Wednesday, May 23, 2007

The Undercover Economist

The Undercover Economist by Tim Harford

I came across this book at Commercial Press a few months ago. The cost was $160. I didn't buy it in the first instance but instead went to the Victoria Park Book Festival hoping to get a discounted copy. Yes, there was a simplified Chinese version of the book at $30 only. I thought simplified Chinese was not a problem for me, but I was wrong. Simplified Chinese characters were not a problem. There were not too many simplified characters and I knew most of them. However, the problem was the translation which carried a lot of phraseology and idioms used in the Mainland. Although I could decipher them for their Cantonese meaning, the process of mental translation slowed me down a lot. I could only finish two chapters in several weeks.

At last, I went to Cosmo to get the original book. Luckily, the new paperback version only cost less than $100. It was not a great penalty to me for buying the second copy of the book. I finished reading the book during a trip to Africa.



The book is a world view from the angle of an economist. It is lucidly written complete with some interesting examples. The main theme circles around the ideal of a perfect market, but unfortunately there are always conditions that destroy it. They are scarcity, incomplete information and externality.

Scarcity

The first few chapters are the most interesting and they concern scarcity. The most striking example, which makes the book famous, is the high price of coffee in prime location shops. Prime locations are scarce, and landlords demand extra high rents. To make the most of the scarce resources, coffee price has to be high. It is possible because there are many price insensitive commuters passing by in a hurry. On the other hand, there are also price sensitive customers who do not mind walking a few hundred metre more to buy normal price coffee. Coffee shops differentiate the customers and create coffees of different prices and varying degree of prestige, like special brands, special flavours and special additions in order to attract both types of customers. There was a coffee bar called Costa Coffee which offered fair trade coffee: products directly marketed for the third world producers. Customers were charged more and they paid thinking they were helping non-privileged farmers. It turns out that the marginal costs of all the high price varieties are very little compared to the big price difference. Owing to customer protests of being cheated, Costa Coffee had to withdraw its so-called fair trade coffee. Notwithstanding that, many customers are willing to pay more for more prestigious products, but with inflated price.

The book also reveals the strategy of supermarkets in setting the price of their merchandise. Besides differential pricing for similar products of slight variations, like organic products and brand name products, supermarkets deliberately arrange them at different shelve locations. Similar products with different prices are not placed side by side for easy comparison. Cheap products are put in inconspicuous location. It really pays if one could spend a little more time comparing prices when shopping in a supermarket.

Incomplete information

The author proposes that the perfect markets are distorted owing to incomplete information, both for buyers and sellers. In an imaginative ideal world of truth, where all information on the true cost of product and the true intention of buyer are known to all parties, there will be a perfect market with the following outcomes:
- Companies are making things the right way.
- Companies are making the right things.
- Things are being made in the right proportions.
- Things are going to the right people.
However, a perfectly efficient market does not always ensure fairness. An example is that interference to the market is made in providing to the poor in the form of subsidized heating fuel. We agree to distort the market so that the poor do not have to face the truth of high fuel cost. For arguments and solutions, you may wish to check out the book for various models proposed by famous economists.

The book also explains the phenomenon of rational insanity. In a complex market, take the stock market for example, there are educated and intelligent rational persons who are capable of gathering all information affecting stock prices. However, if all information leading to a rise or fall in stock prices are known, all rational investors will be capable of predicting stock price movement and act accordingly, leading to no predictability at all. As a result, all that is left to affect the market is unpredictable news. As such, stock prices and indices move at random affected by such unpredictable news. Although the long term trend still reflects the basic analysis, on any given day the trend is dwarfed by random movements. The paradox is that perfectly informed investors produce a random market, but a random market doesn't reward anybody for becoming perfectly informed.

A similar phenomenon is at work at supermarket checkouts: which queue is the quickest? If it was obvious that which queue was the quickest, people would already have joined it, and it wouldn't be the quickest any more. So you may as well stand in your queue and don't worry about it. It is the same as randomly joining any queue which looks shorter.

Externality

Besides the costs to the buyer and the seller, very often a market transaction may involve costs external to them, i.e. costs to a third party. An example quoted in the book is the buying of petrol at gas station where the transaction creates externality effect of causing noise, accidents, traffic congestion and air pollution. One of the solutions to deal with the hidden externality costs which distort the perfect market is to include the cost in the transaction. Some cities have introduced externality tax to drivers in order to control the use of roads, promote better engine performance in noise and emission, raise levy to traffic accident compensation and subsidize low pollution fuel. I think the high tax on tobacco is another form of externality tax as a penalty or compensation to the harm of smoking. The recently proposed tax on plastic bags is also another example of attaching a value to the external cost.

The book raises a viewpoint that the ethical standing of the environmentalists is a result of the fact that public policies do not make evident the environmental costs of our actions. If the effect to the environment of our actions is clearly defined in term of externality costs, environmentalists could argue their points from an economic standpoint. Much of the moral tone would then drain out of the debate and the environment itself would be much more effectively dealt with. When environmentalism is merely a moral issue, even environmentalists themselves cannot work out the real impact of everyday decisions. An example is the initiative to use less disposable diapers which could clog up landfill sites or use more washable diapers which will pollute the environment with the washing process and chemical detergent. The diaper problem, and other environmental issues, will not be solved by a small group arguing inconclusively over the morally appropriate individual action. If the environmentalists could not have the clear cost signal on the environmental damage, the majority of people would not inconvenience themselves even if they understood environmental problems. Both information and incentive in the avoidance of externality cost are necessary.

The last part of the book is on globalization and the economics of why some developing countries stay poor. This is where the book is criticized by many academics of putting forward assumptions without substantiation. I also think that the author is raising swift remarks without convincingly supporting them with sound arguments. However, this does not diminish the value of the book as interesting reading material. It is still a book I recommend, even to those not interested in economics.

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