The first problem in maximizing the flow of output and income from the
capital stock is to obtain the optimum mix of the different types of
capital in the overall stock. A common problem in this regard
arises because the invention of a new idea or technique yields little
return to the inventor since once others become aware of that knowledge
they can use it for free. The resulting lack of incentive to invest in
this type of capital results in an imbalance in the aggregate capital
stock---because knowledge and technology does not expand as fast as the
other forms of capital, the additions to output from continuous growth of
those other types of capital get smaller and smaller as their stock
expands. As a result, the overall income from
the aggregate capital becomes a smaller and smaller fraction of the capital
stock as the aggregate stock increases through time. This problem is
dealt with by the enactment of patent laws that give the inventor of a
technique exclusive rights over it---other users must pay the patent-holder
for permission to use the technology. Proper implementation of such
laws can ensure that the return to investing in knowledge and technology
is equivalent to the return to investing in other forms of capital.
Next there is the problem of ensuring that the flow of income contains the
optimum mix of the various goods that can be produced. The best method
of attacking this problem is to establish legal institutions that allow
free markets to develop and thrive. With many producers and consumers of
each product, producers have incentives to expand production to the
point where the last unit produced costs just what consumers are willing
to pay for it. An "invisible hand" guides producers to produce
the mix of products, in the proper amounts, that consumers want to consume.
The proper mix of additions to the capital stock will be provided in the
same fashion.
While the free market enables the efficient provision of most of the goods
and services the community needs, there are many areas in which it does not
perform satisfactorily. There are many products that can be produced at
lowest costs by a single producer or a small group of producers who have
an incentive to act in unison. By reducing output below the
"optimum" level, these monopolists can raise prices to consumers
above their cost of production and the cost to the economy, earning returns
in excess of what they could earn under a free market. Similarly, workers
and other resource owners who can control the supply of services to the
market can reduce that supply, raising their earnings above what would be
possible under competition, thereby taking advantage of others in the
community.
Another problem is that of externalities which arise when returns
to a product or action are received by individuals or intstitutions that
do not pay for it, or costs are imposed on individuals or institutions
that are not taken into account by the producers of a product. A good
example of a positive externality would arise if there were a free
market in fire protection. Suppose that property owners have to hire
private fire fighting businesses to inspect and protect their property from
fire. Those fire fighters will find it necessary to fight a fire in the
next-door property to protect the property they are responsible for. The
owner of that next-door property will receive benefits that other people
are paying for. It is thus not surprising that the single fire department
in every community is a government organization.
A classic example of a negative externality is smoking. It is now
understood that non-smokers who inhale "second hand" smoke
created by smokers in public areas are more likely to acquire lung cancer
than people who are not exposed to tobacco smoke. Yet smokers pay only
the costs to themselves, which less than the total cost, of smoking
in public areas. As a result, smoking in public places is now illegal in
many jurisdictions.
Is there an economic argument for prohibiting smoking entirely? It might
be thought that by making themselves sick, smokers may impose unnecessary costs
on publicly organized health-care systems, creating a further externality.
It turns out, however, that by dying earlier in life, smokers may place a
smaller demand than other people on the health-care system---it is the
older people, many of whom become physically and mentally infirm in their
senior years, that make the bigest demands on health-care systems. So
perhaps we should subsidize smoking in private? Alternatively, since it is
well-known that smokers are harming themselves, why not be good citizens
and do them a favour, making all smoking illegal to prolongue their life?
Here it is of fundamental importance to recognize that economics has
nothing to say about ethical issues. Economic analysis can tell us
nothing about how income should be distributed or whether individuals
should be prohibited from doing things that make other people feel worse
or be forced to do things that make other people feel good. Economic
analysis should be used to determine the conseqences of actions of public
policy---whether some outcome is ethically good or bad is for the people
in the community to determine through their control over government!
This raises a further issue. Free markets work well in many areas
because individuals pursuing their own interests are automatically channeled
into pursuit of the public interest. But self-interested people operate
not only in the market economy---they also pursue their interests by
operating in the political system. For example, they argue and vote for
tariffs which prevent the community from buying goods more cheaply abroad
than they can be produced at home, raising domestic prices for
self-interested domestic producers at the expense of domestic consumers.
And, since less is then imported, less exports are needed to pay for those
imports, with the result that the income from human and other forms of
capital in the export industries is reduced.
More broadly, virtually every argument one hears in the media about what
the government should or should not do has the arguer's economic
self-interest at its base!
It's time for the test. Think carefully through the questions and
construct your own answers before looking at the ones provided.
We have seen how the stock of capital in the economy produces
a flow of output which, after deducting an allowance for depreciation,
yields a flow of income. The efficiency of resource use determines
the size of this flow of income and the amount of satisfaction the
residents of the community receive from consuming this income flow.