INCENTIVES MATTER: Everything You Need To Know About Economics In A Long Blogpost

| Economics is simple, and here’s all you need to know |

They call economics the “dismal science” but that’s only because people make it so complicated. Not only isn’t it a science, it shouldn’t even be an area of study, because there’s not much there. And what is there can be taught in just one blogpost.

In fact, if you’re really in a hurry, you don’t even need to read the whole thing, because economics can actually be taught with just two words: Incentives matter.

That’s it. If you understand that concept, you know everything you need to know about economics. But just for fun (fun, mind you, nothing dismal here) let’s add three more words: supply, demand, and price. Those are simply the tools that let us measure those incentives. Which matter.

“Supply” is the measurement of how much of something is brought to the market.

“Demand” is the measurement of how much the market wants something.

We were taught those concepts back in high school, right? But we weren’t taught about the most important one of all: price. People don’t think much about price. It’s just what you pay at the store. And that’s a pity because price is one of the most powerful forces in the universe, right up there with electromagnetism and gravity and Taylor Swift videos. Price is the very thing which powers what Adam Smith called the “invisible hand” of the marketplace.

But people don’t get it. Like the residents of the Shire in Lord of the Rings who never grasped how important and powerful Gandalf was, people don’t realize how powerful is the concept of price. Mark Twain once said that the difference between the best word, and the almost best word, is the difference between lightning, and a lightning bug. So what is the best word to use to understand price?

The best word is “messenger.” Price is a messenger, and because of this messenger, economies are able to function. Without this messenger, they die. If you want to kill an economy, remove price, and it will die. Here’s how price works. It’s extremely simple, yet unbelievably important.

When the price for something goes up, two important things change. And when it goes down, those same things change, but in the opposite direction. What are the two things? Supply and demand. Why do they change? Because (all together now) incentives matter.

OK, we’ve already covered close to 100% of the subject, so let’s see how it plays out in the real world.

We’ll start with strawberries. If all other factors are equal, if the price of strawberries goes up, two things will happen: (1) people will buy fewer strawberries, and (2) producers will try to grow more strawberries.

Most people intuitively grasp the first part of the equation: when price goes up, we buy less. But we often forget the equally important second part: when price goes up, producers supply more.

If you operate, say, a fruit orchard as a business, and half of it is planted for strawberries, and the other half, is blueberries, and you find out one day that for some reason the price of strawberries has gone way up, you will probably decide to devote more of your orchard to strawberries. You are incentivized to produce more.

And this is how price operates as a messenger. When the price changes, it’s sending a message to the consumer to buy less. And another message to the producer to produce more. With the consumer now buying less, and the producer producing more, soon the price will stabilize, and may even go back down.

We saw this happen with oil in North Dakota. The price of oil shot up. People found ways to reduce their driving, and oil producers in North Dakota found ways to produce more of it. Suddenly there was so much oil on the market that the price plummeted. Now we’re driving more, and a lot of those Dakota oil fields shut down. Each side “got the message,” first when prices went up, and second, when they went down.

The price, acting as messenger, makes sure both sides do the right thing. Why is this so important? Because the messenger, acting in this way, always balances supply and demand. Why do we care? Because if supply and demand aren’t balanced, either you have shortages (no strawberries at the grocery store), or you have gluts (so many strawberries that the store has to throw out two-thirds of them.) Neither is desirable. And neither can happen other than briefly, in an economy where price is serving as messenger.

But what happens if you shoot the messenger? Plutarch tells the story of a Chinese warlord who cut the head off a scout who delivered bad news. Thereafter, no one would deliver bad news and the warlord’s enemies soon defeated him because he never received accurate intelligence. But how does that apply to an economy? Who shoots the messenger in the marketplace?

In a word: government. Government “shoots the messenger” in many ways in an economy, and it does so for the same reason that Chinese warlord did: lack of tolerance for bad news. When government shoots the messenger, and refuses to let price serve as a messenger to consumers and producers, you typically end up with shortages. Or put another way, when a shortage occurs, it is almost always a result of the price messenger somehow having been crippled, if not shot outright. Let’s take some examples.

Example 1: New York City housing in the seventies. Prices for apartments were skyrocketing, which is another way of saying the price messenger was telling consumers to consider living somewhere else, and also telling producers to build more apartments. But the government of the city didn’t like the bad news that the price messenger was delivering, so it shot the messenger. It imposed price controls (rent controls, they were called) on Manhattan apartments. Result? A shortage. You couldn’t find an apartment for rent in New York. And producers had no incentive to build new ones. Supply and demand were no longer in balance.

