Naked Economics
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This broad view of cost can explain some very important social phenomena, one of which is the plummeting birth rate in the developed world. Having a child is more expensive than it was fifty years ago. This is not because it is more expensive to feed and clothe another little urchin around the house. If anything, those kinds of costs have gone down, because we have become far more productive at making basic consumer goods like food and clothing. Rather, the primary cost of raising a child today is the cost of the earnings forgone when a parent, still usually the mother, quits or cuts back on work to look after the child at home. Because women have better professional opportunities than ever before, it has grown more costly for them to leave the workforce. My neighbor was a neurologist until her second child was born, at which point she decided to stay home. It’s expensive to quit being a neurologist.
Meanwhile, most of the economic benefits of having a large family have disappeared in the developed world. Young children no longer help out on the farm or provide extra income for the family (though they can be taught at a young age to fetch a beer from the refrigerator). We no longer need to have many children in order to ensure that some of them live through childhood or that we have enough dependents to provide for us in retirement. Even the most dour of economists would concede that we derive great pleasure from having children. The point is that it is now more expensive to have eleven of them than it used to be. The data speak to that point: The average American woman had 3.77 children in 1905; she now has 2.07—a 45 percent drop.5
There is a second powerful assumption underpinning all of economics: Firms—which can be anything from one guy selling hot dogs to a multinational corporation—attempt to maximize profits (the revenue earned by selling stuff minus the cost of producing it). In short, firms try to make as much money as possible. Hence, we have an answer to another of life’s burning questions: Why did the entrepreneur cross the road? Because he could make more money on the other side.
Firms take inputs—land, steel, knowledge, baseball stadiums, etc.—and combine them in a way that adds value. That process can be as simple as selling cheap umbrellas on a busy corner in New York City when it starts to rain (where do those guys come from?) or as complex as assembling Boeing’s 787 Dreamliner (a passenger jet that required 800,000 hours on Cray supercomputers just to design). A profitable firm is like a chef who brings home $30 worth of groceries and creates an $80 meal. She has used her talents to create something that is worth far more than the cost of the inputs. That is not always an easy thing to do. Firms must decide what to produce, how and where to produce it, how much to produce, and at what price to sell what they produce—all in the face of the same kinds of uncertainties that consumers deal with.
How? These are massively complex decisions. One powerful feature of a market economy is that it directs resources to their most productive use. Why doesn’t Brad Pitt sell automobile insurance? Because it would be an enormous waste of his unique talents. Yes, he is a charismatic guy who could probably sell more insurance policies than the average salesman. But he is also one of a handful of people in the world who can “open” a movie, meaning that millions of people around the world will go to see a film just because Brad Pitt is in it. That is money in the bank in the risky Hollywood movie business, so studios are willing to pay handsomely to put Brad Pitt in a starring role—about $30 million a film. Insurance agencies would also be willing to pay for the Pitt charisma—but more like $30,000. Brad Pitt will go where he is paid the most. And he will be paid the most in Hollywood because that is where he can add the most value.
Prices are like giant neon billboards that flash important information. At the beginning of the chapter, we asked how a restaurant on the Rue de Rivoli in Paris has just the right amount of tuna on most nights. It is all about prices. When patrons start ordering more of the sashimi appetizer, the restaurateur places a larger order with his fish wholesaler. If tuna is growing more popular at other restaurants, too, then the wholesale price will go up, meaning that fishermen somewhere in the Pacific will get paid more for their tuna catch than they used to. Some fishermen, recognizing that tuna now commands a premium over other kinds of fish, will start fishing for tuna instead of salmon. Meanwhile, some tuna fishermen will keep their boats in the water longer or switch to more expensive fishing methods that can now be justified by the higher price their catch will fetch. These guys don’t care about upscale diners in Paris. They care about the wholesale price of fish.
Money talks. Why are the pharmaceutical companies scouring the rain forests looking for plants with rare healing properties? Because the blockbuster drugs they may uncover earn staggering amounts of money. Other kinds of entrepreneurial activity take place on a smaller scale but are equally impressive in their own way. For several summers I coached a Little League baseball team near Cabrini Green, which is one of Chicago’s rougher neighborhoods. One of our team customs was to go out periodically for pizza, and one of our favorite spots was Chester’s, a small shack at the corner of Division and Sedgwick that was a testimony to the resiliency and resourcefulness of entrepreneurs. (It has since been demolished to make way for a new park as part of an aggressive development of Cabrini Green.) Chester’s made decent pizza and was always busy. Thus, it was basically an armed robbery waiting to happen. But that did not deter the management at Chester’s. They merely installed the same kind of bulletproof glass that one would find at the drive-up window of a bank. The customers placed their money on a small carousel, which was then rotated through a gap in the bulletproof glass. The pizza came out the other direction on the same carousel.
