I. Making Sense of the Facts

MAKING SENSE OF THE FACTS

[T]he simplifications of an analytical method furnish a powerful tool for understanding some of the fundamental controlling interrelationships in historical change. That such a technique makes explicit those daydreams on which our judgment of what is important in history are, always have been, and must be based is no doubt an embarrassment; but, to those who have stomach for this sort of game, it can become the road to a wider and truer understanding.

WILLIAM N. PARKER

HISTORY AND THEORY

That economic development should bring enormous wealth and success to some men but grinding poverty and failure to others, that the unprecedented expansion of some industries should proceed simultaneously with the rapid deterioration of others, that towns should spring up overnight in one region while the people abandon their homes in another—surely all these events seem contradictory within the same nation. Yet these apparent contradictions are prominent facts about the post-Civil War era in America.¹ Clearly the facts will not speak for themselves; to understand them, we must combine facts with theory.

A theory is a logically consistent set of assumptions and implications. It provides a means of relating facts to one another, of organizing and interpreting them so that they make sense. To avoid becoming entangled in a futile attempt to describe reality in all its detail and complexity, the assumptions state only what seems especially relevant to the question, ignoring everything else. From the set of assumptions, we can logically deduce a set of implications that constitute the theory’s predictions or hypotheses. In a test, the facts may or may not conform to a hypothesis. If they do, then the theory provides a means of understanding them; if they do not, then the theory’s assumptions must be rejected or modified. To be of any use, a theory must have hypotheses that could conceivably be refuted by the facts, for otherwise we cannot test it. Of course, quite different theories may be consistent with certain facts. To determine which of the competing theories is the most useful, we must consider questions for which they predict differently.²

To use theories in interpreting history is no novelty. Indeed, any account that goes beyond mere description to a search for causes must use some theory. But typically it is implicit, and the reader must identify it by reading between the lines. Naturally this game of theoretical hide-and-seek gives rise to misunderstandings, since the theories of the author and those of his readers often fail to correspond. Moreover, when the theory is not specified, it is frequently unclear whether the question at issue is really a testable hypothesis and whether the evidence considered is appropriate. To avoid such problems, this chapter makes explicit the theoretical foundation on which the analysis of this book rests. It is hardly surprising that economists have devised the most useful theories for interpreting economic history.

MARKET ORGANIZATION

In relation to the desire for them, economic goods—both commodities and services—are always scarce. Resources being limited, it is impossible to satisfy all wants simultaneously, and people must choose among the alternatives open to them. Should more houses be built? If so, how many, and where? Who will occupy them? By what methods should they be constructed? Millions of such unavoidable choices face every society every day, and the way we make the choices determines the allocation of scarce resources among alternative uses. If, for example, we commit resources to housing construction, then we necessarily forego their use elsewhere, and the most highly valued alternatives foregone constitute the true cost—what economists call the “opportunity cost”—of the housing.

Throughout the post-Civil War era in America free individuals acting within markets made most of these choices.³ No one planned or directed the organization of economic life in any formal, overall way. Individuals themselves decided what, how much, where, when, and how to produce. Yet even though each person pursued his own designs, the overall result was not chaotic; instead, it was orderly and in many ways predictable.

Private property rights are the foundation of the market system of resource allocation. These rights permit an individual to exclude others from the use of his property and to transfer this exclusive ability to others on terms that are mutually agreeable. In a market economy, people often exchange only the rights over the use of property, not the property itself. Secure and well-defined private property rights permit individuals to transact exchanges with the expectation that agreements reached by mutual consent of the contracting parties will be binding. Without this security a market economy cannot function. Within a system of private property rights, individuals who own the means of production may sell them or use them as they see fit; similarly, people are free to dispose of their incomes as they please. Fortunately, in such a system it will usually be in the interest of individuals to act in a way that is also socially desirable, because if many people want more of a particular good, their additional expenditures for it will make its production more remunerative, enticing self-interested producers to provide more of it. These producers, in turn, will bid up the prices of resources to attract them away from their present employment and into more valuable uses.