Example 2: Gasoline, also in the seventies. (Lots of shooting the messenger was going on in the seventies.) The Arab oil embargo reduced the oil coming onto the world market. Gasoline prices shot up, delivering the important message to consumers to consider driving less and buying more fuel efficient cars, and telling producers to find more oil and deliver it to the market. But the government didn’t like the bad news of increasing gasoline prices so it shot the messenger and imposed price controls on gasoline. Result? Five hour gas lines and people shooting each other trying to find gasoline. Just to be clear, it wasn’t the OPEC oil embargo that caused shortages. It was the price controls.

Shortages only happen when there are price controls, and price controls always produce shortages. If you find a shortage, you will find a place where the price “messenger” has been muzzled.

Let’s look for some more of those areas. What do we have a shortage of in America right now? Well, one thing is jobs. We have a high rate of unemployment, especially among those with limited or no skills, or workplace experience. Why is there a shortage? It’s always the same reason: because of price controls. Minimum wage laws are a form of price control, a form of “shooting the messenger.” Because of the large supply of unskilled labor, would-be employers should be happily absorbing all that available resource—at a low price. But they can’t, because it is illegal in this country to pay a worker less than a certain minimum price.

Making it illegal to sell gasoline above a certain price created gas shortages in the seventies. Making it illegal to sell one’s labor below a certain price has created a shortage of entry-level jobs. In Europe it’s far worse, because the minimum wage is set even higher. And government forces the wage higher in several ways. One is simply the number itself. But the onerous regulations that European employers face when hiring someone has the effect of making it that much more costly. Result: a big shortage of jobs, and high unemployment.

Remember: wherever there’s a shortage, someone has shot the messenger and price is not being allowed to function.

Traffic jams during rush hour in major cities, provide another example. What is the shortage? The shortage is available lanes on the freeway. If the freeway had more lanes, there wouldn’t be traffic jams. And we know that anytime there’s a shortage of anything, price isn’t being allowed to function.

How does this apply to freeways? The answer is right there in the name: free. Freeways (and most major multi-lane roads) are, well, free. That means the price is held constant, at zero. No one pays anything to use the freeways. You just get in a car and drive on them. You don’t pay for the privilege. Thus there is no messenger to tell drivers: don’t drive here at this time, and no messenger able to tell highway producers: we need more roads.

Remember, price always sends a double message, to both the consumers and the producers. But no such message is happening with freeways. Producers of freeways (generally governments) aren’t incentivized to build more, because there’s no money to be made from it. And drivers aren’t incentivized to drive less, because they pay no financial penalty. Incentives matter, and when a price is fixed (at zero in this case) a shortage will occur. And boy does it, twice a day.

But how could you bring price to bear, to solve traffic congestion? Easy, and it’s already being done. Enlightened highway engineers have recently discovered the magic of the price mechanism, and governments—against their will—are cautiously experimenting with this radical concept. They’re called “Lexus Lanes.” If you’re willing to pay something for the privilege, you don’t need to be stuck in the traffic jam.

And because Lexus Lanes generate so much cash to the producers of the highways, more of them are being built. (Remember, incentives matter.) There are two very stark examples of this in Colorado. Our major north-south artery, Interstate 25, is continually backed up as it goes through the Denver metropolitan area. A few miles to the East, a toll road was built: E-470. You pay for the privilege, and it lets you bypass the entire congested metropolitan area—for a fee. E-470 has never had a traffic slowdown on it—ever. Supply and demand are in balance: there are enough lanes (enough supply) for the drivers who want to pay to use that road (the demand). Without the possibility of generating revenue, that highway would never have been built. But because price was allowed to function (no one shot the messenger), the highway was built, and it does an excellent job of giving consumers (drivers) a choice. Meanwhile, to the West, I-25 has no price messenger, and the road is in a constant state of “shortage.”

Colorado’s major East-West artery is Interstate 70, which among other things lets Denverites come up to the mountains on weekends. Not surprisingly, It’s solidly backed up going West every Saturday morning, and equally backed up going East Sunday afternoon. Then they created Lexus Lanes. They allowed price to come into the equation. Because of the revenue from the Lexus Lanes, the lanes were able to be built. And if you are willing to pay the market price to have an unclogged highway, you can now have one. Good news! I-25, needing to compete with E-470, has now added Lexus Lanes as well. So you don’t have to be stuck in traffic if you’re willing to pay the market price of an open lane.

Incentives matter. Price is the messenger. And when you shoot the messenger, you get shortages. But sometimes we “shoot the messenger’s horse.” The messenger still functions. It’s not dead. But it’s doing a very poor job of delivering the messages.

This explains what’s happened to health care in America. In one sector of the market, you have Moore’s Law, which states that every few years the power of computers will double, and the price will be cut in half. Some form of Moore’s law applies to most areas of our economy, such as food. Our society now produces vast amounts of food, with little labor, and at amazingly low cost. But why is health care so expensive?

