The Undercover Economist is a book that explains economic principles to the general public, in much the same way that Chaos explains chaos theory to the general public. Harford does this by taking everyday examples and examining why things are this way and who is benefiting. However, this is not a book about business. If anything, it is a book of society and public policy, as Harford spends much of the book examining the effect of economic policy on countries, and why some countries grow richer and others grow poorer.

The first principle of the book is that economic benefits only go to owners of scarce resource. Hartford uses the example of Starbucks. Money is transferred from caffeine-craving consumers to Starbucks because Starbucks has a scarce resource: conveniently located coffee. However, anyone can set up a coffee shop (so it really is not too scarce of a resource), which means that Starbucks needs to outbid people for conveniently located store sites. This raises the rental cost and means that Starbucks has less profit. Since coffee is not really a scarce resource, most of the benefit goes to the landowner, not the coffee vendor (or, for that matter, the coffee growers).

This leads into the second economic principle, which is that the important part of the economy is what happens at the margins, the just-barely-productive sections. Hartford illustrates with an example from David Ricardo, an early nineteenth-century economist who discovered the principle. If there is a large area of undeveloped land, people willing to farm the land can rent the land for very little (lots of land producing no income, few farmers). As more farmers come, the land price increases until farmers start renting land that is less good. The price of the good land is relative to the price of the marginal land.

Economists view a perfect market, that is, a market where everyone pays exactly the price that they are willing to for a particular good or service, as ideal. (By “ideal” they mean “benefits everyone the most.”)  If it were not ideal, then people would pay less, or choose something different. It follows, then, that pricing is very important in economics. In fact, a seller will want everyone to pay exactly the maximum price that they are willing. Of course, you cannot just ask buyers what they are willing to buy, so there are various strategies to get buyers to divulge that information: having different qualities of the same item at different prices, different quantities, different “specialness” (e.g. “organic”), etc.

Unfortunately, sometimes the price does not correctly reflect the cost. The cost of driving a car is not just the car plus the gas. It is also the fact that you are using space on the road (leading to more traffic jams) and polluting the atmosphere. If this is not included in the price, then it is each person’s best interest to take a car trip, leading to pollution and traffic jams. The solution is an externality charge, which is basically someone (the government) increasing the price to reflect the real cost. London instituted a per-trip charge through a certain area, which resulted in a quick and dramatic traffic drop. The marginal cost of a trip to the local grocery store was originally close to zero, so everyone drove. Now it was larger, so more people chose to walk or bike.

Also, sometimes the market cannot set a correct price because of lack of information. Health insurance is expensive because the people that think they are likely to get sick are the ones who will buy insurance, but they insurance company has less information on whether the person will get sick that the person does. You could have the government provide health care, but there is never enough money to go around, so you have to choose who gets what treatment; since there is not a good way of doing this, you get situations like in the U.K. where if you are going blind in both eyes, you can only get one eye treated (and not at all if you are going blind in just one eye). The solution to this sort of problem is keyhole economics. Identify what the scarcities are, allow both parties to get equal information, and let markets take care of the rest.

One example of using price to convey information and accurately describe value is the auction of the U.K. 3G wireless spectrum. The bids were viewable by all parties, but once you stopped bidding, you were out. The other company’s bids gave you an idea of how valuable the market was going to be.

There is a bit of a shift in direction at this point and the rest of the book discusses world trade. One of the major topics is why poor countries are poor. The standard models suggest that if poor countries develop their resources that have actual scarcity they will eventually become rich. Japan and South Korea are good examples of this. However, some countries, like Cameroon, have actually become poorer. The difference is that Cameroon has a dictator whose goal is to stay in power and have the country provide for his personal fortune. If that were all, then the country should still get richer, because it would be in his interest for the country to have more for him to steal. However, he can only remain dictator with the help of many other people, so he needs to provide an atmosphere where they are better off with him than without. So he tolerates a culture of corruption. In order to maximize the opportunity for bribes there is a tremendous bureaucracy involved with anything. As a result, it is enormously expensive to set up a business, not practical to try to collect from customers who do not pay, and the general economic climate is miserable. To make matters worse, since no one has any incentive to invest anything, children are not effectively taught and the national infrastructure has fallen apart, making the country even poorer. Fixing the problem would be relatively simple: enforce laws that are necessary for the proper function of business and remove bureaucracy. The markets will fix the rest. Unfortunately, this cannot happen because of the dictator.

