Defeated in battle and ravaged by bombing in the course of World War II, Germany and Japan nevertheless made postwar recoveries that startled the world. Within ten years these nations were once again considerable economic powers. A decade later, each had not only regained prosperity but had also economically overtaken, in important respects, some of the war’s victors. The surprising swiftness of recovery from disaster was also noted in previous eras. john stuart mill commented on what has so often excited wonder, the great rapidity with which countries recover from a state of devastation; the disappearance, in a short time, of all traces of the mischiefs done by earthquakes, floods, hurricanes, and the ravages of war. An enemy lays waste a country by fire and sword, and destroys or carries away nearly all the moveable wealth existing in it: all the inhabitants are ruined, and yet in a few years after, everything is much as it was before. (Mill 1896, book 1, chap. 5, para. I.5.19) Still, successful recovery is by no means universal. The ancient Cretan civilization may or may not have been destroyed by earthquake, and the Mayan civilization by disease, but neither recovered. Most famously, of course, the centuries-long Dark Ages followed the fall of Rome. Sociologists, psychologists, historians, and policy planners have extensively studied the nature, sources, and consequences of disaster and recovery, but the professional economic literature is distressingly sparse. As a telling example, the four thick volumes of The New Palgrave: A Dictionary of Economics (1987) omit these topics entirely. The words “disaster” and “recovery” do not even appear in the index of that encyclopedic work. Yet disasters are natural economic experiments; they parallel the tests to destruction from which engineers and physicists learn about the strength of materials and machines. Much light would be thrown on the normal everyday economy if we understood behavior under conditions of great stress. The Historical Record Although everyday small-scale tragedies like auto accidents and disabling illnesses are disastrous enough for those personally involved, our concern here is with events of larger magnitude. It is useful to distinguish between community-wide (middle-scale) calamities such as tornadoes, floods, or bombing raids, and society-wide (large-scale) catastrophes associated with widespread famine, destructive social revolution, or defeat and subjugation after total war. In community-wide disasters the fabric of the larger social order provides a safety net, whereas society-wide catastrophes threaten the very fabric itself. The former may involve hundreds or thousands of deaths; the latter, hundreds of thousands or millions. (As a special case, hyperinflations and great business depressions are society-wide events that do not directly generate massive casualties and yet still have calamitous consequences.) Middle-scale community-wide disasters are relatively frequent events, making empirical generalizations possible. In such disasters, it has been observed, individuals and communities adapt. Survivors are not helpless victims. Very soon after the shock they begin to help themselves and one another. In the immediate postimpact period community identification is strong, promoting cooperative and unselfish efforts aimed at rescue, relief, and repair. After the San Francisco earthquake of 1989, for example, inhabitants of a poor neighborhood spontaneously helped rescue motorists trapped by a freeway collapse. And after the

Many people believe that only government intervention prevents rampant discrimination in the private sector. Economic theory predicts the opposite: market mechanisms impose inescapable penalties on profits whenever for-profit enterprises discriminate against individuals on any basis other than productivity. Though bigoted managers may hold sway for a time, in the long run the profit penalty makes profit-seeking enterprises tenacious champions of fair treatment. To see how this works, suppose that male and female hot-dog salesmen are equally productive and that bigoted stadium concessionaires prefer to hire men. The bigger demand for male employees will raise men’s wages, meaning that the concessionaires will have to pay more to hire men than they would to hire equally productive women. The higher wages for men cause employers who insist on all-male workforces to be higher-cost producers. Unless customers are willing to pay more for a hot dog delivered by a man than by a woman, higher costs mean smaller profits. Concessionaires interested in maximizing their profits will forgo prejudice, hire women, reduce their costs, and increase their profits. Even if all concessionaires collude in refusing to hire women, new woman-owned firms can exploit their cost advantage by selling hot dogs for less, an effective way to take away customers. Unless government steps in to protect the bigots from competition, market conditions will end up forcing firms to choose between lower profits and hiring women. Though it may take decades, lower costs for female labor will result in the expansion of equal-opportunity employers. This will increase the demand for female labor and increase women’s wages. Some antiwomen owners may contrive to remain in business, but competition will make their taste for unfair discrimination expensive and will ensure that less of it will occur. An example of the effect of market penalties on prejudicial hiring occurred in South Africa in the early 1900s. In spite of penalties threatened by government and violence threatened by white workers, South African mine owners sought to increase profits by laying off high-priced white workers in order to hire lower-priced black workers. Higher-paying jobs were reserved for whites only after white workers successfully persuaded the government to place extreme restrictions on blacks’ ability to work (see apartheid). Market penalties for discrimination