Relative prices play a crucial role in the market system, their function being to summarize in a form that is immediately meaningful to consumers and producers a mass of information concerning the relative scarcity of resources, the relative efficiency of competing methods of production, and the relative urgency of different desires. Consumers tend to buy more of goods that have become relatively cheaper: workers tend to move to jobs where wage rates have become relatively higher; and producers tend to move to industries or locations where rates of return have become relatively higher. Even in the absence of conscious direction, the actions of individuals pursuing their own self-interest result in an allocation of producers, workers, and other resources that insures that the goods society wants most urgently—as expressed by freely made expenditures—will appear on the market. Similarly, because producers can increase their returns by reducing their costs, they will seek to combine their resources in the most efficient way, which benefits society by making available the most goods obtainable from the limited resources at its disposal.

The market system operates successfully only when consumers, workers, and producers perceive and respond to the signals of changing relative prices. If movements into particular industries or locations are obstructed—in other words, if competition is less than perfect—resources will be misallocated. Society then loses, because it obtains fewer goods than it could under a perfectly competitive allocation of its resources. The monopolization of markets is therefore socially undesirable. To perform well, the market system depends crucially on the free competition of consumers, workers, and producers.

The American economy in the post-Civil War era was not perfectly competitive, which is hardly surprising, since perfect competition is only a “model” that is never observed in the real world. But despite much talk about “monopolies” and “the rise of trusts,” the degree to which the actual economy departed from the theoretical constructs was not great, and therefore we can still interpret the economic history of this period by applying the theory of competitive markets. Indeed, no alternative interpretation yields such an extensive array of hypotheses consistent with the facts.

THE ECONOMICS OF INFORMATION

The preceding discussion of the market system implicitly assumed that all persons possess complete information about the economy. In fact, information itself is a scarce good. It is therefore not free, and individuals must economize in their search for it; everyone must necessarily remain ignorant to some extent. Recognizing the economic basis of ignorance, however, permits us to explain a wide range of historical events for which the simple theory of competitive markets cannot account and at the same time to explain the emergence and growth of a variety of businesses whose main purpose is the creation or dissemination of information.

An example will help to present the basic ideas of the economics of information. Consider a man seeking a job. Other things being the same, he prefers the job with the highest wage rate; but his problem is to find it. Wages differ somewhat from place to place, and changes occur from time to time. (Wage dispersion exists because it typically does not pay an employer to find out exactly what wage rate each of his competitors pays for each grade of labor.) Suppose the job seeker inquires at the nearest factory and finds that he could obtain a job there at $2.00 per hour. Would it pay to look any further? By searching for alternative jobs he incurs costs in two ways: first, he loses the wages he could be earning had he accepted the first job; second, he must sacrifice leisure and incur direct costs in transporting himself about in search of alternatives. But potential gains exist, too. He may discover that the next factory pays $2.25 per hour. If he believes that wages in the neighborhood typically vary widely, he will probably continue his search. Also, if many factories are located nearby, he will be more likely to continue the search than if he had to go to the next town to find another opportunity. He will arrive at a decision by balancing the expected gains from seeking additional information against the expected costs of acquiring it. If expected costs exceed expected gains he will stop searching and seize on the best opportunity found so far; if the converse is true he will continue searching.

If many workers are seeking jobs, a new business is likely to appear. Someone will probably establish an employment agency, keeping informed of job openings, wage rates, working conditions, and skill requirements, and providing this information to job seekers for a price. Since this agency can probably collect information more effectively than the average worker because of its established contacts and accumulated experience, and because once collected the information can be provided to additional persons at very small cost, the employment agency represents a means of greatly enhancing the efficiency of the labor market. Workers need not continue searching for information from place to place. By eliminating repetitious inquiries, the employment agency greatly reduces the quantity of resources used in search activities. The average length of time each worker is unemployed while seeking a new job will probably fall. Employers also gain, because they can now obtain qualified new employees more readily by advertising with the agency. Workers gain, employers gain, and the owner of the employment agency obtains an income that compensates him for his efforts.

