Naked Economics: Undressing the Dismal Science pdfdrive com

part of the cost of smoking at work.
This broad view of cost can explain some very important social phenomena,
one of which is the plummeting birth rate in the developed world. Having a child
is more expensive than it was fifty years ago. This is not because it is more
expensive to feed and clothe another little urchin around the house. If anything,
those kinds of costs have gone down, because we have become far more
productive at making basic consumer goods like food and clothing. Rather, the
primary cost of raising a child today is the cost of the earnings forgone when a
parent, still usually the mother, quits or cuts back on work to look after the child
at home. Because women have better professional opportunities than ever
before, it has grown more costly for them to leave the workforce. My neighbor
was a neurologist until her second child was born, at which point she decided to

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stay home. It’s expensive to quit being a neurologist.
Meanwhile, most of the economic benefits of having a large family have
disappeared in the developed world. Young children no longer help out on the
farm or provide extra income for the family (though they can be taught at a
young age to fetch a beer from the refrigerator). We no longer need to have
many children in order to ensure that some of them live through childhood or
that we have enough dependents to provide for us in retirement. Even the most
dour of economists would concede that we derive great pleasure from having
children. The point is that it is now more expensive to have eleven of them than
it used to be. The data speak to that point: The average American woman had
3.77 children in 1905; she now has 2.07—a 45 percent drop.
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There is a second powerful assumption underpinning all of economics: Firms—
which can be anything from one guy selling hot dogs to a multinational
corporation—attempt to maximize profits (the revenue earned by selling stuff
minus the cost of producing it). In short, firms try to make as much money as
possible. Hence, we have an answer to another of life’s burning questions: Why
did the entrepreneur cross the road? Because he could make more money on the
other side.
Firms take inputs—land, steel, knowledge, baseball stadiums, etc.—and
combine them in a way that adds value. That process can be as simple as selling
cheap umbrellas on a busy corner in New York City when it starts to rain (where
do those guys come from?) or as complex as assembling Boeing’s 787
Dreamliner (a passenger jet that required 800,000 hours on Cray supercomputers
just to design). A profitable firm is like a chef who brings home $30 worth of
groceries and creates an $80 meal. She has used her talents to create something
that is worth far more than the cost of the inputs. That is not always an easy
thing to do. Firms must decide what to produce, how and where to produce it,
how much to produce, and at what price to sell what they produce—all in the
face of the same kinds of uncertainties that consumers deal with.
How? These are massively complex decisions. One powerful feature of a
market economy is that it directs resources to their most productive use. Why
doesn’t Brad Pitt sell automobile insurance? Because it would be an enormous
waste of his unique talents. Yes, he is a charismatic guy who could probably sell
more insurance policies than the average salesman. But he is also one of a
handful of people in the world who can “open” a movie, meaning that millions
of people around the world will go to see a film just because Brad Pitt is in it.
That is money in the bank in the risky Hollywood movie business, so studios are

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willing to pay handsomely to put Brad Pitt in a starring role—about $30 million
a film. Insurance agencies would also be willing to pay for the Pitt charisma—
but more like $30,000. Brad Pitt will go where he is paid the most. And he will
be paid the most in Hollywood because that is where he can add the most value.
Prices are like giant neon billboards that flash important information. At the
beginning of the chapter, we asked how a restaurant on the Rue de Rivoli in
Paris has just the right amount of tuna on most nights. It is all about prices.
When patrons start ordering more of the sashimi appetizer, the restaurateur
places a larger order with his fish wholesaler. If tuna is growing more popular at
other restaurants, too, then the wholesale price will go up, meaning that
fishermen somewhere in the Pacific will get paid more for their tuna catch than
they used to. Some fishermen, recognizing that tuna now commands a premium
over other kinds of fish, will start fishing for tuna instead of salmon. Meanwhile,
some tuna fishermen will keep their boats in the water longer or switch to more
expensive fishing methods that can now be justified by the higher price their
catch will fetch. These guys don’t care about upscale diners in Paris. They care
about the wholesale price of fish.
Money talks. Why are the pharmaceutical companies scouring the rain forests
looking for plants with rare healing properties? Because the blockbuster drugs
they may uncover earn staggering amounts of money. Other kinds of
entrepreneurial activity take place on a smaller scale but are equally impressive
in their own way. For several summers I coached a Little League baseball team
near Cabrini Green, which is one of Chicago’s rougher neighborhoods. One of
our team customs was to go out periodically for pizza, and one of our favorite
spots was Chester’s, a small shack at the corner of Division and Sedgwick that
was a testimony to the resiliency and resourcefulness of entrepreneurs. (It has
since been demolished to make way for a new park as part of an aggressive
development of Cabrini Green.) Chester’s made decent pizza and was always
busy. Thus, it was basically an armed robbery waiting to happen. But that did
not deter the management at Chester’s. They merely installed the same kind of
bulletproof glass that one would find at the drive-up window of a bank. The
customers placed their money on a small carousel, which was then rotated
through a gap in the bulletproof glass. The pizza came out the other direction on
the same carousel.
Profit opportunities attract firms like sharks to blood, even when bulletproof
glass is required. We look for bold new ways to make money (creating the first
reality TV show); failing that, we look to get into a business that is making huge
profits for someone else (thereby creating the next twenty increasingly pathetic
reality TV shows). All the while, we are using prices to gauge what consumers

