Reading 📚 The Undercover Economist

1 🅞🅝🅔 ⱲǶⰙ Ꝓ𐤠ƳⳜ ƑⰙⱤ ƳⰙꓴⱤ ƇⰙƑƑƸƸ? The long commute on public transportation is a commonplace experience of life in major cities around the world, whether you live in New York, Tokyo, Antwerp, or Prague. Commuting dispiritingly combines the universal and the particular. This particular, because each commuter is a rat in his own unique maze: timing the run from the shower to the station turnstiles; learning the timetables and the correct end of the platform to speed up the transfer between different trains; trading off the disadvantages of standing room only on the first train home against a seat on the last one. Yet commutes also produce common patterns-bottlenecks and rush hours that are exploited by entrepreneurs the world over. My commute in Washington DC is not the same as yours in London, New York, or Hong Kong, but it will look surprisingly familiar. 2 Farragut West is the Metro station ideally positioned to serve the World Bank, the International Monetary Fund, and even the White House. Every morning, sleep-deprived, irritable travelers surface from Farragut West into the International Square plaza, and they are not easily turned aside from their paths. They want to get out of the noise and bustle, around the shuffling tourists, and to their desks just slightly before their bosses. They do not welcome detours. But there is a place of peace and bounty that can tempt them to tarry for a couple of minutes. In this oasis, rare delights are served with smiles by attractive and exotic men and women, a charming barista whose name badge reads "Maria." I am thinking, of course, of Starbucks. The café is placed, inescapably, at the exit to International Square. This is no quirk of Farragut West: the first storefront you will pass on your way out of the nearby Farragut North Metro is another Starbucks. You find such conveniently located coffee shops all over the planet and catering to the same desperate commuters. The coffee shop within ten yards of the exit from Washington's Dupont Circle Metro station is called Cosi. New York's Penn Station boasts Seattle Coffee Roasters just by the exit to Eighth Avenue. Commuters through Shinjuku Station, Tokyo, can enjoy a Starbucks without leaving the station concourse. In London's Waterloo station, it is the AMT kiosk that guards the exit onto the south bank of the Thames. 3 At $2.55 a tall cappuccino from Starbucks is hardly cheap. But of course, I can afford it. Like many of the people stopping at that café, I earn the price of that coffee every few minutes. None of us care to waste our time trying to save a few pennies by searching out a cheaper coffee at 8:30 in the morning. There is a huge demand for the most convenient coffee possible in Waterloo Station, for example, seventy-four million people pass through each year. That makes the location of the coffee bar crucial. The position of the Starbucks café at Farragut West is advantageous, not just because it's located on an efficient route from the platforms to the station exit, but because there are no other coffee bars on that route. It's hardly a surprise that they do a roaring trade. 4 If you buy as much coffee as I do you may have come to the conclusion that somebody is getting filthy rich out of all this. If the occasional gripes in the newspapers are correct, the coffee in that cappuccino costs pennies. Of course, the newspapers don't tell us the whole story: there's milk, electricity, the cost of the paper cups and the cost of paying Maria to smile at grouchy customers all day long. But after you add all that up you still get something a lot less than the price of a cup of coffee. According to economics professor Brian McManus, markups on coffee are around 150 percent. It costs forty cents to make a one-dollar cup of drip coffee and costs less than a dollar for a small latte, which sells for $2.55. So somebody is making a lot of money. Who? 5 You might think that the obvious candidate is Howard Schultz, the owner of Starbucks. But the answer isn't as simple as that. The main reason that Starbucks can ask $2.55 for a cappuccino is that there isn't a shop next door charging $2.00. So why is nobody next door undercutting Starbucks? Without wishing to dismiss the achievements of Mr. Schultz, cappuccinos are not in fact complicated products. There is no shortage of drinkable cappuccinos (sadly, there is no shortage of undrinkable cappuccinos either). It doesn't take much to buy some coffee machines and a counter, build up a brand with a bit of advertising and some free samples, and hire decent staff. Even Maria is replaceable. 6 The truth is that Starbucks' most significant advantage is its location on the desired line of thousands of commuters. There are a few sweet spots for coffee bars - by station exits or busy street corners. Starbucks and its rivals have snapped them up. If Starbucks really did have the hypnotic hold over its customers that critics complain about, it would hardly need to spend so much effort getting people to trip over its cafés. The nice margin that Starbucks makes on their cappuccinos is due neither to the quality of the coffee nor to the staff: its location, location, location. 7 But who controls the location? Look ahead to the negotiations for the new rental agreement. The landlord at International Square will not only be talking to Starbucks but to other chains like Cosi and Caribou Coffee, and DC's local companies: Java House, Swing's, Capitol Grounds, and Teaism. The landlord can sign an agreement with each one of them or can sign an exclusive agreement with only one. She'll quickly find that nobody is very eager to pay much for a space next to ten other coffee bars, and so she will get the most advantage out of the exclusive agreement. 8 In trying to work out who is going to make all the money, simply remember that there are at least half a dozen competing companies on one side of the negotiating table and on the other side is a landlord who owns a single prime coffee bar site. By playing them off against each other, the landlord should be able to dictate the terms and force one of them to pay rent, which consumes almost all their expected profits. The successful company will expect some profit but not much: if the rent looks low enough to leave a substantial profit, another coffee bar will be happy to pay a little extra for the site. There is an unlimited number of potential coffee bars and a limited number of attractive sites and that means the landlords have the upper hand. 9 This is pure armchair reasoning. It's reasonable to ask if all of this is actually true. After I explained to a long-suffering friend (over coffee) all of the principles involved, she asked me whether I could prove it. I admitted that it was just a theory-as Sherlock Holmes might say, a piece of "observation and deduction," based on clues available to all of us. A couple of weeks later she sent me an article from the Financial Times, which relied on industry experts who had access to the accounts of coffee companies. The article began, "Few companies are making any money" and concluded that one of the main problems was "the high costs of running retail outlets in prime locations with significant passing trade." Reading accounts is dull; economic detective work is the easy way to get to the same conclusion.

1 __𝐒𝐭𝐫𝐞𝐧𝐠𝐭𝐡 𝐟𝐫𝐨𝐦 𝐬𝐜𝐚𝐫𝐜𝐢𝐭𝐲 Browsing through the old economics books on the shelf at home, I dug out the first analysis of twenty-first-century coffee bars. Published in 1817, it explains not just the modern coffee bar but much of the modern world itself. Its author, David Ricardo, had already made himself a multimillionaire (in today's money) as a stockbroker and was later to become a Member of the Parliament. But Ricardo was also an enthusiastic economist, who longed to understand what had happened to Britain's economy during the then-recent Napoleonic wars: the price of wheat had rocketed, and so had rents on agricultural land. Ricardo wanted to know why. 2 The easiest way to understand Ricardo's analysis is to use one of his own examples. Imagine a wild frontier with few settlers but plenty of fertile meadows available for growing crops. One day an aspiring young farmer, Axel, walks into town and offers to pay rent for the right to grow crops on an acre of good meadow. Everyone agrees how much grain an acre of meadow will produce, but they cannot decide how much rent Axel should pay. Because there is no shortage of land lying fallow, competing landlords will not be able to charge a high rent. Or any significant rent at all. Each landlord would rather collect a small rent than no rent at all, and so each will undercut his rivals until Axel is able to start farming for very little rent - just enough to compensate for the landlord's trouble. 3 The first lesson here is that the person in possession of the desired resource the landlord in this case - does not always have as much power as one would assume. And the story doesn't specify whether Axel is very poor or has a roll of cash in the false heel of his walking boot, because it doesn't make any difference to the rent. Bargaining strength comes through scarcity: settlers are scarce and meadows are not, so landlords have no bargaining power. 4 That means that if relative scarcity shifts from one person to another, bargaining shifts as well. If over the years many immigrants follow in Axel's footsteps, the amount of spare meadow-land will shrink until there is none left. As long as there is any, competition between landlords who have not attracted any tenants will keep rents very low. One day, however, an aspiring farmer will walk into town - let's call him Bob - and will find that there is no spare fertile land. The alternative, farming on inferior but abundant scrubland, is not attractive. So Bob will offer to pay good money to any landlord who will evict Axel, or any of the other farmers currently farming virtually rent-free, and let him farm there instead. But just as Bob is willing to pay to rent meadowland rather than scrubland, all of the meadow farmers will also be willing to pay not to move. Everything has changed, and quickly: suddenly the landlords have acquired real bargaining power, because suddenly farmers are relatively common and meadows are relatively scarce. 5 That means the landowners will be able to raise their rents. By how much? It will have to be enough that farmers earn the same farming on meadows and paying rent, or farming on inferior scrubland rent-free. If the difference in productiveness of the two types of land is five bushels of grain a year, then the rent will also be five bushels a year. If a landlord tries to charge more, his tenant will leave to farm scrubland. If the rent is any less, the scrub farmer would be willing to offer more. 6 It may seem odd that the rents changed so rapidly simply because one more man arrived to farm the area. This story doesn't seem to explain how the world really works. But there is more truth to it than you might think, even if it is oversimplified. Of course, in the real world, there are other elements to consider: laws about evicting people, long-term contracts, and even cultural norms, such as the fact that kicking one person out and installing a new tenant the next day is just "not done." In the real world, there are more than two types of farmland, and Bob may have different options to being a farmer-he may be able to get a job as an accountant or drive a cab. All these facts complicate what happens in reality; they slow down the shift in bargaining power, alter the absolute numbers involved, and put a brake on sudden movements in rents. 7 Yet the complications of everyday life often hide the larger trends behind the scenes, as scarcity of power shifts from one group to another. The economist's job is to shine a spotlight on the underlying process. We should not be surprised if, suddenly, the land market shifts against farmers; or if house prices go up dramatically; or if the world is covered by coffee bars over a period of just a few months. The simplicity of the story emphasizes one part of the underlying reality - but the emphasis is helpful in revealing something important. Sometimes relative scarcity and bargaining strength really do change quickly, and with profound effects on people's lives. We often complain about symptoms - the high cost of buying a cup of coffee, or even a house. The symptoms cannot be treated successfully without understanding the patterns of scarcity which underlie them. 8 __"𝑴𝒂𝒓𝒈𝒊𝒏𝒂𝒍" 𝒍𝒂𝒏𝒅 𝒊𝒔 𝒐𝒇 𝒄𝒆𝒏𝒕𝒓𝒂𝒍 𝒊𝒎𝒑𝒐𝒓𝒕𝒂𝒏𝒄𝒆 The shifts in bargaining power don't have to stop there. While the farming story can be elaborated indefinitely, the basic principles remain the same. For example, if new farmers keep arriving, they will eventually cultivate not only the meadowland but also all of the scrubland. When a new settler, Cornelius, walks into town, the only land available will be the grassland, which is even less productive than scrubland. We can expect the same dance of negotiations: Cornelius will offer money to landlords to try to get onto scrubland, rents will quickly rise on scrubland, and the differential between scrubland and meadow will have to stay the same (or farmers would want to move), so the rent will rise on meadow too. 9 The rent on meadowland, therefore, will always be equal to the difference in grain yield between meadowland and whatever land is available rent-free to new farmers. Economists call this other land "marginal" land because it is at the margin between being cultivated and not being cultivated. (You will soon see that economists think about decisions at the margin quite a lot.) In the beginning, when meadowland was more plentiful than settlers, it was not only the best land, it was also the "marginal" land because new farmers could use it. Because the best land was the same as the marginal land, there was no rent, beyond the trivial sum needed to compensate the landlord for his trouble. Later, when there were so many farmers that there was no longer enough prime land to go around, scrubland became the marginal land, and rents on meadows rose to five bushels a year - the difference in productivity between the meadowland and the marginal land (in this case, the scrubland). When Cornelius arrived, the grassland became the marginal land, meadows became yet more attractive relative to the marginal land, and so the landlords were able to raise the rent on meadows again. It's important to note here that there is no absolute value: everything is relative to that marginal land. 10 __𝑭𝒓𝒐𝒎 𝒎𝒆𝒂𝒅𝒐𝒘𝒔 𝒃𝒂𝒄𝒌 𝒕𝒐 𝒄𝒐𝒇𝒇𝒆𝒆 𝒌𝒊𝒐𝒔𝒌𝒔 A nice story, but those of us who like Westerns may prefer the gritty cinematography of Unforgiven or the psychological isolation of High Noon. So, David Ricardo and I get no prizes for our screenwriting, but we might be excused, as long as our little fable actually tells us something useful about the modern world. We can start with coffee kiosks. Why is coffee expensive in London, New York, Washington, or Tokyo? The commonsense view is that coffee is expensive because the coffee kiosks have to pay high rent. David Ricardo's model can show us that this is the wrong way to think about the issue, because "high rent" is not an arbitrary fact of life. It has a cause. 11 Ricardo's story illustrates that two things determine the rent on prime locations like meadowland: the difference in agricultural productivity between meadows and marginal land, and the importance of agricultural productivity itself. At a dollar a bushel, five bushels of grain is a five-dollar rent. At two hundred thousand dollars a bushel, five bushels of grain is a million-dollar rent. Meadows command high dollar rents only if the grain they help produce is also valuable. 12 Now apply Ricardo's theory to coffee bars. Just as meadow-land will command high rents if the grain they produce is valuable, prime coffee bar locations will command high rents only if customers will pay high prices for coffee. Rush-hour customers are so desperate for caffeine and in such a hurry that they are practically price-blind. The willingness to pay top dollar for convenient coffee sets the high rent, and not the other way around. 