, motivated by self-interest. In the process of such interactions, much information is signaled through prices (see austrian school of economics). Keen sellers cut prices to attract buyers, and buyers reveal their preferences by raising their offers to outcompete other buyers. When a deal is done, no one may be entirely happy with the agreed price, but both contract partners feel better off. If prices exceed costs, sellers make a profit, an inducement to supply more. When other competitors learn what actions lead to profits, they may emulate the original supplier. Conversely, losses tell suppliers what to abandon or modify. Such profit-loss signals coordinate millions of sellers and buyers in the complex, evolving modern economy. The “dollar democracy” of the market ensures that buyers get more of what they want and expend fewer resources on what they do not want. Competitive prices thus work like radio signals; they are easy to perceive, and we do not need to know where they came from. There is no need to analyze all possible causes of the latest energy crisis to learn that we should scrap gas guzzlers and save electricity; and oil companies need to know only that petroleum is getting more expensive to start drilling new wells or to experiment with extracting fuel from oil shale or tar sands. Price competition informs millions of independent people in millions of markets, coordinating them effectively—as if by “an invisible hand,” as Adam Smith, the father of economics, once put it. Suppliers also engage in nonprice competition. They try to improve their products to gain a competitive advantage over their rivals. To this end, they incur the costs and risks of product innovation. This type of competition has inspired innumerable evolutionary steps—between the Wright brothers’ first fence hopper and the latest Boeing 747, for example. Such competition has driven unprecedented material progress since the industrial revolution. Differentiated products may give pioneering suppliers a “market niche.” Such a niche is never entirely secure, however, since other competitors will strive to improve their own products, keeping all suppliers in a state of “creative unease.” Another tool of competition is process innovation to lower costs, which allows producers to undercut competitors on price. This kind of competitive action has given us ubiquitous two-dollar pocket calculators only a generation after the first calculators sold for three hundred times that price! A third instrument to outcompete one’s rivals is advertising to bring one’s wares to buyers’ attention. Suppliers also compete by offering warranties and after-sales services. This is common with complicated, durable products such as cars. It reduces the buyer’s transaction costs and strengthens the supplier’s competitive position. Competition thus obliges people to remain alert and incur costs. Before one can compete effectively in a market, one needs the relevant knowledge. Buyers need to ask themselves what their requirements are, what products are available, what they can afford, and how various products compare, taking prices into account. This imposes search costs—think of the time and effort involved in buying a house, for example. Suppliers have to find out where the demand is, what technical attributes people want in their product, where to obtain the many inputs and components, how to train workers, how to distribute their wares, how to improve products and processes, how competitors will react, and much more. Such efforts—in research, development, and marketing—may be very costly and may still come to naught. For every market bonanza, there are many disappointments. And other costs arise as sellers and buyers negotiate contract details and monitor and enforce delivery. In a dynamic, specialized economy, the costs of searching for knowledge and carrying out exchanges (called “transaction costs”) tend to be high. Therefore, it is not surprising that market participants are keen to reduce transaction costs and associated risks. One method is to agree on set rules (called “institutions”) that help them to economize on knowledge acquisition costs. Markets fulfill people’s aspirations more effectively when there are enforced and expedient rules. Another transaction cost–saving device is to agree on open-ended, long-term relationships, such as employment contracts. Yet another is advertising, a means for sellers to inform buyers and save them some search costs. Deal making is also facilitated by intermediaries—market experts such as brokers, realtors and auctioneers. Despite these methods of reducing transaction costs, competition is uncomfortable and costly to competitors. Some entrepreneurs enjoy the market rivalry per se. But most people are ambivalent about competition in a particular way; they would like to avoid competing on their own side of the market, but welcome competition among those they buy from or sell to. In a free society, people are, of course, entitled to rest on their laurels by not competing, but they will lose market share, and their assets will probably lose value. To escape the competitive discipline, suppliers may try to conclude a “competitive truce,” forming cartels, particularly in markets with few suppliers or suppliers who need large lumps of capital to start operating. For example, the world’s airlines once formed the International Air Transport Association (IATA) cartel, which fixed airfares, schedules, and even such petty details as meal services. Cartels normally fail when a cartel member cheats on the agreed price (see cartels and opec) or when a firm not in the cartel competes by price or product innovation and established suppliers lose market share. For consumers and for the market as a whole, this cheating on cartel agreements is a boon. The only way for cartels or monopolies to avoid competition over the long term is to obtain government protection. All too often, politicians and bureaucrats readily oblige by imposing coercive