ECONOMICS

The Big Ideas and

Scintillating Small Talk
about Markets

EVELINE J. ADOMAIT • RICHARD G. MARANTA

★

The Big Ideas and Scintillating Small Talk about Markets

EVELINE J. ADOMAIT
University of Guelph

RICHARD G. MARANTA

Pearson Canada
Toronto
Library and Archives Canada Cataloguing in Publication

Adomait, Eveline J
Cocktail party economics / Eveline J. Adomait and Richard G. Maranta.
Includes index.
ISBN 978-0-13-266600-8
1. Economics—Popular works. 2. Economics—Humor.
I. Maranta, Richard G. (Richard Gino), 1961- II. Title.
HB171.A36 2011 330 C2011-900398-8

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To students everywhere, especially those who
like economics ... or who want to.
Contents

Each memorable verse of a true poet has two or three times the written content.
Alfred De Musset (1810-1857), French writer

About the Authors xi

Making Introductions 1

Chapter 1 It’s All about Scarcity 8

A Scarcity Mentality 8
A “Stones Story” 9
The Implication of Scarcity 9
The Classic Definition of Economics 11
So What’s It Gonna Cost? 11
Time Is Relative 12
Cocktail Party Etiquette 13
Single, Educated Female Looking for Soulmate 14
The Politics of Choice 15
So, How Does One Get a Drink Around Here? 16
Getting to the Swizzle Stick 17

Chapter 2 Value: Where Emotions and Economics Collide 19

Is Anything Priceless? 19
Value Is Subjective ... It’s Personal 20
... It’s More Than Personal 20
Answering Questions That Have Answers 21
Scarcity Reveals Value 21
Valuing a Jackson Pollock 23
Put Your Money Where Your Mouth Is 23
When Play Becomes Work: Sports as a Business 25
The Special Case of the CEOs 26
The Not-So-Special Case of You 26
The Paradox of Value 27
Of Cabbages and Kings: Value and Price 27
Trading Values 28
 Contents vii

Chapter 3 Exchange: Supply and Demand, Take One 29

A Nightcap ... I Mean, Recap 29
The Basics Are Surprisingly Simple 30
What Is a Market? 30
Adding Money 31
Getting into the Game 33
Laying Blame 36

Chapter 4 Producing Wealth 37

The Wealth of Nations 38
So, What Are We Working With? 38
1. Land 39
2. Raw Materials 40
3. The Environment 40
4. Physical Capital 41
5. Going into Labour 44
6. Entrepreneurial Ability 46
Dotting the I’s: Invention, Innovation, and the Industrial Revolution 48
Patiently Crossing the T’s 48
The Domino Effect 49
Beyond the Basics 49

Chapter 5 The Absolut(e) of Comparative Advantage 51

So, What Do You Want to Be (or Not to Be) When You Grow Up? 51
Specialization Is Special 52
A Tale of Two Writers 53
Getting Technical 54
The Basis of Comparative Advantage 57
Same Difference 57
Bumper Sticker Protectionism 58
Dynamic Change 59
National Sacrifice 60
Under the Influence 61

Chapter 6 Supply Side (A Venti Chapter) 62

Separated but Not Divorced: Supply + Demand 63
The Basic Swing of Things 63
Who Is Making Your Car? 65
viii Contents

Different Players, Same Game 65

Lining Up the Usual Suspects 66
No Longer Nameless 68
Picky Differences 69
Full Range of Movement 70
Another Cost by Any Other Name Is Still a Cost 71
Business Fundamentals 72
Creating Links 75

Chapter 7 Demanding Clients (A Venti Chapter) 76

If I Supply, Will You Demand? 76
Looks the Same on the Outside 77
Consumer Behaviour 80
1. Consumer Preferences 81
2. Consumer Income 82
3. Prices of Related Products 83
4. The Number of Buyers in the Market 84
Meeting of the Lines 85

Chapter 8 Market Forces: A Beautiful Kind (Venti with an Extra

Shot) 86
Love at First Sight 86
Simultaneous Equations 87
Getting Closer to Equilibrium 89
What Drives Equilibrium? 91
Curves Ahead 93
Shifts Happen 94
Telling Stories That Make Sense 94
Irresistible Force 95
Home Inspection 97
Playing Games 100

