The Undercover Economist will help you think like an economist without boring you with endless graphs or complex math. The world functions on economic principles. By thinking like an economist, you’ll learn how to make better decisions every day. This book will help you understand why you make the economic decisions that you do and discuss what happens when the following economic principles that efficiently govern much of the world break down:
The first important economic principle that we’ll examine is scarcity: the idea that strength in negotiation comes from having a scarce resource that others want. Let’s say a wheat farmer is looking for land, and there are a lot of landlords who have land available. In this case, the landlords will attempt to undercut one another to get the wheat farmer’s business, making the land cheap. However, seeing the success of one wheat farmer, more people want to farm wheat in the town, and the scarcity shifts. Now, it’s the land, rather than the farmer, that is the scarce resource. Landlords get increasingly more power and can start to charge higher prices.
The balance of power between the farmers and the landlords can shift quickly. If farmers decide that the landlords’ prices are too high for them to make money on the most fertile land in town (the meadowland), there won’t be any incentive for them to rent from the landlords. They’ll be more likely to rent from the landlords of less fertile land like grassland. These farmers may produce less wheat, but their costs will be lower, making up for the decrease in revenue. The shifts in the scarce resource between farmers and landlords have the potential to go on forever. Once farmers take up all of the meadowland and grassland, and a new aspiring farmer arrives, he’ll rent from the landlords of even less-fertile land like scrubland.
The scrubland, or the lowest-yielding land, will always necessarily be the least profitable. This example illustrates why. Let’s say the new farmers are making $10,000/year on the scrubland, and the old farmers are making $15,000/year on the grassland. If neither farmer is paying anything in rent, the grassland is more profitable. But if the grassland landlords are charging $7,500/year in rent, the old farmers would only take home $7,500/year in profits. If the scrubland was free to farm, the old farmers would all move to the scrubland, because they could take home $10,000/year. Thus, the grassland landlords charge only $5,000/year or less to keep their farmers, because the farmers are only willing to stay if they can make at least as much as they would have made farming scrubland ($10,000/year in profit).
(Shortform note: To better understand how scarcity affects the price (and value) of a good or service, read our summary of Basic Economics.)
While individuals and companies can look to profit from scarcity, they don’t have ultimate power over their consumers. No matter how scarce their resource, if a company sets its price too high, the customer won’t buy what they’re selling. What they can do, though, is employ the strategy of price targeting, or setting different price points for different customers.
A typical Starbucks menu illustrates how companies can set unique price points: They have regular coffees, cappuccinos, or hot chocolates priced at a fairly low rate—let’s say $2. But if you want a larger size, or a special bean, or even a blend of two different types of coffee, you pay more—maybe $3. Customers know it doesn’t cost Starbucks an extra dollar to manufacture these “fancier” items, but some customers are still willing to buy them. The customer who just wants her coffee and is money-conscious might go for the $2 coffee. But the customer who cares less about what her coffee costs and is curious about a particular blend will go with the more expensive option. Businesses are constantly looking for the latter customer or the one who doesn’t care as much about the price.
One way for companies to find customers that care less about the price is to rent storefronts in prime locations. For example, storefronts for coffee shops in train stations are desirable. Customers getting a coffee on the way to catch a train are likely to be less discerning about the price, given that they have a train to catch and don’t have time to leave the station and look for a lower-priced option.
However, even storefronts in prime locations need to practice price targeting. If the coffee shops in train stations sell their coffee at too high a markup, even though they’re the only coffee shop in the area, people will just forgo their coffee. But if they sell coffee at too low of a price, they won’t make enough money to turn a good profit, because their rent is so high due to the desirable location. This is why setting different price points, so that people who are willing to pay more will, and people who aren’t won’t (but will still buy something), works so well.
There’s nothing forcing stores to sell their product for a particular price, nor is there anything forcing customers to buy at a particular price. In the free market, though, products are generally almost equal to the marginal cost, or how much it costs to keep a business afloat, plus modest profits that convince investors it’s a little better to keep their money in the business than in savings.
Imagine, for a second, that everyone in the world has to tell the truth. You go to a coffee shop, and the barista asks you what you’d be willing to pay for the coffee. Being a caffeine addict, you reply, “$15.” But then, as the barista starts making the coffee, you ask, “How much did the beans cost? What about the machines, your salary, and everything else that it takes to run this place?” You find out that the total cost to make the coffee is less than a dollar. You keep going: “Are there any other places that sell similar coffee near here?” you ask. The barista responds that there are and that they sell coffee for a much lower price. You tell the barista that you’ll only buy the coffee at that lower price. You’ve managed to haggle what would have been a $15 coffee down to less than a dollar.
In a free market, when a seller sets an asking price, it’s equal to or higher than the cost to produce it. And when a buyer buys the product, the product is as valuable or more valuable to the buyer than the money changing hands. As the above example illustrates, lots of buyers value coffee more than they currently pay for it—you would have paid $15 for that coffee if necessary! Because the coffee market is competitive, though, firms are constantly trying to undercut one another to get your business. As such, the price of coffee is basically equal to the marginal cost.
This means that when it gets more expensive to make coffee, the price goes up. Anything from an employment shortage to a longer than expected cold season in Brazil can make coffee more expensive. All of this exists within an incredibly complex global economy. We could choose to spend the money that we spend on coffee on anything else. If fewer people wanted coffee daily, there would be fewer coffee shops, and something else would go in that real estate.
The last section demonstrated how perfect markets work in theory. Even though we rarely find perfect markets in the real world, it’s useful to understand the idea of perfect markets because economists usually start there when they see imperfections. Economists attempt to remove these imperfections. In this section, we’ll discuss the effects of these imperfections in the marketplace, or externalities, and discuss when governments should step in to prevent negative externalities.
In the most basic form of the free market, everyone goes about their lives, selling and buying goods, without any regard for how their actions affect others. Often, though, the actions of one buyer or seller can affect a third party, who’s not involved in the sale of goods or services. This is called an externality. To prevent negative externalities, governments may impose externality charges.
Externality charges are the best way to disincentivize an activity that harms others because people will act in self-interest. When the government levies externality charges on activities that are selfish and harm others, it’s usually not in your best interest to continue to pursue the harmful activity. Thus, fewer people pursue harmful activities and there are fewer negative externalities.
Let’s use the example of drivers to expand on externalities and externality charges. Drivers get a lot of benefit from having a car because cars can allow them to get places quickly. But they also end up paying taxes on having a car. Gas taxes, for example, are high all around the world, and in a lot of places, drivers pay a tax for the privilege of having a car in the form of a license fee.
Here, we can see a distinction between average cost and marginal cost. On average, drivers end up paying a lot of money to keep a car. However, one 20-minute drive to a city center has a low marginal cost—the trip doesn’t cost them any more in license fees and probably won’t use much gas. On the other hand, trips into the city make city life worse for everyone without a car, thanks to noise pollution and carbon monoxide pollution. Cities can solve this problem by, instead of having one flat license fee, charging a tax for every time a driver takes a trip in a city.
In other words, lots of people are benefiting from driving themselves. But by benefiting themselves, they’re also harming others. This complicates the idea that everything we do in the market helps create a perfectly efficient system. (If it were perfectly efficient, drivers would have to pay the people whose lives they are making more difficult.)
Charging money for these externalities is a balancing act. We want to keep letting people do things they like, so we don’t want taxes on externalities to be too high. But we also want to make sure that people aren’t destroying the lives of those around them by doing what they want. Essentially, when figuring out externality taxes, we should attempt to imitate perfectly efficient markets as much as possible. We want the total cost to everyone else to be exactly equal to the benefit for one person.
Levying externalities is also situation-dependent. Charging people to drive at busy times in the city is a redistributive tax in the United Kingdom, where poorer people don’t drive. But in the United States, where poor people drive a lot, they end up paying a significantly higher percentage of their income on gas than rich people do. However, even in this case, it’s better to levy taxes on each trip into the city than it is to have one up-front tax. This way, poorer people can reduce their tax burden by choosing not to drive in the city as much, rather than having to pay a big tax every year and then feeling as if they need to justify it by driving in the city a lot.
Ultimately, externality charges are bound to be controversial. They are not an exact science, and some will argue that they are not tough enough, while others will argue that they are too tough.
When one party doing a business deal has more information than the other party, the market is not running efficiently. This section explains the information gap and how to close it.
We’ll use the example of used cars to explain the economic problems inherent in an information gap. Let’s say half the cars on the used car lot are “peaches”—they run well—and the other half are “lemons”—there’s something wrong with them. The car salesman knows which are which, and the buyer does not. The peaches are worth an average of $6,000 to buyers. The buyer offers $3,000, which she thinks is a fair gamble for a car that could be a peach or could be a lemon.
Consequently, buyers offering $3,000 will only ever get lemons. If the buyer offers closer to $6,000 the salesman might give up a peach, but the buyer wouldn’t be willing to put up something like $5,500 for a 50% chance she’s getting a lemon.
In this extreme example, there is literally no market. Buyers who have even an ounce of common sense just won’t shop for a used car. Consequently, sellers won’t sell many used cars. Insider information helps no one. This only occurs when one group is ignorant and the other has knowledge. If both the buyer and the seller are ignorant, the market would resolve itself. The problem is the knowledge gap.
(Shortform note: Read our summary of Freakonomics to learn how unequal access to information affects you when you’re buying a house, and how the Internet is closing the information gap.)
So, how can we solve the knowledge gap? The first way is for vendors to signal quality, or to show customers that they are reliable. There are lots of ways for vendors to do this. In the car salesman example, trustworthy salespeople often have a showroom that’s a lot fancier than a used car lot on the side of a highway. These showrooms are fairly expensive and require long leases. If a salesperson has roots in the community thanks to their lease, they can’t just pick up and leave if they start selling lemons and word gets around that they are not to be trusted. If they can’t quickly leave and move on to a new group of suckers, they’re disincentivized to withhold important information from customers. Thus, customers trust salespeople with showrooms because the quality of the showroom signals that the seller can’t rip the buyer off.
This is also why old banks often found fancy buildings to conduct their business out of. If you’re giving your money over to an organization to hold, you want to make sure that it’s trustworthy. Signposts of trust like a stately building aren’t just nice frills: The expensive lease in the fancy building makes sure that vendors will be honest with customers.