Because the messenger’s horse is dead and the communications aren’t getting delivered properly. It all started when government indirectly took control of health care in WWII. It happened with another government attempt to shoot the messenger: price controls were placed on wages. They weren’t allowed to increase as needed. So (duh) shortages of labor happened. The free market fought back. If it couldn’t pay more in dollars, it would find other ways to pay. Thus was born the concept of health insurance provided by corporations. Not health care, mind you. Health insurance.

Jump ahead sixty years, and almost everyone’s health care is being paid for by a third party: typically an insurance company that the consumer themselves didn’t even choose; their employer chose it.

Thus, when consumers use health care there is no messenger to incentivize them. My own story explains this. When Obamacare caused my policy to cancel, my new policy had no prescription drug benefit. One medication, that had been $15/month, was now $85. Yikes! But because I was paying for it, I did some research and found a site called GoodRX.com. Key in your zip code and your medication, and it will give you half a dozen pharmacies nearby to buy the product, along with prices. (The messenger returns!) I chose the least expensive, and my cost dropped to $8.00/month. I was now saving money by having no insurance, and shopping for health care (drugs in this case) the way I shop for everything else.

If the entire nation started behaving like normal consumers for health care, for prescriptions and procedures both, costs would plummet. How do we know this? Because the free market constantly finds better, less expensive, more efficient ways to deliver products and services. The only reason we have a health care problem in this country is because the price mechanism has not been allowed to function for over sixty years.

The good news is that Obamacare is so awful (with $6k and up deductibles for most plans) that people are being forced to go into the market and actually shop for health care like they shop for most things. Insurance in an Obamacare world is so expensive Americans are dropping it, and are increasingly cash buyers of health services. And that’s good, because it means price will start working again.

Hurricanes provide our final example of where the government shoots the messenger, and chaos occurs. Before a hurricane, people stock up hugely on stuff that they might need, like food, bottled water, batteries, etc. In other words, the demand goes up. After the hurricane, there is often a lot of infrastructure damage, which interrupts delivery of needed goods and services, such as gasoline.

If the price mechanism were allowed to function, the market would solve these problems quickly. Before the hurricane, the prices of food, water, and batteries would climb steeply. Remember this does two things. It incentivizes buyers to maybe not go quite so crazy buying fifty batteries, when they only need a couple. In other words, it slows down the panic buying.

Far more importantly is the message the rising price sends to producers: Stop what you’re doing and find a way to deliver food, water, and batteries to Miami. With consumer demand tempered by the rising price, and the supply of needed goods now soaring because of the rising price, supply and demand are balanced. There are no empty shelves. And the same thing occurs after the hurricane: gasoline prices go up, people choose to buy less, and everyone in the gasoline supply business stops what they were doing and uses all available resources to ship gasoline to Miami. Result: plenty of gasoline, even though it’s a bit more expensive for a few days.

But the first thing government does when a hurricane is approaching is shoot the messenger, via what are called “anti-gouging laws.” During Hurricane Matthew in Florida (October, 2016) the State Attorney General actually set up a telephone hot line to report businesses that were raising prices, so they could be prosecuted.

This is government at its worst. Shooting the messenger at any time is bad, but in the middle of a natural disaster is the worst possible time. Keeping market pricing from functioning, and thus ensuring supplies of the needed product (gasoline, water, etc.) from being available, can literally kill people. More on how bad price-gouging laws are in the wake of hurricanes, is found here.

People react angrily at higher prices around hurricanes because they think the merchant is unfairly taking advantage of them. They have it precisely backwards. The merchant is the one who is making sure the shelves are not empty. A merchant who fails to raise prices when panic buying begins is the one who should be thrown in jail. That merchant is “shooting the messenger” and that merchant is quickly going to be offering only bare shelves to his customer. How does that help the customer? When prices aren’t raised, there is no signal to the consumer to buy only what is truly needed, and no signal to the producers to get off your butts and ship stuff to Miami. A merchant who fails to raise prices at such a time is becoming an accessory to shortages. In a sane world, they would be fined for not raising prices—and thus allowing their shelves to become bare. But in the actual world, because the government always prefers to shoot the messenger, merchants are sent to jail for raising prices.

Finally, we come to that real bugaboo: profits. Oh, don’t we love to hate profits! In the old Soviet Union, earning a profit was itself a crime. Seriously. But in fact, profit is the only reason we get up in the morning. It’s the only reason we get dressed and head to work. If we couldn’t obtain value from such activity (profit) we wouldn’t do it. Profit is the fuel which powers an economy. Without the hope of profit, nothing would get done. The miracles which do happen in a modern economy, happen because there is profit in making them happen.