China, on the other hand, has been a remarkable story of being an economic success. Mao pretty much ruined the country partly through stupid choices, and partly because the system gave no incentive for individuals to improve it. Deng Xiaoping gradually introduced reforms that gave individuals incentive to improve the system, starting with two small areas of the country. Although China’s business climate was not suitable for business, it worked because the economic areas were so small that laws that did not work were quickly replaced. And although China’s laws were insufficient, because of close family connections with Hong Kong and Taiwan, investments were able to be made because family connections provided the necessary trust that the laws did not promote.

Harford also discusses how world trade benefits everyone. Although it is possible for some countries to be self-sufficient, it is more economically efficient (i.e. people are richer) if each country produces what it is good at producing and trades with the rest. Simply put, if you are not doing what you are best at, clearly you are wasting time doing something inefficiently; if you had stuck to doing what you are best at, you could convert that previous inefficiency into wealth through trading. Thus trade is good, and inhibitors to trade (tariffs) are bad. David Friedman illustrates this principle by talking about Detroit car manufacturers and Iowa car growers. Detroit manufactures cars from steel; Iowa grows corn and ships it to a factory called “Japan” which turns it into cars. Tariffs on imports benefit Iowa car growers. Basically a tax on imports is equivalent to a tax on exports.

It also turns out that world trade is not ecologically harmful. Companys go to poor countries for cheap labor, not to pollute. Generally companies build the same plant everywhere in the world because it is more efficient that way. In fact, if anything, world trade imports pollution to rich countries, because they are the countries that have the skilled labor to produce things using concentrated chemicals. World trade is also not harmful to workers. Workers in the poor countries go to the sweatshops voluntarily; as bad as conditions are in the sweatshop, they are even worse outside the sweatshop, or workers would not choose to come there!

The Undercover Economist is a easily understandable introduction to economics. The examples that Harford uses are interesting and relevant and the astute reader should be able to apply them to similar situations elsewhere. A number of these examples debunk commonly held ideas: high prices imply price gouging (they do not if there is real scarcity), trade hurts the economy, government control is good, workers in poor countries are being harmed by sweatshops. He also follows the theory to its conclusions in public policy, which is helpful since the public debate rarely includes relevant theory.

His delight in perfect markets seems to me to be a little like the joke about physicists that ends with “assume a spherical cow.” Cows are not spherical and markets are not perfect. So somewhere the theory is going to break down rather badly, but he does not discuss when economics fail. Business schools like to teach a “efficient market” theory, which says that the stock market perfectly values companies. Clearly this is not the case or we would not have .com bubbles or Warren Buffett investors who beat the market for decades. The implication of “efficient markets” is that Warren Buffett cannot exist (he cannot reliably beat the market if the market truly values companies appropriately), but he does. The “efficient market” is so similar to the economists perfect markets that either the business schools did not understand the limitations of perfect market theory and inappropriately applied it, or economic theory has some substantial limitations that economists do not admit.

That said, this is a good introduction to economics and an interesting analysis of situations all readers are likely to be familiar with and the examples nicely illustrate, or rather, motivate, the principles, so the book will be useful to any reader unfamiliar or only partly familiar with economics.
Review: 8.5
A little simplistic, but good for the target audience. Good principles, good examples. I’m a little unconvinced that this will be a 100 year book, perhaps because although the principles are timeless, the examples are firmly locked in the early twenty-first century.