PDF Summary:The Undercover Economist, by Tim Harford

The Undercover Economist will help you think like an economist without boring you with endless graphs or complex math. By thinking like an economist, you’ll use principles like scarcity, price targeting, the stock market, and game theory to make better decisions every day. By understanding these economic principles, you’ll learn how economics operates in everyday life, why you make the economic decisions that you do, and what happens when these principles break down.

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Charging money for these externalities is a balancing act. We want to keep letting people do things they like, so we don’t want taxes on externalities to be too high. But we also want to make sure that people aren’t destroying the lives of those around them by doing what they want. Essentially, when figuring out externality taxes, we should attempt to imitate perfectly efficient markets as much as possible. We want the total cost to everyone else to be exactly equal to the benefit for one person.

Levying externalities is also situation-dependent. Charging people to drive at busy times in the city is a redistributive tax in the United Kingdom, where poorer people don’t drive. But in the United States, where poor people drive a lot, they end up paying a significantly higher percentage of their income on gas than rich people do. However, even in this case, it’s better to levy taxes on each trip into the city than it is to have one up-front tax. This way, poorer people can reduce their tax burden by choosing not to drive in the city as much, rather than having to pay a big tax every year and then feeling as if they need to justify it by driving in the city a lot.

Ultimately, externality charges are bound to be controversial. They are not an exact science, and some will argue that they are not tough enough, while others will argue that they are too tough.

Missing Information

When one party doing a business deal has more information than the other party, the market is not running efficiently. This section explains the information gap and how to close it.

Used Car Salesmen

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

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

Consequently, buyers offering $3,000 will only ever get lemons. If the buyer offers closer to $6,000 the salesman might give up a peach, but the buyer wouldn’t be willing to put up something like $5,500 for a 50% chance she’s getting a lemon.

In this extreme example, there is literally no market. Buyers who have even an ounce of common sense just won’t shop for a used car. Consequently, sellers won’t sell many used cars. Insider information helps no one. This only occurs when one group is ignorant and the other has knowledge. If both the buyer and the seller are ignorant, the market would resolve itself. The problem is the knowledge gap.

(Shortform note: Read our summary of Freakonomics to learn how unequal access to information affects you when you’re buying a house, and how the Internet is closing the information gap.)

Signaling Quality

So, how can we solve the knowledge gap? The first way is for vendors to signal quality, or to show customers that they are reliable. There are lots of ways for vendors to do this. In the car salesman example, trustworthy salespeople often have a showroom that’s a lot fancier than a used car lot on the side of a highway. These showrooms are fairly expensive and require long leases. If a salesperson has roots in the community thanks to their lease, they can’t just pick up and leave if they start selling lemons and word gets around that they are not to be trusted. If they can’t quickly leave and move on to a new group of suckers, they’re disincentivized to withhold important information from customers. Thus, customers trust salespeople with showrooms because the quality of the showroom signals that the seller can’t rip the buyer off.

This is also why old banks often found fancy buildings to conduct their business out of. If you’re giving your money over to an organization to hold, you want to make sure that it’s trustworthy. Signposts of trust like a stately building aren’t just nice frills: The expensive lease in the fancy building makes sure that vendors will be honest with customers.

There are many signals of quality that don’t involve real estate as well. For example, people like to poke fun at students getting their degree in a subject like philosophy. The popular argument is that philosophy doesn’t give students any marketable skills that will help them make money. But finishing a philosophy degree is another signal of quality. Philosophical arguments are dense. While reading and writing about them might not be directly related to whatever job a philosophy student has after graduation, it shows a level of commitment that employers pick up on. If someone is excited to study philosophy, they likely have a good work ethic.

Remember, though, that all of these examples involve trade-offs. It might not be worth the money to pursue a philosophy degree, even if it does make it marginally easier to secure a job because you can better signal quality.

Finding Quality

While vendors can signal quality if they choose, it is often up to customers to find quality.

Let’s use renting an apartment as an example. When landlords show off an apartment to potential tenants, they are signaling quality by allowing customers to test that everything works in the apartment or look around the place and the neighborhood. But potential tenants and landlords can both find quality in one another to close the information gap. There are all kinds of forums where tenants can share positive or negative experiences about landlords: Potential tenants can seek out this information online, or ask other tenants in the building directly about whether the landlord is responsive. Landlords, though, need information about tenants as well before they agree to rent out their place. They don’t want tenants who can’t pay their rent. So they find quality: They regularly ask for bank statements, proof of employment, and tax returns. When each party has enough information about the other, they can comfortably complete the transaction.