regulations. They tend to hide behind all sorts of excuses—safeguarding jobs, ensuring public health and safety, or protecting nationals from foreign competitors. Yet, in reality, inhibiting competition is most often rewarding for regulators, who obtain moral or financial support for the next election campaign or secure lucrative consultancies. Economists call this “rent seeking” and point out that it is invariably at the expense of the many buyers, who are often unaware of the costs inflicted by political interference. Interventions may offer comfort to a few suppliers, but they harm the wealth of nations, which benefits the many. Most economists, therefore, consider untrammeled competition a public good that governments should protect and cultivate. This conclusion has, for example, inspired political attempts to control mergers, monopolies, union power, and cartels through internal competition policy; and the creation of the World Trade Organization, which was formed to protect international competition from opportunistic governments. Competition works well only if private property rights are protected and people are free to make contracts under the rule of law. Who would incur high knowledge-exploration costs knowing that the hoped-for gains might be expropriated, or that subsequent contracts to market a discovery are prohibited by regulation? That is why secure property rights, the freedom of contract, and the rule of law—in short, economic freedom—make for rapid economic growth, low unemployment, and diminishing poverty. International surveys invariably show that none of the poorest economies in the world is free, and that none of the world’s freest and most competitive economies is poor. From a society-wide viewpoint, lively market competition fulfills three vital functions: Discovery. Human well-being can always be improved by new knowledge. Competitive rivalry among suppliers and buyers is a powerful incentive to search for knowledge. Self-interest motivates ceaseless, widespread, and often costly efforts to make the best use of one’s property and skills. Central planning by government and government provision are sometimes advocated as a better means of discovering new products and processes. However, experience has shown that central committees are not sufficiently motivated and simply cannot marshal all the complex, often petty, and widely dispersed knowledge needed for broad-based progress. Selection and peaceful coordination. Competitive “dollar voting” selects what people really want and exposes errors through the “reprimand of red ink,” in the process dispersing useful knowledge. Since innovators cannot keep their discoveries secret, others see what is profitable and may emulate success. Despite occasional unsettling surprises and changing opportunities, competition fosters orderly evolution, distributing unavoidable adjustment burdens and coordinating divergent expectations. Competing and trading educates people in practicing a “commercial ethic”: pragmatism in problem solving and keeping peace to get on with the job. A competitive market order thus inspires confidence, social optimism, and a can-do spirit. Control of power. Supplier competition empowers consumers; competing employers empower workers. While some may try rent seeking, it is important that wealthy people remain exposed to competitive rivalry. Only then will they reinvest their wealth and talents in further knowledge searches, to the benefit of humankind. They will not always remain successful. Virtually none of the big American fortunes that existed in 1950 is still intact today. Competition tames concentrations of economic power and redistributes wealth. One may indeed go further and say that capitalism is legitimized by competition—the readiness of citizens of property to shoulder the costs of socially beneficial knowledge search. Socialists, with their slogan “Property is theft,” will gain followers only where competition is absent or politically distorted. Competition, as discussed here, hardly figures in standard, neoclassical economics since so-called perfect competition unrealistically assumes perfect knowledge. Yet, in reality, most economic activity is about finding and exploiting knowledge and motivating reluctant people with wealth and talents to do the same. Senator Henry Clay was right when he told the U.S. Senate in 1832, “Of all human powers operating on the affairs of mankind, none is greater than that of competition.” Indeed, competing is part and parcel of the pursuit of happiness. About the Author Wolfgang Kasper is an emeritus professor of economics at the University of New South Wales, Australia. Further Reading   Gwartney, J., and R. Lawson. Economic Freedom of the World. Vancouver: Fraser Institute, published annually. Hayek, F. A. “Competition as a Discovery Procedure.” In F. A. Hayek, New Studies in Philosophy, Politics, Economics and the History of Ideas. London: Routledge and Kegan Paul, 1978. Pp. 179–190. Kasper, W., and M. E. Streit. Institutional Economics: Social Orderand Public Policy. Cheltenham, U.K.: Edward Elgar, 1998. Especially chap. 8. Kirzner, I. M. How Markets Work. London: Institute of Economic Affairs, 1997.   Footnotes 1. We are not concerned here with other forms of competition, such as in sport, among political parties and interest groups, or among states in federations. Related Links Frederic Bastiat, “Competition,” in Economic Harmonies. Timothy Taylor, The Blurry Line Between Competition and Cooperation. February, 2015. Michael Munger, Rent Seek and You Will Find. July, 2006. Ross Emmett. A Century of Risk, Uncertainty, and Profit. December 2018. Arnold Kling, What Makes Capitalism Tick? April, 2018. Russell Roberts, Where Do Prices Come From? June, 2007. Buccholz on Competition, Stress, and the Rat Race. EconTalk, June 2011.   (0 COMMENTS)

