THE UNDERCOVER ECONOMIST
Why should you read this summary?
What can buying coffee teach you about the economy? Did you know that what you buy affects the market? In this book, you will learn about how buyers and sellers affect prices. You will learn about things like pricing strategies, trade, and globalization. Go undercover with this book to find out what drives the economy.
Who will learn from this summary?
Aspiring business owners
Beginners interested in markets, trade, and business
About the author
Tim Harford is an economist and journalist. He writes for the Financial Times and Slate Magazine. He is the author of “The Next Fifty Things That Made the Modern Economy,” “Messy,” and the million-selling “The Undercover Economist.” He also runs a podcast called “Cautionary Tales,” which tells stories of mistakes and how to learn from them. He won the Bastiat Prize for economic journalism in 2007.
THE UNDERCOVER ECONOMIST
When you hear the word “economics,” what pops in your head? You might immediately think it is boring. You only know about it because you were forced to learn it. But the field of economics is rich. It does not have to be confusing or boring. Economics can be fun. What people buy is information for economists. Transactions are signals between buyers and sellers. It affects how much money some people will make. It influences how much goods will be produced. Economists explain why some countries are rich, and others are poor. The systems that contain these activities are called economies. They involve people, businesses, and large organizations. In this book, you will learn how to think like an economist through everyday transactions—for instance, buying coffee and grocery shopping. You will learn about what motivates people to purchase or not. People’s decisions to buy or not affect businesses. Businesses make decisions based on how customers behave. These will help you understand who gets what, how, and why.
Who Pays for Your Coffee?
Imagine that you own land. The land is something that a farmer needs. He uses it to grow crops to earn money. So, the farmer approaches you. He says he would like to buy your land. Let’s say that your land is not like everyone else’s. It is very lush and healthy. Anyone who plants on it will yield plenty of crops. This means that your land has very high productivity. This advantage gives you bargaining strength. Bargaining strength is when you can ask for a higher price than other landowners. This is because potential buyers see your land as more valuable. They will be better off using your land because it can yield better and more crops. But you cannot just declare that you have bargaining strength. You cannot just name a high price immediately. Your bargaining strength depends on scarcity. When a resource is scarce, this means it is not readily available. Scarcity affects how things are priced. Prices, in turn, affect transactions between producers and consumers.
For example, many of your neighbors also have excellent land. Their land is also lush and healthy. So, this kind of land is no longer scarce. Since yours is not unique, you cannot price your land very highly. This is how bargaining strength can change. It is what economists call competition. When a resource is scarce, it is exclusive. When something is exclusive, it is not available to everyone. However, it is something that many people may want or need. This makes it more valuable. This is what allows for its price to be higher. However, other factors can affect prices. Scarcity may not always be the main reason. External factors like the law, government regulation, or crime can affect prices. In London, there is a place called a Green Belt. It is land surrounding the city where it is illegal to farm. This makes the available land for agriculture scarce. That means that the available land will be even more expensive. This is an example of how the law can affect pricing.
How can governments affect prices?
Consider oil as an example. It is a valuable resource to many industries. It is primarily produced in a few countries, like Saudi Arabia, Kuwait, and Iraq. However, the price of oil is very low. This is because it is available in abundant amounts. The Organization of the Petroleum Exporting Countries (OPEC) changed that. In 1973, they ordered the member countries to limit the amount of oil produced. This made the amount of oil scarce. So, prices increased. This resulted in more significant profit. Lastly, there is a crime. Gangs can use violence to keep competition out. Drugs are a typical business for many gangs. To keep profits high, they would like to keep drugs scarce. This means they have to control competition. Trade unions are also a way to keep out competition. Unions keep workers from competing with each other for jobs. It helps workers keep some bargaining power. It also helps control competition. For example, there may be a high demand for electricians. If there is a small supply of electricians, this gives them bargaining power. They can take advantage of their scarcity. This helps them demand higher pay and excellent working conditions.
Starbucks charges $2.55 for a cappuccino. That’s expensive for a cup of coffee. Thousands of people buy coffee at Starbucks on their way to work every day. Why are people willing to pay so much for coffee? Starbucks’ advantage lies in location. They have stores near train station exits and busy street corners. This makes the rent for these locations very expensive. However, people are willing to pay $2.55 for Starbucks cappuccinos. During rush hour, people will be very desperate for coffee. They will also be in a hurry to get to work. It will not be their priority to search for the cheapest coffee along a busy street. So, they are willing to pay more. Customers willing to pay more for the coffee lead to high rent. Is it Starbucks or the landowner who benefits? It is the landowner. That is because the landowner controls the location. She would be able to choose who to lease her location. She could choose between several coffee bars. Her advantage is exclusivity. No coffee bar would want to rent a space near other coffee bars. Remember, they are looking for bargaining power. That is the power of location. So, she could sign an exclusive lease with one coffee bar. That gives her bargaining strength. She can now demand a higher rental price.