13 Spaces suitable for coffee kiosks are like meadows they are the best quality property for the purpose, and they fill up quickly. The ground-floor corner units of Manhattan's Midtown are the preserve of Starbucks, Cosi, and their competitors. Near Washington DC's Dupont Circle, Cosi has the prime spot at the southern exit, and Starbucks has the northern one, not to mention staking out territory opposite the adjacent stations up and down the Metro line. In London, AMT has Waterloo, King's Cross, Marylebone, and Charing Cross stations, and indeed every London station hosts one of the big-name coffee chains. 14 These spots could be used to sell secondhand cars or Chinese food, but they never are. This isn't because a train station is a bad place to sell a Chinese meal or a secondhand car, but because there is no shortage of other places with lower rents from which noodles or cars can be sold - customers are in less of a hurry, more willing to walk, or order a delivery. For coffee bars and similar establishments selling snacks or newspapers, cheaper rent is no compensation for the loss of a flood of price-blind customers. 15 __𝐏𝐨𝐫𝐭𝐚𝐛𝐥𝐞 𝐦𝐨𝐝𝐞𝐥𝐬 David Ricardo managed to write an analysis of cappuccino bars in train stations before either cappuccino bars or train stations existed. This is the kind of trick that makes people either hate or love economics. Those who hate it argue that if we want to understand how the modern coffee business works, we should not be reading an analysis of farming published in 1817. 16 But many of us love the fact that Ricardo was able, nearly two hundred years ago, to produce insights that illuminate our understanding today. It's easy to see the difference between nineteenth-century farming and twenty-first-century frothing, but not so easy to see the similarity before it is pointed out to us. Economics is partly about modeling, about articulating basic principles and patterns that operate behind seemingly complex subjects like the rent on farms or coffee bars. 17 There are other models of the coffee business, useful for different things. A model of the design and architecture of coffee bars could be useful as a case study for interior designers. A physics model could outline the salient features of the machine that generates the ten atmospheres of pressure required to brew espresso; the same model might be useful for talking about suction pumps or the internal combustion engine. Today we have models of the ecological impacts of different disposal methods for coffee grounds. Each model is useful for different things, but a "model" that tried to describe the design, the engineering, the ecology, and the economics would be no simpler than reality itself and so would add nothing to our understanding. 18 Ricardo's model is useful for discussing the relationship between scarcity and bargaining strength, which goes far beyond coffee or farming and ultimately explains much of the world around us. When economists see the world, they see hidden social patterns, patterns that become evident only when one focuses on the essential underlying processes. This focus leads critics to say that economics doesn't consider the whole story, the whole "system." How else, though, could a nineteenth-century analysis of farming proclaim the truth about twenty-first-century coffee bars, except through grossly failing to notice all kinds of important differences? The truth is that it's simply not possible to understand anything complicated without focusing on certain elements to reduce that complexity. Economists have certain things they like to focus on, and scarcity is one of them. This focus means that we do not notice the mechanics of the espresso machine, nor the color schemes of the coffee bars, nor other interesting, important facts. But we gain from that focus, too, and one of the things we gain is an understanding of the "system"- the economic system, which is far more all-encompassing than many people realize. 19 A word of caution is appropriate, though. The simplifications of economic models have been known to lead economists astray. Ricardo himself was an early casualty. He tried to extend his brilliantly successful model of individual farmers and landlords to explain the division of income in the whole economy: how much went to workers, how much to landlords, and how much to capitalists. It didn't quite work, because Ricardo treated the whole agricultural sector as if it were one vast farm with a single landlord. A unified agricultural sector had nothing to gain from improving the land's productivity with roads or irrigation because those improvements would also reduce the scarcity of good land. But an individual landlord in competition with the others would have plenty of incentive to make improvements. Tied up in the technical details, Ricardo failed to realize that thousands of landlords competing with each other would make different decisions than a single one. 20 So Ricardo's model can't explain everything. But we are about to discover that it goes farther than Ricardo himself could ever have imagined. It doesn't just explain the principles behind coffee bars and farming. If applied correctly, it shows that environmental legislation can dramatically affect income distribution. It explains why some industries naturally have high profits, while in other industries high profits are a sure sign of collusion. It even manages to explain why educated people object to immigration by other educated people, while the working classes complain about immigration by other unskilled workers.

1 __𝑫𝒊𝒇𝒇𝒆𝒓𝒆𝒏𝒕 𝒓𝒆𝒂𝒔𝒐𝒏𝒔 𝒇𝒐𝒓 𝒉𝒊𝒈𝒉 𝒓𝒆𝒏𝒕 Do you care if you get ripped off? I do. A lot of things in this life are expensive. Of course, sometimes that expense is a natural outcome of the power of scarcity. For instance, there are not many apartments overlooking Central Park in New York or Hyde Park in London. Because so many people want them, those apartments are expensive, and a lot of people end up being disappointed. There is nothing sinister about that. But it's not nearly so obvious why popcorn is so expensive at the movies - there was no popcorn shortage last time I checked. So the first thing we might want to do is to distinguish between different reasons for things being expensive. 2 In Ricardo's terms, we would like to know the different causes of high rents. Knowing this about meadows is only mildly interesting (unless you are a farmer) but takes on a sudden significance when applied to the question of why your apartment rent seems so extortionate, or whether banks are ripping us off. But we can start with meadows and apply what we learn more widely. 3 We know that rents on the best land are determined by the difference in fertility between the best land and the marginal land. So the obvious reason that rents might be high is that the best land produces very valuable crops relative to the marginal land. As mentioned a couple of pages ago, five bushels of grain is a five-dollar rent at a dollar a bushel, but at two hundred thousand dollars a bushel, five bushels of grain is a million-dollar rent. If grain is expensive, it's only natural that the scarce meadows that produce it will also be expensive. 4 But there's another way to drive rent on meadows up, and it is not nearly so natural. Let's say landlords get together and manage to persuade the local sheriff that there should be what in England they call a "green belt," a broad area of land around the city on which property development is very strongly discouraged by tough planning regulations. The landlords claim that it would be a shame to cover beautiful wild land with farms, and so farming on the land should be made illegal. 5 The landlords stand to benefit hugely from such a ban, because it would drive up the rents on all legal land. Remember that rents on meadowland are set by the difference between the productivity of meadowland and the productivity of the marginal land. Ban farming on that marginal land, and the rent on meadows will jump; where once the alternative to paying rent and farming on meadows was to farm on grassland rent-free, now there is no alternative. Farmers are much more eager to farm on meadows now that farming on the grassland is illegal, and the rent they're willing to pay is much higher too. 6 So we've found two reasons why rents might be high. The first is that it's worth paying a lot for good land, because the grain that good land produces is so valuable. The second is that it's worth paying a lot for good land because the alternatives that should be available are not. 7 Those readers currently renting property in London may have furrowed brows at this point. London is surrounded by the original "Green Belt," created in the 1930s. Is that why property in London is so expensive to rent or buy - not because it's so much better than the alternative, but because the alternative has been made illegal? 8 It is a combination of both: it is certainly true that London is unique, and a better place to put plush apartments or office buildings than Siberia, Kansas City, or even Paris. Rents are high, in part, for that reason. But another reason why property in London is expensive is because of the Green Belt. One effect is to keep London from sprawling out across the surrounding region - which many people think is a good idea. The other effect is to transfer a massive amount of money from London tenants to London landlords: the Green Belt keeps rents and house prices in London much higher than they would be, in exactly the same way as a ban on grassland farming keeps rents on meadow and scrub much higher than they would otherwise be. 9 This is not an argument against the Green Belt. There are lots of benefits in having London's population capped at around six million people, instead of sixteen million or twenty-six million. But it is important that when we are weighing the pros and cons of legislation like the Green Belt, we understand that its effects are more than simply to preserve the environment. Office rents in London's West End are higher than in Manhattan or central Tokyo in fact, the West End is the most expensive place in the world to rent an office, and it also holds the world record for the most expensive home, at £70m (about 130 million dollars). The Green Belt has made property in London scarce relative to the people who want to use it, and of course, strength comes from scarcity. 10 Now it's time for your first economics test. Why would improvements in the quality and price of the commuter train services that bring people into New York's Penn Station from the surrounding suburbs please anyone who rents a property in Manhattan? And why might New York landlords be less enthusiastic about such improvements? 11 The answer is that improved public transportation increases the alternatives to renting a place in the city. When a two-hour commute becomes a one-hour commute, and people are able to get a seat on the train instead of standing, some decide they'd rather save money and move out of Manhattan. Vacant apartments then appear on the market. Scarcity lessens, and rents fall. Improving commuter services wouldn't just affect commuters; it would affect everyone involved in New York's property market. 12 __𝑨𝒓𝒆 𝒘𝒆 𝒃𝒆𝒊𝒏𝒈 𝒓𝒊𝒑𝒑𝒆𝒅 𝒐𝒇𝒇? One of the problems with being an undercover economist is that you start to see "green belts" of one kind or another all over the place. How can we tell the difference between things that are expensive because they are naturally scarce, and things that are expensive because of artificial means legislation, regulation, or foul play? 13 Ricardo's model can help here, too. We need to appreciate a hidden parallel between natural resources, like fields or busy locations, and companies. Fields are ways of turning stuff into different stuff: manure and seed into grain. Companies are the same. A car manufacturer turns steel, electricity, and other ingredients into cars. A gas station turns pumps, big tanks of fuel, and lands gasoline in your tank. A bank turns computers, advanced accounting systems, and cash into banking services. Without perpetuating too much intellectual violence, we can replace "rent" with "profit" throughout Ricardo's model. Rent is the return land-lords receive from their property; profit is the return company owners earn from their property. 14 Let's use banking as an example. Imagine that one bank is very good at producing banking services - it has a fantastic corporate culture, strong brand, and has developed the best specialized banking software. Good people work there and other good people join just to learn from them. All this adds up to what economist John Kay (who explicitly invokes Ricardo's model) calls a "sustainable competitive advantage," meaning the sort of edge over the competition that will produce profits year in and year out. 15 Let's call this uberbank Axel Banking Corporation. A second bank, Bob's Credit and Debt, is not quite so competent: the brand is less trusted, the corporate culture is so-so. It's not bad, but it's not great either. A third bank, Cornelius's Deposit Enterprises, is extremely inefficient: it has a terrible reputation, the tellers are rude to the customers, and control of expenses is nonexistent. Cornelius's bank is less efficient than Bob's outfit and grossly incompetent compared with Axel's Banking Corporation. All this should remind us of the three types of land: meadowland, which is very efficient at producing grain; scrub, which is less efficient; and grassland, which is even less efficient. 16 Axel's bank, Bob's bank, and Cornelius's bank compete to sell banking services by persuading people to open accounts or take out loans. But Axel's bank is so effective that it can either produce banking services more cheaply or produce better quality services for the same cost. At the end of each year, Axel's bank will earn large profits, and Bob's bank, which serves its customers with less ease, will make something rather more modest, and Cornelius's bank will just break even. If the banking market was tougher, Cornelius's bank would go out of business. If the banking market started to get more attractive, Cornelius's bank would start to make a profit, and a new bank, even less efficient than Cornelius's, would enter the business. The new bank would be the marginal bank, just breaking even. 16 Without repeating every step of the analysis, we can remind ourselves that the rent on meadowland was set by comparison with the productivity of meadows to that of the marginal grassland. In the same way, Axel's profits are set in comparison with Cornelius's bank, the marginal bank, which we know should expect to make little or no profits: company profits, like rents, are determined by the alternatives. A company with stiff competition will be less profitable than a company with incompetent rivals. 17 You are probably thinking of a flaw in the analogy: the acreage of meadows is fixed, but companies can grow. But that's only partly true; companies cannot grow overnight without diluting their reputation and the other capabilities that made them successful. On the other hand, while acreage cannot change, the distinctions between different types of land will shift over time as irrigation, pest control, or fertilizer technology develops. Ricardo's model, which ignores these changes over time, will explain trends in agricultural prices over decades but not over centuries, while it will explain corporate profitability over years, but not decades. As with many economic models, the analysis will work well for a certain time scale - in this case, the short and medium term. For other time scales, different models are needed. 18 This is all very well... but what does it have to do with corporate profiteering? The newspapers often point to high corporate profits as a sign that the consumer is being screwed. Are they right? Only sometimes. Ricardo's analysis suggests that there are two reasons why average profits of an industry like banking might be high. If customers really value great service and reputation, both Axel and Bob will make a lot of money (Cornelius's bank is the marginal bank and can expect very little). Newspaper hacks will be able to complain about excessive profits. If customers place only a small value on great service, Axel and Bob will be only moderately more profitable than Cornelius (still the marginal bank, still making very little), and average profits should be low. The commentators will be silent. But the motives and strategies used by the industry haven't changed the only thing that changed was that customers put a premium on great service. Nobody is ripping anybody off; instead, Axel and Bob are being rewarded because they are offering something both scarce and highly valued. 19 But high profits are not always earned so fairly; sometimes the newspaper outrage is justified. There's a second explanation for high corporate profits. What if a kind of banking "green belt" completely excluded Cornelius's bank from the market? In the real world there are lots of reasons why potential new companies cannot enter a market and compete. At times the consumers have only themselves to blame: new firms struggle to enter the market because customers will deal only with established companies. John Kay shows that certain "embarrassing" products, including condoms and tampons, are highly profitable because new entrants find it hard to create a buzz about their products. More frequently, the firms themselves lobby their governments asking to be protected from competition, and many governments around the world grant monopoly licenses, or are highly restrictive of entry into "sensitive" industries like banking, farming, or telecommunications. Whatever the reason, the effect is the same: established companies, free of competition, enjoy high profits. In fact, because of the similarity between the rents that can be charged on land with few substitutes and the profits enjoyed by a firm with few competitors, economists often call those profits "monopoly rents." It may be a confusing term, but you can blame David Ricardo's model and the lack of imagination shown by economists ever since. 20 If I want to know whether I am being ripped off by supermarkets, banks, or drug companies, I can find out how profitable those industries are. If they are making high profits, then initially I am suspicious. But if it seems that it is fairly easy to set up a new company and compete, I become less suspicious. It means that the high profits are caused by a natural scarcity: there are not many really good banking organizations in the world, and good banking organizations are much more efficient than bad ones. (32)