Measuring prices and their rate of change accurately is central to almost every economic issue, from the conduct of monetary policy to measuring economic progress (see economic growth) over time and across countries to the cost and structure of indexed government spending programs and taxes. Most of us are familiar with the prices of many things we purchase. We know what we paid recently for a pound of ground beef or a quart of milk. Renters know how much they pay in rent. Measuring prices, therefore, may seem simple and straightforward, but it is not. The purpose of a price index is to summarize information on the prices of multiple goods and services over time. Consumer spending accounts for about two thirds of the U.S. gross domestic product (GDP). The Consumer Price Index (CPI) and the Personal Consumption Expenditure deflator (PCE) are designed to summarize information on the prices of goods purchased by consumers over time. In a hypothetical primitive society with only one good—say, one type of food—we would not need a price index; we would just follow the price of the one good. When there are many goods and services, however, we need a method for averaging the price changes or aggregating the information on the many different prices. The rate of change of prices—inflation—is important in both macro- and microeconomics. Estimating inflation and real growth, for example, requires measures of price changes, and in a flexible, dynamic modern market economy, obtaining accurate measures is complicated. A single large superstore may contain more than fifty thousand separately priced items. Within that individual store, new items are continually introduced and old items discontinued. The quality of many items improves in some objective way—greater energy efficiency, more durability, less maintenance, to name a few. Of course, many more items claim to have improved. When quality increases but the price stays the same, the real price has fallen. Even with modern scanner technology, summarizing what happened to prices in just one store over a period as short as one month is complicated. Doing so for the entire economy is vastly more complex. To obtain information on various prices requires not only measuring the prices but also weighting the various components in the index. Weighting each price change equally would be simple but not very revealing. For example, if the price of red delicious apples fell by 5 percent and rent rose by 5 percent, such an index would suggest that there had been no change in the overall price level. But that would be silly. We need to “weight” the goods on which consumers spend more of their income more heavily than those on which they spend less. The U.S. CPI and the Cost of Living When economists try to measure the “true” inflation rate—the rate of change of prices—it is to answer the question, “How much more income would consumers need to be just as well off with a new set of prices as the old?” Thus, a cost-of-living concept is at the core of proper measures of prices and of changes in prices. This clearly involves tracking “substitution”—that is, how consumers respond to the changes in the relative prices of various goods. It also requires measuring quality-adjusted prices. One would not want to count as inflation a major improvement in quality that resulted in a tiny price increase. Most traditional consumer price indexes, including the CPI in the United States, measure prices with a fixedweight system, taking the expenditure weights from some base period as given. Table 1 reports the most recent weights on very broad categories of goods from 2002; the Bureau of Labor Statistics (BLS) derives these weights from expenditure surveys that report how much consumers spent on different types of goods and services. For example, at a very broad level of aggregation, those weights are 15.6 percent for food, 6.0 percent for medical care, 40.9 percent for housing, 17.3 percent for transportation, and so on. Within each category, of course, are thousands of specific goods; for example, red delicious apples of a certain size and quality are a component of the apples subcategory, which is a component of fresh fruits, which in turn is a component of fresh fruits and vegetables. Table 1 Relative Importance of Components in the Consumer Price Index (CPI-U) Food and beverages 15.6   At home 8.3   Away from home 6.2   Alcoholic beverages 1.0 Housing (including utilities) 40.9 Apparel and services 4.2 Transportation 17.3   Vehicles 8.2   Gasoline 3.1   Other (parts, repair, insurance, public transport) 6.0 Medical care 6.0 Recreation 5.9 Education and communication 5.8   Education 2.8   Communication 3.0 Other 4.4 TOTAL: 100 Source: Consumer expenditure survey Note: Individual items may not add to totals because of rounding. With these expenditure weights at hand, it still takes a high-quality, expensive operation to track the prices. And whose prices? For commodities purchased where and how? In the United States, there are two closely related consumer price indexes. One measures the change in a weighted average of consumer prices, with the base year expenditure weights, for a typical urban family, the socalled CPI-U. The other, not quite identical, construct is the CPI-W, which measures prices for urban wage and clerical workers. I focus here on the more widely cited CPI-U. Neither of these fixed-weight indexes accounts for substitution, the fact that consumers substitute away from goods whose prices increase more and toward goods whose prices increase less.1 The CPI serves, and should serve, many purposes. For example, the CPI is used to measure consumer inflation on a monthly basis; to make cost-of-living adjustments in Social Security, income tax brackets, and other government programs; to provide price data as inputs to the National Income and Product Accounts (although the Commerce Department now uses its own set of weights and methods to construct its PCE deflator from these raw data). Figure 1 provides recent data on the U.S. CPI-U. The CPI-U sets the index = 100 for the years 1982–1984. As the figure shows, the pace of measured consumer inflation has slowed considerably