What Supermarkets Don’t Want You To Know
Saving money is hard. No matter what you do, how much you earn feels like it is not enough. It is like money is just slipping through your fingers. There are many factors as to why this is the case. A primary reason is your spending habits. Take a look at the different pricing strategies businesses employ. Take note of it the next time you go grocery shopping. Observation is the key. Many businesses use price targeting as a strategy. This is how they find customers who are willing to pay more for a product. The first strategy is called “the unique target” strategy. The second is the “group target” strategy. Lastly, there is the “self-incrimination” strategy. Supermarkets are very good at using the last strategy to earn profits. The unique target strategy charges a single customer based on how much she is willing to pay. For example, people who sell used cars often do this. They will not charge the same price for a vehicle for a married couple versus a single woman.
Businesses have also tried to do this using technology. Amazon used to trace customers’ purchases on their website. They would do this by tracing users’ cookies. Amazon would use this information to customize prices specific to the customer. A product’s price would change depending on the customer. The “group target” strategy is similar. Instead of changing prices per person, it varies per group. For example, businesses offer discounts for senior citizens and students. This works for groups that may be more sensitive to prices. Companies earn money by focusing on customers who are willing to pay more. Disney World offers 50% discounts for locals. This makes it more appealing for locals to visit more often. On the other hand, tourists do not come regularly. They will be less price-sensitive than locals.
So, Disney World will charge them a total price. The last strategy is the “self-incrimination” strategy. This is when a business offers products that vary slightly. The differences will not amount to too much in production costs. They will offer products in different amounts, features, or even locations. This strategy reveals which customers are willing to pay more for a product.
Supermarkets do this by displaying the same product of different brands and prices together. For example, a customer is not sensitive to prices. She will most likely purchase orange juice that tastes delicious. She will not bother to look for a more affordable alternative. On the other hand, a price-sensitive customer will look for a bargain. It may take more time to look around the store. But she is determined to find orange juice that is more affordable. Imagine that you are a tourist in London, visiting the London Eye. On your way there, you want coffee. You find that Costa Coffee bar is the only nearby cafe in the area. Since the London Eye is a tourist attraction, this gives Costa has a scarcity of power. This also means that Costa pays expensive to rent. Plenty of people who go to the London Eye are not residents. Since you are a tourist, you are willing to pay more for the coffee with a view of the London Eye. However, customers can also choose to simply not buy from Costa Coffee. There will be customers who are not willing to pay more just because of the location.
For example, they may be London residents. So, Costa has to come up with other ways to make profits. Costa has two options. They could either sell less coffee at higher prices. Or, they can sell more coffee at lower prices. This is what economists call margins. One strategy Costa tried was selling Fair Trade coffee. Fairtrade coffee is more expensive. It promises to pay the coffee farmers more than the typical wage. This is about eighteen cents more. Most customers think that the extra money they spend goes directly to the farmer. However, it goes to Costa. Coffee beans make up a tiny portion of production costs. Costa earned profit this way. Making fair trade coffee available revealed customers who were willing to pay more for coffee. This is an example of the “self-incrimination” strategy at play.
Perfect Markets and the “World of Truth”
What you choose to spend your money on reveals a lot about you. For example, you have 92 cents available. There are many things you could choose to spend this on. You decide to spend this money. With this purchase, you are providing the market with information. You are telling the market that your money is worth coffee. You chose coffee over something else. Thousands of people may make the same choice. This tells businesses that people are willing to spend 92 cents on coffee. This becomes the market price for a cup of coffee. Prices reveal a lot of information about buyers. If buyers find a product too expensive, they will choose not to buy it. Sellers are the same. They will not sell a product for less than what it cost to make. When buyers and sellers agree to a specific price for a product, this is called efficiency. Both buyer and seller gain something from the sale. The buyer gets the coffee that she thinks is worth her 92 cents. The seller earns the money that is worth the cost of making the coffee. A product’s value depends on the buyer and the seller. It is the price they must both agree on. It is what the buyer is willing to pay. It is also what the seller is willing to sell the product for.
What people buy determines what sellers will produce. This is the law of supply and demand. If people want computers, businesses will supply these. They will build factories, hire employees, and buy materials to produce computers. It is the same for every product. In competitive markets, four things are happening:
Companies are making things the right way. Companies will lose money if they waste resources to create a product. This could result in going out of business. So, products are being made efficiently.
Companies are doing the right things. Businesses are making products that buyers demand. Prices tell sellers what buyers prefer to spend their money on. For example, producing a pastry would cost the same as two cups of coffee. If buyers choose the coffee, this tells the sellers what buyers prefer. So, they will produce more coffee than pastries.
Things are being made in the proper proportions. Businesses make just the right amount of products buyers want. For example, if a company makes too much coffee, it will bring prices down. There is little scarcity of coffee. If businesses make too little, prices will be higher. Power is scarce.
Things are going to the “right” people. The only people who buy products are the ones who are willing to pay for them.
When these things happen, this means a market is efficient. Competitive markets make them efficient. This means that both buyers and sellers benefit from the sales in the market. However, there are also nonmarket systems in the real world. For example, governments provide police protection to all citizens. It is not something you can purchase or shop for. Everyone will receive the same police force in a country. You cannot choose how much police protection you receive. You do not have the choice to spend on it or not. If a police officer is rude, you cannot choose to stop paying for it. You cannot shop for an alternative. Instead of paying, you would have to protest or lobby.