Chapter 9 The Pursuit of Happiness: Efficiency and Equity (A Venti

Chapter) 101
We Hold These Truths to Be ... Undeniable 101
Be Seriously Happy: Optimizing Utility 102
Pick Me, Pick Me! 103
Productive Practices 104
 Contents ix

There Are Limits 104

A Kind Solution 107
Free Market System 107
Even Steven 110
Ignorance Is Bliss 112
eTrade-offs 113
Death and Taxes 113

Chapter 10 The Name of the Game (A Skinny Venti Chapter) 115

Complicating the Problem 115
What Can Possibly Be Wrong? 116
A Numbers Game 116
Getting a Clue 117
Analyze This 118
Competitive Comparisons 120
Monopoly Money 121
Unions and Other Professional Associations 123
Cartels and Collusion 124
Monopsony 125
Trouble 126
Sports Channels 126
Creative Destruction 127
Looking for the Right Answers 128

Chapter 11 Getting an F: A Look at Market Failures 129

Model of Perfection 129
Terms and Conditions 130
1. Market Power: Made from Concentrate 130
Monopoly Power 131
2. External Relations: Spillovers 132
Who Could or Should Pay to Solve the Problem? 135
Good Neighbours Make Good Fences 138
3. Property Lines 139
Public Property 139
Public Health and Education 140
Law and Order 141
The Tragic Commons Revisited 141
4. Government Interference 141
X Contents

5.1 Know Something You Don’t Know 142

Risky Business 143
Casing the Point 145

Chapter 12 Numb€rs: Financial Markets 146

Accounting for the Financials 146
Cadastral Survey 147
Gimme a Break 152
In the Market 154
Markets That Get It Right 155
I Should Be So Lucky 156
Too Big to Fail 159
Calling Information 159
Picking a Lemon 160
Too Small to Play 160
Hazardous to Your Financial Health 161
Law and Order 162
Abnormal Behaviour 163
Closing Markets 164

Conclusions Tying Up Loose Ends 166

Afterword: Rick’s Postpartum 173
Index 174
About the Authors

Eveline Adomait was bom to Dutch immigrants in rural

Ontario. She attended the University of Guelph, intending
to become a doctor until she realized that she couldn’t use a
scalpel on anything alive. This required a change in direc¬
tion. Fortunately, she was taking an introductory economics
course and fell in love with the ideas (and look. Mom ... no
blood!). She has a master’s degree in Economics from the
University of Guelph and for the past 20 years has made
her career as a teaching professor at her alma mater. By her
calculations, she has taught the equivalent of the population of a small city various eco¬
nomics courses at the first-, second-, and third-year levels. Her favourite is the first year,
with class sizes ranging from 300 to 600 students, because this is the year in which many
students experience “aha moments” when it comes to economics. Their 18-year-old
minds also keep her young.

Richard Maranta grew up in Brampton, Ontario, and

graduated with a Master of Arts in English Literature from
the University of Waterloo, focusing on critical theory and
self-destructive American authors such as William Faulk¬
ner. Richard went on to obtain a Bachelor of Education
from the University of Ottawa with the goal of becoming a
secondary school teacher. However, he eventually ended up
working for the dearly departed Nortel Networks in techni¬
cal education and communications. He went on to co-found
a company called Pinched Head, which develops innova¬
tive online courses for corporate clients. Richard continues
to write and work with writers to say what needs to be said.
For fun, he plays video games but has reluctantly come to
realize that that he will never be as good at them as his two
sons, who he used to let win.
 Making Introductions

Either write something worth reading or do something worth writing.