relative to the 1970s and 1980s, has recently been running in very low single digits, and has had considerably less variation than in the high-inflation 1970s and early 1980s. People change their spending patterns over time, and do so specifically in response to changes in relative prices. When the price of chicken increases, for example, people may buy more fish, and conversely. Hence the weights change, and a price index that fails to account for that—as does the fixed-weight base period CPI—overstates the true change in the cost of living. There are two obvious approaches to weighting the prices. The first uses a fixed-base period weighting: quantity or expenditure weights remain fixed at their base period levels, and then we see what happens to the weighted average of prices as prices subsequently change. An alternative possibility is to use the expenditure weights or quantities in the second period, after the substitution. Economic theory strongly supports the idea of taking an average of these two numbers, a point originally made by the great American economist irving fisher (1922). Since 2002, the BLS has computed a closely related measure called the chained-CPI; it has been rising much less rapidly than the traditional CPI-U, suggesting that the failure to account for consumer substitution explicitly is a serious weakness of the official CPI. Similarly, where people make their purchases changes over time. Discount stores and online sales have become more important relative to traditional small retailers. Because price data are collected within outlets, the shift of consumer purchasing from discounters does not show up as a price decline, even though consumers reveal by their purchases that the price decline more than compensates for the potential loss of personal services. Thus, in addition to substitution bias among commodities, there is an outlet substitution bias. Even when purchases are made can become important. We typically measure prices monthly, during a particular week. But if, for example, consumers get wise to post-Christmas discounts and start buying a lot more holiday items after Christmas, surveys that look solely at prices in the second week of December will miss this. Another problem is that price data tend to be collected during the week. In the United States, about 1 percent of price quotes are collected on weekends, despite the fact that an increasing share of purchases is made on weekends and holidays (probably reflecting the increase in prevalence of two-earner couples). Because some outlets emphasize weekend sales, there may be a “when” bias as well as “what” and “where” biases. This phenomenon may explain, in part, recent research suggesting that prices rise less rapidly in data collected by scanners on actual transactions than in that collected by BLS employees gathering data on prices on shelves and racks. Finally, an additional bias results from the difficulty of adjusting fully for quality change and the introduction of new products. In the U.S. CPI, for example, VCRs, microwave ovens, and personal computers were included a decade or more after they had penetrated the market, by which time their prices had already fallen 80 percent or more. Cellular telephones were not included in the U.S. CPI until 1998. The CPI currently overstates inflation by 0.8–0.9 percentage points: 0.3–0.4 points are attributable to failing to account for substitution among goods; 0.1 for failing to account for substitution among retail outlets; and 0.4 for failing to account for new products. Thus, the first 0.8 or 0.9 percentage points of measured CPI inflation is not really inflation at all. This may seem small, but the bias, if left uncorrected for, say, twenty years, would cause the change in the cost of living to be overstated by 22 percent. The U.S. CPI is one of the few economic statistics that is never revised, even if subsequent data reveal that the published statistic is wrong. This is done because many contracts and other government programs are expressly indexed or adjusted to the CPI, and revisions would cause practical and legal complexities. Figure 1 Percentage Change in U.S. CPI-U ZOOM   We know that different sets of consumers have different expenditure weights because they spend different fractions of their income on the various commodities: renters versus homeowners, the middle aged versus the elderly, and so on. Interestingly, most analyses find only modest differences in inflation rates across groups with different expenditure weights. What about differences across groups in prices and rates of change of prices? For example, do the prices paid by the elderly differ from those paid by the general population? And if they do differ, have the differences changed over time? Economic theory suggests the prices will not differ much for most items, but we do not have serious empirical evidence on this score. Thus, inflation—the rate of change of prices—is hard to measure accurately. Government statisticians in all countries, especially those at the U.S. Bureau of Labor Statistics, have made numerous important improvements over the years. Yet, new products are introduced all the time, existing ones are improved, and other products leave the market. Relative prices of various goods and services change frequently, causing consumers to change their buying patterns. Literally hundreds of thousands of goods and services are available in rich, industrialized economies. As we have become richer, our demands have shifted toward services and away from goods, and toward characteristics of goods and services such as enhanced quality, more variety, and greater convenience. But all these factors mean that a larger fraction of what is produced and consumed in an economy today is harder to measure than it was decades ago, when a larger fraction of economic activity consisted of easy-to-measure items such as tons of steel and bushels of wheat. Thus, how to obtain information on who is buying what, where, when, why, and