Trillion Dollar Economists_How Economists and Their Ideas have Transformed Business

by Robert Litan

  Finally, to those with a business background you should know that this is not your standard business or economics book. It will not give you or your company five steps to success, or seven steps to happiness. It will not tell how certain companies were built to last, went from good to great, or fell from grace. I will attempt, however, to draw out some general lessons your business may be able to use from each chapter. As noted earlier, you’ll find those lessons in “The Bottom Line” section at the conclusion of each chapter.

  So, sit back and actually enjoy reading about economics. It will make me happy if you get even half the pleasure reading the book as I have in researching and writing it (feel free to skip things you already may know or anticipate you will disagree with).

  Notes

  1. The statement about Friedman is in Alex Rosenberg and Tyler Curtain, “What Is Economics Good For?,” New York Times Opinionator, August 24, 2013, and Klein’s statement is from Glenn Rifkin, “Lawrence R. Klein, Economic Theorist, Dies at 93,” New York Times, October 21, 2013.

  2. Alan Greenspan, The Map and the Territory: Risk, Human Nature, and the Future of Forecasting (New York: Penguin, 2013). For an excellent summary of the book and a reflection on Greenspan himself, see Gillian Tett, “Crash Course,” Financial Times, October 26–27, 2013, 19.

  3. Interview with Hal Varian, July 15, 2013.

  4. John Siegfried, ed. Better Living through Economics (Cambridge, MA: Harvard University Press, 2012).

  5. Niall Ferguson, The Great Degeneration: How Institutions Decay and Economies Die (New York: Penguin Group, 2012).

  6. Niall Ferguson, “How America Lost Its Way,” Wall Street Journal, June 8, 2013, C1, http://online.wsj.com/article/SB10001424127887324798904578527552326836118.html. It is getting ever-harder to do business in the United States, argues Niall Ferguson, “and more stimulus won’t help: Our institutions need fixing.”

  Chapter 2

  An Easy Introduction to Economics

  If you’ve made it through the first chapter, you’re now probably asking an important threshold question: How much economics do I have to know to understand what follows? The answer is, not much, and what you do need to know before you plunge in, I will now tell you. For readers who have taken economics but forgotten a few things, this refresher may also be helpful. In whatever camp you fall, you will learn the rest of what might be useful to know before you read coming chapters. You will also discover how the economic ideas featured in these chapters use or build upon one or more of the following concepts.

  Rationality

  First, most economists assume that all actors in the economy behave rationally—that is, they act in their self-interest, even if that interest includes altruistic behavior, from which many people derive pleasure. Actually, the notion of pleasure, or utility, is a philosophical idea that predates modern economics and is associated with the British philosopher Jeremy Bentham, who argued that people act in such a way as to maximize their total utility. More sophisticated versions of this concept have appeared since in the writings of many economists, but the notion is that people are made happier more by the pleasure they derive out of doing various activities and, yes, buying things, than from accumulating money per se. Now, it is true that a large majority of people would rather have more money than less, but all of us know that money is not the only thing that drives people’s behavior or makes them entirely happy (often it doesn’t). The key notion for economists, whom one would assume care only about money, is that whatever people value—and money and the things it can buy are certainly important—they act in the workplace and as consumers to maximize what they value. In that sense, they are said to be rational.

  As for businesses, the calculus is simpler, and is generally assumed to be all or almost entirely about money—profits, to be precise. Standard economics textbooks don’t tell firms how to reduce costs or enhance revenues in order to maximize profits, but rather assume that whatever technologies are available for producing goods and services, firms will pick the cheapest ones available to them (some may be proprietary to other firms, giving them a leg up in the competitive race), while selling as much as consumers want at prices set by the market (see next subject). Business schools specialize in teaching future and current business leaders techniques for minimizing costs while maximizing sales. What many business leaders may not realize is that some of the material they learn from their business school professors originated from economists, some of whom you will meet, as well as their ideas, in later chapters.

  The assumption of rationality is important to most economists for two reasons. If actors are rational, then it is easier to predict how they will behave. Consumers will thus buy less of something the more expensive it is, while firms will do the opposite, eagerly producing more of it the higher the price. I’ll have more to say about this famous supply and demand analysis in a moment.

  A related advantage of the rationality assumption is that it makes economic analysis more mathematically tractable—important to economists—since mathematics has become the lingua franca of academic economics. You can have a good idea, but unless it can be expressed mathematically, you are unlikely to be taken seriously among your academic peers—and you’ll have a very small chance of ever winning a Nobel Prize (you’ll meet one famous exception in a later chapter). A number of critics, including many economists themselves, believe the field has become too mathematically abstruse and less relevant to the real world than it used to be. Although I personally find some merit in this critique, I also recognize that economists have used or improved upon a number of mathematical methods to develop important insights and techniques that are used in many businesses today, as I demonstrate in later chapters without writing a single equation!