1 𝙍𝙚𝙨𝙤𝙪𝙧𝙘𝙚 "𝙧𝙚𝙣𝙩𝙨" Landlords and executives are not the only people who like to avoid competition and who like to enjoy monopoly rents. Trade unions, lobby groups, people studying for a professional qualification, and even national governments like them too. Every day people all around us are trying to avoid competition or reap the rewards of others who have succeeded in doing so. Economists call this type of behavior "creating rents" and "rent-seeking." 2 It's not easy to do this. It turns out that the world is a naturally competitive place, and it is no simple matter to steer clear of competition. This is fortunate, because although competition is uncomfortable if you are on the wrong end of it, it is pleasant to be on the right end, as the customer. We all benefit when we are interacting with people who are competing to offer us jobs, newspapers, or vacations in the sun, just as our mythical landlords benefited from competition between Bob and Axel. 3 One way of preventing competition is by controlling a natural resource such as farmland. There is only so much good farmland in the world, and only revolutions in agricultural techniques can change that. But farmland is not the only finite natural resource in the world. Another example is oil. Some parts of the world can produce oil cheaply, most notably Saudi Arabia, Kuwait, Iraq, and other Gulf states. Other parts of the world can produce oil more expensively - Alaska, Nigeria, Siberia, and Alberta. And there are many parts of the world that have oil that is so expensive to extract that nobody is even thinking of doing so. At the moment, places like Alberta produce the marginal oil. 4 The history of the oil industry is a case study in Ricardo's theory of rents. Until 1973, the world's oil supply was produced by "oil meadows," largely in the Middle East. Despite the incredible value of oil to the industrialized economies, the price of oil was very low - less than ten dollars a barrel in today's money, because there was plenty of it available at very low costs. The Organization of the Petroleum Exporting Countries, OPEC, which was sitting on most of the oil meadows, decided in 1973 to take some of its own meadows out of commission, by ordering each member country to restrict oil production. Oil prices leapt to forty dollars a barrel, and then to eighty dollars, in today's money. They stayed high for years, because in the short run there were few alternative sources of oil. (The equivalent in Ricardo's world would have been to abruptly halt the cultivation of meadowland, leaving a delay before grassland could be cleared and plowed, thereby causing a temporary grain shortage, raising rents.) 5 At eighty dollars a barrel, plenty of alternatives looked cheap and were adopted over the years: producing electricity using coal instead of oil; building cars that got better gas mileage; and exploring for oil in places like Alberta and Alaska. More and more "energy scrubland" and "energy grassland" were being cultivated. To keep prices high, OPEC was forced to accept a smaller and smaller share of the world oil market. Eventually, Saudi Arabia broke ranks in 1985 and expanded production. Prices collapsed in 1986, and until just a couple of years ago the price of oil has roughly tracked the cost of production from marginal fields in places like Alberta - around fifteen to twenty dollars a barrel. In the last couple of years we have been tripped up by a combination of unexpectedly high demand in China with disruptions in Saudi Arabia, Iraq, Nigeria, and Venezuela, all of which have caused oil prices to rise to more than fifty dollars a barrel. Yet even at the lower prices prevailing in the 1990s, the oil produced from the cheapest fields in Saudi Arabia and Kuwait, at a cost of a couple of dollars a barrel, was almost pure profit. 6 __𝙒𝙝𝙚𝙣 𝙙𝙤𝙚𝙨 𝙘𝙧𝙞𝙢𝙚 𝙥𝙖𝙮? A lot of the world's economy isn't closely linked to limited natural resources. That means that people have to find other ways to prevent competition. One popular method is through violence, which is particularly popular in the drug trade and other organized crime. Drug dealers prefer not to have competitors driving down the price of drugs. Conceivably, by shooting or beating up enough people, a criminal gang could discourage rival gangs from entering the market and thus enjoy large profits. This is illegal, of course, but so is dealing in drugs; if you're risking prison anyway, there is little point in using half-measures. If drug dealers want to enjoy strength from scarcity, they have to go to some lengths to make the competition scarce. Meanwhile, their customers are hardly likely to complain to the police about being ripped off. 7 Unfortunately for your average drug gang, even violence may not be enough to earn profits. The difficulty is that guns and aggressive young men are both in plentiful supply. Any gang making good money is tempting other gangs to muscle in on its territory and there will be plenty of contenders. Economist Steven Levitt and sociologist Sudhir Venkatesh managed to get hold of the accounts of one American street gang. It turns out that the "foot-soldiers" sometimes take home as little as $1.70 an hour. Promotion prospects are good, considering the rapid turnover of gang membership (people leave, or get killed, quite often); but even considering these prospects, the average wage is less than ten dollars an hour. This is not much given that over four years, the typical gang member can expect to be shot twice, arrested six times, and has a one-in-four chance of being killed. 8 Some criminal enterprises are more successful. Mafia groups often get involved in legitimate businesses, such as wholesale laundry, which can make big profits only if entry is deterred. One way to deter entry is to threaten rivals. This is fairly easy, since laundry trucks and laundries themselves are much easier to find and damage than a bag of cocaine. It's even easier to threaten customers. Fans of The Sopranos know that the Mafia provides overpriced laundry services to restaurants as a way of extorting money. The reasons are clear enough: restaurants are particularly vulnerable to extortion because it doesn't take much disruption to put off customers, while collecting the extorted cash by providing an expensive service makes the protection money tax deductible. Profitable businesses usually attract competition, but in this case the competition reckons that there must be a safer way to make a living. 9 This suggests that it isn't violence as such that creates barriers to entry and sustainable profits - it's the effectiveness of an organization. Axel's bank had it and Cornelius's didn't; the typical street gang lacks it, the Mafia seems to have it in spades. 10 __"𝘾𝙤𝙣𝙨𝙥𝙞𝙧𝙖𝙘𝙞𝙚𝙨 𝙖𝙜𝙖𝙞𝙣𝙨𝙩 𝙩𝙝𝙚 𝙡𝙖𝙞𝙩𝙮" Luckily, in genteel corners of the developed world we are usually sheltered from people who use violence to keep out competition. But it does not mean that people have not worked out other ways to keep competitors at bay. Trade unions are an obvious example. The purpose of a union is to prevent workers from competing with each other for jobs, driving down wages and conditions. If there is a lot of demand for electricians and few people who can do the job, then the electricians have strength from scarcity and should have excellent pay and conditions, with or without a union. If more and more electricians set up shop, this strength is sapped. The new electricians play the role of Bob the farmer. The trade union is designed partly to bargain collectively, but partly to block too much entry into the profession. 11 As mass mechanization spread in the nineteenth century, the incentive to unionize was considerable. Workers were a plentiful commodity: all gathered together in urban concentrations, easily substitutable for each other. Without unionization, wages could be kept very low. With it, competition could be excluded and wages would rise for the lucky ones inside the union. In the United States, trade unions were kept at bay by the law: antitrust laws designed to prevent collusion between large companies were also directed against unions. But as the political climate changed, these laws were ruled inapplicable and trade unions grew in strength. 12 If trade unions were especially successful, then we might expect unionized industries to enjoy enormous salaries, and there have been times and places such as the American auto industry in the 1960s and 1970s - when this has been true. But trade unions face several obstacles to this kind of success. When unions are perceived as making unreasonable demands, causing prices to rise to a level that's deemed unacceptable by a large portion of the public, the public in turn puts pressure on politicians to regulate the unions. Sometimes the unions have their scarcity challenged by international competition, as in the case of American auto workers, who enjoyed excellent wages and job security until the Japanese car industry used more efficient methods and started putting American manufacturers under pressure. 13 In the case of shrinking industries like the British shipwrights or the car industry in the United States, available jobs are disappearing at such a rate that trade unions have great trouble maintaining their scarcity value; the union can never threaten to cut off the supply of workers fast enough to keep pace with a vanishing demand. In other industries, it is not shrinking demand but powerful employers that curtail the power of the unions. In the United States, WalMart has tremendous bargaining power: there were only two unionized WalMarts in North America in the spring of 2004, when WalMart announced that one of them, a branch in Quebec, would be closed because the union was damaging its business model. In the United Kingdom, teachers' wages are low in spite of the fact that there is a shortage of qualified teachers. This is because the government, the single employer, has massive bargaining power. Ordinarily, when there is a shortage of workers, competition between employers would bid up wages. Only a monopoly employer could possibly maintain a situation where there is a serious shortfall of teachers but salaries do not rise to respond. The teachers have some strength from scarcity, but in this case the government has more. 14 Other professionals, like doctors, actuaries, accountants, and lawyers manage to maintain high wages through other means than unionization, erecting virtual "green belts" to make it hard for potential competitors to set up shop. Typical virtual green belts will include very long qualification periods and professional bodies that give their approval only to a certain number of candidates per year. Many of the organizations that are put forth to protect us from "unqualified" professionals in fact serve to maintain the high rates of the "qualified" to whom we are directed. In fact, many of us, informally, are happy to seek legal advice from experienced professionals who lack the formal qualification - even medical advice from medical students, foreign doctors, or alternative therapists. But the legal and medical professions do their best to limit the supply of fully qualified professionals and outlaw any low-cost substitutes: if you can't afford the rent on meadow, the scrub and the grassland are forbidden. Small wonder that George Bernard Shaw said that the professions were "all conspiracies against the laity." 15 __𝘼𝙣𝙙 𝙣𝙤𝙬 𝙛𝙤𝙧 𝙨𝙤𝙢𝙚𝙩𝙝𝙞𝙣𝙜 𝙘𝙤𝙣𝙩𝙧𝙤𝙫𝙚𝙧𝙨𝙞𝙖𝙡 Immigration has always been an emotive issue for America, and although national security has recently become a concern, the debate continues to revolve around an old question: do immi-grants steal our jobs? They may steal your job, but they certainly haven't stolen mine. 16 Well-educated workers with jobs requiring skill and training, along with businessmen in need of cheap labor, tend to welcome immigration as part of an enriching process, which adds to each nation's economic and cultural life, while poorly educated workers tend to reject any further immigration by unskilled immigrants on the grounds that "they steal our jobs." Perhaps that's too much of a caricature, but it makes sense from a self-interested viewpoint. 17 As one of those skilled workers I dislike resistance to immigrants and would like to see more immigration. But then, I would, wouldn't I? If you need skilled and unskilled labor together to get useful work done, then it is in my direct interests to see more unskilled workers come to the country, and directly against the interests of the unskilled workers who are already here. 18 Imagine me and my fellow well-educated citizens as landowners, but instead of "meadow" read "degree." My skills and qualifications are a resource, just as a meadow is a resource. But are my skills a scarce resource? Imagine that I go to work for Wal-Mart's management team. When my skills (let's not be too specific about what they are supposed to be) are combined with the hard work of store assistants and shelf-stackers, we're a productive team. Who gets to enjoy the proceeds depends on whose abilities are scarce. If the country is short of unskilled shelf-stackers, their wages will have to rise to attract people into the job. But if the country is short of skilled managers and full of unskilled shelf-stackers, I'll be paid well for my scarcity value, just as landlords were paid well for scarce land once enough farmers showed up. 19 Some blame working-class resistance to immigration on racism. An alternative, and more convincing, theory suggests that everybody is acting in his own self interest. New workers are good for people who have assets that become relatively scarcer, whether those assets are meadows or degrees; but it is understandable if new workers are loathed by established ones. In fact, the people who are most harmed by new immigration are the previous group of immigrants, who find their wages nailed to the floor. 20 The facts support the application of Ricardo's theory to immigration. Skilled immigrants lower the wages of skilled natives, and unskilled immigrants lower the wages of unskilled natives. In the UK, the salaries of nurses in the National Health Service have been kept low by the influx of thirty thousand foreign nurses; immigrants in the UK are nearly 50 percent more likely than natives to have a university degree. In contrast, in the United States, which takes in a far higher percentage of low-skilled immigrants than the UK does, it is unskilled wages that have stayed low: the income of unskilled workers has not im-proved in thirty years.