how, in an economy, and then to aggregate it into one or a few measures of price change raises a host of complex analytical and practical problems. Price index research and measurement—at one time considered staid and boring—has undergone a renaissance in recent years. Price index research in academia, think tanks, and government agencies, plus practical improvements in real-time government statistics, will be an ongoing effort of major importance and immense practical consequence for many years to come. About the Author Michael J. Boskin is the T. M. Friedman Professor of Economics and a Hoover Institution senior fellow at Stanford University. He was chairman of the Advisory Commission on the Consumer Price Index from 1995 to 1996, and was chairman of the President’s Council of Economic Advisers from 1989 to 1993. Further Reading   Boskin, M. “Causes and Consequences of Bias in the Consumer Price Index as a Measure of the Cost of Living.” Atlantic Economic Journal 33 (March 2005): 1–13. Boskin, M., E. Dulberger, R. Gordon, Z. Griliches, and D. Jorgenson. “Consumer Prices, the Consumer Price Index and the Cost of Living.” Journal of Economic Perspectives 12 (1998): 3–26. Boskin, M., E. Dulberger, R. Gordon, Z. Griliches, and D. Jorgenson. “The CPI Commission: Findings and Recommendations.” American Economic Review 87 (May 1997): 78–83. Boskin, M., and D. Jorgenson. “Implications of Overstating Inflation for Indexing Government Programs and Understanding Economic Progress.” American Economic Review 87 (May 1997): 89–93. Fisher, I. The Making of Index Numbers: A Study of Their Varieties, Tests, and Reliability. Boston: Houghton Mifflin, 1922. Lebow, D., and J. Rudd. “Measurement Error in the Consumer Price Index: Where Do We Stand?” Journal of Economic Literature 41 (March 2003): 159–201. Stewart, K., and S. Reed. “Consumer Price Index Research Series Using Current Methods, 1978–1998.” Monthly Labor Review 122 (June 1999): 29–38. An update is available on the BLS Web site. For more technical discussions of the economic theory of index numbers and the important case of new products, see the following: Diewert, E. “Exact and Superlative Index Numbers.” Journal of Econometrics 4, no. 2 (1976): 115–145. Hausman, J. A. “Valuation of New Goods Under Perfect and Imperfect Competition.” In T. F. Bresnahan and R. J. Gordon, eds., The Economics of New Goods. Chicago: University of Chicago Press, 1997. P. 209. Shapiro, M., and D. Wilcox. “Alternative Strategies for Aggregating Prices in the CPI.” Federal Reserve Bank of St. Louis Review 79 (May/June 1997): 113–125.   Footnotes 1. A recent improvement by the BLS substitutes geometric for arithmetic mean formulas for aggregating at the lower levels for about 60 percent of items, thus allowing for some partial substitution. Related Links Consumer Price Index. U.S. Bureau of Labor Statistics. Standards of Living and Modern Economic Growth, from the Concise Encyclopedia of Economics.  Boudreaux on Monetary Misunderstandings. EconTalk, January 2011. Meltzer on Inflation. EconTalk, February 2009. David Laidler on Money. EconTalk, September 2013.   (0 COMMENTS)

When you buy a good or service, you rarely have perfect knowledge of its quality and safety. You are justifiably concerned about getting “ripped off.” Thus the need for consumer protection. Economic activity flourishes when consumers can trust producers, but the consumer must have grounds for trust. Consumers value, then, not only quality and safety, but also the assurance of quality and safety. Trust depends on assurance. free markets generate numerous forms of assurance. While it may be impossible to verify the quality of prospective transactions, you can often verify that of past transactions. Reports circulate in various forms—from informal gossip to carefully tended data banks and evaluations—generating a producer’s reputation. “Reputation” may be defined as the relevant current opinion of the producer’s trustworthiness. Producers gain by providing assurance, so they seek to build, expand, and project a good reputation. They create and display brand names, logos, and trademarks, umbrellas under which their transactions are grouped in the minds of consumers. They manage the extent and scope of their services to generate the repetition and pattern of dealings that give their name and reputation cogency. Once established, a good reputation can be extended to other lines of service where trust had previously been limited. Gasoline suppliers, for example, built brand names so motorists would trust the product at roadside filling stations, and then extended the trusted name to automotive services. Conversely, a producer’s failings or misdeeds damage his reputation and induce consumers to shun him. For services such as medical therapies or divorces, in which consumers and producers interact perhaps only very infrequently, the grounds for repeat dealings are thin. The demand for assurance in these cases creates opportunities for middlemen to emerge, to serve as a bridge of trust between the consumer and the producer. Consumers, for example, do not buy pharmaceuticals directly from Pfizer or Merck, but rather from established retailers. The local drug store has extended dealings with both the consumer and the producer. Also, the middleman shares some of the producer’s expertise and, to some extent, serves as the consumer’s knowledgeable agent. A nexus then links the parties. To the consumer, the middleman is a friend, and the manufacturer is thus like a friend of a friend. One of the important functions of all retailers, hospitals, clinics, dealers, brokers, and firms is to generate the reputational nexus that brings assurance to parties who would otherwise meet only infrequently or in isolation. Producers typically put on their best face and will tend to conceal their failings, and this creates opportunities for a parallel industry of record-keeping, evaluation, and certification. These third-party practitioners range from neighborhood