57 pages • 1 hour read
The Undercover Economist
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Chapters 3-4Chapter Summaries & Analyses
Chapter 3 Summary: “Perfect Markets and the ‘World of Truth’”
Chapter 3 delves into the advantages and flaws of a free market. To illustrate how a perfectly free market would force people to behave truthfully, Harford opens this chapter with a thought experiment: If everyone is bound to tell the truth, what changes would that instill in an economy? For one, this would make price targeting a lot easier. To ascertain the most profitable price for a cappuccino, a barista could ask a customer how much they are willing to pay, and the customer would be forced to answer truthfully. If the customer is desperate, they might be willing to pay $15 for coffee. However, in this world of complete honesty, the customer could also force the barista to tell the truth about the real cost of producing a cappuccino. Then, the customer would discover that the real cost of the drink is less than $1. The customer could also ask the barista if there are cheaper coffee shops nearby and then use this information to drive down the price of the cappuccino to $1 since the barista’s options are to get a meager profit or none at all.
Harford uses this example to show how prices reveal the basic truth that “stores and customers do not have to buy and sell at a given price—they can always opt out” (65). In a perfectly free market, no one is truly forced to pay for what they don’t need. However, with the introduction of systems of taxation and government, people’s money often gets spent on things they do not necessarily condone, like subsidies for sports stadiums. The free market, on the other hand, is a treasure trove of data and information about people’s spending preferences, which companies further use to determine prices for everyone. Governments, on the other hand, have trouble responding to that complex information. For instance, in Tanzania, coffee was not produced in a free market until the 1990s. Before that point, any profit received from high coffee prices went to the government, which spent it on salary raises for civil servants rather than rewarding the profit-creating farmers.
Without markets, systems work very differently. Although Western society uses the free market in many aspects of life, there are systems that do not utilize it. For instance, taxation is a nonmarket system, which provides funding for services like the police and the fire department. When someone calls 911, the operator doesn’t ask for payment before sending help. However, when these services are provided by rude or incompetent people, the public cannot “shop around” for a different policing option. The only option available is to lobby a local politician and make demands that they can choose to address or not.
Public schooling is another example of nonmarket utilities. Some public schools are good and others are not, often depending on the wealth of their area. The nonmarket system suffers from a crucial problem: “[T]he truth about values, costs, and benefits has disappeared” (71). While nonmarket services are vital and should be supported, they lose the “information about wants, needs, and desires, and about inconveniences and costs” (72). Sometimes the loss of information is worth the benefit, but at other times, the public doesn’t know whether the services they receive are equal to or more or less than the cost of their taxes.
A perfectly competitive market can be viewed as a “giant supercomputer network” that is perfectly efficient (73), reading our minds and distributing resources and taking payment accordingly. This would create perfect efficiency. However, perfect efficiency “is not enough to ensure a fair society” (73). Even though taxes can cause inefficiency by destroying information about preferences that would be signaled by price, they still need to exist in order to ensure parity. After World War II, the leaders of both America and Britain expanded the roles of government in order to address the economic consequences of the great loss of life as well as the lingering effects of the Great Depression. People were largely content to trade some inefficiency for the hope of a more just and equitable society.
However, a young economist named Kenneth Arrow had misgivings about allowing inefficiency to dominate. The solution he came up with was “brilliant” and won him the Nobel Prize for Economics. The author calls Arrow’s idea the “Head-Start Theorem,” and it states that “all efficient outcomes can be achieved using a competitive market, by adjusting the starting position” (76). The example of a 100-meter sprint is introduced: If all of the sprinters are to cross the finish line at the same time, but some are faster than others, moving starting blocks back for the faster runners and forward for the slower ones would achieve an equitable finish to the race. Arrow demonstrated that the same effect could be achieved with the economy by hindering richer companies with “lump-sum payments and levying one-time taxes” (76). A lump-sum tax could be levied against richer people and companies, and lump-sum payments could be given to poorer ones.
Harford acknowledges that the fantasy of the “complete, free, and competitive” market is unattainable (80). However, this fantasy helps explain why problems in the economy arise and what to do about them. It also helps pinpoint failures in the market system so that economists can identify them and find solutions.
Chapter 4 Summary: “Crosstown Traffic”
Several problems—like traffic congestion in big cities—never seem to solve themselves as they would in an imaginary perfect free market. Markets go wrong for three major reasons. The first is scarcity power, explored in earlier chapters. The second is that “some decision makers lack information” (84). The third reason, which will be explored in this chapter, is that decisions made by customers can have side effects on bystanders who did not choose to engage in the choice made by the customer. For instance, a customer could choose to buy fuel for their car, but a bystander does not choose whether or not they inhale the carbon monoxide produced by the customer’s fuel use. These side effects are called “externalities” because they are separate from the original economic decision. These three factors force economies to fall short of the idealized perfect free market.
Some examples of externalities are traffic congestion, accidents that kill drivers and pedestrians, traffic noise, and careless drivers. The use of a car comes at a detriment to everyone else around that car and driver. This is why traffic departs from the perfectly competitive market—people are not allowed to make all the relevant decisions about their own health, activity, and safety.