1 __𝙒𝙝𝙖𝙩 𝙨𝙝𝙤𝙪𝙡𝙙 𝙚𝙘𝙤𝙣𝙤𝙢𝙞𝙨𝙩𝙨 𝙙𝙤? We've been thinking like economists throughout this chapter. But what does that mean? We've used one major economic model to deepen our understanding of a variety of situations. The chapter has moved from some objective-sounding analysis of who makes money from the cappuccino business to the dangerous political territory of planning restrictions and immigration. 2 Some economists would claim that there is no difference between their analysis of coffee rents and their analysis of immigration. In an important sense, that's true. Economics is in many ways just like engineering; it will tell you how things work and what is likely to happen if you change them. The economist can show that allowing lots of skilled immigrants will help control the gap between skilled and unskilled wages, while allowing unskilled immigrants will do the reverse. What societies and their leaders do with the information is another matter. 3 Yet the fact that economics itself is a tool for objective analysis doesn't mean that economists are always objective. Economists study power, poverty, growth, and development. It is hard to wield the models that underlie such subjects and remain unmoved by the real world behind them. 4 So economists often step beyond their role as engineers of economic policy and become advocates. David Ricardo, for example, was an early campaigner for free trade. He was encouraged by his friend, James Mill, to run for parliament; he won a seat in 1819 when he campaigned for repeal of the Corn Laws, which severely restricted the import of grain. Ricardo's theories had demonstrated clearly that the Corn Laws were shoveling money into the pockets of landlords at the expense of everyone else in the country. Ricardo was not content simply to observe the effects of the Corn Laws, he wanted to abolish them. 5 Economists come to similar conclusions today about protectionist laws, which, as we will see in chapter 9, protect privileged pressure groups at the expense of the rest of us in the developed world and the developing world alike. Billions of people could benefit from better economic policies. Millions are dying because of bad ones. Sometimes the logic of economics is so compelling that it's impossible for economists not to take a stand. 6 🆃🆆🅾 ƜӇƛƬ ƧƲƤЄƦMƛƦƘЄƬƧ ƊƠƝ'Ƭ ƜƛƝƬ ƳƠƲ ƬƠ ƘƝƠƜ Those of you who have visited London recently have probably been to the London Eye, the capital's landmark Ferris wheel. On a sunny day you can purchase a cappuccino from Costa Coffee and sit and sip as the capsules on the wheel rotate high above, occasionally passing between you and the sun. . .one of life's simple pleasures. 7 Everywhere you look around the Eye you can see vendors with scarce resources, trying to exploit that scarcity. Costa Coffee is the only coffee bar in the immediate area, for instance. There is also a lone souvenir shop doing brisk business. But the most obvious example is the London Eye itself. It towers over most of London's most famous buildings and is the world's largest observation wheel. The scarcity power is clearly considerable, but it is not unlimited: the London Eye may be unique, but it is also optional. People can always choose not to go. Farther along the river, the Millennium Dome (a colossal government-funded white elephant designed for millennial celebrations) is similarly unique: "the largest fabric structure in the world," boasts the local authority. Yet the Dome has proved a commercial disaster because uniqueness alone wasn't enough to persuade people to pay enough to cover the vast costs of its construction. Businesses with scarcity power cannot force us to pay unlimited prices for their products, but they can choose from a variety of strategies to make us pay more. It's time for the Undercover Economist to get to work and find out more. 8 As the only coffee provider beside the London Eye, the Costa coffee bar wields plenty of scarcity power over the customer. It's not innate to Costa but is reflected glory from the amazing setting. As we know, because customers will pay high prices for coffee in attractive locations, Costa's rent will be high. Costa's landlords have rented out some of this scarcity value to a coffee bar, just like the owners of Manhattan's skyscrapers, or train stations from Water-loo to Shinjuku. Scarcity is for rent at the right price. 9 But how should Costa exploit the scarcity they are renting from the London Eye? They could simply raise the price of a cappuccino from £1.75 (about $3) to £3 (nearly $6). Some people would pay it, but many would not. Remember the Millennium Dome: scarcity gives you power, but not limitless power. Alternatively, they could cut prices and sell much more coffee. They could cover wages and ingredients by charging as little as 60 pence ($1) a cup. But unless they were able to increase their sales dozens of times over, they'd not make enough to cover their rent. That's the dilemma: higher margins per cup, but fewer cups; or lower margins on more cups. 10 It would be nice for Costa to sidestep that dilemma, by charging 60p to people who are not willing to pay more and £3 to people who are willing to pay a lot to enjoy the coffee and the view. That way they would have the high margins whenever they could get them and still sell coffee at a small profit to the skin-flints. How to do it, though? Have a price list saying the, "Cappuccino, £3, unless you're only willing to pay 60p"? Cappuccino for the lavish - £3.00 Cappuccino for the thrifty - 60p It does have a certain something, but I doubt it would catch on with the coffee-buying public of London's South Bank. So Costa has to be more subtle. 11 For a while, Costa hit upon an elegant strategy: Costa, like most other coffee bars these days, offers "Fair Trade" coffee; theirs comes from a leading fair trade brand called Cafédirect. Cafédirect promises to offer good prices to coffee farmers in poor countries. For several years, customers who wished to support third-world farmers and such customers are apparently not uncommon in London - were charged an extra ten pence (about eighteen cents). They may have believed that the ten pence went to the struggling coffee farmer. The evidence suggested that almost none of that money went anywhere but Costa's bottom line. 12 Cafédirect paid farmers a premium of between 40 and 55 pence (up to a dollar) per pound of coffee. That relatively small premium can nearly double the income of a farmer in Guatemala, where the average income is less than $2,000 a year. But since the typical cappuccino is made with a quarter-ounce of coffee beans, the premium paid to the farmer should translate into a cost increase of less than a penny a cup. Of the extra money that Costa charged, more than 90 percent was going missing between the customer and the farmer. So either Costa and Cafedirect were wasting the money (through higher costs) or it was being added to profits. Fair trade coffee associations make a promise to the producer, not the consumer. 13 If you buy fair trade coffee, you are guaranteed that the producer will receive a good price. But there is no guarantee that you will receive a good price. The truth is that fair trade coffee wholesalers could pay two, three, or sometimes four times the market price for coffee in the developing world without adding anything noticeable to the production cost of a cappuccino, because coffee beans make up such a small proportion of that cost. Charging an extra ten pence gave a misleading impression of how much it really cost to get hold of that fair trade coffee. After some inquiries by a certain Undercover Economist, Costa worked out that the whole business gave the wrong impression, and at the end of 2004 began to offer fair trade coffee on request, without a price premium. Costa abandoned the premium of fair trade coffee because it was bad public relations, not because it was unprofitable. 14 But why was it profitable to charge a higher markup on the cost of production on fair trade coffee than on normal coffee? Certainly not because Costa objected to the whole idea of fair trade and tried to discourage such idealistic behavior with their pricing. The reason has nothing to do with fair trade at all: it's because fair trade coffee allowed Costa to find customers who are willing to pay a bit more if given a reason to do so. By ordering a fair trade cappuccino, you sent two messages to Costa. One message interested them very little: "I think that fair trade coffee is a product that should be supported." 15 The second message is the one that they were straining to hear: "I don't really mind paying a bit extra." This immediately gave Costa the information they were look-ing for. They know that socially concerned citizens tend to be less careful with their cash in coffee bars, while unconcerned citizens tend to keep their eyes on the price. Cappuccino for the concerned £1.85 Cappuccino for the unconcerned £1.75 16 Costa's strategy was designed to get maximum value out of the scarcity power they've rented from the London Eye. They are torn between raising prices and losing customers, or lowering prices and losing margins. If they have to charge the same price to every customer, they will simply have to guess the best trade-off between the two options. But if they can charge a high price to the lavish (or concerned) and a low price to the thrifty (or unconcerned), then they can enjoy the best of both worlds. And there is no need to worry on Costa's behalf that this strategy has now been denied to them. Costa has plenty of alternative ways to identify customers for a price increase. Nor is there anything unusually Machiavellian about Costa Coffee. Any well-run business would seek to charge each customer the maximum price he'd be willing to pay and - they do. 17 Starbucks isn't merely seeking to offer a variety of alternatives to customers. It's also trying to give the customer every opportunity to signal that they've not been looking at the price. It doesn't cost much more to make a larger cup, to use a flavored syrup, or to add chocolate powder or a squirt of whipped cream. Every single product on the menu above costs Starbucks almost the same to produce, down to the odd nickel or two. 18 Does this mean that Starbucks is overcharging all of its customers? No. If so, a regular cappuccino or hot chocolate would cost $3.30, and you could have all the frills you wanted for a dime. Perhaps Starbucks would like to do that, but they can't force price-sensitive customers to pay those prices. By charging wildly different prices for products that have largely the same cost, Starbucks is able to smoke out customers who are less sensitive about the price. Starbucks doesn't have a way to identify lavish customers perfectly, so it invites them to hang themselves with a choice of luxurious ropes. (46)

1 __𝐓𝐡𝐞𝐫𝐞'𝐬 𝐨𝐧𝐞 𝐛𝐨𝐫𝐧 𝐞𝐯𝐞𝐫𝐲 𝐦𝐢𝐧𝐮𝐭𝐞: 𝐓𝐰𝐨 𝐰𝐚𝐲𝐬 𝐭𝐨 𝐟𝐢𝐧𝐝 𝐡𝐢𝐦 There are three common strategies for finding customers who are cavalier about price. Let's cover two for now, and leave the best for last. The first is what economists call "first-degree price discrimination," but we could call it the "unique target" strategy: to evaluate each customer as an individual and charge according to how much he or she is willing to pay. This is the strategy of the used-car salesman or the real estate agent. It usually takes skill and a lot of effort; hardly surprising, then, that it is most often seen for items that have a high value relative to the retailer's time-cars and houses, of course, but also souvenirs in African street stalls, where the impoverished merchant will find it worth bargaining for some time to gain an extra dollar. 2 Now, however, companies are trying to automate the process of evaluating individual customers to reduce the time it takes. For instance, supermarkets accumulate evidence of what you're willing to pay by giving you "discount cards," which are needed to take advantage of sale prices. In return for getting a lower price on certain items, you allow the stores to keep records of what you buy, and then in turn offer you coupons for discounts on products. It doesn't work perfectly, because supermarkets can only send "money off" coupons, not "money on" coupons. "Money on" coupons have never been a success. 3 When technology allows, firms with scarcity power may use highly sophisticated methods to target customers. It's no secret anymore that Internet retailers such as Amazon can identify each customer by putting a tracking device called a "cookie" on her computer. Amazon used to tailor their prices based on their records of individual customers. The company really was able to offer "money on" vouchers: two readers buying exactly the same book would be offered a different price based on tendencies shown in previous purchases. Even though it would be more difficult than for online sales, supermarkets could, with the right technology do the same thing - each customer could have an identity tag, and price labels would change according to who was looking at them. 4 Of course, the "unique target" approach is unpopular. In Amazon's case, customers started to realize that if they deleted the cookies on their computers, they were offered different, often lower prices. And when they found out what the company was doing, there was an outcry. Like Costa, Amazon has promised not to do it anymore. 5 Interestingly, people tend not to object nearly so much to the second approach, the "group target" strategy, which is to offer different prices to members of distinct groups. Who could complain about reduced bus fares for children and the elderly? Surely it must be reasonable for coffee shops to offer a discount to people who work nearby, and for tourist attractions to let locals in for a lower rate? It often seems reasonable because people in groups who pay more are usually people who can afford more, and that's because people who can afford more are usually people who care less about price. But we shouldn't forget that this is a convenient coincidence. Companies trying to increase their profits and get the maximum value out of their scarcity are interested in who is willing to pay more, rather than who can afford to pay more. 6 For instance, when Disney World in Florida offers admission discounts of over 50 percent to locals, they're not making a statement about the grinding poverty of the Sunshine State. They simply know that for a reduced price, locals are more likely to come regularly. But tourists will probably come once, and once only, whether it is cheap or expensive. This example gets to the heart of things and tells us what we really mean by "price sensitivity" or "being lavish" or "being cavalier about prices." The important concept is this: when I raise the price, how much do my sales fall? And when I cut the price, how much do my sales rise? Economists tend to call this "own-price elasticity." Personally, I think "price sensitivity" is a bit more descriptive. 