I also owe a different kind of debt. The vast majority of ideas I describe in this book are not my own. Rather, I am a translator whose work derives its value from the brilliance of the original, which in this case is centuries of work done by great thinkers. I hope this book reflects my enormous respect for that work.
Last, I would like to acknowledge those who inspired my interest in the subjects that make up this book. I’ve made the case that economics is often poorly taught. That is true. But it’s also true that the discipline can come alive in the hands of the right person, and I was fortunate to work and study with many of them: Gary Becker, Bob Willis, Ken Rogoff, Robert Willig, Christina Paxson, Duncan Snidal, Alan Krueger, Paul Portney, Sam Peltzman, Don Coursey, Paul Volcker. My hope is that this book will help to transmit their knowledge and enthusiasm to many new readers and students.
naked economics
CHAPTER 1
The Power of Markets:
Who feeds Paris?
In 1989, as the Berlin Wall was toppling, Douglas Ivester, head of Coca-Cola Europe (and later CEO), made a snap decision. He sent his sales force to Berlin and told them to start passing out Coke. Free. In some cases, the Coca-Cola representatives were literally passing bottles of soda through holes in the Wall. He recalls walking around Alexanderplatz in East Berlin at the time of the upheaval, trying to gauge whether there was any recognition of the Coke brand. “Everywhere we went, we asked people what they were drinking, and whether they liked Coca-Cola. But we didn’t even have to say the name! We just shaped our hands like the bottle, and people understood. We decided we would move as much Coca-Cola as we could, as fast as we could—even before we knew how we would get paid.”1
Coca-Cola quickly set up business in East Germany, giving free coolers to merchants who began to stock the “real thing.” It was a money-losing proposition in the short run; the East German currency was still worthless—scraps of paper to the rest of the world. But it was a brilliant business decision made faster than any government body could ever hope to act. By 1995, per capita consumption of Coca-Cola in the former East Germany had risen to the level in West Germany, which was already a strong market.
In a sense, it was Adam Smith’s invisible hand passing Coca-Cola through the Berlin Wall. Coke representatives weren’t undertaking any great humanitarian gesture as they passed beverages to the newly liberated East Germans. Nor were they making a bold statement about the future of communism. They were looking after business—expanding their global market, boosting profits, and making shareholders happy. And that is the punch line of capitalism: The market aligns incentives in such a way that individuals working for their own best interest—passing out Coca-Cola, spending years in graduate school, planting a field of soybeans, designing a radio that will work in the shower—leads to a thriving and ever-improving standard of living for most (though not all) members of society.
Economists sometimes ask, “Who feeds Paris?”—a rhetorical way of drawing attention to the mind-numbing array of things happening every moment of every day to make a modern economy work. Somehow the right amount of fresh tuna makes its way from a fishing fleet in the South Pacific to a restaurant on the Rue de Rivoli. A neighborhood fruit vendor has exactly what his customers want every morning—from coffee to fresh papayas—even though those products may come from ten or fifteen different countries. In short, a complex economy involves billions of transactions every day, the vast majority of which happen without any direct government involvement. And it is not just that things get done; our lives grow steadily better in the process. It is remarkable enough that we can now shop for a television twenty-four hours a day from the comfort of our own homes; it is equally amazing that in 1971 a twenty-five-inch color television set cost an average worker 174 hours of wages. Today, a twenty-five-inch color television set—one that is more dependable, gets more channels, and has better reception—costs the average worker about twenty-three hours of pay.
