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The Undercover Economist

Chapter 1
In 1st chapter Tim tries to put forward the idea that strength comes form
scarcity. He explains this simple idea with many examples like farm land
prices, coffee prices and real estate. He introduces the concept of
marginal decision making. The rent of a superior land will always be the
difference in yield of superior and inferior land. Similar observation can be
made form the real estate prices of London. He also explains that high
cost of coffee at fine location is not arbitrary and is because of location
difference. Rush hour customers are ready to pay a higher price for that
same coffee. Also such places usually have only one coffee house and that
is because that creates an artificial scarcity.
He explains that there are 2 reasons for high rents
1. Natural method Scarcity plays a role in driving rent of prime
locations.
2. Unnatural method An intentional reduction in resource which leads
to artificial scarcity. Producers stand to benefit form this situation as
they can then charge even higher prices. This strategy removes
alternative options for the buyer.
The second method is being used by criminals while selling drugs, by
labor unions while negotiations with management etc.
One important point given is that scarcity is not the only deciding factor.
Authority and bargaining power of both the parties to trade is also very
important.

Chapter 2
Second chapter takes us deeper into the concept of scarcity. He uncovers
the ways of pricing similar products at different price levels. Two coffees
having very minor difference in the content are priced very differently.
Whats more interesting about this concept is that people are not forced to
accept these different prices. Businesses use techniques like emotional
concerns, special prices for the appealing to the status etc. for justifying
high prices.
There are 2 methods to identify a customer who can pay more for a
product
1. Unique target approach - Treat each customer as an individual and
charge them according to their willingness to pay. Although this a
good strategy for a used car salesman but can not be used at a
supermarket.
2. Group target approach Companies are interested in customers
who can not just afford the high price but is willing to accept the
high price. The best example for this approach is the tourist visiting
Disney land in Florida. Disney provides discount to local people
because there are high chances that they will be repeat customers.

Whereas tourist from other locations will most likely not come so
frequently and hence will be willing to pay a higher price.
3. Self incriminating strategy Companies price their products at
different prices and target customers who are willing to pay higher
price for a slight change in the product. This similar concept is used
by supermarket chains as they price their organic products at a
much higher price than the normal one.
These supermarket stores also use many other techniques to trick
customers into paying higher price. They usually keep products ta
different prices which creates a wrong perception in customers that there
is a quality gap in products. Also they place their products so that
customer can no longer compare similar products.
After this the author throws light on an ethical dilemma arising out of
these pricing strategies. Pharmaceutical companies price does not sell life
saving drugs in developing nations and because of that millions of people
due. They do so to provide leakage of products from developing nations to
developed nations. But this price difference creates an inefficiency in the
system. Although, theoretically this dilemma can be solved and system
can be made efficient but that will reduce the profits for the companies.

Chapter 3
This chapter helps to explain how to manage a balance in efficiency of a
market and its fairness. Both these factors have been taken individually.
An efficient market reveals the truth about customers. A customer is not
forced to buy a product in a market and this makes the market efficient.
Both the parties are better off in a trade and makes a choice to to do
business. Efficient markets witness a domino effect and a slight change in
the price of one product may cause ripples in some other market. But
overall the market remains efficient.
This interconnection in markets result in -:
1. Companies making things right away
2. Companies making right things
3. Things being made in right proportion
4. Things going to right people
Now comes the part of fairness in our system. Are we dividing income
equally in our society? Governments tries to solve this problem with the
help of taxes for the rich. But these taxes hide away the information from
the market. Taxes destroy the information carried by prices in perfectly
competitive, efficient markets. It is important to identify how much tax is
to be paid.
All efficient outcomes can be achieved using a competitive market, by
adjusting the starting position. This head start strategy can help us to
ensure both fairness and efficiency. Adjusting the starting point in the race
can help all the participants to reach the end point together.

Chapter 4

Chapter 4: Crosstown Traffic


Chapter 4, deals with negative externalities what the term means, and
how can these problems be reduced for example congestion and pollution
can simply be reduce by ensuring that people pay for the costs of their
actions such as clogging up the road with your car, or warming the earth
with CO2, and how if we take this route rather than regulations, we can
solve the problem cheaper and faster. Basically externality can be defined
as the cost or benefit that affects a party who did not choose to incur that
cost or benefit. Besides the costs to the buyer and the seller, very often a
market transaction may involve costs external to them, i.e. costs to a third
party. An example quoted in the book is the buying of petrol at gas station
where the transaction creates externality effect of causing noise,
accidents, traffic congestion and air pollution. One of the solutions to deal
with the hidden externality costs which distort the perfect market is to
include the cost in the transaction. Some cities have introduced
externality tax to drivers in order to control the use of roads, promote
better engine performance in noise and emission, raise levy to traffic
accident compensation and subsidize low pollution fuel. The high tax on
tobacco is another form of externality tax as a penalty or compensation to
the harm of smoking.
Inefficient market is directly linked with the externality cost. In the
presence of external costs such as pollution, the producer may choose to
produce more of the product than would be produced if the producer were
required to pay all associated environmental costs. Because responsibility
or consequence for self-directed action lies partly outside the self, an
element of externalization is involved. If there are external benefits, such
as in public safety, then producer will produce less of the good than would
be the case if the producer gets the payment for the external benefits to
others. Hence unregulated markets in goods or services with significant
externalities generate prices do not reflect the full social cost or benefit of
their transactions and markets therefore become inefficient.