7 Tourists visiting Florida are less price-sensitive than locals, which means that if Disney World raises its prices, locals are more likely to skip a day at the park. By the same token, if the admission price falls, locals may make repeat visits in a way that tourists probably won't. Being rich is sometimes connected with being insensitive to prices, but not always. Business-class air travel is expensive, because companies are willing to pay, and airlines have the scarcity power to take advantage of that fact. Business telephone calls are inexpensive because although companies would be willing to pay, there is too much competition around for any phone company to force them to. 8 The same is true of discounts at coffee bars for local workers. The AMT coffee bar in Waterloo station in London will knock 10 percent off the cost of your coffee if you work locally. This isn't because the local workers are poor; they include top government officials and the extravagantly remunerated employees of the gigantic oil company Shell. The discount reflects the fact that local workers are price-sensitive despite being rich. Commuters who pass through Waterloo in a hurry see only one or two coffee bars and are willing to pay high prices for convenience. Local workers pop out of the office at 11 am for coffee and could walk in any direction. They can buy from several cafes, all equally convenient, all of which they will have had a chance to sample. They are bound to be more price-sensitive, even if they are rich. 9 The "individual target" strategy is difficult, partly because it requires a lot of information and partly because it tends to be very unpopular. Despite the difficulties, however, it's so profitable that companies always explore new ways to do it. The "group target" strategy of discounts for students or locals is less effective but easier to put into action, and it's usually socially acceptable, even welcomed. Either will deliver more profits than simply treating all customers as a homogenous mass. 10 __𝑻𝒉𝒆 𝒕𝒉𝒊𝒓𝒅 𝒘𝒂𝒚: 𝑻𝒖𝒓𝒌𝒆𝒚𝒔 𝒗𝒐𝒕𝒊𝒏𝒈 𝒇𝒐𝒓 𝑻𝒉𝒂𝒏𝒌𝒔𝒈𝒊𝒗𝒊𝒏𝒈 The cleverest and most common way to persuade turkeys to vote for Thanksgiving is the "self-incrimination" strategy - the one Costa Coffee and Starbucks both use when they persuade some of their customers into confessing that they are not sensitive to price. To get customers to give themselves away, the company has to sell products that are at least slightly different from each other. So they offer products in different quantities (a large cappuccino instead of a small one, or an offer of three for the price of two), or with different features (with whipped cream, or white chocolate, or fair trade ingredients), or even in different locations, because a sandwich in a station kiosk is not the same product as a physically identical sandwich in an out-of-town superstore. 11 It's reasonable to ask how common this tactic really is. Because the products are different, you never quite know whether the firm is using a price-targeting trick or merely passing on added costs. It could be that it really does cost 10p (about 20¢) more to put fair trade coffee in a cappuccino; maybe cans of whipped cream are expensive to refrigerate and troublesome to clean and the staff hates using them; perhaps large cups of coffee take longer to drink, and so the charge is for table space not coffee - in which case, charging a higher price is not a strategy to get me to incriminate myself but simply Costa passing its costs through to me. But I think it's safe to say that companies are always alert for ways to squeeze the maximum advantage out of whatever scarcity power they have, and price-targeting is the most common way to do that. If it looks like price-targeting, it probably is. 12 Although use of this strategy is hard to prove, there's plenty of circumstantial evidence around if you know where to look. For instance, the premium you pay for a large cappuccino instead of a small one is the same whether you drink it in the café or take it away. (Except for my favorite coffee shop, the Monmouth in Covent Garden, in London. They are short of space, and will charge a markup for a large cappuccino if you drink it in the shop. However, they charge less for take-out coffee, and it comes in only one size. I have decided they are far too nice to try to make profits.) That doesn't make sense if it's a charge for taking up space. So we have good reasons to believe that coffee bars try for a "self-targeting" strategy, charging high prices to customers who demonstrate a willingness to pay them. 13 __𝐂𝐨𝐟𝐟𝐞𝐞 𝐛𝐚𝐫𝐬 𝐚𝐫𝐞 𝐧𝐨𝐭 𝐚𝐥𝐨𝐧𝐞 Supermarkets have turned price-targeting into an art, developing a vast array of strategies toward that end. Above the main concourse of London's Liverpool Street station, there's a Marks and Spencer "Simply Food" store, catering to busy commuters on the way in and out of London. We know all about the scarcity value of train stations by now, so perhaps it shouldn't surprise us to find that this store isn't cheap, even compared with another branch of Marks and Spencer merely fifteen hundred feet or so away, on Moorgate. "ᴴᵒʷ ᶠᵃʳ ʷᵒᵘˡᵈ ʸᵒᵘ ʷᵃˡᵏ ᵗᵒ ˢᵃᵛᵉ ³⁰ᵖ?" 14 Other supermarkets are more circumspect about their pricing policy. Going undercover once again, I made a comparison between the smallish Sainsbury's supermarket on Tottenham Court Road in the heart of London's West End, and the large store in Dalston, one of East London's less prosperous neighborhoods. It was harder to find examples of identical products selling for different prices, although by no means impossible. Does this mean that Sainsbury's doesn't price-target as much as M&S? Not at all. They simply go about the whole process with more finesse. 15 When researching Sainsbury's, my approach was the same as with M&S: walk into the shop and see what caught my eye. As you probably know, what catches our eyes as we walk into the supermarket is no coincidence; it's the result of careful planning designed to throw attractive but profitable products in the path of customers. What constitutes an attractive product depends on who those customers are. On Tottenham Court Road the obvious goods were all quite expensive: Tropicana orange juice at £1.95 ($3.66) a liter, Tropicana "Smoothies" at £1.99 ($3.50) for 100ml, 750ml of Vittel mineral water at 80p ($1.50), and so on. It wasn't that these zproducts were more expensive in Tottenham Court Road than in Dalston (only the Vittel was), it was just that in Dalston, cheaper substitutes sprang into view far more readily. 16 For instance, I couldn't find inexpensive orange juice in the Tottenham Court Road store, but in Dalston, Sainsbury's own brand of fresh chilled juice was sitting next to the Tropicana at about half the price, and the concentrated juice was almost six times cheaper than the Tropicana. Brand-name pasta was the same price in both shops, but only in Dalston was it sitting next to Sainsbury's pasta, which again was almost six times cheaper. The effect was to target the whole Tottenham Court Road store at shoppers who are indifferent to prices but to aim the Dalston stores at shoppers with a sharper eye for a bargain - while of course giving any price-blind Dalston shoppers plenty of opportunity to show their true colors. 17 __𝙋𝙧𝙞𝙘𝙚-𝙜𝙤𝙪𝙜𝙞𝙣𝙜 𝙩𝙝𝙚 𝙣𝙖𝙩𝙪𝙧𝙖𝙡 𝙬𝙖𝙮 The best price-targeters pair their efforts to improve profits with apparently virtuous behavior. We've seen how Costa Coffee trumpeted its commitment to fair trade while using it to identify customers with money to burn. It's also good business to offer discounts to the elderly and to students (translation: charge higher prices to people likely to have jobs). Who but a cynic or an economist could object to such commendable behavior? 18 The favored game at the moment has to be price-gouging the natural way, riding the bandwagon of organic food. Organic food is catching on for a variety of reasons, including the fact that in the wake of repeated food health scares, many people think organic food is better for them, or at least won't kill them. The supermarkets have come to the rescue with a plentiful supply of organic products that happen to be marked up far above their additional costs to the supermarket. In British supermarkets, these are often stacked together, apparently for the convenience of the organic shopper but also to the advantage of the supermarkets who thereby reduce the risk that organic shoppers will notice the price of the typical alternative. In Washington DC's Whole Foods store, just across the street from Starbucks, the vast and luxurious fruit and vegetable section contains both organic and conventionally grown produce side by side but always side by side with a completely different product. The organic bananas are next to the "conventional" (that is, nonorganic) apples; the organic garlic is next to the conventional onions. You will never find the organic bananas next to the conventional bananas, or the organic garlic next to the conventional garlic. The price comparison would be too sobering. 19 But is expensive organic food really part of a price-targeting tactic? Organic food should be more expensive: it costs more to produce and, with a shorter shelf life, it is also more expensive to distribute than the standard product. But as with your cappuccino, raw ingredients are only a small part of the price of most food on the supermarket shelves. For example, in the UK, organic milk commands a premium of around fifty cents per quart, but the farmer sees less than twenty cents of this. We should not be surprised that supermarkets are taking the opportunity afforded by the organic food movement to zap customers with well-aimed price increases. My recommendation, if you are convinced of the merits of organic food, is not to let food retailers exploit your enthusiasm: vote with your wallet by supporting any retailer or direct supplier - who brings the price of organic and nonorganic food closer together.

1 __𝘽𝙖𝙧𝙜𝙖𝙞𝙣 𝙨𝙝𝙤𝙥𝙥𝙞𝙣𝙜 𝙖𝙣𝙙 𝙗𝙖𝙧𝙜𝙖𝙞𝙣 𝙨𝙩𝙤𝙧𝙚𝙨 Whenever I mention to people that I live near the Whole foods supermarket in central Washington DC, they comment on how wonderful the store is: Whole foods prides itself on being "The World's Leading Natural and Organic Food Supermarket," touts its community involvement, and offers a jungle of fresh fruit and vegetables alongside hormone-free steaks, European cheeses and beers, and luxury chocolates. It's a fun place to shop and offers great food. But my acquaintances also complain about how expensive Whole foods is. But... is it really expensive? 2 That depends on what you mean by expensive. Presumably, people have some price comparison in mind. A fair one would be to compare prices in Wholefoods with prices in Safeway just five blocks away, a store known to the locals as "Soviet Safeway" because of the small range of products and the harsh decor. Compare the price of the typical Whole foods shopper's basket of goods, and nine times out of ten it will indeed be more expensive than the typical Safeway shopper's basket of goods. But that says more about the shoppers than the stores. As a matter of verifiable fact, when you compare the prices on the same goods, Whole Foods is just as inexpensive as Safeway. 3 Safeway and Wholefoods charge exactly the same for bananas. Exactly the same for a carton of cherry or grape tomatoes. Ad-mittedly, Safeway's prices on yellow onions, Irish butter, and Cheerios are lower. But Wholefoods charges less for mineral water, Tropicana Premium orange juice, and sweet onions. The simple truth is that if you bought a big basket of the same goods from Safeway and from Wholefoods, the price tag would probably come out within a dollar or two - and it would be just as likely that Wholefoods was cheaper. 4 That doesn't quite fit with our commonsense belief that some places are cheap and some places are expensive. But that belief never made much sense. After all, if some places really did predictably charge more for the same product with similar service in a similar location, that would imply that all of their customers were just idiots. Wholefoods is more fun to shop in, but when push comes to shove, it's still just a supermarket, and you wander around filling your own cart just as in Safeway. 5 Wholefoods is not expensive in the sense that it charges more for the same goods. It is expensive because of where its price-targeting policies are focused: prices for the basics may be competitive, but the selection in Wholefoods is aimed at customers with a different view of what "basics" are. For example: Safeway charges more for Tropicana orange juice and for Poland Spring sparkling mineral water than Wholefoods does. For Wholefoods customers Tropicana juice and sparkling water are the basics, and so they need to be priced competitively, while Safeway customers might well consider that tap water and concentrated orange juice were perfectly acceptable alternatives. A Safeway customer who buys sparkling water and fresh Tropicana juice is signaling a taste for luxury. A Wholefoods customer may pass by the cheaper option of Tropicana in favor of a more expensive Smoothie made of fresh-squeezed juice at the in-house juice bar. 6 The basic yellow and sweet onions are priced similarly at both stores. But at Wholefoods, customers have the option to pick fancy varieties: pearl onions, red onions, and even organic onions, at a hefty markup. The Wholefoods shopper who is looking for decently priced products will find them. The Wholefoods shopper who grabs a bag of the first onions he sees will pay dearly for his lack of price-curiosity. 7 That is why a basket of goods from Wholefoods can cost so much more than a basket of goods from Safeway. It's not because Wholefoods is "expensive" and Wholefoods customers are stupid. It's because Wholefoods offers additional, expensive choices, which Wholefoods shoppers are willing to take because they perceive the quality premium is worth it. So here's my advice: if you want a bargain, don't try to find a cheap store. Try to shop cheaply. Similar products are, very often, priced similarly. An expensive shopping trip is the result of carelessly choosing products with a high markup, rather than wandering into a store with "bad value," because price-targeting accounts for much more of the difference between prices than any difference in value between one store and another. 8 𝙈𝙞𝙭 𝙞𝙩 𝙪𝙥! Another very common pricing strategy is sale pricing. We're all so used to seeing a storewide sale with hundreds of items reduced in price that we don't pause and ask ourselves why on earth stores do this. When you think hard about it, it becomes quite a puzzling way of setting prices. The effect of a sale is to lower the average price a store charges. But why knock 30 percent off many of your prices twice a year, when you could knock 5 percent off year-round? Varying prices is a lot of hassle for stores because they need to change their labels and their advertising, so why does it make sense for them to go to the trouble of mixing things up? 9 One explanation is that sales are an effective form of self-targeting. If some customers shop around for a good deal and some customers do not, it's best for stores to have either high prices to pry cash from the loyal (or lazy) customers, or low prices to win business from the bargain hunters. Middle-of-the-road prices are no good: not high enough to exploit loyal customers, not low enough to attract the bargain-hunters. But that's not the end of the story, because if prices were stable, then surely even the most price-insensitive customers would learn where to get particular goods cheaply. So rather than stick to either high or low prices, shops jump between the two extremes. 10 One common situation is for two supermarkets to be compet-ing for the same customers. As we've discussed, it's hard for one to be systematically more expensive than the other without losing a lot of business, so they will charge similar prices on average, but both will also mix up their prices. That way, both can distinguish the bargain hunters from those in need of specific products, like people shopping to pick up ingredients for a cookbook recipe they are making for a dinner party. Bargain-hunters will pick up whatever is on sale and make something of it. The dinner-party shoppers come to the supermarket to buy specific products and will be less sensitive to prices. The price-targeting strategy only works because the supermarkets always vary the patterns of their special offers, and because it is too much trouble to go to both stores. If shoppers could reliably predict what was to be discounted, they could choose recipes ahead of time, and even choose the appropriate supermarket to pick up the ingredients wherever they're least expensive. 