We can easily generalize this example. Whether the question is the worker’s search for the highest-paying job, the consumer’s search for the lowest-priced, highest-quality products, or the businessman’s search for the most remunerative investment opportunities, the same principles apply. In general, the greater the values involved, the greater are the potential gains, and therefore the greater is the amount of search. On the other hand, the larger the market geographically or the higher the costs of transportation and communication, the greater are the costs of search, and therefore the amount of search will be correspondingly reduced. However, the larger the market, not only geographically but also in terms of dollar volume and the number of traders, the more likely information-supplying businesses such as trade journals or brokers are to appear. (We say only “more likely” because discovering the opportunities for obtaining an income by supplying information is also a costly endeavor, and it would not pay anyone to find them all.) In this way business organization adapts to the changing size and demand patterns of the market. By pursuing gains from the provision of information, businessmen—without necessarily knowing or caring about the implications of their efforts—help the whole market system to operate more efficiently.

INVESTMENT AND ECONOMIC GROWTH

In the long run men can consume no more than they produce. The maximum possible output of goods depends on the number of available workers and the size of the capital stock, the produced means of production. Of course, if the labor force grows, more can be produced: and if the capital stock grows proportionately with the labor force, still more can be produced. But even then, we cannot expect the amount of output per worker to increase much. In a larger economy men can specialize to a greater degree, and this specialization can raise the average output per worker. It is difficult, however, to imagine such improvements continuing for long solely as a result of the increasing scale of the economy.

Economic growth means a continuing increase in output per person sustained over the long run, at least over several decades. Such a productivity increase permits, on the average, rising levels of material well-being. Economic growth does not just happen, however. Its gains are the product of deliberate human efforts.

Economic growth results from the accumulation of capital through a continuing series of investments. An increase in the amount of capital the average worker has to assist him in production enables him to produce more output. The relevant stock of capital embraces not only buildings, machinery, equipment, inventories, and improved land, but also the acquired health and skills of the labor force; most important of all, it includes the technology, the body of knowledge relating inputs of resources to outputs of goods.⁴ It is useful, then, to distinguish at least three kinds of capital—material, human, and intellectual. In the long run it is impossible to build up one part of the capital stock without also building up the others. The Commissioner of Patents in 1900 clearly recognized this interdependence: “To employ these devices [American inventions] to the best advantage requires the intelligence of the American workmen, and the result is due to the combination of witty inventions and thinking men. Witless men behind witty machines would be of no use.”⁵ Understanding these interdependencies is at the heart of understanding the process of economic growth, but unfortunately scholars have devoted little attention to them. To build factories is commonly recognized as an investment, but to obtain education, to purchase improved health, to seek new useful knowledge—these too are investments. And the rate of return on investment in a particular kind of capital depends not only on the size of the existing stock but also on the available stocks of complementary kinds of capital.

Information flows are intimately involved in these interdependent investments. The accumulation of intellectual capital, sometimes called technological progress, is simply the augmentation of the stock of useful information about production processes. Investments in the improvement of health often rely on new knowledge of public hygiene and disease or on the wider application of old knowledge. And education, of course, is nothing more than the dissemination of information. Moreover, even material capital accumulation does not stand completely outside this conceptual framework, for new ideas are often useful only when embodied in new capital goods. Investment in material capital then becomes the vehicle for the implementation of technological advance. In an important sense, the economics of rising productivity and the economics of information are inseparable.

Investors generally undertake a project only when the expected returns exceed those obtainable from employing the available resources in their best alternative use. No one would quarrel with this proposition as applied to investments in material capital, but because we have not traditionally considered invention and education as investments, it may be useful to see some examples.