  Other critics, including some economists, have attacked the rationality assumption, especially by individuals. People oftentimes are emotional and they do not have the time or inclination to search out all of the relevant alternatives before buying or selling, and thus do not always pick the perfect or the optimal outcome. One economist, Herbert Simon, a longtime professor at Carnegie Mellon University, even won a Nobel Prize for showing how and why many individuals and firms may be content to settle on an acceptable outcome or one that satisfies rather than optimizes. Simon, and other economists who have elaborated on his work, has also used the term bounded rationality to describe how people often behave: They are rational, but within limits, not wanting or having the time to explore and examine each and every possible option or choice they might pick.1 Research in psychology and a branch of economics called behavioral economics (more about this subject in a moment) shows that offering consumers too many choices can be suboptimal for society—a phenomenon known as choice anxiety.2

  Perhaps the most articulate and vociferous defender of the (unbounded) rationality assumption is another Nobel Prize winning economist, and probably one of the most recognized names in economics, the late Milton Friedman (see the following box). Among his many writings, Friedman penned an essay on just this subject in the 1950s, arguing that it didn’t matter whether everyone in the economy behaved rationally. The key was that the marginal actor—that last purchaser of a particular item—behaved “as if” he or she were rational.3

  Milton Friedman: Capitalism’s Defender

  To economists of my generation, there were three figures who towered above them all. You will meet two of them in this chapter. The first is Milton Friedman.4

  Freidman found economics, like many others, at college through the influence of two professors, Arthur Burns and Homer Jones, who then were teaching at Rutgers University, which Friedman attended on scholarship. But even after finishing college, Freidman was torn between pursuing a career as an applied mathematician or economist, and received graduate scholarships in both subjects. Freidman claims a toss of the coin determined the outcome, though he acknowledges that the challenge of figuring out how countries can escape severe depressions—it was 1932—also played a role. The world woul
d not have been the same had the coin toss turned out differently.

  At the University of Chicago, where he attended graduate school, Friedman was heavily influenced by Jacob Viner, then a leading theorist of international trade, but also by other members of an outstanding faculty. At Chicago, he met and later married another student, Rose Director, the daughter of Aaron Director, a Chicago faculty member who had a profound impact on many economists.

  After graduate school, Friedman joined the faculty at the University of Wisconsin briefly but then went to work at the Treasury Department during World War II, helping to devise the withholding tax system for income taxes (an assignment that Friedman has written his wife never forgave him for, perhaps not entirely tongue in cheek). After the war, Friedman eventually found his way back to Chicago, which was his academic home throughout his teaching career, before he moved in his later years to the Hoover Institution at Stanford.

  Friedman’s academic work was far ranging. He established the monetarist branch of macroeconomics, which emphasized the exclusive role of the money supply in determining inflation; developed a theory of economy-wide consumption; revised an understanding of the tradeoff between unemployment and inflation, which Friedman argued was true only in the short run; and became an ardent advocate for flexible exchange rates, a policy that has governed international markets since the demise of the Bretton Woods system of fixed rates established after World War II.

  Friedman also wrote for a popular audience and was the author or promoter of a wide range of policy ideas, including an all-volunteer military force and vouchers for elementary and secondary schools. He wrote articles for newspapers and magazines throughout his career, most notably Newsweek, alternating with Paul Samuelson of MIT (whom you will meet later in this chapter).

  Friedman also dispensed policy advice to leading Republican politicians in the United States and to leaders of many foreign countries. Although his writings and research did not directly influence business, his tireless advocacy of free market policies found a warm reception among many (but not all) in business.

  His Capitalism and Freedom is one of the most influential economics books of all time (up there with John Maynard Keynes’ classic General Theory of Employment, Money and Interest, and a lot more readable). His widely popular book, Free to Choose, coauthored with his wife, Rose, was made into a television documentary. He was awarded the Nobel Prize in 1976, and died in 2006 at the age of 94.

  The emphasis on that marginal buyer or seller has a long history in economics, and is perhaps most associated with a famous nineteenth century economist, Alfred Marshall. The central insight of the marginalist revolution can be illustrated with a paradox that perplexed the great Adam Smith: Why are diamonds—frivolous and nonessential consumer goods—so much more expensive than water, an essential necessity of life? The answer, the marginalists taught us, is that although water has greater total utility, diamonds have greater marginal utility, and therefore command higher prices.5 That is to say, the value of one extra diamond, because diamonds are so scarce, is much higher than an extra drop of water, which generally is much more plentiful (though in many parts of the country or the world, water is becoming increasingly scarce, and is generally not priced to reflect that scarcity).