Profit opportunities attract firms like sharks to blood, even when bulletproof glass is required. We look for bold new ways to make money (creating the first reality TV show); failing that, we look to get into a business that is making huge profits for someone else (thereby creating the next twenty increasingly pathetic reality TV shows). All the while, we are using prices to gauge what consumers want. Of course, not every market is easy to enter. When LeBron James signed a three-year $60 million contract with the Cleveland Cavaliers, I thought to myself, “I need to play basketball for the Cleveland Cavaliers.” I would have gladly played for $58 million, or, if pressed, for $58,000. Several things precluded me from entering that market, however: (1) I’m five-ten; (2) I’m slow; and (3) when shooting under pressure, I have a tendency to miss the backboard. Why is LeBron James paid $20 million a year? Because nobody else can play like him. His unique talents create a barrier to entry for the rest of us. LeBron James is also the beneficiary of what University of Chicago labor economist Sherwin Rosen dubbed the “superstar” phenomenon. Small differences in talent tend to become magnified into huge differentials in pay as a market becomes very large, such as the audience for professional basketball. One need only be slightly better than the competition in order to gain a large (and profitable) share of that market.
In fact, LeBron’s salary is chump change compared to what talk-show host Rush Limbaugh is now paid. He recently signed an eight-year $400 million contract with Clear Channel Communications, the company that syndicates his radio program around the country. Is Rush that much better than other political windbags willing to offer their opinions? He doesn’t have to be. He need only be a tiny bit more interesting than the next best radio option at that time of day in order to attract a huge audience—20 million listeners daily. Nobody tunes into their second-favorite radio station, so it’s winner-take-all when it comes to listeners and the advertisers willing to pay big bucks to reach them.
Many markets have barriers that prevent new firms from entering, no matter how profitable making widgets may be. Sometimes there are physical or natural barriers. Truffles cost $500 a pound because they cannot be cultivated; they grow only in the wild and must be dug up by truffle-hunting pigs or dogs. Sometimes there are legal barriers to entry. Don’t try to sell sildenafil citrate on a street corner or you may end up in jail. This is not a drug that you snort or shoot up, nor is it ille
gal. It happens to be Viagra, and Pfizer holds the patent, which is a legal monopoly granted by the U.S. government. Economists may quibble over how long a patent should last or what kinds of innovations should be patentable, but most would agree that the entry barrier created by a patent is an important incentive for firms to make the kinds of investments that lead to new products. The political process creates entry barriers for dubious reasons, too. When the U.S. auto industry was facing intense competition from Japanese automakers in the 1980s, the American car companies had two basic options: (1) They could create better, cheaper, more fuel-efficient cars that consumers might want to buy; or (2) they could invest heavily in lobbyists who would persuade Congress to enact tariffs and quotas that would keep Japanese cars out of the market.
Some entry barriers are more subtle. The airline industry is far less competitive than it appears to be. You and some college friends could start a new airline relatively easily; the problem is that you wouldn’t be able to land your planes anywhere. There are a limited number of gate spaces available at most airports, and they tend to be controlled by the big guys. At Chicago’s O’Hare Airport, one of the world’s biggest and busiest airports, American and United control some 80 percent of all the gates.6 Or consider a different kind of entry barrier that has become highly relevant in the Internet age: network effects. The basic idea of a network effect is that the value of some goods rises with the number of other people using them. I don’t think Microsoft Word is particularly impressive software, but I own it anyway because I spend my days e-mailing documents to people who do like Word (or at least they use it). It would be very difficult to introduce a rival word-processing package—no matter how good the features or how low the price—as long as most of the world is using Word.
Meanwhile, firms are not just choosing what goods or services to produce but also how to produce them. I will never forget stepping off a plane in Kathmandu; the first thing I saw was a team of men squatting on their haunches as they cut the airport grass by hand with sickles. Labor is cheap in Nepal; lawn mowers are very expensive. The opposite is true in the United States, which is why we don’t see many teams of laborers using sickles. It is also why we have ATMs and self-service gas stations and those terribly annoying phone trees (“If you are now frustrated to the point of violence, please press the pound key”). All are cases where firms have automated jobs that used to be done by living beings. After all, one way to raise profits is by lowering the cost of production. That may mean laying off twenty thousand workers or building a plant in Vietnam instead of Colorado.
Firms, like consumers, face a staggering array of complex choices. Again, the guiding principle is relatively simple: What is going to make the firm the most money in the long run?
All of which brings us to the point where producers meet consumers. How much are you going to pay for that doggie in the window? Introductory economics has a very simple answer: the market price. This is that whole supply and demand thing. The price will settle at the point where the number of dogs for sale exactly matches the number of dogs that consumers want to buy. If there are more potential pet owners than dogs available, then the price of dogs will go up. Some consumers will then decide to buy ferrets instead, and some pet shops will be induced by the prospect of higher profits to offer more dogs for sale. Eventually the supply of dogs will match the demand. Remarkably, some markets actually work this way. If I choose to sell a hundred shares of Microsoft on the NASDAQ, I have no choice but to accept the “market price,” which is simply the price at which the number of Microsoft shares for sale on the exchange exactly equals the number of shares that buyers would like to purchase.