Consider a hypothetical individual who is contemplating the development and production of a new tool, such as a machine for making nails. Before committing himself to such a project, the inventor will have to form several expectations. First, he needs to know the probable costs of developing and producing such a machine. These costs include not only the money outlays he must make but also the value of the best alternative use of his time and talent he foregoes by working on the project, both items together comprising his full “opportunity cost.” Second, he must estimate, for each year in which his machine will be purchased, the number he can sell at the price he will charge, which tells him the stream of revenues he can expect from future sales. By subtracting the probable costs of production from these yearly revenues, he finds the expected net revenue stream. He can then calculate the present value of the future net revenues.⁶ If the present value of the expected net revenue stream exceeds the development costs, the inventor considers the project worth while and undertakes it. If at one time the project is not worth while but later becomes so, it is because the development cost or the rate of return on the best alternative opportunity has fallen, or because the expected net revenue stream has increased. If, for example, the construction industry grows and the demand for nails increases, then the market for nail-making machinery will be enlarged, and this augmentation of the expected net revenue stream may make the project worth while.

Suppose the inventor undertakes to develop and sell his machine but finds that others then imitate it and “rob” him of sales. Such copying may well turn his expected gains into actual losses. If, however, some legal institution—a patent system—insures that he can capture sufficient gains from his idea, the risk of such “robbery” is reduced; he will therefore be more likely to undertake the project. The patent grant gives the inventor a temporary monopoly over the use of his idea in exchange for its public disclosure. In general, we suppose that monopolies obstruct economic growth, but here the gains that accrue from technological progress can more than compensate for the temporary withholding of information. While the inventor himself receives the encouragement of capturable gains, the overall result can be a gain for society. As the Commissioner of Patents saw very clearly in 1891, “The patent law does not exist for the benefit of inventors. It exists for the benefit of the public.”⁷

Our hypothetical case suggests some general propositions. Whether an invention will be produced depends on the relation between two variables: the expected revenues it will generate, and the expected costs of developing it. Expected revenues are often closely related to the growth of the market—that is, to the expansion of population or income per capita and to the reduction of transportation costs. Expected development costs may decline with the discovery of new scientific knowledge or with the appearance of related inventions. But no matter how promising an invention may appear in a social sense, few inventors will undertake a project unless they expect to reap sufficient gains from their ideas. Private property rights must be defined and enforced for intellectual property as well as for material property if much technological progress is to occur in a market economy.

Consider now a young man contemplating the choice of an occupation in the 1840’s. His interests incline him toward work in designing machinery, toward what we now call mechanical engineering. He soon recognizes, however, that it will not be in his best interests to undertake the several years of specialized education necessary to prepare for such work, because very few jobs of this sort are available. Most firms are small and use little machinery; what they do use they generally design, install, and service themselves as the need arises. The demand for machinery is too small to support a machinery industry where mechanical engineers would be demanded in greater numbers. The young man may well decide to become a carpenter, which requires a shorter and less expensive period of training and offers abundant opportunities for employment.

If we shift our attention forward to the 1870’s and consider the occupation selected by the carpenter’s son, who has interests like his father’s, the choice of occupation may well be different. By this time there are many more firms, each one on the average using more machinery. Consequently the demand for machinery is substantially larger, and a separate industry supplying machinery is beginning to emerge. As a result the demand for mechanical engineers is greater, and it may now pay to undertake the education necessary to prepare for this occupation. The son becomes a mechanical engineer. He is more skilled than his father, and his skills are reflected in his higher real earnings.