If you think that a better, cheaper television set is not the best measure of social progress (a reasonable point, I concede), then perhaps you will be moved by the fact that, during the twentieth century, American life expectancy climbed from forty-seven years to seventy-seven, infant mortality plunged by 93 percent, and we wiped out or gained control over diseases such as polio, tuberculosis, typhoid, and whooping cough.2
Our market economy deserves a lot of the credit for that progress. There is an old Cold War story about a Soviet official who visits an American pharmacy. The brightly lit aisles are lined with thousands of remedies for every problem from bad breath to toe fungus. “Very impressive,” he says. “But how can you make sure that every store stocks all of these items?” The anecdote is interesting because it betrays a total lack of understanding of how a market economy works. In America, there is no central authority that tells stores what items to stock, as there was in the Soviet Union. Stores sell the products that people want to buy, and, in turn, companies produce items that stores want to stock. The Soviet economy failed in large part because government bureaucrats directed everything, from the number of bars of soap produced by a factory in Irktusk to the number of university students studying electrical engineering in Moscow. In the end, the task proved overwhelming.
Of course, those of us accustomed to market economies have an equally poor understanding of communist central planning. I was once part of an Illinois delegation visiting Cuba. Because the visit was licensed by the U.S. government, each member of the delegation was allowed to bring back $100 worth of Cuban merchandise, including cigars. Having been raised in the era of discount stores, we all set out looking for the best price on Cohibas so that we could get the most bang for our $100 allowance. After several fruitless hours, we discovered the whole point of communism: The price of cigars was the same everywhere. There is no competition between stores because there is no profit as we know it. Every store sells cigars—and everything else for that matter—at whatever price Fidel Castro (or his brother Raul) tells them to. And every shopkeeper selling cigars is paid the government wage for selling cigars, which is unrelated to how many cigars he or she sells.
Gary Becker, a University of Chicago economist who won the Nobel Prize in 1992, has noted (borrowing from George Bernard Shaw) that “economy is the art of making the most of life.” Economics is the study of how we do that. There is a finite supply of everything worth having: oil, coconut milk, perfect bodies, clean water, people who can fix jammed photocopy machines, etc. How do we allocate these things? Why is it that Bill Gates owns a private jet and you don’t? He is rich, you might answer. But why is he rich? Why does he have a larger claim on the world’s finite resources than everyone else? At the same time, how is it possible in a country as rich as the United States—a place where Alex Rodriguez can be paid $275 million to play baseball—that one in five children is poor or that some adults are forced to rummage through garbage cans for food? Near my home in Chicago, the Three Dog Bakery sells cakes and pastries only for dogs. Wealthy professionals pay $16 for birthday cakes for their pets. Meanwhile, the Chicago Coalition for the Homeless estimates that fifteen thousand people are homeless on any given night in that same city.
These kinds of disparities grow even more pronounced as we look beyond the borders of the United States. Three-quarters of the people in Chad have no access to clean drinking water, let alone pastries for their pets. The World Bank estimates that half of the world’s population survives on less than $2 a day. How does it all work—or, in some cases, not work?
Economics starts with one very important assumption: Individuals act to make themselves as well off as possible. To use the jargon of the profession, individuals seek to maximize their own utility, which is a similar concept to happiness, only broader. I derive utility from getting a typhoid immunization and paying taxes. Neither of these things makes me particularly happy, but they do keep me from dying of typhoid or going to jail. That, in the long run, makes me better off. Economists don’t particularly care
what gives us utility; they simply accept that each of us has his or her own “preferences.” I like coffee, old houses, classic films, dogs, bicycling, and many other things. Everyone else in the world has preferences, which may or may not have anything in common with mine.
Indeed, this seemingly simple observation that different individuals have different preferences is sometimes lost on otherwise sophisticated policymakers. For example, rich people have different preferences than poor people do. Similarly, our individual preferences may change over the course of our life cycle as we (we hope) grow wealthier. The phrase “luxury good” actually has a technical meaning to economists; it is a good that we buy in increasing quantities as we grow richer—things like sports cars and French wines. Less obviously, concern for the environment is a luxury good. Wealthy Americans are willing to spend more money to protect the environment as a fraction of their incomes than are less wealthy Americans. The same relationship holds true across countries; wealthy nations devote a greater share of their resources to protecting the environment than do poor countries. The reason is simple enough: We care about the fate of the Bengal tiger because we can. We have homes and jobs and clean water and birthday cakes for our dogs.