There are many signals of quality that don’t involve real estate as well. For example, people like to poke fun at students getting their degree in a subject like philosophy. The popular argument is that philosophy doesn’t give students any marketable skills that will help them make money. But finishing a philosophy degree is another signal of quality. Philosophical arguments are dense. While reading and writing about them might not be directly related to whatever job a philosophy student has after graduation, it shows a level of commitment that employers pick up on. If someone is excited to study philosophy, they likely have a good work ethic.
Remember, though, that all of these examples involve trade-offs. It might not be worth the money to pursue a philosophy degree, even if it does make it marginally easier to secure a job because you can better signal quality.
While vendors can signal quality if they choose, it is often up to customers to find quality.
Let’s use renting an apartment as an example. When landlords show off an apartment to potential tenants, they are signaling quality by allowing customers to test that everything works in the apartment or look around the place and the neighborhood. But potential tenants and landlords can both find quality in one another to close the information gap. There are all kinds of forums where tenants can share positive or negative experiences about landlords: Potential tenants can seek out this information online, or ask other tenants in the building directly about whether the landlord is responsive. Landlords, though, need information about tenants as well before they agree to rent out their place. They don’t want tenants who can’t pay their rent. So they find quality: They regularly ask for bank statements, proof of employment, and tax returns. When each party has enough information about the other, they can comfortably complete the transaction.
The stock market is a sector of the economy that is shrouded in secrecy. Complex jargon scares potential investors who don’t have a background in economics or finance. This section will help to lift that curtain. It will explain how stock prices are valued and why companies hire economists to help them play the stock market.
It’s difficult to make more money than an average investor in the market. This is because, if you’re following the law (and not trading off of insider information), everyone is working with the same information. A report that says that stock prices will go up tomorrow, for example, will make stock prices go up today because people will buy them expecting them to go up tomorrow. When investors buy more of a company’s stock than other investors sell, the stock price goes up.
The market is a nearly random walk that trends upwards. Generally, as the world economy continues to grow, more people will put their money into the market. This leads to the upwards trend. It’s nearly random because people who are well informed about market conditions can, on aggregate, make a little bit more money than the average investor.
Economists are hired by investment firms or individuals because they are generally right about the market’s direction a little bit more often than they are wrong. This is because they understand the future of markets a little bit better than the average person.
Stock prices are the representation of what the market thinks a company will earn in the future. Investors and economists are attempting to judge not the current profitability of a company, but what the current numbers and the state of the economy mean for a company’s future profitability.
When you buy a stock, you’re buying a small part of the company. Theoretically, as a shareholder, you get back part of a company’s profits. In practice, though, shares are more about prospects than profits. When a company makes a profit, it generally reinvests that money into growing its business. Companies spend money on development of a new product or advertising of an existing one. As a shareholder in a company, you’re betting that they’ll have more success with their reinvestments and general growth than the market assumes.
The stock market, then, is less about companies’ fundamentals and more about what other people think of a company.
While economists can only be marginally helpful with the stock market, their successes and failures are much more on display when a government or a private company requires problem-solving with game theory.
Game theory is a discipline that is adjacent to economics and mathematics. We’ll define a “game” as an activity in which predicting another’s actions affects your own actions. Many everyday situations, like driving, are games. When you’re behind the wheel, you drive based on the rules of the road but also based on what behavior other cars on the road are exhibiting. If a car is driving erratically, or too quickly, you’ll likely switch into a more defensive driving mode. If a car in front of you is driving too slowly, you’ll attempt to pass.
Many game theorists have been fascinated with poker as an application for their theory. In poker games, you win an entire pot of money if you finish with the best hand. There are rounds of betting in which players make decisions based on how other players are behaving about whether to stay in a hand, in an attempt to win, or whether to get out of the hand and save their money. Players can calculate in real time whether it’s worth paying to stay in.
For example, in the poker game Texas Hold ‘Em, communal cards that everyone can see and use are shown by the dealer after every round of betting. Players are often looking for a specific card or kind of card to complete a hand. It doesn’t take too much math to figure out the probability of a card coming up and whether it's worth it to pay to stay in the hand and look for your card.
Where it gets more complicated, and where game theory comes into play, is what the other players are doing. Players both figure out the probability of their best hand and predict whether their potential hands will beat their opponents’ potential hands. There are clues about what cards an opponent might have based on how they are betting, but they could be “bluffing,” or intentionally attempting to mislead other players into making a bad decision. Players also understand that the other players are analyzing their moves. This is why poker remains so popular and endlessly fascinating. It’s a game of secrets that’s governed by complex game theory and larger understandings of human behavior.
Globalization can refer to many kinds of exchanges among nations, but we will define it as more trade between nations and more direct investment in other nations. Mostly, trade and direct investment take place between rich countries, though globalization is starting to influence poorer countries as well.
If you want to be rich, trade with the world. Take the example of Bruges and Antwerp in Belgium. For centuries, Bruges was a huge trading port. It connected Belgium to the rest of the world. In the 15th century, though, topographical changes made it impossible for ships to enter Bruges’s port. Trading moved to Antwerp, which maintains a huge economic advantage over Bruges to this day.
Increasingly, products made in one remote corner of the world are available for purchase in another.
Much of the success of globalization is due to comparative advantage. Comparative advantage occurs when one group can make a product more efficiently than another group. We’ll use a simple example of building radios and televisions to illustrate this concept. Let’s say that in the United States, a factory worker can build a radio every 30 minutes and a television every hour. In China, a factory worker can produce a radio every 20 minutes and a television every 10 minutes. Without trade, it will take the worker 90 minutes to make a television and a radio in the U.S. and 30 minutes to make both in China. However, let’s say that the Chinese worker decides to make two televisions and the American worker makes two radios, and then they trade, swapping a TV for a radio and vice versa. Now, the Chinese worker has a radio and a TV in 20 minutes (as opposed to 30 minutes), and the American worker has a TV and a radio in an hour (as opposed to 90 minutes). Both win. If we disallow trading, we’re hurting everyone.
Certainly, the world economy is more complex than this example. We use currency and trade with multiple partners, which both obscure this simple principle. However, despite these added complexities, the general principle holds true.
Additionally, when nations put taxes on imports, they are unknowingly placing an equal tax on their exports. For example, if the U.S. puts a high tax on imports of Chinese TVs, effectively banning them, the American TV-making industry will benefit (people will buy the cheaper American TVs rather than the expensive Chinese ones). However, U.S. export industries will suffer: Say the U.S. exports radios in exchange for Chinese currency. Without Chinese imports to spend that currency on, the American industry’s revenue from China is essentially useless. Industries are thus competing with others in their own nation for comparative advantage.
Unfortunately, given the struggle for efficiency, some workers do lose their jobs in the globalized free market—it’s not good for everyone right away. These workers are forced to learn new skills and hope that more efficient producers that now have more demand from around the world will hire them. The government should help people who lose their jobs while continuing to pursue globalization.
(Shortform note: To learn more about the negative consequences of tariffs, read our summary of Economics in One Lesson.)
All of these economic principles—scarcity, price targeting, finding efficient markets, externalities, missing information, the stock market, game theory, and globalization—may have seemed impossibly complex before reading this summary. But The Undercover Economist proves that while economics can sound full of jargon, it is ultimately about people.
The Undercover Economist, written by economist Tim Harford, will help you think like an economist without boring you with endless graphs or complex math. The world functions on economic principles. By thinking like an economist, you’ll learn how to make better decisions every day. This book will help you understand why you make the economic decisions that you do and discuss what happens when the economic principles that efficiently govern much of the world break down.
It’s unlikely that you think much about economics when buying a cappuccino. Getting a coffee is probably part of your routine, and you can get a similar product at thousands of places around the U.S. But when an economist sees your coffee, she understands that even this everyday product is the result of the effort of a lot of people. In other words, no single individual or group is in charge of any sector of the economy: No one makes a coffee from beginning to end. This would take growing and picking the coffee beans, buying, milking, and generally caring for cows, building a coffee machine with all of the steel parts necessary, and throwing a nice cup on the wheel and putting it into a kiln that you’ve also built, all with clay that you’ve harvested yourself.
The system through which you get your coffee is incredibly complex and has evolved over centuries if not millennia. It also generally works well, but it sometimes breaks. The rest of the book will explore how economies work well and what happens when they don’t, using these economic principles as a guide:
We’ll also discuss how these principles affect everyday economic questions like how to fix America’s healthcare system, why poor countries like Cameroon stay poor, and what is behind China’s meteoric rise as an economic power.
In this section, you’ll learn the basics of some essential economic models. After reading, you will have a better understanding of how scarcity, competition, and marginal land principles function and how to apply these principles to real-life situations.
The first important economic principle that we’ll examine is scarcity: the idea that strength in negotiation comes from having a scarce resource that others want. Let’s say a wheat farmer is looking for land, and there are a lot of landlords who have land available. In this case, the landlords will attempt to undercut one another to get the wheat farmer’s business, making the land cheap. However, seeing the success of one wheat farmer, more people want to farm wheat in the town, and the scarcity shifts. Now, it’s the land, rather than the farmer, that is the scarce resource. Landlords get increasingly more power and can start to charge higher prices.
The balance of power between the farmers and the landlords can shift quickly. If farmers decide that the landlords’ prices are too high for them to make money on the most fertile land in town (the meadowland), there won’t be any incentive for them to rent from the landlords. They’ll be more likely to rent from the landlords of less fertile land like grassland. These farmers may produce less wheat, but their costs will be lower, making up for the decrease in revenue. The shifts in the scarce resource between farmers and landlords have the potential to go on forever. Once farmers take up all of the meadowland and grassland, and a new aspiring farmer arrives, he’ll rent from the landlords of even less-fertile land like scrubland.
The scrubland, or the lowest-yielding land, is called the marginal land. The marginal land will always necessarily be the least profitable. This example illustrates why. Let’s say the new farmers are making $10,000/year on the scrubland, and the old farmers are making $15,000/year on the grassland. If neither farmer is paying anything in rent, the grassland is more profitable. But if the grassland landlords are charging $7,500/year in rent, the old farmers would only take home $7,500/year in profits. If the scrubland was free to farm, the old farmers would all move to the scrubland, because they could take home $10,000/year. Thus, the grassland landlords charge only $5,000/year or less to keep their farmers, because the farmers are only willing to stay if they can make at least as much as they would have made farming scrubland ($10,000/year in profit).