11 In fact, it is just as accurate, and more illuminating, to turn the "sale" on its head and view prices as premiums on the sale price rather than discounts on the regular price. The random pattern of sales is also a random pattern of price increases -- companies find it more profitable to increase prices (above the sale price) by a larger amount on an unpredictable basis than by a small amount in a predictable way. Customers find it troublesome to avoid unpredictable price increases and may not even notice them for lower-value goods - but easy to avoid predictable ones. 12 Try to spot other odd mix-ups next time you're in the supermarket. Have you noticed that supermarkets often charge ten times as much for fresh chili peppers in a package as for loose fresh chilies? That's because the typical customer buys such small quantities that he doesn't think to check whether they cost four cents or forty. Randomly tripling the price of a vegetable is a favorite trick: customers who notice the markup just buy a different vegetable that week; customers who don't have self-targeted a whopping price rise. 13 I once spotted a particularly inspired trick while on a search for potato chips. My favorite brand was available on the top shelf in salt and pepper flavor and on the bottom shelf, just a few feet away, in other flavors, all the same size. The top-shelf potato chips cost 25 percent more, and customers who reached for the top shelf demonstrated that they hadn't made a price-comparison between two near-identical products in near-identical locations. They were more interested in snacking. 14 Admittedly, for some people the difference in flavors is important. Some will notice the higher price for salt and pepper flavor and, irritated, pay anyway. Others will prefer the different flavors and count themselves lucky that they have inexpensive tastes. But this is an example of a universal truth about supermarkets: they are full of close (or not so close) substitutes, some cheap, some expensive, and with a strong random element to the pricing. The random element is there so that only shoppers who are careful to notice, remember, and compare prices will get the best bargains. If you want to outwit the supermarkets, simple observation is your best weapon. And if you can't be bothered to do that, you really don't need to save money. 15 __𝙍𝙚𝙖𝙡𝙞𝙩𝙮 𝙘𝙝𝙚𝙘𝙠 𝙣𝙪𝙢𝙗𝙚𝙧 𝙤𝙣𝙚: 𝘿𝙤𝙚𝙨 𝙩𝙝𝙚 𝙘𝙤𝙢𝙥𝙖𝙣𝙮 𝙧𝙚𝙖𝙡𝙡𝙮 𝙝𝙖𝙫𝙚 𝙨𝙘𝙖𝙧𝙘𝙞𝙩𝙮 𝙥𝙤𝙬𝙚𝙧? It's time for a reality check. When we talk about big companies it is easy to get carried away with notions of how they are infinitely powerful and we are infinitely gullible. Not true. Remember that no company has power unless it has scarcity, and often that scarcity is something we give them through our own laziness. Nothing is stopping us from walking down the street or driving from one store to another; certainly nothing is stopping us from a bit of mental arithmetic when buying chilies, or from glancing around for two seconds when buying potato chips. Every store has a tiny amount of scarcity power, if only because it's an effort to walk out and go next door. But some have more scarcity power than others, which is worth thinking about when estimating the risk of being waylaid by price-targeting strategies. 16 For instance, what is the answer to the question we posed in the previous chapter: why does popcorn cost so much at movie theaters? Is it for the same reason that wine is expensive in restaurants? We know that the first-glance answer in both cases is, "Because once they get you in the door they can charge whatever they want." We also know that this first answer is probably not true. Customers may be dumb, but they're not that dumb. People expect to be charged a lot for wine in restaurants and for popcorn and candy in movie theaters before they walk in the door. 17 Now we have a better answer: it's likely to be a price-targeting strategy. Moviegoers who are sensitive to price will bring their own snacks from home, or go without. People who are not sensitive to price - perhaps because they're on a date and don't want to look stingy - will simply pay for the overpriced popcorn. Very clever. 18 This is a much better explanation, since in many towns there is only one movie theater, and even in towns with more than one, there is often only one showing the film you want to see. This gives a theater a lot of scarcity power, and if the manager is smart he'll want to exploit that power to the full. Yet the same story doesn't ring true for pricey wine at restaurants. The typical restaurant has less scarcity power than a movie theater because in most towns there will be a variety of alternatives. Whenever there is little scarcity power, prices need to reflect costs. 19 Yet even the most ordinary restaurants seem to charge a lot for wine. A better explanation is that one of the big costs in a restaurant business is table space. Restaurateurs would therefore like to charge customers for dawdling, but because they cannot do that, they charge higher prices for products that tend to be consumed in longer meals: not just wine but also appetizers and desserts. 20 We go to a movie theater to see a movie and to a restaurant to eat, so is the truth also that we always get gouged on "options"? Not at all. One option available in both movie theaters and in restaurants is the option to use the restrooms; this is always an option provided free of charge. Tap water is also free in restaurants. It is not the option that invites the gouging, it's the lack of price sensitivity that allows a business with scarcity power to practice price-targeting. (60)

****1 1 __𝙍𝙚𝙖𝙡𝙞𝙩𝙮 𝙘𝙝𝙚𝙘𝙠 𝙣𝙪𝙢𝙗𝙚𝙧 𝙩𝙬𝙤: 𝘾𝙖𝙣 𝙩𝙝𝙚 𝙘𝙤𝙢𝙥𝙖𝙣𝙮 𝙥𝙡𝙪𝙜 𝙡𝙚𝙖𝙠𝙨? Perhaps you are a company director rubbing your hands with glee as you read this, planning to deploy a range of clever price-targeting strategies in your own business. Before you get too excited, you'll need to deal with the leaks in your price-targeting system. There are two potentially catastrophic leaks or great holes in an otherwise brilliant marketing scheme. If you don't deal with them, your plans will be in ruins. The first problem is that supposedly price-insensitive customers may not play the self-targeting game. It's not hard to persuade price-sensitive customers to steer clear of an expensive product, but sometimes it is more difficult to prevent the price-insensitive customers from buying the cheaper one. This is not a problem in the case of small price differences; we have already seen that you can get some customers to pay a modest markup in absolute terms, but the markup can be huge in relative terms, just by wrapping some chilies in a plastic bag, or moving a bag of potato chips up onto the top shelf. When it comes to more substantial buying decisions it is not always so easy. 2 Some of the most extreme examples come from the travel industry: traveling first class by train or air is much more expensive than buying the coach-class seats, but since the fundamental effect is to get people from A to B, it may be hard to wring much money out of the wealthier passengers. In order to price-target effectively, firms may have to exaggerate the differences between the best service and the worst. There is really no reason at all why coach-class train cars shouldn't have tables, as they typically don't in the UK, for instance, except that potential customers for first class might decide to buy a cheaper ticket when they see how comfortable coach has become. So the coach-class passengers have to suffer. 3 There is a famous example from the early days of the trains in France: It is not because of the few thousand francs which would have to be spent to put a roof over the third-class carriage or to upholster the third-class seats that some company or other has open carriages with wooden benches.... What the company is trying to do is prevent the passengers who can pay the second-class fare from traveling third class; it hits the poor, not because it wants to hurt them, but to frighten the rich. And it is again for the same reason that the companies, having proved almost cruel to the third-class passengers and mean to the second-class ones, become lavish in dealing with first-class customers. Having refused the poor what is necessary, they give the rich what is superfluous. 4 The shoddy quality of most airport departure areas across the world is surely part of the same phenomenon. If the free departure areas became comfortable, then airlines would no longer be able to sell business-class tickets on the strength of their "executive" lounges. And it would also explain why flight attendants sometimes physically restrain coach passengers from stepping off the plane before the passengers from first and business class. This is a "service" aimed not at economy-class passengers but at those looking on in pity and disgust from the front of the plane. The message is clear: keep paying for your expensive seats, or next time you might be the wrong side of the flight attendant. 5 In the supermarkets, we see the same trick: products that seem to be packaged for the express purpose of conveying awful quality. Supermarkets will often produce a store-brand "value" range, displaying crude designs that don't vary whether the product is lemonade, bread, or baked beans. It wouldn't cost much to hire a good designer and print more attractive logos. But that would defeat the object: the packaging is carefully designed to put off customers who are willing to pay more. Even customers who would be willing to pay five times as much for a bottle of lemonade will buy the bargain product unless the supermarket makes some effort to discourage them. So, like the lack of tables in coach-class trains and the uncomfortable seats in airport lounges, the ugly packaging of "value" products is designed to make sure that snooty customers self-target price increases on themselves. 6 The most surprising examples of all come from the world of computers. For instance, IBM's "LaserWriter E," a low-end laser printer, turned out to be exactly the same piece of equipment as their high-end "Laser Writer" - except that there was an additional chip in the cheaper version to slow it down. The most effective way for IBM to price-target their printers was to design and mass-produce a single printer, then sell it at two prices. But of course to get anyone to buy the expensive printer they had to slow down the cheap one. It seems wasteful, but presumably it was cheaper for IBM to do this than design and manufacture two completely different printers. Intel, the chip manufacturer, played a similar game by selling two very similar processing chips at different prices. In this case, the inferior chip was actually more expensive to produce: it was made by taking the superior chip and doing extra work to disable one of its features. 7 Software packages often have two or more versions: one has full functionality (the "professional" package), and the other sells to the mass market at a considerably reduced price. What some people don't realize is that the professional version is typically designed first, and certain features are disabled for the mass-market version. Despite the high price of the professional version, it's the cheaper version that actually has an extra up-front cost for the developer, and of course both versions are sold on CDs, which cost the same to manufacture. Computer hardware, and in particular software, has a strange cost structure because of intensive research and development costs, and relatively low manufacturing costs. At the height of the Internet bubble, giddy gurus were claiming that the different cost structure changes everything-but, as we've seen, the basic rules of making money in the hi-tech business are not so different from the rules for train operators or coffee bars. 8 The first "leak" in a price-targeting strategy, then, is that rich customers may buy cheap products, unless the products are deliberately sabotaged. The second "leak" is a particularly difficult one for companies using a group-target strategy to plug: their products may leak from one group to another. The risk is that the customers who are being offered a discount buy the product and then resell it at a profit to the customers who are being charged a higher price. Up until now, we've mostly been discussing services that can't be resold (like a bus trip or a visit to Disney World) or products that are probably too much hassle to resell (such as a sandwich or a cup of coffee). That's not coincidence. Services and convenience products are the most fertile grounds for price-targeting strategies, because they don't leak. The really great pricing tricks take place on airlines, in restaurants and cocktail bars (not many bookstores have a "happy hour"), in supermarkets, and at tourist attractions. 9 In contrast, some products are inherently leaky: they're expen-sive, easy to transport, and nonperishable. The obvious examples are digital media (CDs, DVDs, and software) and pharmaceuticals. Companies go to tremendous lengths to plug leaks, which in an age where Internet shopping allows us to order products from anywhere in the world are becoming increasingly difficult to prevent. For instance, the DVD industry agreed on a system of regional coding so that DVDs bought in the United States would not work in Europe. But that system is being circumvented by an alliance of customers and DVD-machine suppliers who willingly equip machines to read a DVD from anywhere in the world. 10 If your instincts are anything like mine, it all seems like a pretty shabby trick. But the same popular opinion that despises the DVD industry for trying to sell their products at different prices in different markets also believes that the big pharmaceutical companies should supply drugs to poor countries at discounted prices. Confusingly, our moral intuitions seem to be sending us contradictory messages. 12 Maybe the story is as simple as this: when it's an important product like a treatment for HIV/AIDS, the most important thing is to get it to the poor; when it's as trivial as a DVD, our irritation at being ripped off is the dominant emotion. But that doesn't quite add up: DVDs make it to very poor areas, and surely we should be at least somewhat pleased that the poor get to watch movies in bars and village halls across the developing world? Or, conversely, shouldn't we be even more outraged that the pharmaceutical companies are overcharging for crucial treatments in the developed world? An economist cannot solve these ethical conundrums, but economics can unwrap them so that at least the ethical question becomes clearer. 12 __𝙒𝙝𝙚𝙣 𝙥𝙧𝙞𝙘𝙚-𝙩𝙖𝙧𝙜𝙚𝙩𝙞𝙣𝙜 𝙞𝙨 𝙖 𝙜𝙤𝙤𝙙 𝙩𝙝𝙞𝙣𝙜 Here is a thought experiment. Imagine a hypothetical pharmaceutical company called PillCorp, which has developed a uniquely powerful new treatment for HIV/ AIDS. Assume that it doesn't engage in any price-targeting and charges the same price across the globe. PillCorp will set the global price so that the gain in sales from cutting the price exactly balances the loss of margin from a price cut. For example, say that PillCorp cut prices and reduced their margins by half. Unless they doubled sales this would reduce profits. They could raise prices and double their margins, but if sales dropped by more than half that would also reduce profits. PillCorp will maximize profits by pricing at the point where either a price cut or a price increase would slightly damage the bottom line. 13 The price will be high, because people in rich countries will pay a lot for an effective treatment, and there is no point in losing customers who are paying thousands of dollars in an effort to pick up customers who are paying pennies. That looks like bad news. PillCorp is using its scarcity power to charge a high price for a life-saving drug. As a result, people in poor countries don't get the drug. People are dying because of PillCorp's greed. 14 Actually, it's only half bad news. People are also living because of PillCorp's greed. PillCorp developed the life-saving treatment because it was encouraged to do so by the hope of a lucrative patent. Pharmaceuticals are very expensive to research and develop, and somebody has to pay the bill. The current system is that public and private insurers pay, and since the United States is easily the largest market, innovation is driven by and largely paid for there. 15 Although PillCorp is making money by selling its drug at a high uniform global price, they could be doing better and so could everybody else. Economists don't just have in mind a shrug-your-shoulders -- life's-like-that-sometimes "could be better." We mean something more precise: PillCorp could be making more money and serving the world better. 