also mitigated the effects of prejudice in the McCarthy era when profit-maximizing producers defied the Motion Picture Academy’s blacklist and secretly hired blacklisted screenwriters. Although government intervention often blunts the market mechanisms that penalize bigotry, people who unequivocally support such intervention often do so because they believe that unfair discrimination exists whenever outcomes for a particular group differ from those of the population as a whole. Economist Thomas Sowell calls the idea that “various groups would be equally represented in institutions and occupations were it not for discrimination . . . the grand fallacy of our times.”1 People differ in their tastes, aptitudes, and childhood experiences, in the skills they acquire from their extended families, and in the geography they must adapt to. People who have lived in cities for generations are less likely to become farmers. Those whose families have spent generations in rural areas may

Compound Rates of Growth In the modern version of an old legend, an investment banker asks to be paid by placing one penny on the first square of a chessboard, two pennies on the second square, four on the third, etc. If the banker had asked that only the white squares be used, the initial penny would have doubled in value thirty-one times, leaving $21.5 million on the last square. Using both the black and the white squares would have made the penny grow to $92 million billion. People are reasonably good at forming estimates based on addition, but for operations such as compounding that depend on repeated multiplication, we systematically underestimate how quickly things grow. As a result, we often lose sight of how important the average rate of growth is for an economy. For an investment banker, the choice between a payment that doubles with every square on the chessboard and one that doubles with every other square is more important than any other part of the contract. Who cares whether the payment is in pennies, pounds, or pesos? For a nation, the choices that determine whether income doubles with every generation, or instead with every other generation, dwarf all other economic policy concerns. Growth in Income per Capita You can figure out how long it takes for something to double by dividing the growth rate into the number 72. In the twenty-five years between 1950 and 1975, income per capita in India grew at the rate of 1.8 percent per year. At this rate, income doubles every forty years because 72 divided by 1.8 equals 40. In the twenty-five years between 1975 and 2000, income per capita in China grew at almost 6 percent per year. At this rate, income doubles every twelve years. These differences in doubling times have huge effects for a nation, just as they do for our banker. In the same forty-year time span that it would take the Indian economy to double at its slower growth rate, income would double three times—to eight times its initial level—at China’s faster growth rate. From 1950 to 2000, growth in income per capita in the United States lay between these two extremes, averaging 2.3 percent per year. From 1950 to 1975, India, which started at a level of income per capita that was less than 7 percent of that in the United States, was falling even farther behind. Between 1975 and 2000, China, which started at an even lower level, was catching up. China grew so quickly partly because it started so far behind. Rapid growth could be achieved in large part by letting firms bring in ideas about how to create value that were already in use in the rest of the world. The interesting question is why India could not manage the same trick, at least between 1950 and 1975. Growth and Recipes Economic growth occurs whenever people take resources and rearrange them in ways that make them more valuable. A useful metaphor for production in an economy comes from the kitchen. To create valuable final products, we mix inexpensive ingredients together according to a recipe. The cooking one can do is limited by the supply of ingredients, and most cooking in the economy produces undesirable side effects. If economic growth could be achieved only by doing more and more of the same kind of cooking, we would eventually run out of raw materials and suffer from unacceptable levels of pollution and nuisance. Human history teaches us, however, that economic growth springs from better recipes, not just from more cooking. New recipes generally produce fewer unpleasant side effects and generate more economic value per unit of raw material (see natural resources). Take one small example. In most coffee shops, you can now use the same size lid for small, medium, and large cups of coffee. That was not true as recently as 1995. That small change in the geometry of the cups means that a coffee shop can serve customers at lower cost. Store owners need to manage the inventory for only one type of lid. Employees can replenish supplies more quickly throughout the day. Customers can get their coffee just a bit faster. Although big discoveries such as the transistor, antibiotics, and the electric motor attract most of the attention, it takes millions of little discoveries like the new design for the cup and lid to double a nation’s average income. Every generation has perceived the limits to growth that finite resources and undesirable side effects would pose if no new recipes or ideas were discovered. And every generation has underestimated the potential for finding new recipes and ideas. We consistently fail to grasp how many ideas remain to be discovered. The difficulty is the same one we have with compounding: possibilities do not merely add up; they multiply. In a branch of physical chemistry known as exploratory synthesis, chemists try mixing selected elements together at different temperatures and pressures to see what comes out. About a decade ago, one of the hundreds of compounds discovered this way—a mixture of copper, yttrium, barium, and