We can apply this understanding to coffee shops in cities.
Nearby most train stations in the world are coffee shops. Because of their prime location, they can charge more money for their coffee than other coffee shops in less busy transverses. Busy commuters don’t want to look for a coffee place that will take them out of their way and cost them time. Instead, they’re willing to pay the markup for the convenient location.
This markup is made with the full implicit understanding, amongst everyone involved, that coffee doesn’t actually cost much money to make, especially if it’s being done on a large scale like at a Starbucks. The margins get significantly bigger when places have a location near a busy place like a train station and can thus charge higher prices.
However, finding a good location is expensive itself. There are many coffee places that would want a storefront next to Penn Station in New York, for example. So the landlords have the advantage in this interaction, and they can ratchet up the price for their in-demand storefront.
You’ve probably heard that coffee costs a lot of money in cities because coffee shops pay more money in rent so they charge higher prices. But this explanation doesn’t account for why rent is high in the first place. Locations only become “prime” if customers are willing to pay a lot of money for coffee. So it’s actually the other way around: Customers during rush hour are willing to pay a lot of money for coffee if it’s convenient. This allows landlords to charge a high price because they own valuable land.
(Shortform note: To better understand how scarcity affects the price (and value) of a good or service, read our summary of Basic Economics.)
There are many reasons things are expensive. Returning to the original farmer and wheat example, at the most basic level, prime land will be more expensive because it can produce more profit.
We can apply this model to all businesses. The first kind of profit-building is providing the best services. Sometimes, the most successful businesses make the most money because they have the best business model and consumers want to pay more for their services. If there are three banks, one of which is well respected, one of which is fairly well respected, and one of which is not well respected, then the first bank will likely make good margins. If interest in the banks’ services increases, then the market will dictate that an even less reputable bank will open. This is just like the example of marginal land. As interest in a business increases, increasingly less desirable land (or services) will enter the market. While the amount and type of land are fixed and the competency of a company is not, it’s difficult to build a trusted and competent company, making quality somewhat fixed as well. Thus, the model works for short- and medium-term scenarios.
However, this model can break down over the long-term. The second kind of profit-building involves companies working with the government or each other to increase profits. Let's say all of the landlords band together and successfully convince the city to outlaw farming on the marginal land, citing the protection of wilderness. This will drive up the price of their land even more because there won’t be an alternative for farmers, and they’ll have to bid on the existing land.
This sort of legislation happens constantly. In most major cities, there are zoning restrictions that prevent developers from building large buildings in certain parts of the city. Paris is the most extreme example—within the city limits, there are laws limiting the height of buildings after a backlash to skyscrapers built there in the 1960s and 70s. But a lot of people still want to live in Paris. The housing stock of the city is thus extra valuable because there isn’t much of it.
This has wide-reaching implications. Many of the suburbs right outside of Paris have tall buildings to accommodate more office space and people. Additionally, these regulations create some strange incentives. Landlords who own buildings inside of the Paris city limits aren’t likely to support initiatives to improve transportation in and out of the city, because that will make people more willing to live somewhere else.
This is true in industries that don’t involve land as well. Firms will often lobby governments to artificially protect them from competition. If governments, for whatever reason, acquiesce, these firms set their own prices without competition and make a lot of money. These sorts of profits are called “monopoly rents.” Governmental intervention can make goods expensive for consumers.
To increase profits, many industries try to avoid competition, but they often fail. Think about the oil industry in the 1970s. Oil-producing countries banded together to form the Organization of Petroleum Exporting Countries (OPEC), which began to restrict oil production. Oil prices around the world thus ballooned because the resource was scarce. But as the oil prices got much higher, it became clear that it would be cheaper to find different sources of energy and new places to extract oil where before these methods seemed too expensive. Oil drilling began in Alberta and Alaska and the coal industry grew significantly to prove an alternate energy source to oil.
By drilling and expanding alternative energy sources, other countries forced OPEC into a smaller oil share, until finally, Saudi Arabia agreed in 1985 to expand oil production again. This drove oil prices back down significantly. Still, producing oil is so cheap for most OPEC countries that even when oil prices were down, given that they had the best land, they made by far the most profit.
The same sort of attempts at competition-prevention happen in other industries. Trade unions are set up to bargain as a group but also to block people not in the union from entering the market and competing with them. However, this is not always so easy. Trade unions with inflated wages can expect international competition and government attempts to regulate their union to stand in the way of their success. In the U.S. car industry, for example, demand has vanished for auto workers as more cars can be made more cheaply overseas, in places without trade unions that are inflating salaries for their workers.
The same sort of competition extends to immigration. Well-educated, white-collar workers in the United States generally welcome more immigration into the U.S. from unskilled workers, because they believe this process to be a public good: It gives people opportunities to change their fortunes and enriches the U.S. by adding different cultures and outlooks on the world to the country.
However, more poorly educated workers are less likely to be willing to support immigration because they are concerned about competition from immigrants. Well-educated workers become more scarce relative to the general population if we’re letting in less-educated immigrants, whereas less-educated workers become less scarce. The last batch of unskilled immigrants is most likely to be harmed by an expansion of unskilled immigration because their jobs or wages might be at risk if they are no longer scarce.
Critics of economics argue that the discipline robs situations of their complexity. They believe that using the old model of farmers and land to explain 21st-century economics is reductive and doesn’t consider all kinds of factors like government intervention or how people’s behaviors change based on various external factors. They argue additionally that not everyone is always perfectly self-interested, which many economic models presume.
Harford responds to this by saying that everything is complicated, but to understand larger systems, we have to simplify and focus on certain parts of these systems. By focusing specifically on economic systems, we can gain a much more comprehensive understanding of the way the world works than most people would assume. The basic farmer-and-land model goes far, and, as we’ve seen, can explain phenomena like why unskilled laborers object to immigration policies that promote other unskilled workers.
There also exists the question of what economists should do with this information. Often, economists move beyond just modeling information and become public policy advocates, lobbying the government based on their research to pursue policies like expansions of free trade.
This chapter explores how companies can charge different prices to different customers. Once you realize that sellers base their prices in part on what they think you’re willing to pay, you can make better decisions about what you buy, where you buy it, and how much to spend on it.
While individuals and companies can look to profit from scarcity, they don’t have ultimate power over their consumers. No matter how scarce their resource, if a company sets its price too high, the customer won’t buy what they’re selling. What they can do, though, is employ the strategy of price targeting, or setting different price points for different customers.
A typical Starbucks menu illustrates how companies can set unique price points: They have regular coffees, cappuccinos, or hot chocolates priced at a fairly low rate—let’s say $2. But if you want a larger size, or a special bean, or even a blend of two different types of coffee, you pay more—maybe $3. Customers know it doesn’t cost Starbucks an extra dollar to manufacture these “fancier” items, but some customers are still willing to buy them. The customer who just wants her coffee and is money-conscious might go for the $2 coffee. But the customer who cares less about what her coffee costs and is curious about a particular blend will go with the more expensive option. Businesses are constantly looking for the latter customer or the one who doesn’t care as much about the price.
One way for companies to find customers that care less about the price is to rent storefronts in prime locations. For example, storefronts for coffee shops in train stations are desirable. Customers getting a coffee on the way to catch a train are likely to be less discerning about the price, given that they have a train to catch and don’t have time to leave the station and look for a lower-priced option.
However, even storefronts in prime locations need to practice price targeting. If the coffee shops in train stations sell their coffee at too high a markup, even though they’re the only coffee shop in the area, people will just forgo their coffee. But if they sell coffee at too low of a price, they won’t make enough money to turn a good profit, because their rent is so high due to the desirable location. This is why setting different price points, so that people who are willing to pay more will, and people who aren’t won’t (but will still buy something), works so well.
There are three ways that businesses go about finding desirable customers:
1. The first strategy is to think of every customer as a “unique target.” The sellers in this scenario attempt to sell each of their products at the highest price that each customer is willing to pay. However, it requires a lot of time, energy, and skill as a salesperson to ascertain exactly what each customer is willing to pay. This wouldn’t work for a coffee shop, for example. Generally, it’s salespeople renting homes or selling used cars who will employ this strategy. The items sold have to have enough value that it’s worth the time of the salesperson to figure out their customer’s price. While this strategy is time-consuming, it’s also theoretically how salespeople can make the most money, because they’re charging each one of their customers exactly how much that customer is willing to pay.
Because it can be so profitable, companies have started attempting to automate this process. Some supermarkets, for example, will give you “loyalty” or “discount” cards, which lets them track what you are purchasing (and thereby what you are willing to buy). It’s not a perfect system, because the data only lets them provide individual customers with coupons to lower the price of some goods, but it’s still an attempt to understand each customer’s individual preferences. In the past, large internet companies like Amazon have experimented with charging some customers more money for the same product than others based on their purchasing history, but when customers found this out, they were angry, and Amazon had to stop the practice.
2. The next strategy is to split customers into groups and charge each group different prices. While people were angry at Amazon for charging different prices based on individual purchasing tendencies, they don’t tend to get upset about group discounts or price hikes. Think about how museums will charge less money for students and the elderly, who likely have less disposable income, and the grand majority of people find this fair.
We should remember, though, that companies doing the group strategy are not truly concerned with what their customers can afford. Rather, they’re concerned with what customers are willing to pay. At Disney World, they have a 50 percent discount for locals. This isn’t because everyone who lives near Disney World is poor, but because they’re less willing to pay full freight given that they live in the area and are not on vacation, a time when many people are more careless about money. The people who live near Disney World might come four times a year if Disney World reduces prices, while vacationers will almost certainly go only once a year at most, no matter the price. Essentially, what every business should ask themselves is how much less are we selling when we raise the price, and how much more are we selling when we lower the price? We’ll call this question price sensitivity.
