Book SummaryThe Undercover Economist, by Tim Harford

1-Page Summary1-Page Book Summary of The Undercover Economist

The Undercover Economist will help you think like an economist without boring you with endless graphs or complex math. The world functions on economic principles. By thinking like an economist, you’ll learn how to make better decisions every day. This book will help you understand why you make the economic decisions that you do and discuss what happens when the following economic principles that efficiently govern much of the world break down:

• Scarcity
• Price Targeting
• Externalities
• Missing Information
• The Stock Market
• Game Theory
• Globalization

Scarcity

The first important economic principle that we’ll examine is scarcity: the idea that strength in negotiation comes from having a scarce resource that others want. Let’s say a wheat farmer is looking for land, and there are a lot of landlords who have land available. In this case, the landlords will attempt to undercut one another to get the wheat farmer’s business, making the land cheap. However, seeing the success of one wheat farmer, more people want to farm wheat in the town, and the scarcity shifts. Now, it’s the land, rather than the farmer, that is the scarce resource. Landlords get increasingly more power and can start to charge higher prices.

The balance of power between the farmers and the landlords can shift quickly. If farmers decide that the landlords’ prices are too high for them to make money on the most fertile land in town (the meadowland), there won’t be any incentive for them to rent from the landlords. They’ll be more likely to rent from the landlords of less fertile land like grassland. These farmers may produce less wheat, but their costs will be lower, making up for the decrease in revenue. The shifts in the scarce resource between farmers and landlords have the potential to go on forever. Once farmers take up all of the meadowland and grassland, and a new aspiring farmer arrives, he’ll rent from the landlords of even less-fertile land like scrubland.

The scrubland, or the lowest-yielding land, will always necessarily be the least profitable. This example illustrates why. Let’s say the new farmers are making $10,000/year on the scrubland, and the old farmers are making $15,000/year on the grassland. If neither farmer is paying anything in rent, the grassland is more profitable. But if the grassland landlords are charging $7,500/year in rent, the old farmers would only take home $7,500/year in profits. If the scrubland was free to farm, the old farmers would all move to the scrubland, because they could take home $10,000/year. Thus, the grassland landlords charge only $5,000/year or less to keep their farmers, because the farmers are only willing to stay if they can make at least as much as they would have made farming scrubland ($10,000/year in profit).

(Shortform note: To better understand how scarcity affects the price (and value) of a good or service, read our summary of Basic Economics.)

Price Targeting

While individuals and companies can look to profit from scarcity, they don’t have ultimate power over their consumers. No matter how scarce their resource, if a company sets its price too high, the customer won’t buy what they’re selling. What they can do, though, is employ the strategy of price targeting, or setting different price points for different customers.

A typical Starbucks menu illustrates how companies can set unique price points: They have regular coffees, cappuccinos, or hot chocolates priced at a fairly low rate—let’s say $2. But if you want a larger size, or a special bean, or even a blend of two different types of coffee, you pay more—maybe $3. Customers know it doesn’t cost Starbucks an extra dollar to manufacture these “fancier” items, but some customers are still willing to buy them. The customer who just wants her coffee and is money-conscious might go for the $2 coffee. But the customer who cares less about what her coffee costs and is curious about a particular blend will go with the more expensive option. Businesses are constantly looking for the latter customer or the one who doesn’t care as much about the price.

One way for companies to find customers that care less about the price is to rent storefronts in prime locations. For example, storefronts for coffee shops in train stations are desirable. Customers getting a coffee on the way to catch a train are likely to be less discerning about the price, given that they have a train to catch and don’t have time to leave the station and look for a lower-priced option.

However, even storefronts in prime locations need to practice price targeting. If the coffee shops in train stations sell their coffee at too high a markup, even though they’re the only coffee shop in the area, people will just forgo their coffee. But if they sell coffee at too low of a price, they won’t make enough money to turn a good profit, because their rent is so high due to the desirable location. This is why setting different price points, so that people who are willing to pay more will, and people who aren’t won’t (but will still buy something), works so well.

Finding Efficient Markets

There’s nothing forcing stores to sell their product for a particular price, nor is there anything forcing customers to buy at a particular price. In the free market, though, products are generally almost equal to the marginal cost, or how much it costs to keep a business afloat, plus modest profits that convince investors it’s a little better to keep their money in the business than in savings.

