Economic Drivers in Harford’s “The Undercover Economist”

Scarcity Influences the Power of Bargain

Tim Harford’s “The Undercover Economist” advances various arguments regarding the forces that drive economics. This paper presents five of the main arguments, as well as reasons why the writer agrees with the assertions. In the chapter “Who Pays for Your Coffee?”, Harford introduces the notion that market prices are largely shaped by scarcity. Resources (whether natural or artificial) are either abundant or scarce at any given time. Thus, the market forces around these resources determine their price based on their scarcity or availability. For instance, the amount of rent that the tenants are willing to pay is dictated by whether the resource is readily available. Where potential tenants are many and the land is scarce, they (tenants) have little power of bargain. At the same time, the property owner feels confident enough to ask for an incredibly high rent because he or she holds a valuable resource. However, in line with Durevall’s claims, it is crucial to realize that the property owner may be charging high since he has to disburse some of the funds to intermediaries (property managers) and tax (2).¹ Harford also emphasizes this point (9).²

The same property owner in the above scenario would respond differently to an offer from a potential tenant if land happens to be abundant in another place. In such a case, the proprietor would have no chance to ask for a high rent because no one would be willing to pay a premium price when land is indeed abundant. In other words, according to McCaffrey, it is possible for a resource that is highly valued today to be virtually valueless sometime in the future (par.24).³ The shift in demand depends on scarcity whereby all other market conditions stay constant. Harford’s explanation of scarcity and demand is based on the 1817 model of bargaining power introduced by David Ricardo.

The Ricardian model attempted to explain why the various market forces influence the demand, price, and even scarcity of an item. Another argument that Harford posits is that scarcity can be either natural or artificial (16).⁴ The scenario of landowner and tenant above is an instance of natural scarcity at play. Conversely, a situation where proprietors come together to set a high price for their lands may lead to artificial scarcity. Harford believes that artificial scarcity can be avoided if one is keen enough. I agree with this argument. Naturally, one would assume coffee shops located in the downtown of a busy city to sell their coffee expensively because the rent in such a place is quite high. While this claim is true, other factors also affect the price. In particular, according to Diallo et al., clients’ perception of a commodity influences their desire to acquire or ignore it (1134).⁵ Similarly, the willingness of customers to pay the high price influences the demand for premium-priced coffee in this part of the town.

Targeting Different Types of Customers

Harford uses the example of Costa Coffee to explain the common types of customers. One type is the socially concerned clients who value social wellbeing, as opposed to money. The opposite of this claim is true of the unconcerned customers whose primary interest is the price of an item. When Costa wanted to raise the price of coffee, it first sought to understand the type of customers it was dealing with. Thus, it introduced two types of coffee, one that had the normal price while the other one was slightly expensive. Customers were informed that the extra money in the premium coffee would be used toward bettering the lives of coffee farmers in upcoming countries. However, the truth was that Costa wanted to know if some customers would be willing to pay extra. Once equipped with this information, the company could raise the price of coffee.

This strategy can be seen in many companies and in retail stores where products are assigned different prices. Businesses use differences in price to imply that the higher the price, the better the quality of the product. Spiller and Belogolova introduce another element, namely, taste, which lures customers into believing, “one product is a better match with their own personal preferences” (970).⁶ However, in practice, the quality is usually the same. Additionally, the company does not incur a much higher cost to make the often more priced item. It is just a strategy used to appeal to customers’ willingness to pay more. In other words, because companies cannot tell customers who are willing to pay more, they invite them to choose the prices themselves. This way, they take care of both customers, namely, the price-sensitive and those who are not. Further, Harford advances two strategies for finding customers who do not mind the price of items (20).⁷ The first strategy identifies customers based on what they are individually willing to pay. The strategy is effective when used with items that are being bought repeatedly to the extent that companies can obtain customer records. For instance, supermarkets provide coupons to customers, and sequentially use them to obtain customers’ purchase preferences.

The second strategy is less individualized. Instead, it targets a group. The approach, which is known as the “group target” strategy, allows dealers to offer varying prices to individuals categorized into distinct groups. In addition, this strategy emphasizes the approach of who is willing to pay more, as opposed to who would be in a position to afford to pay more. For example, Disney World-Florida has been offering discounts on admission to locals. Here, the focus is on locals because they are likely to show up to utilize the discount. Otherwise, tourists must show up whether the admission is cheap or expensive. I agree with Harford’s assertion because businesses sell their scarcity power to customers based on their willingness to spend on it (scarcity) in the first place.