3. The final strategy is to let customers tell you how much they’re willing to spend on a good or service. This is called price targeting. This is what coffee shops like Starbucks do: By offering goods that are just slightly different from one another, they’re basically asking customers how much they would like to pay for their coffee. Obviously, this is a simplification. When two products are similar (but not the same), it’s difficult to know whether a company is trying to price target or whether one product is simply more expensive for the company to produce. However, companies are attempting to make as much money as they can, so it’s probably more likely that if two products are similar but one costs a decent amount more than another, the company is price targeting.
This doesn’t just happen with similar products. As we described in the introduction to this section, where a store is located will likely change how they price their goods as well. For example, if they’re closer to a major transportation hub, products will be more expensive. Customers could always walk to a less expensive place a ways away, but it’s not worth the walk for enough customers that these places continue to make money.
Generally, successful businesses also do some virtue signaling. Think back to the example of charging children and the elderly less for admission to a museum. It’s hard to object to a decision like this, as it looks like a public good. The most widespread example of this in recent years has been the proliferation of organic or fair trade goods. People who are less concerned about how much money they’re spending on their groceries are generally much more willing to buy goods labeled organic or fair trade because they believe these products to be better for themselves and for the world. They are likely correct. But these products are also marked up a lot, and supermarkets make a lot of money off of the markups. Rarely will stores put the organic and non-organic versions of the same product right next to each other, because customers would be too shocked by the price disparity.
People think Whole Foods is an expensive grocery store. But compare the prices of regular onions at a Whole Foods to the prices of regular onions at an “inexpensive” grocery store like Safeway. They’re the same. The reason that most customers think Whole Foods is so expensive is that when they’re there, they’re buying expensive goods. A sense of what is “luxurious” is different between Whole Foods and Safeway. Whole Foods stocks more expensive goods, so the scale shifts. While buying seltzer at Safeway might be luxurious, at Whole Foods, it looks more like a basic because of all the more expensive goods around. While the price of regular onions at the two stores is the same, Whole Foods has the option of many more varieties of more expensive onions. Bargains don’t come from “inexpensive stores” but from buying inexpensive goods.
As we’ve demonstrated, power in the market comes from scarcity. However, businesses often achieve greater scarcity more from consumers’ laziness than from any unique place they have in the market. Coffee shops or grocery stores next to train stations can charge huge markups not because they’re the only business of their kind in a two-mile radius, but because they’re the only business of their kind in a quarter-mile radius, and people are too lazy or in too much of a rush to search further afield.
These businesses will often even charge wildly different prices within their stores, sometimes marking up a vegetable, for example, by a factor of three every few weeks. The people who notice likely won’t buy that particular vegetable the week it’s much more expensive, but a lot of people simply aren’t paying close attention.
While it seems like companies have great power over consumers, there are two major ways where this can go wrong for companies. Here are the potential problems and how companies solve them:
1. When customers don’t self-target. It can sometimes be difficult to get customers not to buy the cheaper goods. While it’s true that many customers are lazy, they also have eyes, and so they might turn away from something that they deem to be overpriced. This was especially a problem with travel–everyone on the same airplane or train is going from point A to point B, so it often makes little sense to buy more expensive tickets.
To solve the problem of people being unwilling to buy first class tickets, train and airplane companies decided they had to make the least expensive options so unappealing that rich people would decide they wanted to spend the extra money. The “value” aisle at supermarkets, which is often meant to look shoddy, serves the same purpose. IBM once made two printers, a “value” version and an expensive version. The printers were the same, except that IBM inserted a chip into the value printer to slow it down. The best way for many companies to price-target is to make the cheap options untenable. They sabotage some of their business to convince wealthier customers to buy the non-sabotaged version.
2. When discount customers resell their products. Not all products can be resold. Supermarkets and airlines don’t have this issue, so they can more easily price gouge. The DVD industry, though, does have this problem. In an attempt to mark up their services in Europe, the industry made sure that DVDs bought in the States wouldn’t function properly in Europe. However, various other competitors have popped up who have agreed to rig up DVD machines in Europe to read DVDs from the U.S. In industries that are more susceptible to resale, there’s a constant push and pull between companies attempting to price target and customers attempting to get around these efforts.
So far in this section, it’s likely seemed like companies are constantly looking for ways to scam customers to make more money themselves. Think about the pharmaceutical industry. Pharma companies put huge amounts of money into the research and development of new drugs only because they know that if these drugs work, they’ll be able to sell them at huge markups. Often, a drug that costs $10 to produce can sell for $1000 in much of the world, especially if it’s a life-altering treatment. However, in some places in the world, people can’t afford to spend $1000, even if they really need the treatment. So pharma companies might sell their pills to poorer people for $50 instead of $1000. If pharma companies knew that they could only sell their goods for $50 around the world, it wouldn’t be worth it for them to put so much effort and money into the development of new drugs. But knowing that they can price target allows them to create life-saving treatments.
Just like price targeting can lead to a public good, it can also lead to bad outcomes. Lots of train and airplane companies will sell a few seats for a big discount (maybe at $50) and the rest for $100. In this situation, some people who need to get on that flight can’t, because they didn’t manage to secure a discounted ticket, can’t pay $100, but would have been willing to pay $90. Some of the people who did get a discounted ticket, by contrast, would have only been willing to pay $60 for their seat and aren’t in such a rush to get to their destination. What ends up happening is people who need the seat less (and are willing to pay less) end up with the seat. In this case, it would have been better to just set one price.
Basically, we can consider the two scenarios, and price targeting in general, like this: If price targeting creates new markets without affecting old ones, it’s good. If it doesn’t expand old markets and rather allows people who value products less to acquire them, it is worse than having a uniform price. A lot of price targeting ends up falling somewhere in between the two scenarios—it opens up some new markets but also creates inefficiencies and puts people off of the old markets.
This exercise will delve into how companies direct price targeting at you.
What are some goods that you buy at higher than the lowest possible price (a fancier-than-basic coffee, for example)?
Why are you willing to pay a higher price?
What are some goods that you will only buy at the lowest possible price?
Why aren’t you willing to pay a higher price?
There’s nothing forcing stores to sell their product for a particular price, nor is there anything forcing customers to buy at a particular price. In the free market, though, products are generally almost equal to the marginal cost, or how much it costs to keep a business afloat, plus modest profits that convince investors it’s a little better to keep their money in the business than in savings.
Imagine, for a second, that everyone in the world has to tell the truth. You go to a coffee shop, and the barista asks you what you’d be willing to pay for the coffee. Being a caffeine addict, you reply, “$15.” But then, as the barista starts making the coffee, you ask, “How much did the beans cost? What about the machines, your salary, and everything else that it takes to run this place?” You find out that the total cost to make the coffee is less than a dollar. You keep going: “Are there any other places that sell similar coffee near here?” you ask. The barista responds that there are and that they sell coffee for a much lower price. You tell the barista that you’ll only buy the coffee at that lower price. You’ve managed to haggle what would have been a $15 coffee down to less than a dollar.
In a free market, when a seller sets an asking price, it’s equal to or higher than the cost to produce it. And when a buyer buys the product, the product is as valuable or more valuable to the buyer than the money changing hands. As the above example illustrates, lots of buyers value coffee more than they currently pay for it—you would have paid $15 for that coffee if necessary! Because the coffee market is competitive, though, firms are constantly trying to undercut one another to get your business. As such, the price of coffee is basically equal to the marginal cost.
This means that when it gets more expensive to make coffee, the price goes up. Anything from an employment shortage to a longer than expected cold season in Brazil can make coffee get more expensive. All of this exists within an incredibly complex global economy. We could choose to spend the money that we spend on coffee on anything else. If fewer people wanted coffee daily, there would be fewer coffee shops, and something else would go in that real estate.
This is true in any industry. Think about how the rise of technology-based jobs changed the economy. As personal computers became increasingly popular, there weren’t enough people who knew how to build them for the increasing demand. So, computer companies had to raise their salaries in the hopes of hoarding talent. Lots of people noticed that this industry was paying well, and so decided to go to college to get these high-paying jobs. They made the economic decision to spend money on college with the understanding that after getting a degree in computer science, they would be able to enter a high paying industry.
There are a few principles that explain why the free market works so well:
These principles show that the free market is efficient. The companies that survive price popular goods at a rate that will make people buy enough of them for the company to stay afloat.
While we are striving for efficiency in the free market, we must remember that this doesn’t always produce a fair society. As a market concept, efficiency makes some people better off without making anyone worse off. But the efficient free market itself does not make everyone better off. A functioning society does have to rely on some non-market goods.
While most of the goods and services in the West are part of the free market, there are also segments of society, like the police, that are not subject to the market. If you’re calling the police, you don’t decide whether you want to pay for them to respond. The government has decided that it’s a public good to afford its citizens protection. However, this system can lead to inefficiencies as well. If there’s a bad police officer who responds to your call, you can’t decide that you don’t want him to be your cop anymore—he’s there, and that’s it. Or, if you think there aren’t enough police in your neighborhood, you can’t hire more.
The same principles apply to public school systems. Some are good and some are bad, but basically the only way to improve them is to either petition the government or attempt to move to a better school district. The government system actually reinforces that rich people get better treatment and service than poor people. We can’t know whether parents would pay more for their childrens’ education than their tax burdens currently ask them to because they don’t have the option of doing so in a free market.
We want a lot of things from the government—better schools, better healthcare, better infrastructure. The problem is, it’s impossible to know what our actual collective priorities are if we can’t make the choice of where to invest the money ourselves. The free market loses information about what its denizens want. Now, this is not all bad. Sometimes the government can ensure equality with its social service programs. But without information about what people want, the government often flounders.
Taxes are also a significant source of inefficiency in the marketplace. In the perfectly efficient marketplace, the price of something will be equal to all the costs associated with its production. But taxes raise that cost. Let’s say a sandwich costs exactly $10 to produce. With a 10% sales tax, the price of the sandwich then goes up to $11. If someone is only willing to pay up to $10.50 for the sandwich, they’ll end up not buying the sandwich at all. The business won’t make their $10 and the government won’t make their $1. Now, if the government knew that a customer would only pay $10.50, they’d be happy to levy a smaller tax—they’d rather have $0.50 than $0. So governments will engage in the same kind of behavior as companies do setting their prices when they set their taxes. Taxes on cigarettes, for example, are high because people are addicted to them, so they’ll pay larger fees than they might for a sandwich.