oxygen—was found to be a superconductor at temperatures far higher than anyone had previously thought possible. This discovery may ultimately have far-reaching implications for the storage and transmission of electrical energy. To get some sense of how much scope there is for more such discoveries, we can calculate as follows. The periodic table contains about a hundred different types of atoms, which means that the number of combinations made up of four different elements is about 100 × 99 × 98 × 97 = 94,000,000. A list of numbers like 6, 2, 1, 7 can represent the proportions for using the four elements in a recipe. To keep things simple, assume that the numbers in the list must lie between 1 and 10, that no fractions are allowed, and that the smallest number must always be 1. Then there are about 3,500 different sets of proportions for each choice of four elements, and 3,500 × 94,000,000 (or 330,000,000,000) different recipes in total. If laboratories around the world evaluated one thousand recipes each day, it would take nearly a million years to go through them all. (If you like these combinatorial calculations, try to figure out how many different coffee drinks it is possible to order at your local shop. Instead of moving around stacks of cup lids, baristas now spend their time tailoring drinks to individual palates.) In fact, the previous calculation vastly underestimates the amount of exploration that remains to be done because mixtures can be made of more than four elements, fractional proportions can be selected, and a wide variety of pressures and temperatures can be used during mixing. Even after correcting for these additional factors, this kind of calculation only begins to suggest the range of possibilities. Instead of just mixing elements together in a disorganized fashion, we can use chemical reactions to combine elements such as hydrogen and carbon into ordered structures like polymers or proteins. To see how far this kind of process can take us, imagine the ideal chemical refinery. It would convert abundant, renewable resources into a product that humans value. It would be smaller than a car, mobile so that it could search out its own inputs, capable of maintaining the temperature necessary for its reactions within narrow bounds, and able to automatically heal most system failures. It would build replicas of itself for use after it wears out, and it would do all of this with little human supervision. All we would have to do is get it to stay still periodically so that we could hook up some pipes and drain off the final product. This refinery already exists. It is the milk cow. And if nature can produce this structured collection of hydrogen, carbon, and miscellaneous other atoms by meandering along one particular evolutionary path of trial and error (albeit one that took hundreds of millions of years), there must be an unimaginably large number of valuable structures and recipes for combining atoms that we have yet to discover. Objects and Ideas Thinking about ideas and recipes changes how one thinks about economic policy (and cows). A traditional explanation for the persistent poverty of many less-developed countries is that they lack objects such as natural resources or capital goods. But Taiwan started with little of either and still grew rapidly. Something else must be involved. Increasingly, emphasis is shifting to the notion that it is ideas, not objects, that poor countries lack. The knowledge needed to provide citizens of the poorest countries with a vastly improved standard of living already exists in the advanced countries (see standards of livingand modern economic growth). If a poor nation invests in education and does not destroy the incentives for its citizens to acquire ideas from the rest of the world, it can rapidly take advantage of the publicly available part of the worldwide stock of knowledge. If, in addition, it offers incentives for privately held ideas to be put to use within its borders—for example, by protecting foreign patents, copyrights, and licenses; by permitting direct investment by foreign firms; by protecting property rights; and by avoiding heavy regulation and high marginal tax rates—its citizens can soon work in state-of-the-art productive activities. Some ideas such as insights about public health are rapidly adopted by less-developed countries. As a result, life expectancy in poor countries is catching up with that in the leaders faster than income per capita. Yet governments in poor countries continue to impede the flow of many other ideas, especially those with commercial value. Automobile producers in North America clearly recognize that they can learn from ideas developed in the rest of the world. But for decades, car firms in India operated in a government-created protective time warp. The Hillman and Austin cars produced in England in the 1950s continued to roll off production lines in India through the 1980s. After independence, India’s commitment to closing itself off and striving for self-sufficiency was as strong as Taiwan’s commitment to acquiring foreign ideas and participating fully in world markets. The outcomes—grinding poverty in India and opulence in Taiwan—could hardly be more disparate. A poor country like India can achieve enormous increases in standards of living merely by letting in the ideas held by companies from industrialized nations. With a series of economic reforms that started in the 1980s and deepened in the early 1990s, India has begun to open itself up to these opportunities. For some of its citizens, such as the software developers who now work for firms located in the rest of the world, these improvements in standards of living have become a reality. This same type of opening up is causing a spectacular transformation of life in China. Its growth in the last twenty-five years of the twentieth century was driven to a very large extent by foreign investment by multinational firms. Leading countries like the