Perfect Markets and the Truth

The truth is essential for the smooth running of free markets. As Harford points out, the prices of products are optional, implying that they provide detailed information. Particularly, people buy items at what they perceive to be the right price. In other words, according to Lamb et al., the price of an item reveals information such as its quality and demand (340).⁸ Again, using the example of the coffee shop in a busy downtown street, Harford explains that the price of a product is set by the prevailing market conditions. As such, the price must reflect the true market value of the coffee. If the price is high, it means that profits are also high.

This situation invites other coffee shops to venture into the business, thus causing the price to lower. However, if the price lowers below the margin, not all coffee sellers will make any profits. Thus, in a perfect market, the cost of a product should be equivalent to its marginal cost. I agree with this argument. Many people believe that businesses set the prices of the items they are selling. However, according to Mennell, the truth is that prices depend on the prevailing market conditions such as the demand and the location of the business (21).⁹ This claim is in line with Chen et al.’s views concerning elements that shape commodity prices (1455).¹⁰ If customers believe they are being overcharged, they can boycott a product. Thus, in a free market, companies can only set the prices of their products subject to the prevailing market prices such as those of competitors.

Externalities: The Case of Traffic Jams

Externalities are costs or benefits that are not contemplated when making a present decision, although they somehow affect the outcome of such a decision. Harford argues that individuals pursue what makes them happy without considering how obtaining it will affect others. Somehow, there are always bystanders who will suffer detriment when others enjoy their rights. For instance, driving around the city presents with it some form of enjoyment. However, such enjoyment inconveniences other road users, especially where a traffic jam ensues. In a traffic jam, people will experience delays, as well as the possibility of developing breathing difficulties due to motor vehicle pollution. Thus, traffic congestion occurs because drivers are not made to pay for the true cost of the inconvenience they cause. The best solution would be to have drivers pay the “externality charge”, which can be utilized to compensate bystanders who suffer detriment from their (drivers) actions. However, chances are that making drivers financially accountable would miraculously cause the traffic jams to disappear altogether.

The concept of the marginal cost could be used to limit the amount of pollution that each driver causes. Marginal cost in this sense refers to the cost of making an extra trip. Ordinarily, drivers are taxed for using public roads based on an average estimation. Harford argues that such an amount is not adequate to make drivers more accountable for the inconveniences they cause to others on the road, including fellow drivers and pedestrians. An average tax would only be enough if it could apply to the entire number of trips that a driver makes in his or her car. However, any extra trip made is not accounted for, a situation that encourages drivers to make numerous trips. It is for this reason that drivers should be made to pay more at the margin, as opposed to an average price. Obviously, a question emerges concerning whether the taxes that drivers pay in the form of fuel are commensurate to the ‘damage’ they inflict upon third parties. For instance, commotion in traffic is caused by road users in the major cities. At the same time, they pay the same amount of tax as the road users in rural areas who do not cause traffic congestion at all.

I agree with Harford that the rationale behind an externality charge is not to stop people from engaging in any activity that can inconvenience others. Rather, it is to make such people accountable (or take into account) the inconvenience they are causing to other people. For this reason, an externality charge must differentiate between pleasure and trouble. If an activity brings one person so much pressure while only causing another trouble, a huge externality charge may be unnecessary. In other words, an externality charge should be equivalent to no more than the inconvenience caused. The essence of free markets is to have all people do what they enjoy doing but without inconveniencing others. Should this freedom become curtailed, the essence of free markets ceases to exist.

The Key Role that Inside Information Plays in Free Markets

Free markets thrive if the parties to a transaction are at par concerning the information they possess about an imminent deal. According to Harford, if sellers or buyers have too much information about a product, they may impede the smooth operation of a free market. George Akerlof, a renowned economist, argues that inside information ruins the free markets because it places either or both parties to a transaction at a disadvantage. Buyers are looking for proof before making a purchase while at the same time the sellers are unwilling to provide this proof. If sellers had much information about the product, they would appear as the real winners against the buyers. However, as Harford points out, there are no winners whenever inside information is involved.