The Stock Market

The stock market is a sector of the economy that is shrouded in secrecy. Complex jargon scares potential investors who don’t have a background in economics or finance. This section will help to lift that curtain. It will explain how stock prices are valued and why companies hire economists to help them play the stock market.

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

The market is a nearly random walk that trends upwards. Generally, as the world economy continues to grow, more people will put their money into the market. This leads to the upwards trend. It’s nearly random because people who are well informed about market conditions can, on aggregate, make a little bit more money than the average investor.

Future Value

Economists are hired by investment firms or individuals because they are generally right about the market’s direction a little bit more often than they are wrong. This is because they understand the future of markets a little bit better than the average person.

Stock prices are the representation of what the market thinks a company will earn in the future. Investors and economists are attempting to judge not the current profitability of a company, but what the current numbers and the state of the economy mean for a company’s future profitability.

When you buy a stock, you’re buying a small part of the company. Theoretically, as a shareholder, you get back part of a company’s profits. In practice, though, shares are more about prospects than profits. When a company makes a profit, it generally reinvests that money into growing its business. Companies spend money on development of a new product or advertising of an existing one. As a shareholder in a company, you’re betting that they’ll have more success with their reinvestments and general growth than the market assumes.

The stock market, then, is less about companies’ fundamentals and more about what other people think of a company.

Game Theory

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

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

Poker

Many game theorists have been fascinated with poker as an application for their theory. In poker games, you win an entire pot of money if you finish with the best hand. There are rounds of betting in which players make decisions based on how other players are behaving about whether to stay in a hand, in an attempt to win, or whether to get out of the hand and save their money. Players can calculate in real time whether it’s worth paying to stay in.

For example, in the poker game Texas Hold ‘Em, communal cards that everyone can see and use are shown by the dealer after every round of betting. Players are often looking for a specific card or kind of card to complete a hand. It doesn’t take too much math to figure out the probability of a card coming up and whether it's worth it to pay to stay in the hand and look for your card.

Where it gets more complicated, and where game theory comes into play, is what the other players are doing. Players both figure out the probability of their best hand and predict whether their potential hands will beat their opponents’ potential hands. There are clues about what cards an opponent might have based on how they are betting, but they could be “bluffing,” or intentionally attempting to mislead other players into making a bad decision. Players also understand that the other players are analyzing their moves. This is why poker remains so popular and endlessly fascinating. It’s a game of secrets that’s governed by complex game theory and larger understandings of human behavior.

Globalization

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

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

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

Comparative Advantage

Much of the success of globalization is due to comparative advantage. Comparative advantage occurs when one group can make a product more efficiently than another group. We’ll use a simple example of building radios and televisions to illustrate this concept. Let’s say that in the United States, a factory worker can build a radio every 30 minutes and a television every hour. In China, a factory worker can produce a radio every 20 minutes and a television every 10 minutes. Without trade, it will take the worker 90 minutes to make a television and a radio in the U.S. and 30 minutes to make both in China. However, let’s say that the Chinese worker decides to make two televisions and the American worker makes two radios, and then they trade, swapping a TV for a radio and vice versa. Now, the Chinese worker has a radio and a TV in 20 minutes (as opposed to 30 minutes), and the American worker has a TV and a radio in an hour (as opposed to 90 minutes). Both win. If we disallow trading, we’re hurting everyone.

Certainly, the world economy is more complex than this example. We use currency and trade with multiple partners, which both obscure this simple principle. However, despite these added complexities, the general principle holds true.

Additionally, when nations put taxes on imports, they are unknowingly placing an equal tax on their exports. For example, if the U.S. puts a high tax on imports of Chinese TVs, effectively banning them, the American TV-making industry will benefit (people will buy the cheaper American TVs rather than the expensive Chinese ones). However, U.S. export industries will suffer: Say the U.S. exports radios in exchange for Chinese currency. Without Chinese imports to spend that currency on, the American industry’s revenue from China is essentially useless. Industries are thus competing with others in their own nation for comparative advantage.

Unfortunately, given the struggle for efficiency, some workers do lose their jobs in the globalized free market—it’s not good for everyone right away. These workers are forced to learn new skills and hope that more efficient producers that now have more demand from around the world will hire them. The government should help people who lose their jobs while continuing to pursue globalization.

(Shortform note: To learn more about the negative consequences of tariffs, read our summary of Economics in One Lesson.)

All of these economic principles—scarcity, price targeting, finding efficient markets, externalities, missing information, the stock market, game theory, and globalization—may have seemed impossibly complex before reading this summary. But The Undercover Economist proves that while economics can sound full of jargon, it is ultimately about people.