Remember our prime directive? Incentives matter. Profit is the incentive. Without it, everything grinds to a halt. We should never demonize profits. We should celebrate them. Profits are the very thing which keeps people incentivized to find better, more efficient, less costly ways of delivering products and services. Profits are the reason we all live in nice homes with air conditioning and color television, and aren’t back in caves trying to make flint spears as we sit around a fire.

Yet for some reason when it comes to the really important things in life, too many Americans believe profits are somehow evil. One of my relatives remarked that “no one [in the health care industry] should be allowed to profit off someone being sick.” Really? Then who is going to care for that sick person? You? Probably not. You’re too busy going to work every day and trying to earn a profit to feed yourself or your family. So if caring for the sick person won’t generate a profit for anyone, the sick person will die.

I’d rather a world where providing care to sick people was one of the most profitable activities available to anyone. So everyone would be incentivized to do it. And the services would get better and better, and less and less expensive, as entrepreneurs came up with improved techniques, inventions, and delivery systems.

When southern Florida is without gasoline because of a hurricane, I want some entrepreneur Bubba over in Alabama to be incentivized to load up his pickup truck with 30 gallon drums of gasoline and drive them to Miami, where he can sell them for three times his cost. And where he’ll then turn around and do it all over again. And again. And hundreds of others will too. And soon Florida will be awash in gasoline.

I want health care companies to make zillions of dollars caring for sick people, so they will be incentivized to do more of it, and become that much more efficient, and where others will be incentivized to compete with them, and all of it together will continuously drive down costs and deliver better and better care.

In Venezuela today they’ve shot all the messengers and imposed price controls on everything. The result, of course, is a shortage of everything, especially health care. In Venezuela, people are dying in hospitals for lack of anyone to take care of them. And when they die their bodies are left there because there is no profit in moving them. They are left there so long they get bloated and explode.

So there you have it: exploding dead bodies in Venezuela, thanks to government-imposed price controls, and the demonizing of profits in the care of sick people.

About those Lexus Lanes.

But, I can hear you say, why should that rich guy in his Lexus be able to bypass all the regular folk stuck in a traffic jam, just because he’s rich? What kind of a society is that?

It’s a society that functions properly. We all make decisions with our money. Sure, rich folk have more of it, and so they’re going to enjoy the finer things in life. That’s why it’s better to be rich than poor. That’s why so many people get up in the morning and try to make profits, with their workday activity, so they can have more of those things.

But what’s most important is that as a society collectively makes decisions, and sets priorities on what to spend money on, more of those desirable things get created. In South Florida after a hurricane, people decide to spend money on gasoline, because it’s critical. They’ll happily spend three times the normal price if they need to, to obtain gasoline, if the alternative is no gasoline at all. So because of that priority, more gasoline gets delivered. The shortage gets stamped out.

Lexus lanes on highways means you always have the option of paying more to get to your destination faster. And someone in danger of missing an international flight, or hurrying to a hospital to deliver a baby, or not wanting to be late to an important job intervi—will happily pay. And as more people pay for this service (uncongested highways) more uncongested highways will be built. Supply and demand will be balanced.

But doesn’t this mean the poor are always getting the short end of the stick? How is that fair? What kind of a society do we have that worships profit and doesn’t care about the poor?

Worshiping profit, or rather the freedom of an economy to use price to always balance supply and demand, helps the poor most of all. Look at the poor people in a free-market economy. And then look at poor people in a controlled economy. In America, even our poorest typically have a roof over their heads (public housing and welfare), are not starving (food stamps), and generally have the basics of modern life such as air conditioning, running water, television, Internet and even cell phones. And they also have free education and all the other benefits of an advanced economy.

Allowing the price mechanism to work, refusing to shoot the messenger, is what makes economies function efficiently, and what makes countries rich. Rich countries (like America) have fewer poor people, and the poor people that do exist can be much better taken care of, precisely because America is so rich. It doesn’t help the poor if—in the desire to make everyone equal and stamp out profits—everyone is made poor. Again, this is what just happened in Venezuela. It was once the most prosperous country in South America, and has more oil reserves than any country in the world. But because Socialists were determined to make everyone equal, they destroyed the economy, and now people are dying of starvation and disease, and their bodies are exploding. They made everyone equal alright. When everyone’s corpses are exploding equally, you know you’ve truly leveled the playing field.

Anyway, the above are merely examples of what happens when you shoot the messenger and seek to control price. It’s the fastest way yet discovered to destroy economies. Shooting the messenger wiped out housing in New York City, it caused five hour gasoline lines in the Seventies, it produces high unemployment continuously, if ensures shelves are empty before and after hurricanes, it causes traffic jams on highways twice a day, it makes health care unaffordable, and it kills entire populations in places like Venezuela. Why? Because incentives matter.

Congratulations. You now know everything you need to know about economics. Hopefully, you’ll use your knowledge as a force for good! And profit from it.

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