This example can be generalized to explain why the entire labor force becomes more skilled in a growing economy. The larger the market, the greater is the number of highly skilled, specialized jobs that the market will support. The more potential jobs, the greater is the incentive for workers to invest in becoming skilled specialists. In principle, the person considering an investment in acquiring skills would calculate the present value of the expected net revenue stream associated with having such skills and compare that with the opportunity cost of the training. As in the case of other economic decisions, it need not be true that individuals actually make such elaborate calculations; even though they reach their decisions by considering their alternatives only in a rough-and-ready fashion, still they generally act as if they had performed such calculations. And even if initial decisions were randomly made, only the “correct” ones would be rewarded in the market. Observation of such accidental successes would then encourage subsequent decision makers to move in the most rewarding direction.⁸

TRANSFORMATION

As incomes rise, the demand for some goods grows even more rapidly, while the demand for other goods hardly increases at all. The amount spent on food, for example, grows relatively slower than incomes, and therefore consumers spend a progressively smaller proportion of their incomes on food. For other goods, like personal transportation or recreation, expenditures grow faster than income, and such goods come to occupy a larger part of consumers’ budgets. Because of such changing demand patterns, relative prices are altered as incomes grow, and the rate of return on the production of some goods is enhanced while that of other goods deteriorates. These changes induce wealth-seeking businessmen to expand the production of goods for which the demand is growing most rapidly, and in the process they bid up the prices of resources to attract them into the expanding industries. The upshot of these actions is a reallocation of resources among industries and a change in the composition of the economy’s total output. In this way resources have shifted out of agriculture and into manufacturing, transportation, and services during the past century and a half.

Similar reallocations of resources occur because productivity—output per unit of input—typically grows at different rates among industries, because, for example, the pace of technological progress is greater in some industries than in others. Gains in productivity reduce the costs of production, which increases the rate of return to entrepreneurs. Greater returns induce other producers to enter the industry, and this entry—along with the expansion of existing producers—expands supply, driving prices down and attracting more buyers. Eventually, excessive entrepreneurial returns are eliminated as prices fall, and new entry into the industry ceases; but in the process a redistribution of output and resources among industries occurs. For example, in steel making, where productivity advanced very rapidly during the post-Civil War era, output also expanded more rapidly than in most other industries, and the steel industry grew from an “infant” into one of the nation’s largest.

Finally, because of discovery, depletion, accumulation, or migration, changes occur over time in the resources—both human and nonhuman—available in particular places. These changes in resource endowment affect the rates of return on different economic activities, inducing a reallocation of enterprises among regions. When Ohio was first settled, for example, its economic activities were primarily agricultural, but by 1914 the state was, by comparison with other states, heavily engaged in manufacturing. This change occurred because skilled workers migrated to Ohio and because entrepreneurs accumulated much material capital there during the nineteenth century. With its resource endowment in 1914 the state was best suited for nonagricultural activities, and farming had largely shifted to states farther west, where the resource endowment was relatively favorable to agriculture.

In sum, we can identify at least three important concomitants of economic growth: changing patterns of demand; differing rates of productivity gain among industries; and changing resource endowments among regions. Among the important transformations that these forces produce in a market economy are: changes in the composition of the economy’s total output; changes in the distribution of productive resources, including workers, among industries; and regional shifts in production and employment. (Another important aspect of transformation, urbanization, is discussed in some detail in Chapter III.)

Not everyone welcomes these changes, and some people actively resist them. New ideas, new skills, and new machinery add to the economy’s average productivity, but they also give rise to a different distribution of the total product. Those committed to old skills or obsolete machinery, employed in declining industries, or located in areas where important natural resources are exhausted, often suffer. Although changes in the relative income and wealth of different groups are inherent in the process of economic growth, those who suffer the relative (and sometimes absolute) losses have rarely perceived the true source of their misfortune. Often they have ascribed responsibility for their hardship to the successful groups; typically they have sought government intervention to protect them from the vagaries of the market. Of course, people need not be misinformed to react in these ways. Much of what is nowadays described as the “farm problem,” for example, is nothing more than an attempt to resist the transformation of agriculture, to maintain a larger amount of resources in farming than can be supported there without assistance from the government. Many modern farmers surely understand their dilemma; their political actions furnish a good example of a well-informed effort to obstruct the economy’s transformation. To the extent that people fail to adjust to the economy’s transformed structure, economic growth is retarded. Transformation is not only a consequence of growth; it is a condition for further growth. However, for those who must make the adjustments, this transformation is often a painful and costly process, and the economic historian’s inability to measure many of these costs makes them no less real. David A. Wells summarized the issue clearly in 1889 when he said that “pending the interval or necessary period for adjustment, the problem of what to do to prevent a mass of adults, whose previous education has not qualified them for taking advantage of the new opportunities which material progress offers to them, from sinking into wretchedness and perhaps permanent poverty, is a serious one, and one not easy to answer.”⁹ Ultimately, of course, no one offered an “answer”; people simply struggled as best they could, sometimes failing utterly. The market system could be efficient to the point of ruthlessness. Inevitably, transformation affected not only economic welfare but political power and social status as well; new attitudes and values appeared in the process. Measuring the growth of per capita income is only a very crude way of indicating a population’s changing well-being, but clearly welfare in a more all-embracing sense is inextricably tied to economic growth and transformation.