  “Thinking on the margin” means to consider the economic consequences of the next step forward.6 That is, individuals and firms should consider only the additional costs and benefits of the next unit—not prior sunk costs—when making decisions. Since we can’t do anything about the past, it’s best to focus on the present and the future if we want to maximize utility or profits. Admittedly, this is often hard to do. If we’ve sunk a lot of money into a project or an item, it is often difficult to walk away from putting even more money into it, even though if we stop and think rationally about it, we may never recover what we’ve put in already.

  The emphasis on marginal thinking nonetheless has huge implications for how economies behave. In particular, as long as the last (or marginal) buyer and seller meet at a price both can agree upon, that is all that matters for markets to clear. It doesn’t matter that many uninformed or less-than-rational buyers (less so sellers) are in the market.

  Economists have debated Friedman’s as-if metaphor for years, and this is a debate I have no desire or need to resolve, because I will provide examples of ideas that are essentially on both sides of the debate that have found their way into the business world. The efficient markets hypothesis associated with the setting of stock prices, the subject of Chapter 8, is a clear example of Friedman’s hypothesis at work, and real money has been made by enterprising entrepreneurs using that concept.

  At the same time, there is a newer school of economists who have paired with psychologists, or drawn from their literature, who draw out the implications of behaviors that are not always rational in the way either Friedman or other economists would define. These behavioral economists, such as Herbert Simon, have noticed many situations in which people do not always act rationally, and the results in the marketplace do not look like they follow Friedman’s as-if assumption.

  Behavioral economists look at the way people actually behave and find out that context matters. For example, setting the default option can lead to very different outcomes. Take, for example, the seemingly simple choice of whether to set aside a percentage of people’s salary each month in a tax-deferred savings account to build up money for retirement, commonly called 401k accounts (or variations of them). If you tell workers they have to affirmatively opt in to such automatic salary deductions, they are much less likely to save than if you switch the default setting to an opt out—that is, everyone is presumed to sign up unless they affirmatively decide not to. Or changing the food options in a school cafeteria toward healthier food can nudge kids to choose healthier and less fattening items.

  One popular book featuring behavioral economics is Nudge, co-authored by a lawyer, Cass Sunstein of Harvard Law School, and economist Richard Thaler of the University of Chicago.7 Sunstein and Thaler focus on policies that firms and governments can take to nudge people toward decisions that are better for them and for society as a whole. When met with the objection that these policies take away people’s freedom, the two authors respond that almost every decision that people must make is framed in a certain way, and that accepting one particular framing over another always happens, either implicitly or explicitly. They would rather have those decisions made explicit and create contexts that enhance the broader social welfare.

  Behavioral economics has had an important impact on the world of finance, as you will learn in Chapter 8. The development of the field has many intellectual fathers, but one of the most influential is not even an economist at all, but rather a psychologist, Daniel Kahneman. Readers who want a nontechnical guide to his work should read his popular book Thinking, Fast and Slow.8

  Markets

  A second economic proposition it would be useful to know is that in capitalist economies—those in which individuals and firms can own and trade property, including goods and services—the market is the central institution that sets prices, rather than any governmental body (there is a limited exception to this rule, discussed shortly).9 Prices, in turn, are really important in any economy—even in the former communist countries—as key signals to guide the behavior of producers and consumers. Hold that thought, however, until I quickly define the term market.

  Actually, there are multiple kinds of markets, and each tends to be suitable for different kinds of goods and services. One kind of market is an organized exchange, like the stock markets (there are many of them, but that is a detail), where millions of people and institutions submit and buy and sell orders for stocks and more complicated financial products known as derivatives (such as options or futures contracts whose values are derived from the value of some other underlying financial instrument or commodity). Exchanges are ideal for completing trades and thus determining the prices of fungible or standardized items, such as a stock cer
tificate, or many commodities, such as oil, corn, or wheat.

  In the old days, human specialists and traders who worked on the floors of stock exchanges would match buy and sell orders, or complete the transactions themselves, hoping to profit from a later trade. Today, computers do the matching and complete much of the trading (all this is discussed in greater detail in Chapter 12).

  More commonly, when economists refer to the market they are thinking about the aggregation of millions or billions of uncoordinated actions of buyers and sellers of often very different goods and services. In most cases, the items are offered on a take-it-or-leave-it basis by a vendor (a retail outlet, restaurant, or a service provider such as a doctor or a lawyer). Most items now for sale on the Internet are offered the same way. If buyers like the price, they purchase; if they don’t they go somewhere else, either on foot, by car, or by clicking their computers, or touching their phones, each hooked to the Internet. Providers who have difficulty selling their wares eventually may lower their prices, while those who can’t keep up with demand may raise them. Although there may be no single market clearing price for every good and service, the market in the aggregate tends to iterate so that prices for identical items or services converge. There are exceptions to this tendency, when prices are not readily apparent, as is generally the case in health care, but even in that sector, there should be movement over time toward greater transparency, which should lead to more price convergence.