Benjamin Franklin (1706-1790), American politician and polymath1

I am a woman2 3 who is optimistic, extroverted, and an economist. (Oh dear, this sounds
like one of those profiles in a dating service. All it needs is ... who enjoys long walks on
the beach and going to parties.) As frivolous as it sounds, I really do enjoy going to par¬
ties: cocktail parties, wine and cheese parties, dinner parties, and ordinary barbecues.
Dress-up parties hold a special place in my heart. The more haute’, the better. It’s not
just the party itself that I enjoy, but I find getting ready for the party fun as well. I can
spend hours deciding which of my many little black dresses I should wear; I have more
than I need but that doesn’t stop me from buying another. These dresses call to me from
the store window as I pass by them. (Let’s not mention shoes, shall we?) Black is such a
slimming colour, and it can be accessorized with elegant shawls and jewellery of all
kinds. I favour bigger, flashier pieces right now. If writing a book called Cocktail Party
Economics requires experience at cocktail parties, then I have it.
So, how did I come to the write an economics book? It wasn’t on a dark and stormy
night or in a land far, far away. Rather, it all started after attending different social gath¬
erings where, as an economics professor, I am often asked economics-type questions
such as

• “Have interest rates bottomed out and should I lock in my mortgage?”

• “As a recent grad, what can I do to get a good job?”
• “Should the government bail out the car companies?”
• “What is the subprime mortgage market anyway, and why has it thrown Wall Street
and the global economy into disarray?”

Usually, in order to do these questions justice, I find myself having to embark on a five-
minute mini-lesson in economics. Since I am at a social affair, I’m not sure people want
to spend a lot of time on this. In these kinds of situations, I feel like I end up arming
people with random bits of ineffective economic knowledge without providing the

1 A polymath is a person who has expertise in many and diverse areas. Benjamin Franklin was an inventor,
writer, scientist, postmaster, printer, civic activist, and diplomat, as well as a founding father of the United
States. I think it’s safe to say he did things worth writing about and wrote things worth reading.
2 This book follows the tradition of Freakonomics, which is the result of a writing partnership between
economist Steven Levitt and author Stephen Dubner. Good writing requires both something worth saying
and the ability to say it well. We thought that the use of a single voice—that of the economist, Eveline
Adomait—would improve the book.
3 Haute couture is French for “high sewing” or “high dressmaking” and refers to the creation of exclusive
custom clothing.

1
2 Cocktail Party Economics

necessary context within the big picture. However, big pictures require time to
create—time that’s not always available at a cocktail party.
On other occasions, the encounters are more confrontational in nature (this can
happen after a few too many drinks). During the usual small talk at a cocktail party, an
individual might make a bold statement that has something to do with economics. This
person might assert any of the following while frantically waving a swizzle stick:

• “We should stop buying all this cheap stuff from China. It’s costing us jobs.”
• “How can you drink anything other than fair trade coffee?”
• “The government is selling the environment down the river by letting power plants
buy pollution permits.”
• “It’s outrageous how much money athletes make.”

It is a difficult party for me indeed if I hear all of these statements on the same night.
At some point, I have to decide whether to enter into the fray. If I choose to respond, the
ensuing debate can often feel like a “hit and run” encounter that I am sure to regret
the next morning. (I have on more than one occasion told my husband to nudge me if the
conversation goes on too long or becomes too intense.)

ECONOMICS + COCKTAIL PARTY = A BOOK

Economics is the study of mankind in the ordinary business of life.

Alfred Marshall (1842-1924), British economist

I find that any answers I provide, both to the polite questions and during any ensuing
conflicts, end up being unsatisfying mostly because of their brevity. This dissatisfaction
with my own ability to communicate economics clearly and concisely during cocktail
parties has motivated me to write a book that fleshes out the various conversations I
have started at social functions. When I told my friends what I planned to do, they
thought it was a great idea for their own separate reasons. But one thing was common:
They were all tired of feeling lost when presented with complicated economic news
stories or financial discussions. Since most of them do not have the time or inclination to
take a university course to learn more, I decided to offer this book as an easy way for
them to gain a more complete understanding of economic principles.
My friends kindly warned me that the book would have to be fun to read or no one
would buy it. Gasp ... I definitely did not want to write a book that no one would want
to buy. I am an economist, after all. So I asked myself, How can / write a book about
economics that is also entertaining to read? To be honest, I didn’t really know. So, I
solicited friends, family, colleagues, and even random strangers I met at parties for help,
and help me they did. Their every critique, comment, and question caused me to edit my
manuscript. (This book has been rewritten more times than I want to think about.) One
particularly helpful comment came from my darling husband, who reminded me:
“People like stories, and you should add as many as you can.” I took his advice to heart
and decided to start every chapter with a party story that in some way connects with the
ideas in that chapter. What is unusual about these stories is that I have placed you,
the reader, in them. Don’t worry, the scenarios are relatively ordinary party situations
 Making Introductions 3