Imagine, for a second, that everyone in the world has to tell the truth. You go to a coffee shop, and the barista asks you what you’d be willing to pay for the coffee. Being a caffeine addict, you reply, “$15.” But then, as the barista starts making the coffee, you ask, “How much did the beans cost? What about the machines, your salary,...

The Undercover Economist Summary Introduction and Chapter 1: Uncovering Basic Economic Principles

The Undercover Economist, written by economist Tim Harford, will help you think like an economist without boring you with endless graphs or complex math. The world functions on economic principles. By thinking like an economist, you’ll learn how to make better decisions every day. This book will help you understand why you make the economic decisions that you do and discuss what happens when the economic principles that efficiently govern much of the world break down.

It’s unlikely that you think much about economics when buying a cappuccino. Getting a coffee is probably part of your routine, and you can get a similar product at thousands of places around the U.S. But when an economist sees your coffee, she understands that even this everyday product is the result of the effort of a lot of people. In other words, no single individual or group is in charge of any sector of the economy: No one makes a coffee from beginning to end. This would take growing and picking the coffee beans, buying, milking, and generally caring for cows, building a coffee machine with all of the steel parts necessary, and throwing a nice cup on the wheel and putting it into a kiln that you’ve also...

The Undercover Economist Summary Chapter 2: Price Targeting and Finding the Perfect Customer

This chapter explores how companies can charge different prices to different customers. Once you realize that sellers base their prices in part on what they think you’re willing to pay, you can make better decisions about what you buy, where you buy it, and how much to spend on it.

Multiple Price-Points

While individuals and companies can look to profit from scarcity, they don’t have ultimate power over their consumers. No matter how scarce their resource, if a company sets its price too high, the customer won’t buy what they’re selling. What they can do, though, is employ the strategy of price targeting, or setting different price points for different customers.

A typical Starbucks menu illustrates how companies can set unique price points: They have regular coffees, cappuccinos, or hot chocolates priced at a fairly low rate—let’s say $2. But if you want a larger size, or a special bean, or even a blend of two different types of coffee, you pay more—maybe $3. Customers know it doesn’t cost Starbucks an extra dollar to manufacture these “fancier” items, but some customers are still willing to buy them. The customer who just wants her coffee and is...

Shortform Exercise: Identify Price Targeting in Your Life.

This exercise will delve into how companies direct price targeting at you.

What are some goods that you buy at higher than the lowest possible price (a fancier-than-basic coffee, for example)?

The Undercover Economist Summary Chapter 3: Finding “Perfect Markets”

There’s nothing forcing stores to sell their product for a particular price, nor is there anything forcing customers to buy at a particular price. In the free market, though, products are generally almost equal to the marginal cost, or how much it costs to keep a business afloat, plus modest profits that convince investors it’s a little better to keep their money in the business than in savings.

Imagine, for a second, that everyone in the world has to tell the truth. You go to a coffee shop, and the barista asks you what you’d be willing to pay for the coffee. Being a caffeine addict, you reply, “$15.” But then, as the barista starts making the coffee, you ask, “How much did the beans cost? What about the machines, your salary, and everything else that it takes to run this place?” You find out that the total cost to make the coffee is less than a dollar. You keep going: “Are there any other places that sell similar coffee near here?” you ask. The barista responds that there are and that they sell coffee for a much lower price. You tell the barista that you’ll only buy the coffee at that lower price. You’ve managed to haggle what would have been a $15 coffee down to less...

The Undercover Economist Summary Chapter 4: Externalities

The last section demonstrated how perfect markets work in theory. Even though we rarely find perfect markets in the real world, it’s useful to understand the idea of perfect markets because economists usually start there when they see imperfections. Economists attempt to remove these imperfections. In this section, we’ll discuss the effects of these imperfections in the marketplace, or externalities, and discuss when governments should step in to prevent negative externalities.

In the most basic form of the free market, everyone goes about their lives, selling and buying goods, without any regard for how their actions affect others. Often, though, the actions of one buyer or seller can affect a third party, who’s not involved in the sale of goods or services. This is called an externality. To prevent negative externalities, governments may impose externality charges.

Externality charges are the best way to disincentivize an activity that harms others because people will act in self-interest. When the government levies externality charges on activities that are selfish and harm others, it’s usually not in your best interest to continue to pursue the harmful...