At first glance, it appears we’re left with choosing between whether we want our markets to be efficient and whether we want the government to be able to provide some degree of help to the less fortunate in society.
But in the post-WWII period, economist Kenneth Arrow came up with a different theory, which we’ll call “head start theory.” In a race, if we give the slower runners a head start, they’ll have a better shot at crossing the finish line ahead of the quicker runners. We can apply the same principles to the economy, according to Arrow.
To give some runners a head start, according to Arrow, the government needed to use lump-sum taxes and payments.
A lump-sum tax is what it sounds like—you make a group of people pay the government one equal sum of money. A lump-sum payment from the government is the opposite—the government gives some group of people one sum. Unlike sales tax or income tax, there’s nothing you can do to avoid these taxes, so they don’t change your behavior. A lump-sum tax is essentially making some runners wait to start the race after the starting gun, and a lump-sum payment from the government allows some runners to begin running before the starting gun.
The idea of this program in theory would be that, with these taxes/payments in place, the free market could do the rest—there would be no more need for a sales tax or income tax, which both create inefficiencies. In practice, though, it’s not so practical. The benefit of the lump-sum tax is that it doesn’t change your behavior, but in order for this to be true, it would be best to levy the tax at birth, before you have a chance to alter your behavior to avoid the tax. But while it’s possible to account for people’s economic circumstances before they are born, it’s not possible to account for who they’ll turn into. How would we levy a big lump-sum on a sports star who greatly exceeds expectations? And if we decide simply to levy the lump-sum taxes on kids who grow up wealthy, then we’ve basically created another form of income tax that parents will be willing to change their behavior to skirt.
Nevertheless, there are some scenarios where the lump-sum taxes and payments can work. Think about the cost of heating in the winter. A lot of seniors need desperately to properly heat their homes or they’ll die. In the UK alone, 25,000 seniors per year die because of poor heating. If the government is practicing “price targeting,” it makes sense for the tax on heating materials to be high, because people need to heat their homes, so they’ll be willing to pay the tax. However, the fact that many seniors die due to poor heating suggests that maybe the government needs to lower their taxes. Instead of doing that, though, they can give seniors a heating stipend every year. This lump-sum payment helps the government continue to make good tax revenue while also doing a social good—it gives the seniors a head start. While they aren’t always practical, governments should always ask whether a lump-sum payment or tax can be better than any alternatives.
The last section demonstrated how perfect markets work in theory. Even though we rarely find perfect markets in the real world, it’s useful to understand the idea of perfect markets because economists usually start there when they see imperfections. Economists attempt to remove these imperfections. In this section, we’ll discuss the effects of these imperfections in the marketplace, or externalities, and discuss when governments should step in to prevent negative externalities.
In the most basic form of the free market, everyone goes about their lives, selling and buying goods, without any regard for how their actions affect others. Often, though, the actions of one buyer or seller can affect a third party, who’s not involved in the sale of goods or services. This is called an externality. To prevent negative externalities, governments may impose externality charges.
Externality charges are the best way to disincentivize an activity that harms others because people will act in self-interest. When the government levies externality charges on activities that are selfish and harm others, it’s usually not in your best interest to continue to pursue the harmful activity. Thus, fewer people pursue harmful activities and there are fewer negative externalities.
Let’s use the example of drivers to expand on externalities and externality charges. Cars clog up all of the biggest and best cities in the world. The air pollution that results from this literally kills some bystanders—estimates in the U.S. suggest that 15,000 people die a year from air pollution that’s caused by burning diesel fuel in car engines. In addition to the worst possible externality, death, there are lots of others that come from cities being so clogged by cars, including huge time delays because of traffic that slows down public transportation like buses. Then, there’s the noise, which can drive people out of a city entirely or discourage them from walking so much, which ironically leads to more cars on the streets and more noise pollution.
In other words, lots of people are benefiting from driving themselves. But by benefiting themselves, they’re also harming others. This complicates the idea that everything we do in the market helps create a perfectly efficient system. (If it were perfectly efficient, drivers would have to pay the people whose lives they are making more difficult.)
Drivers do end up paying taxes for having a car. Gas taxes, for example, are high all around the world, and in a lot of places, drivers pay a tax for the privilege of having a car in the form of a license fee.
Here, we can see a distinction between average cost and marginal cost. On average, drivers end up paying a lot of money to keep a car. However, one 20 minute drive to a city center has a low marginal cost—the trip doesn’t cost them any more in license fees and probably won’t use much gas. Drivers thus use their cars frequently in cities because of the low marginal cost, but this clogs up city streets for everyone else. Cities can solve this problem by, instead of having one flat license fee, charging a tax for every time a driver takes a trip in a city.
Charging money for these externalities is a balancing act. We want to keep letting people do things they like, so we don’t want taxes on externalities to be too high. But we also want to make sure that people aren’t destroying the lives of those around them by doing what they want. Essentially, when figuring out externality taxes, we should attempt to imitate perfectly efficient markets as much as possible. We want the total cost to everyone else to be exactly equal to the benefit for one person.
Levying externalities is also situation-dependent. Charging people to drive at busy times in the city is a redistributive tax in the United Kingdom, where poorer people don’t drive. But in the United States, where poor people drive a lot, they end up paying a significantly higher percentage of their income on gas than rich people do. However, even in this case, it’s better to levy taxes on each trip into the city than it is to have one up-front tax. This way, poorer people can reduce their tax burden by choosing not to drive in the city as much, rather than having to pay a big tax every year and then feeling as if they need to justify it by driving in the city a lot.
Ultimately, externality charges are bound to be controversial. They are not an exact science, and some will argue that they are not tough enough, while others will argue that they are too tough. It is clear, though, that externality charges are the best way to disincentivize an activity that harms others. People will act in self-interest, and if we levy externality charges on activities that are selfish and harm others, it will be increasingly less in their self-interest to continue to pursue the harmful activity.
When making decisions about where to tax and what to fund, governments are attempting to decide how valuable our lives are. Putting in extra stop signs or funding scientific research can help to save lives, but they can also cost citizens money that they might need for their personal expenses. So how do governments make these decisions? They look at their citizens’ behavior. We make all kinds of decisions that establish how much we value our time and our life. For example, some people decide to pay for carbon monoxide tests and get smoke alarms for their houses while some do not.
Let’s say two jobs require about the same amount of training and skill but one is more dangerous than the other. We can measure how much people value their lives by how much better paying the more dangerous job is.
Naturally, every government policy that relies on this information makes assumptions and isn’t perfect. With externality pricing, though, we can rely on people to make their own decisions. If the government levies a relatively heavy tax on driving into a city, then individual actors have to choose how often it’s worth it for them to pay that tax.
An example can explain this phenomenon of choice. The EPA in the United States wanted to reduce acid rain. So, they set up a system where businesses got a quota of “emission permits” that allowed them to emit a certain, small amount of sulfur dioxide, which is what causes acid rain. They were then allowed to choose—buy more emission permits at auction from the government or clean up their emissions by using clean coal or building or installing sulfur scrubbers.
The grand majority of businesses chose the latter—it turned out that when the government attempted to force them to clean up, most businesses just lied about how much money this would cost, but when they were faced with the decision to buy a permit or clean up, they chose to clean up because this was often the cheaper option. Even as prices for these permits began to go down, few polluters decided to buy them—it turned out that at scale, it was cheap to install sulfur scrubbers. The government both reduced emissions in the short term and better understood how much sulfur scrubbers cost, which helped them with their long-term environmental goals.
This leads to a larger point—we should be talking about climate change in terms of economics rather than in terms of morality. As we’ve already seen, people generally make choices based on their own self-interest. So if the government were to start thinking about the climate change problem as fixable through the kind of regulations that the EPA put on sulfur dioxide, we could begin to change individual behavior. Moral posturing doesn’t have the same impact. Pollution creates a huge externality—if the government taxed it as such, polluters would manage to find cheap ways to keep producing energy without having to pay the tax.
Just as there are many actions that create negative externalities, there are many others that create positive externalities. If someone opens up a lovely sidewalk café, the streets are more pleasant. If another agrees to vaccinate her children, then everyone around her kids is safer. Sometimes, though, people don’t do actions that create positive externalities because they are too expensive or time consuming.
So, just like with taxes on negative externalities, we should do the inverse for positive externalities. If subsidies were available for vaccinating children or opening up a nice, community-serving business, more people would avail themselves of those opportunities.
However, governments should be careful of spending money when they don’t need to. The private sector can sometimes perfectly solve their problems. A landlord, for example, is likely to be willing to spend some money on paint for her tenants, because not only will this improve the quality of life for the tenants, but it will also allow the landlord to raise the price on the home to the next group of tenants who move in. The government has no reason to step in in this situation.
Economics vs. GDP: Many people mistakenly confuse the economy with figures like the Gross Domestic Product, or GDP. Government actions like pollution taxes might make the GDP of a nation smaller, but they’ll help the economy because the wider ranging “economy” is concerned more with how to improve people’s quality of life.
When one party doing a business deal has more information than the other party, the market is not running efficiently. This chapter explains the information gap, discusses how to close it, and examines how to solve broken health care systems using these economic principles.
We’ll use the example of used cars to explain the economic problems inherent in an information gap. Let’s say half the cars on the used car lot are “peaches”—they run well—and the other half are “lemons”—there’s something wrong with them. The car salesman knows which are which, and the buyer does not. The peaches are worth an average of $6,000 to buyers. The buyer offers $3,000, which she thinks is a fair gamble for a car that could be a peach or could be a lemon.
Consequently, buyers offering $3,000 will only ever get lemons. If the buyer offers closer to $6,000 the salesman might give up a peach, but the buyer wouldn’t be willing to put up something like $5,500 for a 50% chance she’s getting a lemon.
In this extreme example, there is literally no market. Buyers who have even an ounce of common sense just won’t shop for a used car. Consequently, sellers won’t sell many used cars. Insider information helps no one. This only occurs when one group is ignorant and the other has knowledge. If both the buyer and the seller are ignorant, the market would resolve itself. The problem is the knowledge gap.
(Shortform note: Read our summary of Freakonomics to learn how unequal access to information affects you when you’re buying a house, and how the Internet is closing the information gap.)