and involve believable conversations, so you shouldn’t feel uncomfortable. There’s

nothing outrageous.
As well, the book contains illustrations and real-world examples to help make the
economic concepts relevant. The footnotes are extensive, sometimes expanding a
thought and other times offering a bit of relevant trivia. I also happen to be a “quote-
aholic” and have littered the pages with quotations4 that are sometimes discussed directly
in the text or are obliquely connected. (If a quotation doesn’t make much sense to you, I
wouldn’t worry about it. There will be plenty more.) I have tried to make my examples
and illustrations accessible and make the text as entertaining as possible. I hope it works
for you.

Thinking Like an Economist

Art consists of limitation. The most beautiful part of every picture is the frame.

Gilbert K. Chesterton (1874-1936), British author

Although one of my goals is to make economics fun to read, this book follows the
pattern of a typical introductory text in terms of logic and topic progression. The logic of
economics requires a systematic approach in order to truly understand what is going on.
Because economics is fundamentally a way of thinking rather than a collection of idio¬
syncratic examples, after 20 years of telling a particular story I can’t really write an
economics book that doesn’t build from the ground up. I want people to learn something
about the elegant framework that surrounds all of the interesting applications found in
the popular economics books on the market today. Like a great little black dress, basic
economic concepts are timeless—relevant during both economic crisis and economic
calm. Therefore, while I wrote this book to be understood by people who have never
picked up an economics textbook, those who are taking or have taken an introductory
economics course will recognize the flow of ideas but without the mathematics. Think of
this book as Econo-Lite—enough to give you a buzz but not enough to have your keys
taken away from you. For those of you who have no background in economics, don’t
worry. This one’s for you. My friends made sure of it.

Reconcilable Differences
Burn the mathematics.

Alfred Marshall (1842-1924), English economist

We have to thank the eminent economist Alfred Marshall for the mathematical direction
that economics textbooks have taken, although—as we can see from the quotation—
even he felt that analysis had to be more than just high-powered math. Out of necessity,
most economists have become pretty good at math, which can be a conversation killer at
parties if the economic conversation drifts toward calculus or algebra. (A bit of advice:

4 In order to satisfy copyright laws, most quotations are from people who have been dead for at least 50
years or who are quoted in a book. This eliminated great quotations from speeches, television or radio
interviews, songs, poems, and general hearsay. I hope the loss isn’t felt too keenly. Look at this book as
containing a brief history of old thoughts!
4 Cocktail Party Economics

Should you discover that an economist is coming to your party, hide the paper napkins
and remove any pens from sight beforehand. This will prevent mathematical doodling.)
Thankfully, this does not mean that the underlying ideas can be understood only with the
language of mathematics. This book uses plain English and simple stories to explain the
central concepts of economics that, in some form or another, we can find discussed eve¬
rywhere—from media outlets to dinner parties. Sometimes the economics concept is
accurately represented, but not always. I want to help you be able to tell the difference.
Having said that words and stories will be the main vehicle used to travel down this
road of economic enlightenment, I must confess that you will find a couple of chapters
(well, actually, more than a couple, if a couple for you literally means two) that will
require you to look at a few pictures. Okay, okay, I mean graphs. But don’t let that scare
you. If you consider them equivalent to a root canal, you can detour around them to
more palatable sections. However, I promise that if you persevere, you will be way
ahead of others when it comes to understanding how markets work. I have tried to make
these chapters as user-friendly as possible. To give you a heads up, I have designated
them as Venti5.

A Few Caveats
Again, most of the chief distinctions marked by economic terms are differences not of kind but
of degree.