The Undercover Economist Summary Chapter 5: Missing Information

When one party doing a business deal has more information than the other party, the market is not running efficiently. This chapter explains the information gap, discusses how to close it, and examines how to solve broken health care systems using these economic principles.

Used Car Salesmen

We’ll use the example of used cars to explain the economic problems inherent in an information gap. Let’s say half the cars on the used car lot are “peaches”—they run well—and the other half are “lemons”—there’s something wrong with them. The car salesman knows which are which, and the buyer does not. The peaches are worth an average of $6,000 to buyers. The buyer offers $3,000, which she thinks is a fair gamble for a car that could be a peach or could be a lemon.

• If the car is a lemon, the seller will jump at the chance to sell a car he knows is worth less than $3,000.
• If the car is a peach, the seller will refuse to sell a car he knows is worth more than $3,000.

Consequently, buyers offering $3,000 will only ever get lemons. If the buyer offers closer to $6,000 the salesman might give up a peach, but the buyer wouldn’t be willing to put up something like $5,500 for...

The Undercover Economist Summary Chapter 6: The Stock Market

The stock market is a sector of the economy that is shrouded in secrecy. Complex jargon scares potential investors who don’t have a background in economics or finance. This chapter will help to lift that curtain. It will explain how stock prices are valued and why companies hire economists to help them play the stock market. In addition, it will explain why it’s safest to “run with the crowd,” or follow other investors when making your own investment decisions.

It’s difficult to make more money than an average investor in the market. This is because, if you’re following the law (and not trading off of insider information), everyone is working with the same information. A report that says that stock prices will go up tomorrow, for example, will make stock prices go up today because people will buy them expecting them to go up tomorrow. When investors buy more of a company’s stock than other investors sell, the stock price goes up.

The market is a nearly random walk that trends upwards. Generally, as the world economy continues to grow, more people will put their money into the market. This leads to the upwards trend. It’s nearly random because people who are well...

The Undercover Economist Summary Chapter 7: Game Theory

While economists can only be marginally helpful with the stock market, their successes and failures are much more on display when a government or a private company requires problem-solving with game theory.

Game theory is a discipline that is adjacent to economics and mathematics. The mathematician John von Neumann created much of the theory behind modern game theory in his 1944 book Theory of Games and Economic Behavior.

We’ll define a “game” as an activity in which predicting another’s actions affects your own actions. Many everyday situations, like driving, are games. When you’re behind the wheel, you drive based on the rules of the road but also based on what behavior other cars on the road are exhibiting. If a car is driving erratically, or too quickly, you’ll likely switch into a more defensive driving mode. If a car in front of you is driving too slowly, you’ll attempt to pass.

Poker

Von Neumann and many of his game theory contemporaries were fascinated with poker as an application for their game theory. In poker games, you win an entire pot of money if you finish with the best hand. There are rounds of betting in which players make decisions based on...

Shortform Exercise: Learn To Apply Game Theory.

This exercise will help you understand how game theory can help you in your daily life.

Name a game (an activity in which predicting what another person will do affects your own actions) that you play in your daily life (for example, when you change lanes in traffic or when you play rock, paper, scissors).

The Undercover Economist Summary Chapters 8-10: Globalization, and How Poor Countries Can Get Richer

Now that you understand some basic economic principles better, we’ll move on to how those principles play out around the world. We’ll begin with a discussion about how globalization has changed the way the world economy functions and then move on to two case studies: Cameroon and China.

Globalization

Globalization can refer to many kinds of exchanges among nations, but we will define it as more trade between nations and more direct investment in other nations. Mostly, trade and direct investment take place between rich countries, though globalization is starting to influence poorer countries as well.

If you want to be rich, trade with the world. Take the example of Bruges and Antwerp in Belgium. For centuries, Bruges was a huge trading port. It connected Belgium to the rest of the world. In the 15th century, though, topographical changes made it impossible for ships to enter Bruges’s port. Trading moved to Antwerp, which maintains a huge economic advantage over Bruges to this day.

Increasingly, products made in one remote corner of the world are available for purchase in another.

Comparative Advantage

Much of the success of globalization is due to...

Shortform Exercise: How Does Globalization Affect Your Life?

This exercise will challenge you to consider some of the ways globalization has affected your own life.

Do you attempt to buy products locally? If so, is it difficult to find certain products manufactured locally?