Chapter 5
Chapter 5: The Inside Story
This chapter focuses its attention on Asymmetric information and its
impacts. Asymmetric information arises when either side of the party in an
economic transaction or trade possesses greater material knowledge than
the other one. The impact of this situation are far reaching and observed
in our daily lives. The author takes a wonderful example of comparison of
health insurance and facilities provided by three countries US, UK and
Singapore. In an ideal case, there are two sets of people who require

health insurance Peaches and Lemons. Peaches are those who are
healthy and hence should require to pay less for the insurance and lemons
are people who have greater chances of getting sick and hence should be
required to pay more for the premium. In US, the author explains, is the
cost of medical services are really high as people are required to purchase
their own health insurances otherwise the cost of medical expenses is
really high. But a few people who have other priorities (example young
poor) wont buy the insurance and this will result in insurance companies
charging more premium from its other customers. Another problem that
arises is that since insurance companies have to pay the bill, they are the
ones who decide which treatment to go for. This results in partial coverage
and high costs in US system. In the Britain system, the government pays
for the medical expenses and service is almost free. This results in
overcrowding, which further leads to inefficiencies. This is because
everyone will demand same best treatment from the best surgeon and
this puts pressure on a single point of contact. This is what we call the
moral hazard arising out of asymmetric information. Just because the
service is free, people will want to take the service even if they do not
require one. Lastly, if we compare the Singapore system, it involves the
participation of both the markets and the government and the model is
successful for almost two decades. In the private system, people have the
incentive to provide the right information to get the right coverage, and in
the public system, government can ensure minimum level of coverage.
This results in a better system.

Chapter 6
Chapter 6: Rational Insanity
This chapter presents a paradox: economists study rational behavior, but
the more rational the behavior of stock market investors, the more erratic
the behavior of the stock market becomes. We learn how a market full of
unexploited opportunities offers big rewards to any investor willing to
research them and how a rational investment in Grolsch beer keeps the
market nearly-random. The author slowly and steadily breaks all the
myths related to market valuations. Take for instance the popular example
of Amazon. Amazon was doing really good at its inception and its stocks
were valued high in expectations that future profits will be more. But
eventually the stocks collapsed owing to the dot com burst. This is what
happens in most cases. As more and more people tends to think that a
particular stock is going to pay off, the shares will rise but that will happen
unto a point. After that, people will realize the stocks they are holding are
not that worth and hence start selling. In the long run, the P/E ratio roams
around 16. This shows that people making rational choices while buying

and purchasing stocks is not really rational and many people have
exploited this trend. For example, in case of Grolsch Beer, an investor
impacted the investor sentiments by showing the success of Grolsch Beer
in a particular town which resulted in increase of the stock price. This
helped the investor make money but in the long run, the company did not
perform well and eventually the stock prices came down. The author also
blasts the common belief that companies entering the markets first are
most profitable by taking the example of Google. Google came into
market after Yahoo but due to its superior service was able to gain the
major position in the markets. So the main power comes from offering a
service or product which cannot be matched. As an investor, if you want
to make money, then you need to have a clear idea of what you think you
know and what the market insiders are ignoring. Simply relying on market
patterns is useless in an efficient market as the pattern is random.

Chapter 7
Summary: The Men Who Knew the Value of Nothing
In chapter 7 of The Undercover Economist author tells readers is
how game theory can be linked and applied to what Economic has
done to the world. Game like poker unexpectedly explains the real
story seen in everyday life that you need to analyses your
opponents moves in order to play the game, and be careful not
to be predictable in order to win. This has nothing/or little
difference compared to the Economic activities done in the real
world. It is just like playing a game, but what you get in return is
much more, whether it is a huge benefit or a fail limitation. He
explains it by giving an example of bidding house how a person sells
its house who he thinks is of worth 300000 at 3000 and similar type
of house in neighborhood gets sold in more than expected value.
Poker needs luck and skill to achieve victory, as well as bidding a
house. No one actually has all the idea whether the business would
be profitable or not, even the bidders themselves. In one way, it can
suddenly make lose, as customers who look for house may not bid
and just leave it for the cheapest price to be bought. They can
always look for other new opportunities.
Then he discusses about the way auction is done and the reasons
behind the strategy of getting correct bid. Its just like knowing an
optimal bid amount just above your competitor. Bidding at spectrum
of 3g in UK was crashed due to simple mistake of not rounding off
the bid value that indicated competitor value intention and

expected bid. The competitors avoided the competition with each


other and started bidding much less .In April 1997 it earned revenue
less than one person that it expected. Then he discusses various
methods used while auctioning like paying amount of second
highest bidder to increase the bid amount and get maximum
possible bid and apply a strategy where even game theory or
mathematics fail to provide solutions.

Chapter 8
WHY POOR COUNTRIES ARE POOR
In this chapter there is discussion of why poor nations are poor,
using Cameroon as an exemplar. According to Harford he is not
convinced by different explanations for the poverty prevailing in the
third world. He depicts a picture where he believes corrupt
governments are sole reason and general cause for the condition of
poverty. Poor countries should have higher return on investment as
they have high scope of impact for the same amount of investment
in rich countries by theory of diminishing returns. Whether
through a big push or otherwise, many poor countries have
managed to grow quickly over the past few decades, so why have
so many others been left behind? The reason according to Harford is
government banditry, planning infrastructure are useless until the
state is administered in a proper way. It is imposing politically
correct policies that developed nation advocate. He describes one
such instance where he visited a new build library which lacked in
basic requirement the number and quality of books, such a big
infrastructure was not needed it all at. The lesson from instance
appears to be that self-interested and ambitious people in power are
often the cause of wastefulness in developing countries. As Harford
states, This Nepalese example is yet another demonstration that if
a society cannot provide the right kind of incentives to behave
productively, no amount of technical infrastructure can save it from
poverty .