Alfred Marshall

We all know that how we use words makes a difference. Unfortunately, economists
take everyday, ordinary words and use them to describe very specific economic
concepts— words like scarcity, costs, producers, firms, money, and investments. Within
economics, these words take on very precise and, some would say, peculiar meanings.
The familiar is used in an unfamiliar way, which can cause some confusion until you
understand exactly what is meant. If a word seems strange in the way it’s used, try to
suspend judgment about it until you have finished reading the book. I promise that the
words will begin to take on new meaning for you in the context of economics.
Furthermore, like most social sciences, economics has some measure of the common
sense about it. You don’t need to understand economic concepts to live out your
economic life any more than you need to understand psychology to be a good parent or
boss. But “knowledge is power,” or so they say.6 By understanding the big ideas behind
economics and getting to know the lingo, you can feel smarter, especially at a party. It
will also give you another topic of conversation in addition to your work, family, or
favourite sports team. Seriously, though, it can make your common sense work a little
harder for you as you make important life decisions.
Finally, while it is very tempting to jump directly to the chapter that most interests
you, I recommend that you read the book from beginning to end. I have sequenced the
ideas in a logical progression to lay the foundation for the economic ideas that follow.

5 Venti means 20 in Italian and is the largest size of coffee (20 oz.) sold by Starbucks. Coffee helped me to
write this book.
6 From the Latin phrase scientia potentia est, stated originally by Sir Francis Bacon in Meditations Sacrae
(1597).
 Making Introductions 5

The goal of this approach is to help you better understand the underlying economics of
any real-world situation. Hopefully your conversations at cocktail parties about economics
will have not only sizzle but substance as well. Also, wouldn’t it feel great to be able to
move on to another conversation when some show-off at a party goes on and on about
the markets—not because you don’t understand what he or she is saying but because
other conversations and people interest you more? I hope this book empowers you in
this way.

The One-Liner Notes

All we are trying to do is give the public good entertainment. That is all they want.

Walter Elias “Walt” Disney (1901-1966), American creator of Walt Disney Productions
Taken from The Gospel According to Disney: Faith. Trust, and Pixie Dust1

I truly wish I could say that my

goal is solely to entertain, but
that wouldn’t be true. I also want
you to learn some economics,
and that can only happen if you
read Cocktail Party Economics
carefully. Because it can take
some time to work your way
through a chapter, it may be
possible that you will lose sight
of the main point once you reach
the end of the chapter. To help
prevent this from happening, I
have included a feature called
the Cocktail Napkin Note. This
one-liner summarizes the main
idea of the chapter—the take¬
away thought, so to speak. Here
is this chapter’s note. 1 hope by
now (or at least by the end of the
book) you will be able to agree
with it.

Stargazing
Martyrdom ... is the only way in which a man can become famous without ability.

George Bernard Shaw (1856-1950), Irish playwright

Taken from The Devil's Disciple (1901)

As an added touch, somewhere in each chapter I feature a famous economist in a section

called Gossip Column. (This is the equivalent to name-dropping at a party.) I have

7 By Mark I. Pinsky (Louisville, K.Y: Westminster John Knox Press, 2004).

6 Cocktail Party Economics

included many of the early economics writers along with a few Nobel Memorial Prize8
laureates.
To get things rolling, let me introduce you to a man mentioned four times in this chap¬
ter. Unfortunately for him, he never won the Nobel Prize in Economics (worth 10 million
Swedish kronor) because he died before the first one was handed out in 1969. Neverthe¬
less, he changed how economics would be taught forever. His name is Alfred Marshall.

Gossip Column
Alfred Marshall was born in 1842 in London, England, and died in 1924 in Cambridge,
England. He was one of the most influential economists of his time, teaching at
Cambridge University. He wrote a textbook called Principles of Economics (1890) that,
through its eight editions, was the dominant economics textbook for half a century. (Most
textbook authors can only dream of such a run.) This book laid the foundation for all
future introductory texts. In terms of ideas, Marshall was the first to draw a demand and
supply curve in a book (although it was relegated to the book's appendix). These curves
are now the mainstay of any economics book. He also contributed the concepts of
elasticity of demand and of consumer and producer surplus.9 For many years, a com¬
mon saying among economists was “It’s all in Marshall.”
Marshall was really good at mathematics and could keep up with the best of
academia, but he never wanted ordinary people to feel that economics was beyond
them. In a letter10 written in 1906 to Arthur Bowley, he laid out (in interesting grammar)
the following system:

(1) Use mathematics as shorthand language, rather than as an engine of inquiry. (2) Keep
to them till you have done. (3) Translate into English. (4) Then illustrate by examples that
are important in real life. (5) Burn the mathematics. (6) If you can't succeed in 4, burn 3.
This I do often.