mavens to industry inspectors to product raters to medical schools. In any of these varieties, the agent may be called a “knower.” Knowers have some knowledge that the consumer values but does not have. (Some use the term “certifier,” but that term is too narrow.) Sometimes, the consumer pays knowers for reporting on producers. Consumers pay Consumers Union for its magazine, Consumer Reports; patients pay doctors to recommend drugs; employers pay agencies to screen prospective employees; employees pay agencies to screen prospective employers; and home hunters pay agents and inspectors to evaluate properties. Other times, the producers pay knowers. Electronics manufacturers pay Underwriters’ Laboratories to evaluate the safety of their products; corporations and governments pay Moody’s or Standard and Poor’s to evaluate the securities they issue; corporations pay accounting firms to conduct an audit; kosher foods manufacturers pay Orthodox Union to certify their preparations; and students pay universities, institutes, and training programs to certify their abilities. In all such cases, the producer applies to the knower and hopes to receive a certification or seal of approval that he can broadcast to prospective consumers. Word of his trustworthiness may freely flow to anyone. Consumers (or their savvy agents and middlemen) recognize such seals of approval and gain assurance of trustworthiness. The knowers, after a fashion, rent out their own good reputation to producers and have a strong incentive to do so responsibly; if they do not, other knowers may displace them. In the assurance-producing industry, as in any industry, free competition works well. In addition to these practices, five other paths to assurance exist: 1. Producers demonstrate quality and safety and make the content of promises clear and publicly understood by such means as advertisements, displays, sales assistance, labeling and packaging, and try-out periods. 2. Traders restructure the relationship to reserve for the consumer an advantage held until the end of the relationship, by such means as warranties, guarantees, return policies, security deposits, and simply withheld payment. 3. Consumers and their agents test and monitor producers and third-party knowers using unannounced inspections, decoys, undercover operatives, investigations, and second opinions. 4. The failings of a producer are exposed by rival producers in competitive advertising, product comparisons, and contests. 5. By making visible investments that would be profitable only for a high-quality product, producers signal quality by advertising, obtaining accreditations, and making long-term investments in design, facilities, and so on. The Internet is vastly expanding all forms of information exchange and reputation building. Critics regularly fault e-commerce for failings in privacy, security, or trust, but the pattern has been for each trouble to be fleeting. Almost as fast as the troubles emerge, entrepreneurs invent e-solutions, usually taking the form of a middleman (such as PayPal, Amazon, and eBay) service or a knower service (such as TrustE, BBBOnline, and Verisign). On top of all these creative efforts, there is tort law and contract law, which work on the principle of allow-and-respond. That is, we are free to enter into transactions, but once authorities determine some kind of tort or undue hazard, the activity responsible is curtailed or the damages are redressed. When a surgeon cuts into the wrong organ, he is liable for damages. A quack who persists in defrauding consumers may face a court injunction on his products or services. The late political scientist Aaron Wildavsky argued that the allow-and-respond approach provides for open-ended creative developments, self-correction, and resilience. Another form of consumer protection is government regulation. For example, the U.S. Food and Drug Administration (FDA) calls itself “the world’s premier consumer protection regulatory agency.” Other examples of consumer protection by regulation are occupational licensing, housing codes, the Federal Trade Commission, the Consumer Product Safety Commission, the Securities and Exchange Commission, and the National Highway Traffic Safety Administration. These kinds of protections generally involve restrictions on freedom of producers to sell goods or services that the government has not certified. Here the principle is banned-until-permitted. The main problem with such restrictions is that, by reducing the range of choices available to consumers, they make consumers worse off. Even if some of the goods and services would have been “rip-offs,” the vast majority of suppressed goods and services would have fulfilled the consumer’s expectations. The case of suppression best documented by economists is the FDA’s suppression of drug development and information, but economists have shed light on many other cases of suppression, such as those from licensing restrictions. Thus, the regulations impose costs. The question is: Do they deliver benefits that redeem those costs? To assess the benefits of consumer protection laws, we need to understand how well protection is (or would be) supplied absent the governmental “protections.” In his 1962 classic, Capitalism and Freedom, Milton Friedman posed a fundamental challenge to occupational licensing. His challenge still stands, and, indeed, applies to all the banned-until-permitted-type regulations: even if you believe that information and assurance are, for whatever reason, inadequately supplied, that might justify, at most, a government effort to supply the missing information. Instead of occupational licensing, Friedman preferred a governmental system by which practitioners could earn state certification in the occupation, but were left free to practice and market their services even if they chose not to be state certified. Consumers would be able to choose from a free, legitimate market of plumbers, electricians, barbers, and doctors, both state