16 Say that a year's supply of drugs for one customer costs $10 for PillCorp to produce, and retails at $1,000. For rich customers willing to pay or who have insurance that will pay - that's not really a problem. Each year of treatment transfers $990 from those living with AIDS to those who produced the treatment. But a taxi driver in Cameroon might be willing to pay only $50 a year for treatment; beyond that, he'd rather buy food, or gas for his taxi. Because of PillCorp's global price policy, the taxi driver loses out on the treatment, and PillCorp loses out on the chance to make some profit. But if PillCorp were able to make a one-time discount to the taxi driver and sell him the treatment for any price between $10 and $50 - say $30 - everybody would be better off. The taxi driver gets treatment for $30 when he was willing to pay $50. PillCorp receives $30 in revenues for a $10 pill - a profit of $20. 17 That is what economists mean when we say a situation "could be better." If we can point to a change that could make at least one person better off, and nobody worse off, we say that the current situation is inefficient, or, in everyday language, that it could be better. (We also say that the current situation is efficient if every change that could make at least one person better off will also make somebody else worse off. It doesn't mean that an efficient situation can't be improved; it's just that there is no costless way to improve it.) 18 Now imagine that PillCorp practices price-targeting, continuing to charge $1,000 in rich Western countries but supplying people in developing countries, like the Cameroon taxi driver, for $30. Suddenly, a whole new market opens up for PillCorp: the new discount allows the company to acquire millions of new customers at a profit of $20 a year, but at the same time, it still makes all the sales it used to make in rich countries. 19 This assumes the cheap pills don't "leak" back, which in practice is a massive concern for pharmaceutical companies. The current leakage of cheap drugs from Canada is a problem for drug companies who want to take advantage of the high willingness to pay in the United States, but who also sell to Canadian health care providers who refuse to pay high prices for drugs. The risk, if the leakage continues, is that American providers simply refuse to offer discounts to Canada any more. 20 The example should also make us realize that the greater price transparency brought about by the Internet and other improvements in communications occasionally has a downside: a company with scarcity power may be discouraged from offering discounted products because they are more likely to leak. 21 PillCorp's dual pricing policy creates a much better situation. Customers in rich countries are no worse off. Shareholders in PillCorp are better off. And people living with HIV/AIDS in poor countries are also better off. To use the business-school jargon, this is a win-win situation, or as an economist would say, a clear improvement in efficiency. 22 This doesn't mean the new situation is perfect; it just means that it is unambiguous progress from the previous situation, where PillCorp's scarcity power was causing a huge inefficiency...and huge loss of life in poor countries. Perhaps we are outraged to see the poor denied drugs that cost pennies to produce, not because that is unfair (many things are unfair) but because it is also so wasteful of life. (67)

1 __𝙒𝙝𝙚𝙣 𝙥𝙧𝙞𝙘𝙚-𝙩𝙖𝙧𝙜𝙚𝙩𝙞𝙣𝙜 𝙞𝙨 𝙖 𝙗𝙖𝙙 𝙩𝙝𝙞𝙣𝙜 PillCorp's new price-targeting program was a win-win affair. But sometimes price-targeting is a losing proposition all around. Consider another hypothetical organization, TrainCorp, a passenger train company. Train Corp owns a train that always travels full. Some of the seats go at a discount of $50 to leisure travelers who booked in advance, to senior citizens, to students, or to families. The other tickets cost the full price of $100 and are bought by commuters and other business travelers. This is a fairly standard group-targeting strategy: by giving away a few low-price tickets, TrainCorp restricts supply and acquires the ability to demand high prices by offering tickets to only the buyers with the highest willingness to pay. (It might be profitable for Train Corp just to fence off some of the seats and restrict supply that way, but it's even better for them to fill the spare seats if they can.) 2 We know at once - if we are economists - that this is inefficient. In other words, we can think of something that would make at least one person better off without making anyone else worse off. That something is to find a commuter who was willing to pay a little less than $100, say $95, and who decided to travel by car instead, and offer him a seat for $90. Where does the seat come from, since the train is full? Well, you take a student who is in no great hurry and was willing to pay a little more than $50, say $55, for the seat and politely throw him off the train. But you refund the price of his ticket, plus an extra $10 for his trouble. 3 Where do we stand now? The commuter was willing to pay $95 but only paid $90. He's better off by $5. The student was willing to pay $55 for a $50 ticket, so if he'd been allowed to ride, he'd have been only $5 better off. But he has just been given $10, so the student is also happy. And what about TrainCorp? Well, TrainCorp just transformed a $50 ticket into a $90 ticket and made a more profitable sale. Even after paying $10 compensation to the student, the company is $30 ahead. Now everyone's a winner; or they would be if TrainCorp adopted this system instead of its group price-targeting strategy. 4 But of course, that's not what happens, because if Train Corp tried it, commuters who were willing to pay $100 would hang around for the $90 tickets, and students who weren't willing to pay $50 would buy tickets anyway and wait to be paid to get off. The whole affair would turn out badly for TrainCorp, who is the one who gets to set the prices. In case your head is spinning a little, here's the quick-and-dirty summary: the group price-targeting strategy is inefficient because it takes seats away from customers who are willing to pay more, and gives them to customers who are willing to pay less. Yet airlines and railroads still use it, because the alternative of individual price-targeting isn't feasible. 5 OK, so sometimes price-targeting is less efficient than a uniform price, as in the case of the train; sometimes it's more efficient than a uniform price, as in the case of the HIV/AIDS drugs. But we can say more than that. Whenever price-targeting fails to expand the number of sales and merely moves products from people who value them more, like commuters, to people who value them less, like students, as in the case of TrainCorp, it will definitely be less efficient than a uniform price. Whenever price-targeting opens up a new market without affecting the old market, as with PillCorp, it will definitely be more efficient than a uniform price. 6 And there's a middle position. A lot of group price-targeting does a bit of both: it opens up some new markets but also wastefully moves products away from high-value users to low-value users. For example, this book is published in hardcover at a high price, and then the paperback edition emerges later, at a lower price. The aim is to target a higher price at people impatient to hear what I have to say and at libraries. One good result is that the publisher will be able to sell paperbacks more cheaply, because some costs will be offset by the hardcover sales, and so the book will reach more people. One bad result is that the early version is much more expensive than it would be if there was only a single paperback edition, and some buyers will be put off. 7 That's what life is like in a world of scarcity: when companies with scarcity power try to exploit it, the situation will almost always be inefficient, and equivalently - we economists will almost always be able to think of something better. I say "almost" because a company, which is able to practice perfectly individualized price-targeting strategy, would never miss a sale: rich or desperate customers would pay a lot, poor or indifferent customers would pay very little, but no customers willing to pay the cost of production would be turned away. The situation would be efficient. 8 Being realistic, though, it's most unlikely that any company would have so much information about its customers as to be able to make such perfectly efficient sales. The company would need to peer into the heart of every possible customer and find out how badly he or she wanted the product; it would need a supercomputer to operate the cash registers. That just isn't plausible. But perhaps it makes you think. What if you could plug every customer's preferences into a supercomputer? What if you had all the information you needed to never miss a sale? Would the world be a better place? 9 Something else may have caught your attention. When PillCorp changed its global pricing policy, it did something that was not only profitable but also both efficient and fair. Can we say anything more generally about when private greed will serve the public interest? For the answers to all these questions, and more. read on. 10 🅣🅗🅡🅔🅔 ꝒƸⱤƑƸƇƬ 𐒄𐤠ⱤƘƸƬⳜ 𐤠ƝƊ ƬǶƸ "ⱲⰙⱤȴƊ ⰙƑ ƬⱤꓴƬǶ" You might not expect Jim Carrey films and economics to have much in common, but in fact there is much we can learn from the rubber-faced comedian. Consider the film, Liar, Liar, which tells the story of Fletcher Reede. As a result of his son's birthday wish, Fletcher Reede finds that he is compelled to tell the truth for twenty-four hours. This is problematic for Fletcher because he is a lawyer or a liar, as his son understands it and hilarity predictably ensues as a horrified Fletcher incriminates himself by helplessly blurting out truthful answers to every question he is asked. They don't make as much of a feel-good movie, but free markets are just like Fletcher Reede's son - they force you to tell the truth. Yet while the results were humiliating for Jim Carrey's character, we will discover that a world of truth leads to a perfectly efficient economy, one in which it is impossible to make someone better off without making someone else worse off. 11 In this chapter we'll see what truth means in economic terms, how it leads to efficiency, and why efficiency is good. We'll also explore efficiency's shortcomings: how efficiency isn't always fair, and why we have taxes. As we'll see, taxes are like lies: they interfere with the world of truth. But I'll reveal one way in which taxes can be implemented, which is both fair and efficient. This could be good news for seniors struggling to pay their winter heating bills, but bad news for Tiger Woods. 12 Imagine if you will that Fletcher's son gets his birthday wish, not just for his smooth-talking dad but for the whole world. So, let's buy a cappuccino in the world of truth. Before frothing up the half-and-half for you, the barista looks you up and down and asks: "What's the most you're willing to pay for this coffee?" You'd like to lie and pretend that you don't really want it, but the truth just slips out: "I'm in caffeine withdrawal. Fifteen bucks." With a smirk, the barista prepares to ring up the extortionate sum, but you have a few questions of your own: "How much did those coffee beans cost?" "How much did you pay for the plastic lid and the cup?" "How much does it cost to raise a cow, and how much milk can you get from one?" "How much did the electricity cost for the refrigeration, heating, and light in here?" 13 Now it is the barista's turn to have a Fletcher Reede moment. No matter how she tries to evade the questions or froth up the cost of the cappuccino, she cannot tell a lie. It turns out that the cappuccino costs not fifteen dollars, but less than one. The barista tries to haggle, but you have one more killer question: "Are any other places within thirty yards selling coffee like this?" "Yes..." she moans, her head thudding to the counter in a gesture of abject defeat. You walk out of the shop with the coffee safely in your possession for the bargain price of ninety-two cents. 14 __𝙋𝙧𝙞𝙘𝙚𝙨 𝙖𝙧𝙚 𝙤𝙥𝙩𝙞𝙤𝙣𝙖𝙡, 𝙬𝙝𝙞𝙘𝙝 𝙢𝙚𝙖𝙣𝙨 𝙩𝙝𝙚𝙮 𝙧𝙚𝙫𝙚𝙖𝙡 𝙞𝙣𝙛𝙤𝙧𝙢𝙖𝙩𝙞𝙤𝙣 There's a basic truth incorporated into any system of prices. That truth comes from the fact that stores and consumers do not have to buy or sell at a given price - they can always opt-out. If you'd been willing to pay only fifty cents for the coffee, nobody could have forced you to raise your offer or forced the barista to drop the price. The sale simply would not have occurred. Of course, you sometimes hear people complaining that if they want something - say, an apartment on Central Park West-then they have to pay the exorbitant asking price. That's true, but although prices sometimes seem unfairly high, you hardly ever have to pay them. You could always use your money to buy an apartment in Harlem or a house in Newark or a million cups of coffee instead. 15 In a free market, people don't buy things that are worth less to them than the asking price. And people don't sell things that are worth more to them than the asking price (or if they do, it's never for long; firms that routinely sell cups of coffee for half of what they cost to produce will go out of business pretty quickly). The reason is simple: nobody is forcing them to, which means that most transactions that happen in a free market improve efficiency, because they make both parties better off or at least not worse off-and don't harm anyone else. 16 Now you can begin to see why I say that prices "tell the truth" and reveal information. In a free market, all the buyers of coffee would prefer to have coffee than the money the coffee cost, which is shorthand for saying they prefer coffee to whatever else they might have spent ninety-two cents on. That is, the value of the product to the customer is equal to or higher than the price; and the cost to the producer equal to or lower than the price. Painfully obvious, perhaps, but the implications turn out to be dramatic. 17 It may seem trivial to say that in a free market we know customers value coffee more than the money they pay for it. Yet it's not quite as trivial as it looks. For a start, this "trivial" piece of information is already more than we can say about anything that is paid for outside the market - for example, Washington DC's hugely controversial new baseball stadium. The Montreal Expos baseball team agreed to move to DC on the condition that the DC government subsidize the cost of a new stadium. Some say the subsidy will be $70 million, others that it will be far higher. Maybe this is a good idea, and maybe not. It's not clear how we decide whether this is a good way of spending taxpayers' money. 18 When decisions are made inside a market system there's no such controversy. If I decide to pay $70 for a ticket to see a baseball game, nobody questions whether it's worth it; I made my choice, so obviously I thought so. This free choice produces information about my priorities and preferences, and when millions of us make choices, market prices aggregate the priorities and preferences of us all. (67)