¹ In this book the expression “post-Civil War era” refers to the years 1865–1914.

² For a lucid discussion of scientific theories in economics, see Milton Friedman, Essays in Positive Economics (Chicago: University of Chicago, 1953), pp. 3–43. Friedman’s essay is particularly valuable for its emphasis that scientific theories cannot be judged by the “realism” of their assumptions. The most useful theory is the one that yields the most accurate predictions. For an excellent discussion of scientific theories in general, see Karl R. Popper, The Logic of Scientific Discovery (New York: Harper Torchbooks, 1965).

³ The concept of a market is rather complicated. “From the point of view of a consumer, the market consists of those firms from which the consumer could buy the product; from the point of view of the producer, the market consists of those buyers to whom he could sell the product. The factors that delineate a given market depend partly on the prices that prevail, partly on the point of view being examined, and partly on such factors as distance. Other complications include the fact that the area of a market for a product is partially dependent on the nature of that product, and that we may have difficulty in defining the product exactly; in fact, the same product may have different market definitions for different buyers.” Sec Richard G. Lipsey and Peter O. Steiner, Economics (New York: Harper and Row, 1966), p. 249. Resource markets, especially those for labor and loanable funds, display additional complexities.

⁴ To some extent the technology can be augmented without a commitment of resources to that purpose, through learning from experience. This kind of technological progress is considered below, pp. 103–105.

⁵ U. S. Patent Office [C. H. Duell], Annual Report of the Commissioner of Patents for 1900 (Washington: Government Printing Office, 1901), p. ix.

⁶ The calculation of the present value is necessary because receipts at different points in time are not directly comparable. A dollar receivable next year is worth less than a dollar receivable today because today’s dollar can be used to produce earnings—for example, by lending it at interest—or because it can be used for immediate consumption, but one has no command over the dollar receivable next year. Immediate availability commands a positive price, the rate of interest. If receipts R(1), R(2), . . . , R(n) are expected to be receivable after 1, 2, . . . , n years, the present value of the revenue stream is given by the formula:

where i is the rate of return on one’s best alternative investment. See Armen A. Alchian and William R. Allen, University Economics, 2d ed. (Belmont, Calif.: Wadsworth, 1967), pp. 199–209.

⁷U. S. Patent Office [W. E. Simonds], Annual Report of the Commissioner of Patents for 1891 (Washington: Government Printing Office, 1892), p. v. Whether the benefits of the American patent system actually have outweighed its costs is a hotly debated question. It is really a question of fact, but the facts in this case are particularly difficult to determine, for both conceptual and empirical reasons. For an excellent discussion of this complex problem, see Fritz Machlup, “Patents,” in International Encyclopedia of the Social Sciences (New York: Macmillan, 1968).

⁸ Armen A. Alchian, “Uncertainly, Evolution, and Economic Theory,” Journal of Political Economy. LX (June 1950); and Milton Friedman, Essays in Positive Economics, pp. 16–23.

⁹ David A. Wells, Recent Economic Changes (New York: Appleton, 1889), p. 437.