April 8, 2020 Reading Time: 6 minutes

Do economists and enthusiasts for free markets believe that free markets are inscrutable magic? In the last few days, I’ve been catching up with reading and reviewing what has been on my plate for a while, and I’ve come across words like “sorcery” (in Eugene McCarraher’s The Enchantments of Mammon) and “magic” and “faith” (in Lawrence Glickman’s Free Enterprise: An American History).

Both are extremely skeptical of Leonard Read’s classic essay “I, Pencil” — Glickman devotes a chapter to it, which my AIER colleague Phil Magness discusses in his review of Free Enterprise here — and they make what I think is a crucial mistake: they confuse “No single person knows how to make a pencil” (true) with “We don’t know how markets work, so just have faith that they will give us the right outcomes” (false).

I think these critics are missing the forest for the trees. Those of us who (try to) teach economics to college students semester in and semester out know the struggle. As my intermediate micro professor wrote on the board on the first day of class when I took it way back in 1999 and as I remind my students pretty regularly, “economics is hard.” It’s abstract, it’s counterintuitive, and studying it is, at times, a little like watching a magic show. 

I still remember the “whoa — no way” feeling I had when my intermediate micro professor, Akram Temimi, explained the fundamental theorems of welfare economics. If you’re interested, here’s the Google Books preview of a recent edition of Steven Landsburg’s Price Theory and Its Applications, which I used in the course. Start on page 253. My pulse quickened on looking at Exhibit 8.21 on page 256. It seems simply incredible to suggest that order and prosperity emerge without being consciously and deliberately planned by some higher authority.

This is Read’s message in “I, Pencil.” He illustrates how simple, voluntary exchange leads to social “miracles” like the pencil. Or Pepsi. Or the smartphone. Read is explaining how, to borrow from Adam Smith’s contemporary Adam Ferguson, so many of the things we take for granted are the results of human action within a framework that respects private property rights and that allows voluntary exchange but are not the product of deliberate human design.

Of course, someone does design a pencil, but she does so using others’ knowledge of processes she hasn’t learned and doesn’t understand. Importantly, there are a lot of ways to make something you can call a “pencil.” Economic calculation using market prices, as Ludwig von Mises explained, is essential if we are going to discover the “right” way — that is, the design and production processes that give us pencils without leaving more urgent wants unsatisfied.

In “I, Pencil,” Read is stripping away the complications and laying bare the underlying essence of the issue, which is something that I find absolutely amazing every time I teach comparative advantage and gains from trade. Specialization and division of labor mean we have consumption possibilities in excess of our individual production possibilities. We get more from the sweat of our brow because we can specialize and exchange.

Here’s a simple numerical example. Consider two people: David and Ricardo. They can produce two goods: potatoes and tomatoes. Suppose that in a day David could grow twelve potatoes or six tomatoes. Ricardo, however, lives on better land that might be especially suitable for tomatoes. Suppose Ricardo can grow twenty potatoes or a hundred tomatoes in a day.

For simplicity’s sake, assume David spends all his time growing potatoes and Ricardo spends all his time growing tomatoes. David eats twelve potatoes a day and no tomatoes. Ricardo eats a hundred tomatoes a day and no potatoes. Then, one day, David offers to trade Ricardo one tomato for one potato. Ricardo accepts the deal.

Here is where the “magic” happens. I put “magic” in quotation marks because it isn’t actually magic, of course, and we do understand it pretty well. That doesn’t mean it isn’t amazing. Instead of twelve potatoes and no tomatoes, David now gets eleven potatoes and a single tomato from the sweat of his brow. The fruit of Ricardo’s labor now consists of 99 tomatoes and one potato.

That doesn’t seem particularly remarkable until you ask what David would have had to give up to get a tomato if Ricardo weren’t there. Remember David’s production possibilities — twelve potatoes or six tomatoes — and remember where he started — twelve potatoes and no tomatoes. Had he wanted to grow a tomato on his own, it would have cost him the opportunity to grow two potatoes (12/6=2, so each tomato costs him two potatoes). If he switched completely from potato production to tomato production, he would have given up twelve potatoes to get six tomatoes.