So, information about your preferences is not considered. This is an example of how a nonmarket system can hide the true cost of a product. It is not determined by how much customers are willing to pay. It is also not determined by how much it costs to produce. Another example would be government-provided schooling. Not all of these schools are of the same quality. Some will be better than others. In a market system, parents willing to pay more would choose better schools. In this case, parents will have to protest or lobby. They will move to neighborhoods with the best schools. This hides information about demand. It does not reveal parents’ preferences based on prices. It also does not tell how much it costs to produce a quality school.
Beer, Fries, and Globalization
Imagine that you are a country. You want to be rich. The only way to be rich is to do business with other countries. There is a possibility that you have a comparative advantage. This advantage can make other countries want to do business with you. If both of you do business—which is called trade—then you will get benefits. Comparative advantage is about maximizing what you do best. For example, you may be an expert in biology. However, you are not good at economics. Your friend may be an expert in economics. However, she is terrible at biology. So, you would be better off working as a biologist to earn money. Your friend would be better off as an economist. You are more likely to make more money in the subject where you excel. Let us apply this concept to countries. Let’s say American workers produce drills. Chinese workers make TVs.
An American worker can produce a machine drill in 30 minutes. They can also build a TV in 60 minutes. On the other hand, a Chinese worker can create a drill in 20 minutes. They can also make a TV in 10 minutes. The Chinese worker has a comparative advantage over the TV. The American worker takes six times longer to produce it. If the US and China do not trade, it takes 90 minutes for the US to produce a TV and a drill. It will take China 30 minutes. Let’s say they trade. The Chinese worker can make two TVs in 20 minutes. The American worker will make two drills in 60 minutes. They can trade one drill for one TV. Now, the US and China have both TVs and drills. They will also have worked less. Both countries benefit from the trade. Some people worry that trade could lead to people losing jobs. So, they resort to restricting trade. This is called a trade barrier. For example, a country will ban the import of a product, like tea. In other words, tea is not allowed to enter your country. This will result in locally producing that tea instead.
However, the local tea will not be exported. In other words, they will not be sold in other countries. That is because the foreign currency they would earn from the exports cannot be used. The trade barrier restricts people from spending that money on imports. This shows how trade barriers cause more disadvantages than advantages.
Competition from other countries does not put your country in danger of going out of business. Your country would still need to produce goods to sell. This will earn you profits. The profits will allow you to purchase goods from the other country, known as imports. The trade barrier can be problematic. Sure, Americans may no longer have to produce TVs. Their trade agreement means they will produce drills and import Chinese TVs. This could lead to TV manufacturers closing down. However, that does not mean that the US has made losses. Trade has not made the US worse off. A specific group of people may experience the loss－the American workers producing TVs.
Author Tim Harford suggests that the solution to this is to support and retain these groups. Healthy economies lose jobs but also create new ones. So, trade benefits countries. They trade products, services, technology, information, and investments. Most people associate this with globalization. Companies from wealthy countries can make investments in poor countries. For example, they can build factories. It creates jobs and provides knowledge or technology. Trade makes people wealthier. However, this does damage the environment. Transport costs and energy consumption add to the effects of climate change. Governments will have to create policies to balance the damage. For example, they can tax sulfur or carbon emissions from countries like the US and China. They could stop subsidizing fossil fuels, which negatively affect the ozone layer.
First, you learned about scarcity. Scarcity affects how a product, like land, is valued. This determines its price. When a resource is scarce, it gives the owner bargaining power. Second, you learned about the three pricing strategies. The individual target strategy is about changing prices per person. Group target strategies are similar. For example, discounts are offered to senior citizens. Lastly, there is a self-incrimination strategy. These include offering similar products at different prices. This shows the seller how much a buyer is willing to pay. Third, the law of supply and demand affects prices. People’s preferences dictate what they buy. When people want a product, they are willing to pay for it. This leads sellers to make more of those products. When there is a large supply of products, this brings down prices. When there is a small supply of a product, that means it is scarce. Fourth, in a free market, prices reveal the truth. It provides information on what buyers are willing to pay for. It helps producers know what and how much to make of a product. This affects how businesses make decisions.
Fifth, you learned about trade and globalization. Trade can benefit the countries that are exchanging goods and services. One country may have a comparative advantage over the other. Trade allows both countries to have both products. This means they are both better off. Trade brings in an exchange of goods and much more from all over the world. This is globalization. Globalization has its advantages and disadvantages. It can create jobs and help countries prosper. It can also cause negative impacts on the environment. It can lead to wasting resources and transport costs. However, that does not mean globalization is terrible. Globalization helps the spread of knowledge. Knowledge can help many countries flourish.
Governments have to do their part to address the negative effects. Healthy economies allow competition between businesses. Understanding markets can make you a better consumer. You can be more mindful of your purchases. Remember, your preferences can affect prices. Knowledge of pricing strategies and consumer behavior is also helpful. You can use these concepts to build a successful business. Maybe one day, you will be a successful entrepreneur.