So, how can we solve the knowledge gap? The first way is for vendors to signal quality, or to show customers that they are reliable. There are lots of ways for vendors to do this. In the car salesman example, trustworthy salespeople often have a showroom that’s a lot fancier than a used car lot on the side of a highway. These showrooms are fairly expensive and require long leases. If a salesperson has roots in the community thanks to their lease, they can’t just pick up and leave if they start selling lemons and word gets around that they are not to be trusted. If they can’t quickly leave and move on to a new group of suckers, they’re disincentivized to withhold important information from customers. Thus, customers trust salespeople with showrooms because the quality of the showroom signals that the seller can’t rip the buyer off.
This is also why old banks often found fancy buildings to conduct their business out of. If you’re giving your money over to an organization to hold, you want to make sure that it’s trustworthy. Signposts of trust like a stately building aren’t just nice frills: The expensive lease in the fancy building makes sure that vendors will be honest with customers.
There are many signals of quality that don’t involve real estate as well. For example, people like to poke fun at students getting their degree in a subject like philosophy. The popular argument is that philosophy doesn’t give students any marketable skills that will help them make money. But finishing a philosophy degree is another signal of quality. Philosophical arguments are dense. While reading and writing about them might not be directly related to whatever job a philosophy student has after graduation, it shows a level of commitment that employers pick up on. If someone is excited to study philosophy, they likely have a good work ethic.
Remember, though, that all of these examples are trade-offs. It might not be worth the money to pursue a philosophy degree, even if it does make it marginally easier to secure a job because you can better signal quality.
While vendors can signal quality if they choose, it is often up to customers to find quality.
Let’s use renting an apartment as an example. When landlords show off an apartment to potential tenants, they are signaling quality by allowing customers to test that everything works in the apartment or look around the place and the neighborhood. But potential tenants and landlords can both find quality in one another to close the information gap. There are all kinds of forums where tenants can share positive or negative experiences about landlords: Potential tenants can seek out this information online, or ask other tenants in the building directly about whether the landlord is responsive. Landlords, though, need information about tenants as well before they agree to rent out their place. They don’t want tenants who can’t pay their rent. So they find quality: They regularly ask for bank statements, proof of employment, and tax returns. When each party has enough information about the other, they can comfortably complete the transaction.
The knowledge gap is a big problem in the health insurance industry, especially in nations with broadly private health insurance systems like the United States. Let’s say that people who are prone to sickness are lemons and people prone to good health are peaches. If peaches—young people without health problems—don’t buy insurance, the market starts to disappear. Without their money paying into the system, insurance gets more expensive for those between a lemon and a peach, and their plans become too expensive to be worth the expenditure.
In turn, insurance becomes unreasonably expensive for the lemons who need it. In practice, the system doesn’t collapse like this, because people are often willing to pay more than a fair price for health insurance as essentially a bulwark against a giant, unexpected medical bill. In some senses, insurance in general, including health insurance, is able to depend on mutual ignorance. Without knowing what will happen in the future, it’s safer to pay into the system. But health insurance is particularly plagued with high costs.
Often, people know more about whether they’re likely to get sick than health insurance companies. So insurers attempt to find quality from their customers. They do so by offering different kinds of plans. A plan with a higher deductible and a lower premium is attractive to people who are generally healthy because these plans cost less money each month. But for people who do have health problems, a low deductible, high premium plan is more attractive because if they do get sick, their insurance will cover more of their bills. The large insurance company Aetna has deductibles that range from $500 all the way to $5,000 per month.
When insurance companies know too much about a potential customer, though, they can deny coverage. If they know that you’re likely to get sick frequently, they’ll be more likely to deny coverage entirely, because even if you pay high premiums, you’ll likely cost them money.
(Shortform note: In the United States, the Affordable Care Act, passed after this book was written, attempted to prevent health insurance companies from denying coverage to potential customers with pre-existing conditions.)
The United States has a large health insurance problem. Only 17% of Americans are happy with the healthcare system and believe it requires no changes. In many other countries, buying healthcare is compulsory, and how much you pay for your healthcare depends on how much money you make, not how risky of an investment you are. In the United States, buying healthcare is not compulsory, and when you decide to do so, you pay based on how risky your insurance company thinks it will be to cover you.
The system in the U.S. has three major issues. It’s expensive, bureaucratic, and patchy.
While the United States has a poor, market-based health insurance system, those run by governments have their own issues. Take England as an example. The system is often overcrowded, there are long lines for resources, and there isn’t much patient choice. The survey that found that only 17% of Americans are pleased with the healthcare system found that only 25% of people in England are happy with their system, which is run by the National Health Service (NHS).
The National Institute for Health and Care Excellence, or NICE, makes a lot of decisions within the NHS. And they are not always popular ones. The Royal National Institute of the Blind, for example, is angry with NICE for being unwilling to approve photodynamic therapy, a treatment that can make eye problems much better. NICE has agreed only to allow for photodynamic therapy to be covered by the NHS in extreme cases, and even in those cases, only in one eye.
The challenge for NICE is that the NHS has limited resources. It’s difficult to determine how to allocate those resources, and from there how to decide which procedures or treatments to allow for. NICE calculates what is “worth it” through a system called Quality-Adjusted Life Years, or QUALYs. A procedure will have a better QUALY score if it solves a medical problem for 10 years rather than one, for example. The National Institute for the Blind might argue that being blind is a debilitating condition to get NICE to approve photodynamic therapy. But if it’s so bad already to be blind, then the National Institute for the Blind is arguing that blind people’s lives matter less than the lives of people with vision. In this scenario, if a blind person develops a heart condition, they’ll be lower on the priority list than people with vision who have heart conditions. The National Institute for the Blind can’t argue that being blind is debilitating without driving the QUALY score for non-vision-related operations for blind people way down. It’s a classic Catch-22.
To solve the problems with healthcare in market-based and government-based systems, we need to target problems directly and precisely. There are four potential failures in the healthcare system that we have discussed in this summary so far: scarcity power, externalities, fairness, and imperfect information.
1. Scarcity Power: The healthcare industry doesn’t have a big scarcity issue. Mostly, especially in the developed nations we are discussing, there are enough doctors and treatment options.
2. Externalities: Externalities are only a problem in specific cases, like the transmission of a disease like HIV/AIDS. The solution is simple—introduce some regulatory oversight and subsidies to boost inoculation rates.
3. Fairness: Fairness is not a specific market issue, but it’s still something to be concerned with because we don’t want to deprive the poor of health coverage. We can solve the fairness issue in healthcare by using the “head start” strategy and redistributive taxes discussed in previous chapters. If we can solve poverty issues, we can solve healthcare issues.
4. Imperfect Information: This is the biggest market problem. While a government takeover of the industry might seem appealing, as the issues in England show, this won’t solve the problem according to Harford. For this issue, a two-part treatment is necessary.
First, make healthcare information widely available. It should be easy to get second opinions, call helplines, find verified information online, and we should be providing informational services in places like grocery and drug stores.
Second, let patients use the new information that they have. Currently, either an insurance company or the government is making a lot of choices on a patient’s behalf. The best system would have patients pay for most of their choices, but leave the big bills to the government or private insurance. Rather than having health insurance for everything, we should have only catastrophic health insurance, which would cover large procedures or accidents. Data shows this type of insurance is about $1500 per year per person cheaper for the government or insurance companies. Citizens should be mandated to put this extra $1500/year in a savings account that can cover smaller health costs. If they don’t incur a lot of health costs, their money in the account will grow, and if they die with money in that account, they can pass it off to their children. Singapore uses this system and has been successful with it.
One final problem with insurance in general is how it changes people’s behavior. If your car is insured against theft, you’ll be more likely to park it on the street, whereas if it isn’t, you might be willing to pay for a car lot. This is called a moral hazard.
For example, moral hazards are inherent in public unemployment insurance. When people have unemployment insurance, they’re less motivated to find a new job. But as a society, we don’t want people to starve. So we’re left, once again, with a trade-off—incurring some moral hazard is necessary in a benevolent society. The government tries to solve this problem by only giving unemployment insurance to people who are actively looking for a job. But it’s impossible to monitor exactly how motivated someone is in their search, so we’re left with imperfect information.
Imperfect information also affects how people are paid. There is a reason year-end bonuses are generally only a small part of someone’s overall salary. If a boss could tell exactly how hard everyone was working at all times, he could pay people only based on their performance. But once again, this is impossible, so people are paid a base salary and then sometimes receive a bonus for exemplary performance.
The stock market is a sector of the economy that is shrouded in secrecy. Complex jargon scares potential investors who don’t have a background in economics or finance. This chapter will help to lift that curtain. It will explain how stock prices are valued and why companies hire economists to help them play the stock market. In addition, it will explain why it’s safest to “run with the crowd,” or follow other investors when making your own investment decisions.
It’s difficult to make more money than an average investor in the market. This is because, if you’re following the law (and not trading off of insider information), everyone is working with the same information. A report that says that stock prices will go up tomorrow, for example, will make stock prices go up today because people will buy them expecting them to go up tomorrow. When investors buy more of a company’s stock than other investors sell, the stock price goes up.
The market is a nearly random walk that trends upwards. Generally, as the world economy continues to grow, more people will put their money into the market. This leads to the upwards trend. It’s nearly random because people who are well informed about market conditions can, on aggregate, make a little bit more money than the average investor.
Economists are hired by investment firms or individuals because they are generally right about the market’s direction a little bit more often than they are wrong. This is because they understand the future of markets a little bit better than the average person.
Stock prices are the representation of what the market thinks a company will earn in the future. Investors and economists are attempting to judge not the current profitability of a company, but what the current numbers and the state of the economy mean for a company’s future profitability.
When you buy a stock, you’re buying a small part of the company. Theoretically, as a shareholder, you get back part of a company’s profits. In practice, though, shares are more about prospects than profits. When a company makes a profit, it generally reinvests that money into growing its business. Companies spend money on development of a new product or advertising of an existing one. As a shareholder in a company, you’re betting that they’ll have more success with their reinvestments and general growth than the market assumes.