However, drivers also pay vehicle and fuel taxes. They could argue that those taxes should cover the damage they cause to the environment and their fellow humans. While drivers certainly pay enough, their tax money is not going toward “the right things” (86). There is a difference, though, in the types of costs for driving. The cost of having a car and taking it out on the roads is high, which is the “average” price. However, once someone has that car and the license to drive it, additional trips cost very little—the cost for extra driving is “marginal.” The fact that the average price of driving is high but the marginal cost is low gives drivers no incentive to drive less. A better solution would be to either provide more attractive non-driving options or charge drivers for their mileage; this externality charge would raise the marginal price of driving and give them an incentive to drive less.
Externality pricing, however, often relies on “shaky information” to calculate the perceived harm of actions for which a charge should compensate. No one knows what people really would pay to reduce externalities like pollution or what the cheapest way might be to reduce these externalities. By charging more intelligently and strategically, lawmakers can encourage better behavior on the whole. Externality charges have the advantage of not trying to force people to behave in a particular way but simply creating consequences for particular behaviors.
There are positive externalities as well. If a person paints their home and landscapes their yard, the whole street looks better, but no one subsidizes the paint or the plants for that person. Externality subsidies alongside charges are a good way to encourage behavior that benefits others while discouraging behavior that inconveniences or harms others.
Chapters 3-4 Analysis
Chapters 3 delves into the workings of a free-market system, exploring themes such as pricing, competition, efficiency, and the role of government intervention. The theme of government intervention in the market recurs in Chapter 4, which discusses externalities and how they can be dealt with in the most efficient manner.
One prominent theme in Chapter 3 is the concept of pricing as a mechanism for revealing preferences and values. Building on the ideas in Chapters 1 and 2, Chapters 3 further explores the ways that prices in a free-market system convey information about individuals’ desires and necessities. The chapter provides concrete examples of the principle, especially utilizing the scenario of a “world of truth” that simplifies economic analysis by imagining a world in which no one can hide their true priorities. Customers in this world would reveal exactly how much they are willing to pay for goods and services, which would reflect their personal preferences, and businesses would reveal the true cost of their goods and also how much they would be willing to drop their prices in the face of competitors who offer similar goods and services. Harford uses the “world of truth” analogy to emphasize the efficiency of a perfectly free and competitive market. In this type of market, customers would benefit from competition and information, and prices would align with the marginal cost of production. Businesses, too, would benefit from not overproducing or wasting resources since they have a clear understanding of customer needs and preferences. With this analogy, Harford reveals his preference for and belief in the free-market system.
However, Harford acknowledges that the perfect free-market system does not exist and cannot exist since real-world markets are imperfect and complex. In this way, he reminds his readers that economic theories and models are only ways to understand the market rather than blueprints that fit the workings of actual markets. This is a caveat he introduced in Chapter 1, when he discussed the work of David Ricardo and how it could still be applied to current markets. Harford cautioned readers that in economic models, complexity has to be reduced in order to effectively study the system. This is why no economic model can satisfactorily explain everything, and economists should not try “to explain everything” (17).
Harford then introduces one element that complicates the notion of a perfect free market: government intervention. While he shows that government policies often cause inefficiencies in the market—by using the examples of Tanzania in the 1990s, when the government incentivized civil servants rather than farmers when coffee production went up—he also acknowledges that government policies in the form of taxation are imperfect but necessary to ensure a more equitable society. However, since public goods do not have the advantages of competition and information about customer preferences like the free market, they are often difficult to overhaul, even when they do not meet the expectations of consumers. The example of public schooling illustrates how non-market systems may also fail to allocate resources based on true preferences, leading to inequalities.
Chapter 4 continues this theme of government regulation of the market while discussing externalities. Harford explains the problem of externalities using the example of a car owner who contributes to traffic jams and causes delays for others. The car owner does not bear the costs of their decision, which creates an externality and results in the waste of other people’s time and money. Harford says that externality charges decided upon by government agencies, although controversial, can align personal choices with social costs. For example, to alleviate traffic congestion, externality charges may take the form of governments levying higher taxes on car owners based on the car’s mileage, thereby rewarding drivers who use their cars less frequently. Harford acknowledges the challenges of calculating externalities but advocates for their incorporation, thereby arguing that government intervention in market dynamics is necessary. One of the major themes of this book—The Role of Incentives on Shaping Behavior—would be the foundation for government agencies’ rationale while calculating externality charges that aim to create consequences for certain types of behaviors rather than banning them. Harford’s argument here marks a departure from more traditional neoliberal free-market philosophies that decry government interference.
In these chapters, Harford continues his strategy of employing various literary devices to convey economic concepts effectively. Analogies and metaphors are used to simplify complex economic ideas. For instance, the market is likened to a “giant supercomputer network,” emphasizing its efficiency. The head-start theorem, a pioneering social equity philosophy, is metaphorically illustrated through a 100-meter sprint analogy, providing a vivid image to enhance understanding. The use of anecdotes, such as the example of coffee production in Tanzania, adds a human touch to economic principles, allowing readers to see the effects of economics on micro and macro settings. Describing the impact of government intervention in coffee prices reveals the real-world consequences of economic policies, making the ideas relatable and the humans involved more vivid and sympathetic.
Chapters 3 and 4 provide a comprehensive exploration of economic themes, which highlight the efficiency of the ideal, nonexistent, perfectly competitive market. It also covers the implications of government intervention in the market and the challenges posed by externalities. Through the use of examples and anecdotes, Harford successfully communicates intricate economic principles and makes them accessible to a broader audience.
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