Most markets do not look quite so much like the textbooks. There is not a “market price” for Gap sweatshirts that changes by the minute depending on the supply and demand of reasonably priced outerwear. Instead, the Gap, like most other firms, has some degree of market power, which means very simply that the Gap has some control over what it can charge. The Gap could sell sweatshirts for $9.99, eking out a razor-thin profit on each. Or it could sell far fewer sweatshirts for $29.99, but make a hefty profit on each. If you were in the mood to do calculus at the moment, or I had any interest in writing about it, then we would find the profit-maximizing price right now. I’m pretty sure I had to do it on a final exam once. The basic point is that the Gap will attempt to pick a price that leads to the quantity of sales that earn the company the most money. The marketing executives may err either way: They may underprice the items, in which case they will sell out; or they may overprice the items, in which case they will have a warehouse full of sweatshirts.
Actually, there is another option. A firm can attempt to sell the same item to different people at different prices. (The fancy name is “price discrimination.”) The next time you are on an airplane, try this experiment: Ask the person next to you how much he or she paid for the ticket. It’s probably not what you paid; it may not even be close. You are sitting on the same plane, traveling to the same destination, eating the same peanuts—yet the prices you and your row mate paid for your tickets may not even have the same number of digits.
The basic challenge for the airline industry is to separate business travelers, who are willing to pay a great deal for a ticket, from pleasure travelers, who are on tighter budgets. If an airline sells every ticket at the same price, the company will leave money on the table no matter what price it chooses. A business traveler may be willing to pay $1,800 to fly round trip from Chicago to San Francisco; someone flying to cousin Irv’s wedding will shell out no more than $250. If the airline charges the high fare, it will lose all of its pleasure travelers. If it charges the low fare, it will lose all the profits that business travelers would have been willing to pay. What to do? Learn to distinguish business travelers from pleasure travelers and then charge each of them a different fare.
The airlines are pretty good at this. Why will your fare drop sharply if you stay over a Saturday night? Because Saturday night is when you are going to be dancing at cousin Irv’s wedding. Pleasure travelers usually spend the weekend at their destination, while business travelers almost never do. Buying the ticket two weeks ahead of time will be much, much cheaper than buying it eleven minutes before the flight leaves. Vacationers plan ahead while business travelers tend to buy tickets at the last minute. Airlines are the most obvious example of price discrimination, but look around and you will start to see it everywhere. Al Gore complained during the 2000 presidential campaign that his mother and his dog were taking the same arthritis medication but that his mother paid much more for her prescription. Never mind that he made up the story after reading about the pricing disparity between humans and canines. The example is still perfect. There is nothing surprising about the fact that the same medicine will be sold to dogs and people at different prices. It’s airline seats all over again. People will pay more for their own medicine than they will for their pet’s. So the profit-maximizing strategy is to charge one price for patients with two legs and another price for patients with four.
Price discrimination will become even more prevalent as technology enables firms to gather more information about their customers. It is now possible, for example, to charge different prices to customers ordering on-line rather than over the phone. Or, a firm can charge different prices to different on-line customers depending on the pattern of their past purchases. The logic behind firms like Priceline (a website where consumers bid for travel services) is that every customer could conceivably pay a different price for an airline ticket or hotel room. In an article entitled “How Technology Tailors Price Tags,” the Wall Street Journal noted, “Grocery stores appear to be the model of one price for all. But even today, they post one price, charge another to shoppers willing to clip coupons and a third to those with frequent-shopper cards that allow stores to collect detailed data on buying habits.”7
What can we infer from all of this? Consumers try to make themselves as well off as possible and firms try t
o maximize profits. Those are seemingly simple concepts, yet they can tell us a tremendous amount about how the world works.
The market economy is a powerful force for making our lives better. The only way firms can make profits is by delivering goods that we want to buy. They create new products—everything from thermal coffee mugs to lifesaving antibiotics. Or they take an existing product and make it cheaper or better. This kind of competition is fabulously good for consumers. In 1900, a three-minute phone call from New York to Chicago cost $5.45, the equivalent of about $140 today. Now the same call is essentially free if you have a mobile phone with unlimited minutes. Profit inspires some of our greatest work, even in areas like higher education, the arts, and medicine. How many world leaders fly to North Korea when they need open-heart surgery?
At the same time, the market is amoral. Not immoral, simply amoral. The market rewards scarcity, which has no inherent relation to value. Diamonds are worth thousands of dollars a carat while water (if you are bold enough to drink it out of the tap) is nearly free. If there were no diamonds on the planet, we would be inconvenienced; if all the water disappeared, we would be dead. The market does not provide goods that we need; it provides goods that we want to buy. This is a crucial distinction. Our medical system does not provide health insurance for the poor. Why? Because they can’t pay for it. Our most talented doctors do provide breast enhancements and face-lifts for Hollywood stars. Why? Because they can pay for it. Meanwhile, firms can make a lot of money doing nasty things. Why do European crime syndicates kidnap young girls in Eastern Europe and sell them into prostitution in wealthier countries? Because it’s profitable.