certified and noncertified. Likewise, the FDA could offer safety and efficacy certification services; manufacturers could seek FDA certification if they so desired, but would be left free to produce and market the product without FDA certification. This would free consumers and their agents and knowers (doctors and pharmacists) to choose a certified or noncertified drug. Friedman, in other words, said that the supposed deficiencies could justify, at most, only governmental certification services analogous to those of Underwriters’ Laboratories—that is, without compulsion. This approach would allow for competing forms of assurance; it would not lock in or privilege the governmental form. Despite the fact that Friedman’s basic challenge has often been posed over the last forty-five years, to my knowledge no one has ever offered a counterargument, much less a persuasive counterargument. About the Author Daniel B. Klein is professor of economics at George Mason University and an associate fellow at the Ratio Institute, Stockholm, Sweden. He is the editor of Reputation: Studies in the Voluntary Elicitation of Good Conduct (University of Michigan Press, 1997). With Alex Tabarrok, he has applied ideas about voluntary consumer protection to issues involving the Food and Drug Administration. Klein is also editor of the online scholarly economics journal Econ Journal Watch. Further Reading Early Works   Calkins, Earnest Elmo. Business the Civilizer. Boston: Little, Brown, 1928. An advertising executive’s earnest and highly instructive account of how businesses succeed by ensuring quality and safety. Smith, Adam. “The Influence of Commerce on the Manners of a People.” 1776. In R. L. Meek, D. D. Raphael, and P. G. Stein, eds., Lectures on Jurisprudence. New York: Oxford University Press, 1982.   Introductory   Klein, Daniel B. “The Demand for and Supply of Assurance.” In Tyler Cowen and Eric Crampton, eds., Market Failure or Success: The New Debate. Cheltenham, U.K.: Edward Elgar, 2002. Pp. 172–192. Klein, Daniel B., and Alexander Tabarrok. Is the FDA Safe and Effective? Oakland: Independent Institute, 2002. Online at: http://www.FDAReview.org. Summarizes how medicine proceeds without the FDA (particularly in off-label prescribing), and the strong evidence for the claim that costs of FDA restrictions are huge. Moorhouse, John C. “Consumer Protection Regulation and Information on the Internet.” In F. E. Foldvary and D. B. Klein, eds., The Half-Life of Policy Rationales: How New Technology Affects Old Policy Issues. New York: New York University Press, 2003. Pp. 125–143. Explains how technology is revolutionizing consumer information and how quickly things are evolving. Poole, Robert W. Jr., ed. Instead of Regulation: Alternatives to Federal Regulatory Agencies. Lexington, Mass.: D.C. Heath, 1982. A landmark challenge to the then-burgeoning “consumer protection” movement, with chapters on most of the major federal agencies; still highly instructive.   Advanced   Ippolito, Pauline M., and Janis K. Pappalardo. Advertising Nutrition and Health: Evidence from Food Advertising, 1977–1997. Bureau of Economics Staff Report. Washington, D.C.: U.S. Federal Trade Commission, 2002. A good empirical analysis of whether and how manufacturers furnish quality information to consumers. Svorny, Shirley. “Licensing Doctors: Do Economists Agree?” Econ Journal Watch 1, no. 2 (2004): 279–305. Although there is a body of economic literature on occupational licensing, the topic is much more important than the degree of interest would suggest. Because most licensing is particularistic, it is a hard topic to research. Svorny provides a comprehensive review of the judgments economists have rendered on licensing restrictions. Wildavsky, Aaron. Searching for Safety. New Brunswick, N.J.: Transaction Publishers, 1988. An analysis of “anticipation” (banned-until-permitted approaches) versus “resilience” (allow-and-respond approaches).   Related Links Capitalism, from the Concise Encyclopedia of Economics.  Risk and Safety, from the Concise Encyclopedia of Economics. Daniel B. Klein, Drug-Approval Denationalization. April 2009. Phillip Maymin, Why Financial Regulation is Doomed to Fail. March 2011. Peltzman on Regulation. EconTalk, November 2006. Townsend on Development, Poverty, and Financial Institutions. EconTalk, March 2011. Admati on Financial Regulation. EconTalk, August 2011. Bureau of Consumer Protection, Federal Trade Commission. Consumer Protection, FDIC. (0 COMMENTS)

Joseph Schumpeter (1883–1950) coined the seemingly paradoxical term “creative destruction,” and generations of economists have adopted it as a shorthand description of the free market’s messy way of delivering progress. In Capitalism, Socialism, and Democracy (1942), the Austrian economist wrote: The opening up of new markets, foreign or domestic, and the organizational development from the craft shop to such concerns as U.S. Steel illustrate the same process of industrial mutation—if I may use that biological term—that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. (p. 83) Although Schumpeter devoted a mere six-page chapter to “The Process of Creative Destruction,” in which he described capitalism as “the perennial gale of creative destruction,” it has become the centerpiece for modern thinking on how economies evolve. Schumpeter and the economists who adopt his succinct summary of the free market’s ceaseless churning echo capitalism’s critics in acknowledging that lost jobs, ruined companies, and vanishing industries are inherent parts of the growth system. The saving grace comes from recognizing the good that comes from the turmoil. Over time, societies that allow creative destruction to operate grow more productive and richer; their citizens see the benefits of new and better products, shorter work weeks, better jobs, and higher living standards. Herein lies the paradox of progress. A society cannot reap the rewards of creative destruction without accepting that some individuals might be worse off, not just in the short term, but perhaps forever. At the same time, attempts to soften the harsher aspects of creative destruction by trying to preserve jobs or protect industries will lead to stagnation and decline, short-circuiting the march of progress. Schumpeter’s enduring term reminds us that capitalism’s pain and gain are inextricably linked. The process of creating new industries does not go forward without sweeping away the preexisting order. Transportation provides a dramatic, ongoing example of creative destruction at work. With the arrival of steam power in the nineteenth century, railroads swept across the United States, enlarging markets, reducing shipping costs, building new industries, and providing millions of new