Here is a nettlesome policy question: Is it fair for those of us who live comfortably to impose our preferences on individuals in the developing world? Economists argue that it is not, though we do it all the time. When I read a story in the Sunday New York Times about South American villagers cutting down virgin rain forest and destroying rare ecosystems, I nearly knock over my Starbucks latte in surprise and disgust. But I am not they. My children are not starving or at risk of dying from malaria. If they were, and if chopping down a valuable wildlife habitat enabled me to afford to feed my family and buy a mosquito net, then I would sharpen my ax and start chopping. I wouldn’t care how many butterflies or spotted weasels I killed. This is not to suggest that the environment in the developing world does not matter. It does. In fact, there are many examples of environmental degradation that will make poor countries even poorer in the long run. Cutting down those forests is bad for the rest of us, too, since deforestation is a major contributor to rising CO2 emissions. (Economists often argue that rich countries ought to pay poor countries to protect natural resources that have global value.)
Obviously if the developed world were more generous, then Brazilian villagers might not have to decide between destroying the rain forest and buying mosquito nets. For now, the point is more basic: It is simply bad economics to impose our preferences on individuals whose lives are much, much different. This will be an important point later in the book when we turn to globalization and world trade.
Let me make one other important point regarding our individual preferences: Maximizing utility is not synonymous with acting selfishly. In 1999, the New York Times published the obituary of Oseola McCarty, a woman who died at the age of ninety-one after spending her life working as a laundress in Hattiesburg, Mississippi. She had lived alone in a small, sparsely furnished house with a black-and-white television that received only one channel. What made Ms. McCarty exceptional is that she was by no means poor. In fact, four years before her death she gave away $150,000 to the University of Southern Mississippi—a school that she had never attended—to endow a scholarship for poor students.
Does Oseola McCarty’s behavior turn the field of economics on its head? Are Nobel Prizes being recalled to Stockholm? No. She simply derived more utility from saving her money and eventually giving it away than she would have from spending it on a big-screen TV or a fancy apartment.
Okay, but that was just money. How about Wesley Autrey, a fifty-year-old construction worker in New York City. He was waiting for the subway in Upper Manhattan with his two young daughters in January 2007 when a stranger nearby began having convulsions and then fell on the train tracks. If this wasn’t bad enough, the Number 1 train was already visible as it approached the station.
Mr. Autrey jumped on the tracks and shielded the man as five train cars rolled over both of them, close enough that the train left a smudge of grease on Mr. Autrey’s hat. When the train came to a stop, he yelled from underneath, “We’re O.K. down here, but I’ve got two daughters up there. Let them know their father’s O.K.”3 This was all to help a complete stranger.
We all routinely make altruistic decisions, albeit usually on a smaller scale. We may pay a few cents extra for dolphin-safe tuna, or send money to a favorite charity, or volunteer to serve in the armed forces. All of these things can give us utility; none would be considered selfish. Americans give more than $200 billion to assorted charities every year. We hold doors open for strangers. We practice remarkable acts of bravery and generosity. None of this is incompatible with the basic assumption that individuals seek to make themselves as well off as possible, however they happen to define that. Nor does this assumption imply that we always make perfect—or even good—decisions. We don’t. But each of us does try to make the best possible decision given whatever information is available at the time.
So, after only a few pages, we have an answer to a profound, age-old philosophical question: Why did the chicken cross the road? Because it maximized his utility.
Bear in mind that maximizing utility is no simple proposition. Life is complex and uncertain. There are an infinite number of things that we could be doing at any time. Indeed, every decision that we make involves some kind of trade-off. We may trade off utility now against utility in the future. For example, you may derive some satisfaction from whacking your boss on the head with a canoe paddle at the annual company picnic. But that momentary burst of utility would presumably be more than offset by the disutility of spending many years in a federal prison. (But those are just my preferences.) More seriously, many of our important decisions involve balancing the value of consumption now against consumption in the future. We may spend years in graduate school eating ramen noodles because it dramatically boosts our standard of living later in life. Or, conversely, we may use a credit card to purchase a big-screen television today even though the interest on that credit card debt will lessen the amount that we can consume in the future.