The stock market, then, is less about companies’ fundamentals and more about what other people think of a company. Two English investors once got into a discussion about the stock price of Grolsch beer. Grolsch had taken off in London, and it was served at every major pub in the city. Grolsch hadn’t found the same foothold in the rest of the country. However, a lot of big investors in England live in London. And many of the investors who live in London assumed, incorrectly, that Grolsch beer is popular everywhere. Thus, these investors thought that Grolsch stock was undervalued, bought a lot of the stock, and drove the price up.
Even if you know that Grolsch isn’t popular in the rest of the country, if you realize that London’s investors are about to buy a large quantity of Grolsch stock, you can get in at a lower price and make a lot of money. The fundamentals of the business catch up with the stock eventually. If Grolsch’s quarterly reports don’t show the growth that investors expect, they might start to sell off. But if you’re playing the stock market, buying and selling companies fairly frequently, the fundamentals of a company don’t matter nearly as much as what other investors think about the quality of a company.
As the above example showed, when playing the market it’s generally safest to run with the crowd. If a lot of people think a company is going to be successful, buy stock in it, because the stock price is likely to go up. This theory, though, also means that the stock market makes a lot of mistakes.
Often, investors can get an entire industry wrong. The dot com bubble of the early 2000s happened because investors started investing a lot of money in every internet company, no matter how unsuccessful they looked. At the height of the bubble, the market was pricing internet companies as if they would grow more quickly in the future than any group of companies ever.
Some technology companies, like Microsoft, did have good fundamentals and withstood the bubble better than many. But lots of internet companies didn’t have a clear growth plan, and so, after they couldn’t report growth, came crashing back down to earth. Investors ran with the crowd upwards until the argument for historic growth became untenable. Then, they ran with the crowd on the way down. This sort of groupthink can lead to wild swings in the market.
A good way to value a company is to look at the ratio of the price of the stock to the earnings of a company. Historically, the total price to earnings ratio has hung around 16 to one. Before making a long-term investment in a company, always take a look at the company’s fundamentals. But in particular, if the company’s stock price is more than 16 times greater than its earnings, take an even closer look. This means that the market thinks the company will grow quickly. It also means that it’s due for a crash. Again, in the dot com bubble, the total price to earnings ratio of internet companies skyrocketed past 16 to one.
The shares of a company should only rise if the market has good reason to believe that the future profits of a company will be high. This doesn’t have much to do with wider changes in the global economy. We might assume that during the railroad boom, if an investor got in at the ground floor with a successful rail company, they’d make huge dividends. But even the best rail companies only reaped a modest dividend, while the less successful went bankrupt because competition between rail companies kept profits for all of them modest.
New technology can also change the way an industry competes and affect stock prices. The internet, for example, devalued portions of the music industry that relied on album sales from brick and mortar stores. The internet also enabled new music companies to rise and reap the benefits of internet sales.
The company Amazon is a good case study for this. Its original business model was to use the internet to sell books. It provided a service using a new technology. The company was overvalued at the height of the dot com bubble, selling for almost $100 per share. It crashed back down to around $10 per share and has since climbed back to about $40 per share. The $40 per share price, though, still suggests that investors believe the company will grow more quickly than its numbers indicate. It’s possible that once again, investors going with the crowd has driven the price of Amazon stock up beyond where it should be priced. The fundamentals of the company will ultimately determine its success, but in the short term, going with the crowd on the way up can still make an investor money.
(Shortform note: This analysis is based on market conditions at the time The Undercover Economist was published, in 2005. In late 2020, Amazon stock was trading at around $3,100 per share. If you had invested $4,000 in Amazon when The Undercover Economist was published, for 100 shares at $40 per share, and held your position, you’d have about $310,000 worth of Amazon stock.)
While economists can only be marginally helpful with the stock market, their successes and failures are much more on display when a government or a private company requires problem-solving with game theory.
Game theory is a discipline that is adjacent to economics and mathematics. The mathematician John von Neumann created much of the theory behind modern game theory in his 1944 book Theory of Games and Economic Behavior.
We’ll define a “game” as an activity in which predicting another’s actions affects your own actions. Many everyday situations, like driving, are games. When you’re behind the wheel, you drive based on the rules of the road but also based on what behavior other cars on the road are exhibiting. If a car is driving erratically, or too quickly, you’ll likely switch into a more defensive driving mode. If a car in front of you is driving too slowly, you’ll attempt to pass.
Von Neumann and many of his game theory contemporaries were fascinated with poker as an application for their game theory. In poker games, you win an entire pot of money if you finish with the best hand. There are rounds of betting in which players make decisions based on how other players are behaving about whether to stay in a hand, in an attempt to win, or whether to get out of the hand and save their money. Players can calculate in real time whether it’s worth paying to stay in.
For example, in the poker game Texas Hold ‘Em, communal cards that everyone can see and use are shown by the dealer after every round of betting. Players are often looking for a specific card or kind of card to complete a hand. It doesn’t take too much math to figure out the probability of a card coming up and whether it's worth it to pay to stay in the hand and look for your card.
Where it gets more complicated, and where game theory comes into play, is what the other players are doing. Players both figure out the probability of their best hand and predict whether their potential hands will beat their opponents’ potential hands. There are clues about what cards an opponent might have based on how they are betting, but they could be “bluffing,” or intentionally attempting to mislead other players into making a bad decision. Players also understand that the other players are analyzing their moves. This is why poker remains so popular and endlessly fascinating. It’s a game of secrets that’s governed by complex game theory and larger understandings of human behavior.
Governments and private companies also often use game theory to make big decisions. For example, multiple national governments have sold the rights to their air to telecom companies, with widely varying results based on how successful their game theory strategies were.
In selling the rights to air to telecom companies, the companies and the government are engaged in a complex game. Individual telecom companies’ goal is to buy the rights to use valuable airspace for as little money as possible. The government is attempting to sell radio-spectrum licenses (which govern the rights to use their air) to telecom companies that they think will provide a good service to their citizens, while also getting a good value on the air.
The United States had a disastrous rollout of leasing air. They devised a system in which competing firms would submit public bids for licenses that governed various parcels of air. The system was intended to encourage open and honest competition between firms that would drive up the price on all of the licenses the government was offering.
The private firms, though, found a loophole in the system. They realized that there were enough licenses available for purchase that every firm could be satisfied with a portion, and developed a system to communicate with one another through their public bids. If a firm wanted control of the airspace over one particular zip code in the United States, they would submit a bid of the “price” of the zip code. If a firm wanted control of the airspace over 90039, for example, they would submit a bid of $900.39. This public bid signaled to all of the other companies to back off of 90039. By working together publicly, all of the companies ended up with licenses for parcels of air they were satisfied with. And they paid only a fraction of these licenses’ market value.
The United Kingdom learned from the failures of the United States. They hired a team of game theory experts to run their sale of telecom licenses. After the U.S. failed with the auction system, many experts were unsure if an auction would work. One of the members of the game theory team, though, used a simple problem to explain why it would. He took two of his peers’ wallets. Then, he asked them, without communicating directly with one another, to bid on the money in the wallets combined. They couldn’t figure out a good strategy. Game theory, if applied in auctions, works in the same way. You know how much money is in your own wallet, and thus how much it's worth to you, but have no idea how much money is in the other wallet. It’s like poker: You know how much you value something, but don’t know how much other people value it. And others’ behavior can change the way you think about the value of something in real time.
England had five telecom licenses to sell. They devised an online auction where everyone in the online room agrees to pay the highest bid for each license. Essentially, each buyer has to decide how much each license is worth. The buyers who believe a license is worth a lot of money are also the buyers who are confident in their ability to innovate and deliver a service that people like. This solves the problem of both making a lot of money and delivering a public good. The buyers without confidence in their technology will leave once the price becomes too high. As buyers leave, other companies revise what they think a license is worth, because the act of a company leaving gives them more information. This makes it impossible to bluff much because if buyers leave quickly, a company will be stuck paying a price it doesn’t want to.
This type of auction only works if there are many good buyers. The team set about finding these buyers next. There were already four big telecom companies in England, and many others interested in getting into the game. This worked out to 13 companies in total, all of which agreed to pay a 50 million pound deposit to bid for the five licenses for 3G service.
The team set aside one license, “License A,” for one of the nine new companies. All 13 could bid for the other four. Competition for License A drove competition for the other four licenses. As the price of License A climbed above the other four, those became a good deal. Each company had to submit a high bid for a license each round and had three “passes,” where they didn’t have to bid at all.
The English government estimated that they would raise 3 billion pounds from the auction. They reached that after 50 rounds, but all 13 companies were still in, and the bidding kept climbing, with no signs of slowing down. After a few months, the government had raised 10 billion, and one of the bidders dropped out. Five bidders then dropped out in quick succession—they learned from each other’s estimates what the 3G was worth. Other companies staying in longer than expected had forced the companies to reevaluate in real time. Eventually, the auction raised a total of 22.5 billion pounds for the five licenses. Ultimately, the strategy along with the scarcity of the licenses raised the price. Some telecom companies desperately wanted a 3G license, and there were only five on offer. The auction forced them to pay a lot of money for a scarce product.
While game theory is successful in certain cases, one problem is it relies on rational actors. In the case of the bidding in England, the companies all acted rationally, because they had big teams and data models that led them to the conclusion that the licenses were worth a lot of money. In a friendly poker game, it’s harder to use knowledge of game theory to your advantage, because your opponents often don’t act in their own self-interest. The creators of game theory were accomplished mathematicians who could do complex calculations in their heads. Don’t assume this to be the case with everyone involved in any game you are playing.
This exercise will help you understand how game theory can help you in your daily life.
Name a game (an activity in which predicting what another person will do affects your own actions) that you play in your daily life (for example, when you change lanes in traffic or when you play rock, paper, scissors).
How can you apply game theory to your chosen game?
How do others apply game theory to your chosen game?
Will applying game theory principles help you get ahead in your game?
Now that you understand some basic economic principles better, we’ll move on to how those principles play out around the world. We’ll begin with a discussion about how globalization has changed the way the world economy functions and then move on to two case studies: Cameroon and China.
Globalization can refer to many kinds of exchanges among nations, but we will define it as more trade between nations and more direct investment in other nations. Mostly, trade and direct investment take place between rich countries, though globalization is starting to influence poorer countries as well.
