EVENTS

Date:	Wednesday, November 9, 2005
Time:	1:00 PM -- 2:30 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

November 2005

The Undercover Economist: Bringing Economics to Life

 

On November 9, the AEI-Brookings Joint Center for Regulatory Studies hosted an event featuring the book The Undercover Economist written by economist, author, and Financial Times columnist Tim Harford. This book has gained wide popularity; Harford writes for an intelligent--but not necessarily knowledgeable--audience, and uses everyday examples rather than abstract theorems to illustrate the principles of economics. The result is a book that is as entertaining as it is informative. At the event, Harford discussed the economics of price discrimination, the operation of free markets, and the benefits of accountability through a number of everyday examples.

Tim Harford
Financial Times

Tim Harford began by explaining that prices are strategically designed to motivate people willing to pay more for an item to do so. He illustrated this with three examples of companies splitting customers into multiple groups in order to achieve this objective. First, he gave the example of a restaurant with high-quality food which offers two seating locations: the dining room and the bar. In the first, a polite and polished waiter serves a meal priced at $50; in the second, an unfriendly man covered in tattoos he got in a Russian prison serves the same meal for $10. Harford explained that this is a careful strategy of the restaurant. The owners still make some profit on the low-priced meal but deliberately choose a rude waiter for the bar to induce customers who are willing to pay higher prices to go to the dining room. The owners still offer the bar seating option so that those who would normally not frequent an expensive restaurant are still lured to their restaurant.

Second, he gave an example of eight-roll and three-roll packs of paper towels, each package targeted to a different customer group. The prices between the two packages are similar; the eight-roll package costs only slightly more than the three-roll package. This is a strategic move on the part of the company; those who are happy to pay the higher price per roll (and avoid carrying home a large package of more paper towels than they will really need for the immediate future) buy the three-pack. Those who might otherwise be deterred from buying that particular brand due to the high price per roll in the three-pack are enticed to stick with the brand and buy the eight-pack, which has a lower price per roll.

Third, he gave the example of the eight-ounce cappuccino offered by Starbucks. This size is not offered on the menu or on Starbucks’ website. Harford explained that this omission is probably to entice people to buy the larger, more expensive sizes. Nonetheless, customers who know can order the eight-ounce size at a lower price. Starbucks wants to push those willing to pay for larger sizes to buy them. If a customer is willing to get a larger cup and still come to Starbucks, the company does not want the customer to be enticed by the lower-priced eight-ounce cup, so it does not appear on the menu. This trick captures some of the extra surplus from customers willing to pay more but keeps the customer who wants a low price to keep coming to Starbucks for an eight-ounce cup.

Harford then discussed poverty. He explained that poor countries remain poor not because they are full of evil, stupid people; all countries have people like this. In poor countries, however, these people are less likely to be held accountable. Harford illustrated this with an example of an expensive but poorly designed and poorly built library in Cameroon. The library held no books four years after its construction because of many design problems. Unfortunately, a woman with an agenda and little understanding of architecture pushed forward the project and others did not try to stop her out of fear or indifference. The result? A substantial waste of public funds. Without any accountability, a nation is destined to remain poor because money will not be spent in the most efficient way possible. Harford concluded with the message that free and unfettered markets are critical for an economy to function well. Attempts to inhibit the market mechanism often reflect our desire to obscure the truth by hiding the signals generated by the market.

Tyler Cowen
George Mason University

Tyler Cowen began by complimenting Harford on his work--in particular the humble and honest “British” voice prevalent throughout the book. He then discussed two points on which he disagreed with Harford: his views on health insurance and his discussion of Starbucks. First, Cowen explained that Harford’s book outlines an ideal health insurance plan under which individuals pay for small items and the government pays for large items. Cowen argued that we should not subsidize catastrophic care; on the contrary, we should probably even tax it. Second, Cowen summarized Harford’s view of Starbucks: the landlords who own the property on which the coffee shops are located have the real power; Starbucks does not. Cowen said that Starbucks does have real power, and this real power comes from décor. That is, the image Starbucks has forged in people’s minds and the atmosphere it has patented draws people and has been profitable to the stockholders and others who got in early. Markups are determined by décor, and Starbucks has mastered this art.

Sebastian Mallaby
Washington Post

Sebastian Mallaby complemented Harford’s use of everyday examples to illustrate price discrimination and other principles of economics and offered some of his own. He explained how Microsoft designed the professional versions of its software first, and simply disabled several components in order to make the less expensive, home version. Thus, the less expensive version actually required more work, clearly showing that its creation was a part of Microsoft’s price discrimination scheme. He also described a printer that was manufactured and sold at one price. Then the manufacturers added a chip to the printer to make it work more slowly and sold the slower printer at a lower price. While the slower printer actually cost more to make, it was sold at a lower price, thereby allowing the company to segment the market into consumers with differing willingness to pay. Mallaby concluded by saying that Harford’s book is generally well written, but that he should qualify some of what he says, such as his proposed solution to health care problems.

Question and Answer Session

Following the presentations, Cowen and Harford both responded to the issue of whether landowners or Starbucks have market power. There seemed to be a consensus that the issue comes down to whether good décor comes from something that the company rents from their location or whether good décor is something that the company was lucky enough to come up with in their business plan and design work. Harford and Cowen agreed that both are important. One audience member asked if the panelists thought the American public had more economic sophistication now than thirty years ago. Cowen said that key leaders may be more sophisticated, but that the general public is not. Harford said that books like his own and like Freakonomics might not have increased economic literacy directly, but may have done so indirectly. Another audience member expressed his concern about the market power that accompanies price discrimination. Harford answered that he likes price discrimination and is only worried that advances in technology may make it more difficult for companies to price discriminate.

Katrina Kosec, a research associate at the AEI-Brookings Joint Center for Regulatory Studies, prepared this conference summary.