1 __𝙋𝙚𝙧𝙛𝙚𝙘𝙩 𝙢𝙖𝙧𝙠𝙚𝙩𝙨: 𝙏𝙝𝙚 𝙩𝙧𝙪𝙩𝙝, 𝙩𝙝𝙚 𝙬𝙝𝙤𝙡𝙚 𝙩𝙧𝙪𝙩𝙝, 𝙖𝙣𝙙 𝙣𝙤𝙩𝙝𝙞𝙣𝙜 𝙗𝙪𝙩 𝙩𝙝𝙚 𝙩𝙧𝙪𝙩𝙝 So the trivial piece of information that in a free market customers value cappuccinos more than the money they pay for them is not so trivial after all. But we needn't stop there. Imagine now that the coffee market is not only free but extremely competitive, that entrepreneurs are always starting new firms with fresh ideas and entering the market in an attempt to undercut the incumbent companies. (Profits in a competitive industry are high enough only to pay workers and persuade entrepreneurs that their money isn't better off in a savings account - no higher.) The competition will force the price of coffee down to the "marginal cost" - the cost the coffee bar incurs when making one more cappuccino, which we may remember is just under a dollar. 2 In a perfectly competitive market, the price of coffee would equal the marginal cost of coffee. If the price were lower, firms would go out of business until it rose. If the price were higher, new firms would enter or old firms would expand their output until it fell. Suddenly, the price is not conveying a vague fact ("this coffee is worth ninety-two cents, or more, to the buyer, and it cost the coffee bar ninety-two cents, or less") but a precise truth ("this coffee cost the coffee bar exactly ninety-two cents"). What if other industries were also perfectly competitive? That would mean that for every product, the price equaled the marginal cost. Every product would be linked to every other product through an ultracomplex network of prices, so when something changes somewhere in the economy (there's a frost in Brazil, or a craze for iPods in the US) everything else would change - maybe imperceptibly, maybe a lot to adjust. A frost in Brazil, for example, would damage the coffee crop and reduce the worldwide supply of coffee; this would increase the price coffee roasters have to pay to a level that discourages enough coffee drinking to offset the shortfall. Demand for alternative products, like tea, would rise a little, encouraging higher tea prices and extra supply of tea. Demand for complementary products like coffee creamer would fall a little. In Kenya, coffee farmers would enjoy bumper profits and would invest the money in improvements like aluminum roofing for their houses; the price of aluminum would rise and so some farmers would decide to wait before buying. That means demand for bank accounts and safety deposit boxes would rise, although for unfortunate farmers in Brazil with their failed crops, the opposite may be happening. The free-market supercomputer processes the truth about demands and about costs, and gives people the incentive to respond in astonishingly intricate ways. 3 That may seem like a ridiculous hypothetical scenario. But economists can measure and have measured some of these effects: when frosts hit Brazil, world coffee prices do indeed rise, Kenyan farmers do buy aluminum roofing, the price of roofing does rise, and the farmers do, in fact, time their investment so that they don't pay too much. Even if markets are not perfect, they can convey tremendously complex information. Governments or any organizations - find it hard to respond to such complex information. In Tanzania, coffee is not produced in a free market, and the government, rather than the farmers, receives any windfalls from high coffee prices. Historically, the government has failed to spend the money sensibly, blowing too much on unsustainable salary rises for civil servants, and failing to realize that the price spike was temporary. 4 To appreciate why markets do such a good job of processing complex information, first think about the customer. We know that he won't buy a cappuccino unless he values it more than anything else he could buy with the same money. But what else could he buy with the same money? In our world of truth, he could buy anything that costs the same as, or less than, a cappuccino. If he chooses the coffee he's saying that of all the things in the world that cost the same as coffee, he would like coffee to be made. 5 Elsewhere, of course, there are other people spending their money not on coffee but on movie tickets, bus fares, or underwear; and there are others choosing not to spend their money at all and to put it in the bank instead. All of these competing demands pull producers to respond. If people want computers, then manufacturers will build factories, hire workers, and buy plastics and metals, which will be diverted from other uses to go into computers. If people want coffee instead of underwear, then more land will be devoted to coffee and less to other uses, like parks or housing or tobacco farming. Lingerie shops will be replaced by coffee shops. Of course, start-up companies will borrow money from banks, and interest rates will rise or fall, depending on the balance between the number of people wanting to save and the number of people wanting to borrow. Interest rates are just another price: the price of spending today instead of next year. (You might have thought that interest rates were set by central bankers like Alan Greenspan at the Federal Reserve or Mervyn King at the Bank of England. Actually, Greenspan and King chair committees that set "nominal" interest rates. True interest rates are interest rates after inflation - set by the market in response to the central bankers.) 6 The changes don't stop there. The ripples in the price system continue outward. They whip through some parts of the economy at tremendous speed and cause slow but powerful seismic shifts in others, like education or technology. For example, if there aren't enough trained workers to produce computers, manufacturers like Dell and Compaq will have to train them, or raise wages to poach them from other manufacturers like Apple and Gateway. As the wages for skilled workers rise, people will see that it's worth taking time off and paying to go to college. Manufacturers' interest in producing cheaper or better computers will give a boost to research labs and engineering schools. Higher demand for plastics will raise the price of the raw material crude which will in turn encourage those who use oil for energy to switch to cheaper substitute fuels or to invest in energy-saving technology. And so it continues. Some of these effects will be tiny. Others will be enormous. Some will have an instant effect. Others will not be realized for decades. But in the world of truth - the world of perfect markets, all of them will have an impact. What is the result of a set of perfectly competitive markets interconnected like this? 7 ᴄᴏᴍᴘᴀɴɪᴇs ᴀʀᴇ ᴍᴀᴋɪɴɢ ᴛʜɪɴɢs ᴛʜᴇ ʀɪɢʜᴛ ᴡᴀʏ. Any company that wastes resources, over-produces, or uses the wrong technology, will go out of business. Every product is produced in the most efficient way. ᴄᴏᴍᴘᴀɴɪᴇs ᴀʀᴇ ᴍᴀᴋɪɴɢ ᴛʜᴇ ʀɪɢʜᴛ ᴛʜɪɴɢs. The price of a product equals the cost to make it. The price also reflects the terms at which customers can trade off one priority against another. (Two cups of coffee cost the same as one Danish; which would you prefer?) The price is a direct line of communication from what products cost to what customers prefer, and back again. 8 ᴛʜɪɴɢs ᴀʀᴇ ʙᴇɪɴɢ ᴍᴀᴅᴇ ɪɴ ᴛʜᴇ ʀɪɢʜᴛ ᴘʀᴏᴘᴏʀᴛɪᴏɴs. If too much coffee were being produced, manufacturers would cut prices; and if too little, prices would rise. Either way, the situation would correct itself. In the competitive market, price equals cost; there is no incentive for anyone to produce less (giving up profitable sales) or to produce more (creating products that cost more than anyone is willing to pay). The competitive rule - price equals cost equals value to the consumer - keeps things efficient. ᴛʜɪɴɢs ᴀʀᴇ ɢᴏɪɴɢ ᴛᴏ ᴛʜᴇ "ʀɪɢʜᴛ" ᴘᴇᴏᴘʟᴇ. The only people who buy products are the people who are willing to pay the appropriate price. Let's say I confiscate a cappuccino from Axel and give it to Bob. In the world of truth, this is wasteful. Axel was willing to pay for coffee, and Bob was not, which means Axel values cof-fee more than Bob, and my confiscation is inefficient. Notice that here I am equating "right" with "efficient," an assumption we'll examine and challenge shortly. So: if the right things are being made right in the right quantities and going to the people who value them most, there is no room for any gains in efficiency. To put it another way, you can't get more efficient than a perfectly competitive market. And it all follows perfectly naturally from the truth contained in the price system: prices are true representations of cost to firms, and also true representations of value to customers. 9 __𝙇𝙞𝙛𝙚 𝙬𝙞𝙩𝙝𝙤𝙪𝙩 𝙢𝙖𝙧𝙠𝙚𝙩𝙨 Because Western society relies heavily on free markets, we find it difficult to imagine what it would be like if we didn't, or to take a step back and see quite how profound the effect of the market is. Yet any modern democracy provides goods outside the market system, and looking at the way such goods are provided gives us a hint of the strengths and weaknesses of markets. Think of your friendly local police force, which is paid for by a non-market system of taxation. The non-market system has some advantages - for one thing, when you dial 911 nobody asks for your credit card details. The government is supposed to afford the same level of protection to the rich and poor, although it does not always seem that way. 10 But the non-market system also has some disadvantages. For instance, if a police officer is rude or incompetent, you don't have the option to shop for a different police force. If you think that the level of police protection you receive is excessive, it's not up to you to cut back a bit. Neither can you spend more if you decide that you'd like extra service. No, you have to lobby your local politicians and hope they consider your demands. 11 Government-provided schooling is another example of a non-market service that many of us use. In both Britain and the United States, most people send their children to government-funded schools. But those schools are different from each other - different atmospheres, different academic emphases. Most importantly, some are good schools, and some are not. The market solution for schools is similar to the market solution for food: the best food goes to the people who are willing - which also implies able to pay the most for it. But within the government sector, there are no prices. What happens instead? Parents line up, haggle, and protest. They move to districts with better schools. In Britain, government-run religious schools often have the best academic records, so atheists take their children to church every Sunday to get good references from priests and get their children into these schools. 12 As with the police, the non-market system has the cozy advantage of concealing the fact that the poor don't get the same quality of education that the rich do. But again, the non-market system suffers from a serious problem: the truth about values, costs, and benefits has disappeared. It is impossible to tell which parents enroll their children in church schools for religious reasons and which parents are just looking for better results. It is also impossible to know how much parents would be willing to pay for more teachers and better materials. In a market system, the truth would emerge about how much it costs to provide good schools, and who would be willing to pay for them. The non-market system struggles with these basic questions. 13 It seems that there is a willingness to pay for good schools, and we see it emerge because house prices are higher in the areas of schools with the best reputation. The non-market system, which gives preference to local children, channels the money that parents are willing to pay for a good school into the hands of property owners near existing good schools. This hardly seems sensible. A market system would simply direct the money to pay for more good schools. 14 __𝙏𝙝𝙚 𝙨𝙞𝙜𝙣𝙖𝙡𝙞𝙣𝙜 𝙛𝙪𝙣𝙘𝙩𝙞𝙤𝙣 𝙤𝙛 𝙥𝙧𝙞𝙘𝙚𝙨 Prices perform two functions, not just one. In a market system, prices provide a way of deciding who gets to enjoy a limited supply of schools: whoever pays most gets to send their children to the best schools, an uncomfortable state of affairs, which the government-school system is designed to prevent. But prices also give the sig-nal to build more schools, hire more teachers or raise their wages if they're in short supply, and buy better materials. In the longer term, a price system will transform a high willingness to pay for good schools into a lot of good schools, just as surely as it will transform a high demand for coffee into a lot of cappuccino. 15 Don't politicians know that we value good schools already? Should they be making government money available? The difficulty is that politicians hear that we want good schools, but they also hear that we want more police on the streets, a better health service, lots of big roads, excellent welfare benefits, low taxes, and a double-shot caramel Venti latte. It's easy for us to demand all of these things, but prices, by forcing us to put money where our mouths are, uncover the truth. Taxes have their advantages, but many don't contribute to truth because we cannot choose whether or not to pay them, depending on whether each penny is spent according to our wishes. Because prices are optional, they reveal information. 16 None of this amounts to a knockdown argument against providing a police service or a school system with a non-market process. Nonmarket systems have their advantages, but they also lose something important: information, information about wants, needs, and desires, and about inconveniences and costs. Sometimes the loss of information is worthwhile because it is offset by gains in equality or stability. But sometimes the loss of information can leave an economy, and a society, floundering in waste and confusion. We think that the value we get from schools and police are more than what they cost us in taxes, but we don't know for sure. Not so with the cappuccino. 17 __𝙀𝙛𝙛𝙞𝙘𝙞𝙚𝙣𝙘𝙮 𝙫𝙚𝙧𝙨𝙪𝙨 𝙛𝙖𝙞𝙧𝙣𝙚𝙨𝙨: 𝘾𝙖𝙣 𝙬𝙚 𝙝𝙖𝙣𝙙𝙡𝙚 𝙩𝙝𝙚 𝙩𝙧𝙪𝙩𝙝? A perfectly competitive market is like a giant supercomputer network. With amazing processing power and sensors in every part of the economy - reaching even inside our brains to read our desires the market is constantly reoptimizing production and allocating the results perfectly. Remember that when economists say the economy is inefficient, they mean that there's a way to make somebody better off without harming anybody else. While the perfectly competitive market is perfectly efficient, efficiency is not enough to ensure a fair society, or even a society in which we would want to live. After all, it is efficient if Bill Gates has all the money and everybody else starves to death... because there is no way to make anybody better off without making Bill Gates worse off. We need something more than efficient. 18 So it's hardly surprising we sometimes prefer the cozy white lies: it is expensive, for example, to heat the house of an elderly lady in Minnesota, but we may prefer to subsidize the fuel, not wanting her to face the truth of that expense. Even more than subsidies, taxes are a common cause of inefficiency: the government taxes market transactions and spends the money on, we hope, good things like police forces and schools. Why are taxes inefficient? Because they destroy the information carried by prices in perfectly competitive, efficient markets: price no longer equals cost, so cost no longer equals value. For example, a sales tax of 10 percent creates a "lie" in the following circumstances: **Cost of cappuccino: ninety cents • Price of cappuccino in perfectly competitive market: ninety cents • Price of cappuccino after tax: ninety-nine cents • Willingness to pay for a cappuccino: ninety-five cents • Cappuccino sold: none Tax raised: 𝘇𝗲𝗿𝗼 19 There was a sale that could have created five cents of efficiency gains (cappuccino cost ninety cents but was valued at ninety-five cents) but which never happened because of the tax. What's worse, the tax wasn't even paid. If the government were able to waive the tax in such circumstances, they would be no worse off, but the coffee buyer would be better off: a clear efficiency gain. 20 It's hard for tax officials to know when to charge the tax (situ-ations where taxes will not change buyers' behavior) and when to waive the tax (because potential buyers would have avoided it anyway, by not buying coffee). But they try to do so using the kind of price-targeting strategies outlined in chapter 2. Taxes are often higher when price-sensitivity is low. For example, the government charges high taxes on gasoline and cigarettes, not for environmental and health reasons but because people who buy these products need to drive and are addicted to smoking; they won't change their behavior much even in the face of large taxes. 21 We are faced with a dilemma. We want to avoid inefficiency, because that would leave us passing up an opportunity to make somebody better off at no cost to anyone else. But taxes cause inefficiency, and most of us think we need taxes to redistribute income (to a greater or lesser extent) from the rich to the poor. We seem to be facing two contradictory imperatives: avoid the needless waste that is "inefficiency," but make sure that wealth is at least somewhat evenly spread. What we need is a way to make our economies both efficient and fair.