United States, Canada, and the members of the European Union cannot stay ahead merely by adopting ideas developed elsewhere. They must offer strong incentives for discovering new ideas at home, and this is not easy to do. The same characteristic that makes an idea so valuable—everybody can use it at the same time—also means that it is hard to earn an appropriate rate of return on investments in ideas. The many people who benefit from a new idea can too easily free ride on the efforts of others. After the transistor was invented at Bell Laboratories, many applied ideas had to be developed before this basic science discovery yielded any commercial value. By now, private firms have developed improved recipes that have brought the cost of a transistor down to less than a millionth of its former level. Yet most of the benefits from those discoveries have been reaped not by the innovating firms, but by the users of the transistors. In 1985, I paid a thousand dollars per million transistors for memory in my computer. In 2005, I paid less than ten dollars per million, and yet I did nothing to deserve or help pay for this windfall. If the government confiscated most of the oil from major discoveries and gave it to consumers, oil companies would do much less exploration. Some oil would still be found serendipitously, but many promising opportunities for exploration would be bypassed. Both oil companies and consumers would be worse off. The leakage of benefits such as those from improvements in the transistor acts just like this kind of confiscatory tax and has the same effect on incentives for exploration. For this reason, most economists support government funding for basic scientific research. They also recognize, however, that basic research grants by themselves will not provide the incentives to discover the many small applied ideas needed to transform basic ideas such as the transistor or Web search into valuable products and services. It takes more than scientists in universities to generate progress and growth. Such seemingly mundane forms of discovery as product and process engineering or the development of new business models can have huge benefits for society as a whole. There are, to be sure, some benefits for the firms that make these discoveries, but not enough to generate innovation at the ideal rate. Giving firms tighter patents and copyrights over new ideas would increase the incentives to make new discoveries, but might also make it much more expensive to build on previous discoveries. Tighter intellectual property rights could therefore be counterproductive and might slow growth. The one safe measure governments have used to great advantage has been subsidies for education to increase the supply of talented young scientists and engineers. They are the basic input into the discovery process, the fuel that fires the innovation engine. No one can know where newly trained young people will end up working, but nations that are willing to educate more of them and let them follow their instincts can be confident that they will accomplish amazing things. Meta-ideas Perhaps the most important ideas of all are meta-ideas—ideas about how to support the production and transmission of other ideas. In the seventeenth century, the British invented the modern concept of a patent that protects an invention. North Americans invented the modern research university and the agricultural extension service in the nineteenth century, and peer-reviewed competitive grants for basic research in the twentieth. The challenge now facing all of the industrialized countries is to invent new institutions that encourage a higher level of applied, commercially relevant research and development in the private sector. As national markets for talent and education merge into unified global markets, opportunities for important policy innovation will surely emerge. In basic research, the United States is still the undisputed leader, but in key areas of education, other countries are surging ahead. Many of them have already discovered how to train a larger fraction of their young people as scientists and engineers. We do not know what the next major idea about how to support ideas will be. Nor do we know where it will emerge. There are, however, two safe predictions. First, the country that takes the lead in the twenty-first century will be the one that implements an innovation that more effectively supports the production of new ideas in the private sector. Second, new meta-ideas of this kind will be found. Only a failure of imagination—the same failure that leads the man on the street to suppose that everything has already been invented—leads us to believe that all of the relevant institutions have been designed and all of the policy levers have been found. For social scientists, every bit as much as for physical scientists, there are vast regions to explore and wonderful surprises to discover. About the Author Paul M. Romer is the STANCO 25 Professor of Economics in the Graduate School of Business at Stanford University and a senior fellow at the Hoover Institution. He also founded Aplia, a publisher of Web-based teaching tools that is changing how college students learn economics. Further Reading   Easterly, William. The Elusive Quest for Growth. Cambridge: MIT Press, 2002. Helpman, Elhanan. The Mystery of Economic Growth. Cambridge: Harvard University Press, 2004. North, Douglass C. Institutions, Institutional Change, and Economic Performance. Cambridge: Cambridge University Press, 1990. Olson, Mancur. “Big Bills Left on the Sidewalk: Why Some Nations Are Rich, and Others Poor.” Journal of Economic Perspectives 10, no. 2 (1996): 3–23. Rosenberg, Nathan. Inside the Black Box: Technology and Economics. Cambridge: Cambridge University Press, 1982. Romer, Paul. “Endogenous Technological Change.” Journal of Political Economy 98, no. 5 (1990): S71–S102.   (0 COMMENTS)

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)