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April 13, 2006

Why Do Starbucks' cappuccinos cost so much? Tim Harford explains this and other "mysteries" of economics: The Undercover Economist - Tim Harford

Posted by Tim Worstall

The Undercover Economist
by Tim Harford
Pp. 276. London: Little, Brown, 2006
Hardback, 17.99

Tim Worstall reviews Tim Harford's new book, The Undercover Economist.

Economics tends to get a bad name: people read the business pages with the estimates of GDP, currencies and the like are slumbering again, face down in the cornflakes. For those who think that this is what the subject is actually about, Tim Harford's book The Undercover Economist will be a welcome relief. As he says:

Most economics has very little to do with GDP. Economics is about who gets what and why.
A much more interesting subject even if not one of the great chat-up lines of history. He starts out with that classic economist's folk tale (exemplified in I Pencil) that no one actually knows how to make anything. No one individual, that is, has all of the knowledge to make any single object, plus all of the associated machinery required and so on. In e-mail Harford has told me that he didn't realise that I Pencil was a real piece, thinking it was some sort of handed down story, meaning that he used the example of a cappuccino. Fortunately so, as he is then able to segue into why the things cost so much.

The answer being that value is created by scarcity (no, sorry Marxists, it isn't the value of the labour that goes into their production) and the thing which is actually scarce in the production of a drinkable cup of coffee is the premises to sell it from. Thus most of the price actually paid by the consumer goes to the landlord, not the barista, the coffee farmers or the corporation's shareholders. He's also able, staying on the same subject, to use the cup of java as an object lesson in price discrimination. Just how should or could a seller work out which potential buyers are willing to pay more for essentially the same product than others? As this example from Division of Labour - a blog by a collection of pro-market academic economists - shows, not even all economists immediately grasp this point:

Note: according to the menu board, Starbucks will also sell you "shaken" iced tea for an extra dollar. Why would anyone pay an extra buck just to have his iced tea shaken?
So that Starbucks can find out who will pay an extra dollar to have their ice tea shaken being the answer.

Harford then moves on to how supermarkets apply the same basic techniques: you'll never find the organic bananas sitting next to the conventionally grown ones as no one wants you to notice quite how much you're paying to please Peter Melchett.

What's so good about the way in which these lessons (stories? anecdotes? perhaps, although they're backed by good theory) is that they are told not in the oh so boring textbook manner that turns so many off the subject in the first place. They're obviously lines of thought that have been followed for some years and refined as Harford has moved around in his career. The coffee stories are all based in London (where he worked for Shell) and a later chapter on Cameroon clearly comes from a field trip for a later employer, the World Bank (an article edited down from that chapter can be read at Reason, a very good introduction to his style).

The basic building blocks of the economist's toolkit are explained in the same light and jovial yet accurate manner. Ricardian rent as above in the discussion of scarcity (and if you've never quite wrapped your brain around that concept I recommend his extraordinarily clear exposition) and then on to one of the great current debates, just how should we account for external effects of people's actions. Pollution and the like, whether of noise, water or the atmosphere, should it be banned or taxed? If taxed, in what manner? Gordon Brown's flat fee on SUVs was of course well after the book went to press but unsurprisingly it is exactly the wrong type of tax - being that it is a flat fee rather than a charge on the marginal use of the car.

Why you can't ever buy a decent used car is the starting point for the discussion of asymmetrical information: the important point being that in such cases it isn't just that markets don't work very well, they can't exist at all. There are corrective measures that can be taken but will these really work in the US health care insurance market, currently perhaps the largest such problem featuring this asymmetry?

The book closes with the above mentioned chapter on Cameroon and then contrasts this with the growth of wealth that is making China rich. Just how did they move from a hidebound plan to a vibrant (if decidedly still imperfect) capitalist economy? The secret offered is that they did not in fact either abolish or abandon the planning, it was simply frozen. Thus all new growth, all the new sectors of the economy, as soon as they appeared were outside the planning process. As the economy grew, more and more of it was market based until in recent years that remnant of the State directed economy is a rump that can finally be dealt with, being such a small proportion of the overall economy now.

Of course, no economics book is complete without a mention of comparative advantage so that gets a look in too, along with a discussion of whether globalisation is good or bad for the environment. Given the comment:

The environmentalist movement should be manning the barricades to demand global free trade immediately. One day, perhaps they will.
you might be able to guess his views here. Quite my favourite lines are these:
...David Friedman observes, for instance, that there are two ways for the United States to produce cars: they can build them in Detroit or they can grow them in Iowa. Growing them in Iowa makes use of a special technology that turns wheat into Toyotas: simply put the wheat onto ships and send them out into the Pacific Ocean...
For those who don't understand what comes next as well as for those who do I strongly recommend the book.

Only one quibble. I hadn't realised that the British book market was in quite such a poor state. The initial print run is only 3,000 copies and I can't believe that they are going to last all that long.

Tim Worstall graduated from the LSE and immediately went into small business where he has remained for twenty odd years, working in the US, UK and Russia in fields as diverse as newspaper distribution, offshore programming and exotic metals. He is the author of 2005 Blogged: Dispatches from the Blogosphere and blogs at www.timworstall.com


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This reminds me of Margaret Thatcher telling Sir Humphrey Appleby that she wanted him to "abolish economists".

Posted by: Robert H. Olley at April 25, 2006 05:10 PM
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