If you want to be rich, trade with the world. Take the example of Bruges and Antwerp in Belgium. For centuries, Bruges was a huge trading port. It connected Belgium to the rest of the world. In the 15th century, though, topographical changes made it impossible for ships to enter Bruges’s port. Trading moved to Antwerp, which maintains a huge economic advantage over Bruges to this day.
Increasingly, products made in one remote corner of the world are available for purchase in another.
Much of the success of globalization is due to comparative advantage. Comparative advantage occurs when one group can make a product more efficiently than another group. We’ll use a simple example of building radios and televisions to illustrate this concept. Let’s say that in the United States, a factory worker can build a radio every 30 minutes and a television every hour. In China, a factory worker can produce a radio every 20 minutes and a television every 10 minutes. Without trade, it will take the worker 90 minutes to make a television and a radio in the U.S. and 30 minutes to make both in China. However, let’s say that the Chinese worker decides to make two televisions and the American worker makes two radios, and then they trade, swapping a TV for a radio and vice versa. Now, the Chinese worker has a radio and a TV in 20 minutes (as opposed to 30 minutes), and the American worker has a TV and a radio in an hour (as opposed to 90 minutes). Both win. If we disallow trading, we’re hurting everyone.
Certainly, the world economy is more complex than this example. We use currency and trade with multiple partners, which both obscure this simple principle. However, despite these added complexities, the general principle holds true.
Additionally, when nations put taxes on imports, they are unknowingly placing an equal tax on their exports. Nations have trouble selling their products when they won’t buy anyone else’s without high taxes. This is called the “Lerner Theorem” after economist Abba Lerner, who developed it in 1936.
For example, if the U.S. puts a high tax on imports of Chinese TVs, effectively banning them, the American TV-making industry will benefit (people will buy the cheaper American TVs rather than the expensive Chinese ones). However, U.S. export industries will suffer: Say the U.S. exports radios in exchange for Chinese currency. Without Chinese imports to spend that currency on, the American industry’s revenue from China is essentially useless.
Industries are thus competing with others in their own nation for comparative advantage. Factories in the U.S. that build radios will only survive in the long run if they can be more efficient than factories that build televisions. This is because, in the free market, consumers can get their products from more efficient factories overseas.
(Shortform note: To learn more about the negative consequences of tariffs, read our summary of Economics in One Lesson.)
Unfortunately, given the struggle for efficiency, some workers do lose their jobs in the globalized free market—it’s not good for everyone right away. These workers are forced to learn new skills and hope that more efficient producers that now have more demand from around the world will hire them. The government should help people who lose their jobs while continuing to pursue globalization.
Principles of comparative advantage highlight the positives of globalization. But globalization still has its skeptics. Mostly, skeptics focus on the arguments that globalization is bad for the planet and bad for the poor.
People who argue that globalization is bad for the planet list the following reasons for concern:
Here are the reasons why each of these arguments is misguided:
Rather than fear free trade, environmentalists should embrace it.
Some anti-poverty advocates argue that multinational corporations keep people poor by paying them poor wages. This is not the case; multinational corporations are not the cause of poverty. People accept work at sweatshops because they have no better options. And in fact, when there are more factories that belong to multinational companies in developing countries, wages begin to rise because of an increase in competition. Rather than chastise companies for developing in poorer nations, we should encourage this behavior.
When a group of people decides to buy only “fair trade” goods, this adversely affects sweatshop workers more than anyone else. If people buy more “fair trade” goods, then there’s less demand for the goods that sweatshop workers make, and companies can either pay them lower wages or shut down their factories. Tariffs that stop people from buying sweatshop goods only benefit some unions, who have outsized political power in many developed nations. When special interests like unions have less power, governments always lower tariffs and promote free trade.
(Shortform note: To learn more about how international trade can improve standards of living around the world, read our summary of Naked Economics.)
Economists and those who live in or have an interest in Cameroon and its people are curious about the same two questions: Why is Cameroon poor? And what can we do to make it less poor? This chapter explains Cameroon’s problems and how globalization could help Cameroonians.
To answer these questions, we’ll begin with the current state of the Central African nation. Currently, Cameroon has few good roads. The roads that are paved are littered with potholes and shopkeepers who have set up their business in the middle of the street. There are no rules that govern traffic. The Cameroonian president, Paul Biya, has been in power since 1982. Amnesty International grades the country as one of the most corrupt nations in the world.
Cameroonians by and large hate their government because it doesn’t provide them with basic services. They believe that it is riddled with corruption that begins with Biya. Biya, though, does have some incentive to help the nation thrive to an extent. Even if he is purely self-interested and a complete bandit, he doesn’t steal everything from his people, because then there will be nothing to take the next year. A nation with a successful economy would lead to more profit for Biya.
The problem is, Biya is not in as much control as many of his people believe. He is the head of the government, but to stay in power, he has to please many actors—in particular the civil servants and the military below him—to stay in power. Biya might prefer that the police department, for example, solicit fewer bribes. However, he needs the backing of the police to hold onto the nation, so he has to allow their corruption to protect his own. Certainly, Biya doesn’t have the best interests of Cameroon at heart. His taxes are arbitrary and discourage investment, and he tolerates corruption from all parts of government to stay in power. But while the rife corruption comes from the top, it extends well beyond Biya.
Some economists argue that wealth is simply the combination of:
If we model economic advancement based on the above resources, it stands to reason that poor countries like Cameroon would naturally catch up with the rest of the world due to diminishing returns. In a developed nation like the United States, there are already many roads, decent education systems, and a lot of technological know-how. Investment into new infrastructure, for example, might help the country move forward a bit, but not nearly as much as building a well-paved and safe highway through the middle of Cameroon would do for them.
Thus, there’s another reason why Cameroon stays poor: the absence of strong institutions. Weak institutions that are rife with corruption stop Cameroon from catching up with the rest of the world.
World Bank economists argue that poor countries should make a “big push” to catch up, meaning they should invest in all of the above resources all at once. This is a good theory, and it might help to a degree, but a case study in Cameroon explains why even with investment, weak institutions lead to stagnation.
At one of Cameroon’s fancier schools, there’s a library without any books in it. From the outside, this library looks beautiful. It has a fancy design, and it’s one of two buildings on campus that is taller than one story.
However, the library is unusable. Its design mistakenly created a gutter that directs rain right onto the middle of the roof. The library is only four years old, but it’s filled with leaks, and the inside is musty. Books couldn’t survive one rainy season inside the new library. The campus has an older library, where the librarian continues to keep the books.
The building of the library was plagued with systemic problems. The principal of the school wanted to convert the school into a university, so he needed an impressive building. The principal controls all of the hiring and the firing, and the teachers wanted to keep their jobs, so they couldn’t disagree with the design. Additionally, the principal is part of what Cameroonians call the “Bafut Mafia.” Most education professionals are from the Bafut region and know one another. The principal was thus able to find money for the library based on his social network. This incident proves that Cameroon doesn’t have any institutions that can hold self-interested people in check.
Kleptocracy makes sure that poor countries stay poor. Laws don’t encourage development and no one establishes official businesses for fear of taxation. These problems explain the gap between rich and poor countries. A meritocracy would begin to solve these problems, but there is none in Cameroon.
Cameroon has manifest economic problems, some of which could be solved by undertaking legal reforms or making it easier to set up businesses. But the best way to lift a nation like Cameroon out of poverty is through globalization.
China is in a period of intense economic growth. Once a poor nation, it has managed to pull itself out of poverty, and it now has a lot of economic power that continues to grow. China’s rail system is state of the art and they are attracting all kinds of foreign investment—things are good. So, how did they pull themselves out of poverty?
To understand where China is now, we have to move back in time. For a long time, China was closed to free trade. In the late 1950s and early 1960s, China, ruled by Communist leader Mao Zedong, enacted economic policies that he called “The Great Leap Forward.” He attempted to take advantage of China’s comparative advantage in iron production and agriculture by refocusing the entire economy. He forced his citizens to melt down all kinds of basic items they used in their day-to-day lives in village furnaces in service of the state. The plan failed miserably and resulted in a famine that left a death toll of between 10 million and 60 million.
After Mao Zedong died in 1976, Deng Xiaoping ascended to the head of China’s government. He embarked on a policy of liberalization, which consisted of slowly shifting China’s economy from a complete command economy (state controlled) into a market-based system. He did so by maintaining state ownership over factories but allowing them to make their own choices. Efficient firms that surpassed their state-created production targets used that extra revenue to expand, while the Chinese government continued to prop up inefficient firms.
This was an attempt to gradually foster competition, as firms wanted to expand more quickly than their neighbors, and it worked well. Production increased in many places. It was not privatization, but competition, that drove much of China’s economic growth.
Satisfied with the results of his early liberalization policies, Deng Xiaoping began to let in private firms from other nations to compete with the state-run Chinese firms and other firms that were owned by local governments and townships. Foreign firms succeeded, and Chinese firms held their own. As this policy worked, China allowed more foreign investment. They maintained competitive advantages—labor is cheap in China—and used them to tap into the world economy and grow quickly. They also began to use foreign technology to get as efficient as possible. The government committed to education and had enough money to build infrastructure like the high-speed rail system.
As part of China’s opening, they used a strategy of Special Economic Zones (SEZs) to foster growth. Because China still operates partially under a command economy, they had to establish geographic areas, or SEZs, where the command economy didn’t apply, and the market could reign free. They used their geographic proximity to Hong Kong and Taiwan, both free market-driven nations, and placed large SEZs right next to each of those nations. This way, they managed to reap the benefits of the free market while maintaining some state control.
The SEZs helped reforms and wealth spread throughout China. These are important because they made people’s lives better.
All of these economic principles—scarcity, price targeting, finding efficient markets, externalities, missing information, the stock market, game theory, and globalization—may have seemed impossibly complex before reading this summary. But The Undercover Economist proves that while economics can sound full of jargon, it is ultimately about people.
This exercise will challenge you to consider some of the ways globalization has affected your own life.
Do you attempt to buy products locally? If so, is it difficult to find certain products manufactured locally?
Has this book made you change your mind about the virtue of fair trade goods?
How did you understand globalization before reading? Has this understanding changed?