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want. Of course, not every market is easy to enter. When LeBron James signed a
three-year $60 million contract with the Cleveland Cavaliers, I thought to
myself, “I need to play basketball for the Cleveland Cavaliers.” I would have
gladly played for $58 million, or, if pressed, for $58,000. Several things
precluded me from entering that market, however: (1) I’m five-ten; (2) I’m slow;
and (3) when shooting under pressure, I have a tendency to miss the backboard.
Why is LeBron James paid $20 million a year? Because nobody else can play
like him. His unique talents create a barrier to entry for the rest of us. LeBron
James is also the beneficiary of what University of Chicago labor economist
Sherwin Rosen dubbed the “superstar” phenomenon. Small differences in talent
tend to become magnified into huge differentials in pay as a market becomes
very large, such as the audience for professional basketball. One need only be
slightly better than the competition in order to gain a large (and profitable) share
of that market.
In fact, LeBron’s salary is chump change compared to what talk-show host
Rush Limbaugh is now paid. He recently signed an eight-year $400 million
contract with Clear Channel Communications, the company that syndicates his
radio program around the country. Is Rush that much better than other political
windbags willing to offer their opinions? He doesn’t have to be. He need only be
a tiny bit more interesting than the next best radio option at that time of day in
order to attract a huge audience—20 million listeners daily. Nobody tunes into
their second-favorite radio station, so it’s winner-take-all when it comes to
listeners and the advertisers willing to pay big bucks to reach them.
Many markets have barriers that prevent new firms from entering, no matter
how profitable making widgets may be. Sometimes there are physical or natural
barriers. Truffles cost $500 a pound because they cannot be cultivated; they
grow only in the wild and must be dug up by truffle-hunting pigs or dogs.
Sometimes there are legal barriers to entry. Don’t try to sell sildenafil citrate on
a street corner or you may end up in jail. This is not a drug that you snort or
shoot up, nor is it illegal. It happens to be Viagra, and Pfizer holds the patent,
which is a legal monopoly granted by the U.S. government. Economists may
quibble over how long a patent should last or what kinds of innovations should
be patentable, but most would agree that the entry barrier created by a patent is
an important incentive for firms to make the kinds of investments that lead to
new products. The political process creates entry barriers for dubious reasons,
too. When the U.S. auto industry was facing intense competition from Japanese
automakers in the 1980s, the American car companies had two basic options: (1)
They could create better, cheaper, more fuel-efficient cars that consumers might
want to buy; or (2) they could invest heavily in lobbyists who would persuade

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Congress to enact tariffs and quotas that would keep Japanese cars out of the
market.
Some entry barriers are more subtle. The airline industry is far less
competitive than it appears to be. You and some college friends could start a
new airline relatively easily; the problem is that you wouldn’t be able to land
your planes anywhere. There are a limited number of gate spaces available at
most airports, and they tend to be controlled by the big guys. At Chicago’s
O’Hare Airport, one of the world’s biggest and busiest airports, American and
United control some 80 percent of all the gates.
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Or consider a different kind of
entry barrier that has become highly relevant in the Internet age: network effects.
The basic idea of a network effect is that the value of some goods rises with the
number of other people using them. I don’t think Microsoft Word is particularly
impressive software, but I own it anyway because I spend my days e-mailing
documents to people who do like Word (or at least they use it). It would be very
difficult to introduce a rival word-processing package—no matter how good the
features or how low the price—as long as most of the world is using Word.
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

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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

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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