If he decided to grow a tomato on his own, he would only be able to enjoy ten potatoes and one tomato rather than the eleven potatoes and one tomato he is able to enjoy because he can trade. In this example, growing a tomato himself would have cost him two potatoes. Because he can trade with Ricardo, each tomato only costs him a single potato. His daily “bread” with trade — eleven potatoes and one tomato — would have been impossible to achieve on his own.

Since David is better off, he has clearly taken advantage of Ricardo, right? Wrong, and here again is a crucial point: David makes himself better off by making Ricardo better off too. Ricardo went from 100 tomatoes and zero potatoes to 99 tomatoes and one potato. What if Ricardo hadn’t had the opportunity to trade with David and had decided to grow his own potato?

If he switched completely from tomatoes to potatoes, he would give up 100 tomatoes for 20 potatoes, so each potato would cost him 5 tomatoes. With trade, Ricardo enjoys 99 tomatoes and 1 potato. Without trade, the best he would be able to do is 95 tomatoes and 1 potato. Ricardo’s daily “bread” with trade — 99 tomatoes and 1 potato — would have been impossible to achieve on his own — just like David. Without trade, each tomato would cost David 2 potatoes. With trade, each tomato only costs David 1 potato. Without trade, each potato would cost Ricardo 5 tomatoes. With trade, each potato costs Ricardo only 1 tomato.

The rest, they say, is economics: the entire dismal science rests on this very, very simple insight: specialization makes our labor more productive. We could complicate this in all sorts of different ways, and that’s exactly what we do when we move from specialization to supply and demand. My references to Landsburg’s textbook above are references to an intermediate microeconomics text. 

The contexts and settings become more complicated, but the essential insight — that specialization and exchange gives us more of what we value — doesn’t change. The inescapable logic of this simple example blows up the notions so popular among those who denounce economics as “sorcery” that there is only so much stuff to go around, that all of history is a story of class struggle, and that the only way for Ricardo to be one of the Haves is for David to be one of the Have Nots.

Our critics also overlook one of the central lessons of economics generally and “I, Pencil” specifically. Exchange helps us share knowledge. David the expert potato cultivator is able to use the knowledge of Ricardo the expert tomato cultivator. David doesn’t need to know the finer points of the care and feeding of tomatoes. Ricardo doesn’t need to know the finer points of the care and feeding of potatoes. Friedrich Hayek referred to such “local knowledge” as “the knowledge of the particular circumstances of time and place.” Exchange allows David to harness and deploy all of Ricardo’s tomato-growing expertise without actually having this expertise himself.

“This might be all well and good in theory,” you might be saying, “and I’m sure it works nicely in the context of your very abstract classroom example — but when do we see this in the real world?” My answer: pretty much any time you do literally anything. Earlier this morning, the guy who rakes our yard came by. Because he specializes in leaf-raking, my time was freed up for writing economics articles.

In just a little bit, I’m going to make lunch. Is it free, or even cheap? Absolutely not: making lunch takes time, which means I’m giving up the opportunity to do something. The COVID-19 pandemic means we’ve been baking a lot of bread at home. Is this cheaper than getting it from the store or a bakery? Absolutely not: fresh, warm, homemade bread is quite a treat, but it’s expensive — not unlike the tomatoes for which David would have to sacrifice a princely two potatoes if he didn’t have the opportunity to buy them from Ricardo.

I occasionally wax rhapsodic in the classroom because I do think economics is beautiful. I find it especially interesting that so many problems have, as Landsburg points out, the same logical structure. As I recall Hoover Institution economist John Cochrane putting it (though I can’t find the link, unfortunately), it’s remarkable how many seemingly disparate problems can be explained and understood using supply and demand when you think hard about them. Determination of wages in competitive markets? 

Supply and demand. Loanable funds? Supply and demand. Insurance? Supply and demand. Education? Supply and demand. Religion? Supply and demand. Broccoli? Supply and demand. Pornography? Supply and demand. The problems differ in their details, obviously, but they share an underlying logical structure.

Art Carden

Art Carden

Art Carden is a Senior Fellow at the American Institute for Economic Research. He is also an Associate Professor of Economics at Samford University in Birmingham, Alabama and a Research Fellow at the Independent Institute.

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