The governance of corporations encompasses a wide range of checks and balances that affect the monitoring and incentives of firms’ management. Sound corporate governance is particularly important when a firm’s managers are not the owners. Without appropriate corporate governance, nonowner managers might not work very hard to maximize profits for shareholders and instead might spend money on perks and pursue the quiet life—or some other goal near and dear to the hearts of the managers such as personal profit maximization involving theft or fraud. The difference between the goals of the principals (i.e., owners) and the goals of their agents (i.e., managers) is typically called the “agency problem.” Aligning the incentives of the managers so that they act in the interest of the owners rather than themselves is the core challenge of corporate governance. In their classic 1932 book, Adolf Berle and Gardiner Means warned that the separation of ownership and control in the modern corporation “destroys the very foundation on which the economic order of the past three centuries has rested . . . it is rapidly increasing, and appears to be an inevitable development” of the modern corporate system (p. 8). Many contemporary scholars, such as Jensen (1989, 1993) and Roe (1990, 1994), have voiced similar concerns but argue that the problem is not inherent in capitalism; instead, they maintain that tax incentives, antitrust policies, regulations, and political pressures to adopt antitakeover statues that protect incumbent managers have led to what Mark Roe (1994) calls “strong managers and weak owners.”1

Corporations are easier to create than to understand. Because corporations arose as an alternative to partnerships, they can best be understood by comparing these competing organizational structures. The presumption of partnership is that the investors will directly manage their own money rather than entrusting that task to others. Partners are “mutual agents,” meaning that each is able to sign contracts that are binding on all the others. Such an arrangement is unsuited for strangers or those who harbor suspicions about each other’s integrity or business acumen. Hence the transfer of partnership interests is subject to restrictions. In a corporation, by contrast, the presumption is that the shareholders will not personally manage their money. Instead, a corporation is managed by directors and officers who need not be investors. Because managerial authority is concentrated in the hands of directors and officers, shares are freely transferable unless otherwise agreed. They can be sold or given to anyone without placing other investors at the mercy of a new owner’s poor judgment. The splitting of management and ownership into two distinct functions is the salient feature of the corporation. To differentiate it from a partnership, a corporation should be defined as a legal and contractual mechanism for creating and operating a business for profit, using capital from investors that will be managed on their behalf by directors and officers. To lawyers, however, the classic definition is Chief Justice John Marshall’s 1819 remark that “a corporation is an artificial being, invisible, intangible, and existing only in contemplation of law.”1 But Marshall’s definition is useless because it is a metaphor; it makes a corporation a judicial hallucination. Recent writers who have tried to recast Marshall’s metaphor into a literal definition say that a corporation is an entity (or a fictitious legal person or an artificial legal being) that exists independent of its owners. The entity notion is metaphorical too and violates Occam’s razor, the principle that explanations should be concise and literal. Attempts by economists to define corporations have been equally unsatisfactory. In 1917 Joseph S. Davis wrote: “A corporation [is] a group of individuals authorized by law to act as a unit.”2 This definition is defective because it also fits partnerships and labor unions, which are not corporations. Economist Jonathan Hughes wrote that a corporation is a “multiple partnership” and that “the privilege of incorporation is the gift of the state to collective business ventures.”3 Economist Robert Heilbroner wrote that a corporation is “an entity created by the state,” granted a charter that enables it to exist “in its own right as a ‘person’ created by law.”4 But charters enacted by state legislatures literally ceased to exist in the mid-nineteenth century. The actual procedure for creating a corporation consists of filing a registration document with a state official (like recording the use of a fictitious business name), and the state’s role is purely formal and automatic. To call incorporation a “privilege” implies that individuals have no right to create a corporation. But why is government permission needed? Who would be wronged if businesses adopted corporate features by contract? Whose rights would be violated if a firm declared itself to be a unit for the purposes of suing and being sued or holding and conveying title to property, or that it would continue in existence despite the death or withdrawal of its officers or investors, or that its shares are freely transferable, or if it asserted limited liability for its