Similarly, we balance work and leisure. Grinding away ninety hours a week as an investment banker will generate a lot of income, but it will also leave less time to enjoy the goods that can be purchased with that income. My younger brother began his career as a management consultant with a salary that had at least one more digit than mine has now. On the other hand, he worked long and sometimes inflexible hours. One fall we both excitedly signed up for an evening film class taught by Roger Ebert. My brother proceeded to miss every single class for thirteen weeks.
However large our paychecks, we can spend them on a staggering array of goods and services. When you bought this book, you implicitly decided not to spend that money somewhere else. (Even if you shoplifted the book, you could have stuffed a Stephen King novel in your jacket instead, which is flattering in its own kind of way.) Meanwhile, time is one of our most scarce resources. At the moment, you are reading instead of working, playing with the dog, applying to law school, shopping for groceries, or having sex. Life is about trade-offs, and so is economics.
In short, getting out of bed in the morning and making breakfast involves more complex decisions than the average game of chess. (Will that fried egg kill me in twenty-eight years?) How do we manage? The answer is that each of us implicitly weighs the costs and benefits of everything he or she does. An economist would say that we attempt to maximize utility given the resources at our disposal; my dad would say that we try to get the most bang for our buck. Bear in mind that the things that give us utility do not have to be material goods. If you are comparing two jobs—teaching junior high school math or marketing Camel cigarettes—the latter job would almost certainly pay more while the former job would offer greater “psychic benefits,” which is a fancy way of saying that at the end of the day you would feel better about what you do. That is a perfectly legitimate be
nefit to be compared against the cost of a smaller paycheck. In the end, some people choose to teach math and some people choose to market cigarettes.
Similarly, the concept of cost is far richer (pardon the pun) than the dollars and cents you hand over at the cash register. The real cost of something is what you must give up in order to get it, which is almost always more than just cash. There is nothing “free” about concert tickets if you have to stand in line in the rain for six hours to get them. Taking the bus for $1.50 may not be cheaper than taking a taxi for $7 if you are running late for a meeting with a peevish client who will pull a $50,000 account if you keep her waiting. Shopping at a discount store saves money but it usually costs time. I am a writer; I get paid based on what I produce. I could drive ninety miles to shop at an outlet in Kenosha, Wisconsin, to save $50 on a new pair of dress shoes. Or I could walk into Nordstrom on Michigan Avenue and buy the shoes while I am out for lunch. I generally choose the latter; the total cost is $225, fifteen minutes of my time, and some hectoring from my mother, who will invariably ask, “Why didn’t you drive to Kenosha?”
Every aspect of human behavior reacts to cost in some way. When the cost of something falls, it becomes more attractive to us. You can learn that by deriving a demand curve, or you can learn it by shopping the day after Christmas, when people snap up things that they weren’t willing to buy for a higher price several days earlier. Conversely, when the cost of something goes up, we use less of it. This is true of everything in life, even cigarettes and crack cocaine. Economists have calculated that a 10 percent decrease in the street price of cocaine eventually causes the number of adult cocaine users to grow by about 10 percent. Similarly, researchers estimated that the first proposed settlement between the tobacco industry and the states (rejected by the U.S. Senate in 1998) would have raised the price of a pack of cigarettes by 34 percent. In turn, that increase would have reduced the number of teenage smokers by a quarter, leading to 1.3 million fewer smoking-related premature deaths among the generation of Americans seventeen or younger at the time.4 Of course, society has already raised the cost of smoking in ways that have nothing to do with the price of a pack of cigarettes. Standing outside an office building when it is seventeen degrees outside is now part of the cost of smoking at work.
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