An illustration of how inside information can adversely affect the free markets is seen in the case of used cars. Buyers wish to buy used cars because they believe they have value. At the same time, sellers only wish to sell their cars if they have dropped in value and are no longer useful to them. If buyers could be certain that the particular car is being sold for being valueless, they would avoid buying it in the first place. If both the buyer and the seller are ignorant regarding the quality of the product in question, the transaction goes on much smoothly because a buyer would be willing to pay a huge amount for an item whose quality is unknown. At the same time, the seller would be willing to accept a low price because he or she is unaware of the true value of the product. This lack of inside information maintains a balance of information between the parties. It is important to note that this scenario does not address concerns such as where one party is duped by the other. Rather, it focuses on the possibility of a transaction to occur smoothly between parties because they are willing to transact with each other.

Another area where inside information can be problematic is health insurance. The cost of procuring quality health care can be too high for the average client (Harford 54).¹¹ This situation necessitates buying an insurance cover. According to Lopert and Gleeson, people often buy healthcare insurance based on whether or not they believe they will become unwell in the near future (8).¹² For this reason, the health insurance market is divided between those who are likely to fall sick and those who are healthy. Here, inside information operates in the sense that it motivates those who are likely to fall sick to seek health insurance. On the other hand, those unlikely to fall sick avoid taking an insurance cover. As a result, the insurance company ends up with people who are highly likely to make claims. To reverse the scenario, the insurance company attempts to find out information about the patient. If insurance companies have accurate information about the patients, they can provide insurance cover to more patients. Harford’s assertions are correct because insurance depends on the lack of knowledge about the future. In other words, an insurance company can only insure a person if both parties are uncertain that the insured risk will happen in the future.

Works Cited

Chen, Shu-Ling, et al. “What Drives Commodity Prices?” American Journal of Agricultural Economics, vol. 96, no. 5, 2014, pp. 1455-1468.

Diallo, Mbaye, et al. “How Do Price Perceptions of Different Brand Types Affect Shopping Value and Store Loyalty?” Psychology & Marketing, vol. 32, no. 12, 2015, pp. 1133-1147.

Durevall, Dick. “Are Fair Trade Prices Fair? Evidence from the Swedish Coffee Market.” Digital Assets, Web.

Harford, Tim. The Undercover Economist. Oxford University Press, 2012.

Lamb, Charles, et al. MKTG. Cengage Learning, 2013.

Lopert, Ruth, and Deborah Gleeson. “The High Price of “Free” Trade: US Trade Agreements and Access to Medicines.” The Journal of Law, Medicine & Ethics, vol. 41, no. 1, 2013, pp. 199-223.

McCaffrey, Matthew. “Five Erroneous Ways to Argue About Resource Economics.” Quarterly Journal of Austrian Economics, vol. 15, no. 1, 2014, Web.

Mennell, Stephen. “What Economists Forgot (and what Wall Street and the City Never learned): A Sociological Perspective on the Crisis in Economics.” History of the Human Sciences, vol. 27, no. 3, 2014, pp. 20-37.

Spiller, Stephen, and Lena Belogolova. “On Consumer Beliefs about Quality and Taste.” Journal of Consumer Research, vol. 43, no. 6, 2017, pp. 970-991.

Footnotes

1. For more information, see Durevall 1-2 where the author shows how retailers end up being paid higher than the producers for the same commodity.
2. In page 9, Harford discourages people from assuming that property owners always have significant financial powers.
3. For detailed information, see McCaffrey (par.24) where the author illustrates the point using land, which may gain marginal value following the advancement of capitalistic systems.
4. For more information on this issue, visit Harford on pages 16-18.
5. Consult Diallo et al. 1134-1135 for more details.
6. Spiller and Belogolova assert that clients are ready to acquire high-priced commodities if they are convinced that the items are of superior taste that satisfies their preferences.
7. On page 20-21, Harford reveals that customers will naturally give more money for premium products and services.
8. For more information on the link between price and quality, visit Lamb, Hair, and McDaniel on page 340-341.
9. According to the author, “The faith in ‘free markets’ has been associated with blindness to power relationships and indifference to economic inequality” (20).
10. Chen et al. assert, “the nature of production and storage of commodities as well as the costs of arbi­trage over time” (1456) determine the prices of items in the market.
11. See Harford 54-55 where the author says how a high fee may not be an issue for well-to-do clients.
12. For more information, see Lopert and Gleeson 8-9.