Naked Economics (5 page)

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.”
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What can we infer from all of this? Consumers try to make themselves as well off as possible and firms try to 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.

In fact, criminals are some of the most innovative folks around. Drug traffickers can make huge profits by transporting cocaine from where it is produced (in the jungles of South America) to where it is consumed (in the cities and towns across the United States). This is illegal, of course; U.S. authorities devote a great amount of resources to interdicting the supply of such drugs headed toward potential consumers. As with any other market, drug runners who find clever ways of eluding the authorities are rewarded with huge profits.

Customs officials are pretty good at sniffing out (literally in many cases) large caches of drugs moving across the border, so drug traffickers figured out that it was easier to skip the border crossings and move their contraband across the sea and into the United States using small boats. When the U.S. Coast Guard began tracking fishing boats, drug traffickers invested in “go fast” boats that could outrun the authorities. And when U.S. law enforcement adopted radar and helicopters to hunt down the speedboats, the drug runners innovated yet again, creating the trafficking equivalent of Velcro or the iPhone: homemade submarines. In 2006, the Coast Guard stumbled across a forty-nine-foot submarine—handmade in the jungles of Colombia—that was invisible to radar and equipped to carry four men and three tons of cocaine. In 2000, Colombian police raided a warehouse and discovered a one-hundred-foot submarine under construction that would have been able to carry two hundred tons of cocaine. Coast Guard Rear Admiral Joseph Nimmich told the
New York Times,
“Like any business, if you’re losing more and more of your product, you try to find a different way.”
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The market is like evolution; it is an extraordinarily powerful force that derives its strength from rewarding the swift, the strong, and the smart. That said, it would be wise to remember that two of the most beautifully adapted species on the planet are the rat and the cockroach.

Our system uses prices to allocate scarce resources.
Since there is a finite amount of everything worth having, the most basic function of any economic system is to decide who gets what. Who gets tickets to the Super Bowl? The people who are willing to pay the most. Who had the best seats for the Supreme Soviet Bowl in the old USSR (assuming some such event existed)? The individuals chosen by the Communist Party. Prices had nothing to do with it. If a Moscow butcher received a new shipment of pork, he slapped on the official state price for pork. And if that price was low enough that he had more customers than pork chops, he did not raise the price to earn some extra cash. He merely sold the chops to the first people in line. Those at the end of the line were out of luck. Capitalism and communism both ration goods. We do it with prices; the Soviets did it by waiting in line. (Of course, the communists had many black markets; it is quite likely that the butcher sold extra pork chops illegally out the back door of his shop.)

Because we use price to allocate goods, most markets are self-correcting.
Periodically the oil ministers from the OPEC nations will meet in an exotic locale and agree to limit the global production of oil. Several things happen shortly thereafter: (1) Oil and gas prices start to go up; and (2) politicians begin falling all over themselves with ideas, mostly bad, for intervening in the oil market. But high prices are like a fever; they are both a symptom and a potential cure. While politicians are puffing away on the House floor, some other crucial things start to happen. We drive less. We get one heating bill and decide to insulate the attic. We go to the Ford showroom and walk past the Expeditions to the Escorts.

When gas prices approached $4 a gallon in 2008, the rapid response of American consumers surprised even economists. Americans began buying smaller cars (SUV sales plunged while subcompact sales rose). We drove fewer total miles (the first monthly drop in 30 years). We climbed on public buses and trains, often for the first time; transit ridership was higher in 2008 than at any time since the creation of the interstate highway system five decades earlier.
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Not all such behavioral changes were healthy. Many consumers switched from cars to motorcycles, which are more fuel efficient but also more dangerous. After falling steadily for years, the number of U.S. motorcycle deaths began to rise in the mid-1990s, just as gas prices began to climb. A study in the
American Journal of Public Health
estimated that every $1 increase in the price of gasoline is associated with an additional 1,500 motorcycle deaths annually.
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High oil prices cause things to start happening on the supply side, too. Oil producers outside of OPEC start pumping more oil to take advantage of the high price; indeed, the OPEC countries usually begin cheating on their own production quotas. Domestic oil companies begin pumping oil from wells that were not economical when the price of petroleum was low. Meanwhile, a lot of very smart people begin working more seriously on finding and commercializing alternative sources of energy. The price of oil and gasoline begins to drift down as supply rises and demand falls.

If we fix prices in a market system, private firms will find some other way to compete.
Consumers often look back nostalgically at the “early days” of airplane travel, when the food was good, the seats were bigger, and people dressed up when they traveled. This is not just nostalgia speaking; the quality of coach air travel has fallen sharply. But the price of air travel has fallen even faster. Prior to 1978, airline fares were fixed by the government. Every flight from Denver to Chicago cost the same, but American and United were still competing for customers. They used quality to distinguish themselves. When the industry was deregulated, price became the primary margin for competition, presumably because that is what consumers care more about. Since then, everything related to being in or near an airplane has become less pleasant, but the average fare, adjusted for inflation, has fallen by nearly half.