I like to think that Marshall would have approved of the non-mathematical approach I
took in writing this book along with my extensive use of footnotes, which was also his
practice. However, he would probably not approve of my career. It seems that he
became increasingly opposed to the granting of degrees to women, which is quite odd

This prize is technically not a Nobel Prize. Alfred Nobel, the inventor of dynamite, left funds for five
prizes. They are awarded in Peace, Literature, Chemistry, Physiology or Medicine, and Physics, and were
first awarded in 1901. Sweden’s central bank established The Sveriges Riksbank Prize in Economic
Sciences in Memory of Alfred Nobel in 1968. It is added to the mix with the other prizes and is awarded
using the same system. Depending on the exchange rate, this prize is worth approximately US$1.5 million.
The new prize is not without controversy, however. Peter Nobel, the great-grandnephew of Alfred, has
criticized the creation of this award and its association with authentic Nobel Prizes. The Nobel Foundation
refers to it as the Prize in Economics, with no mention of Nobel.
g See Chapter 9 for more on the concepts of producer and consumer surplus.
10 The letter to Bowley was included in a book on Marshall, which was edited by Marshall’s protege Arthur
Cecil Pigou (another famous economist). The book is Memorials of Alfred Marshall, published by
Macmillan in 1925, and the letter is on pages 427 and 428. Bowley took only a short course with Marshall
but it changed the direction of his life. He became an economist who worked on economic statistics.
 Making Introductions 7

given that he married one of his students, Mary Paley Marshall. Mary was one of the
first women to study at Cambridge University, but she was debarred from graduation
because she was a woman. This did not stop her from doing the work of an academic.
She lectured at Cambridge and was regarded as an excellent teacher, economist, and
unofficial collaborator of Marshall’s work. It is not entirely clear why he opposed the
granting of degrees to women.11
Marshall was raised to enter the clergy but defied his parents and became an
academic in mathematics and economics instead. I, on the other hand, was raised by
a member of the clergy (like Mary and Arthur) but was never expected to become a
minister, or to become an academic for that matter—especially in the field of
economics. My parents are both surprised by and proud of my accomplishments. I am
so grateful that universities now grant degrees to women.

11 The Oxford Dictionary of National Biography offers more about the lives of economists Alfred and Mary
Marshall.
 CHAPTER

It’s All about Scarcity

It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one
that most people consider a "dismal science. ” But it is totally irresponsible to have a loud and
vociferous opinion on economic subjects while remaining in this state of ignorance.

Murray Newton Rothbard (1926-1995), American economist

Taken from Making Economic Sense (1995)

It has been a long day and you just want to go home and watch American Idol, but your
employer has asked you to attend a networking cocktail party on behalf of the firm. As
you enter the room, clusters of people catch your attention. Straight ahead, in front of the
French doors leading to the patio, a group of men appear to conduct several simultane¬
ous conversations with each other and with their BlackBerrys. You overhear their verbal
competition about who is busier and getting less sleep. One thing they all do agree on:
There are not enough hours in a day.
On your right, stationed near a food table, a group of well-dressed women gather,
each with a martini in one hand and a plate of crudites in the other. Earlier in the day they
wore jackets over sheath dresses, but for this event the jackets are off and high heels
and “bling” have been added. Vogue would be proud of them for their transformation from
office to evening wear using the same basic dress. Most of them nod in agreement as
one woman states matter-of-factly, “Dating is so difficult. It seems all the good ones are
taken.”
Suddenly your attention is diverted by raised voices between two “suits" in the cor¬
ner. Words like idiotic and ridiculous are volleyed back and forth as they argue over how
the government should spend the taxpayers’ money. It is clear that they unashamedly
support different political parties. You start to wonder if both of them have taken their
blood pressure meds—but, then again, that might not mix well with the 12-year-old
Scotch they're drinking.
Before joining any of these conversations, you decide that it might be a good idea to
get fortified for the evening ahead. As you walk to the bar you think to yourself, “What
kind of party is this going to be, anyway?”

A SCARCITY MENTALITY
The first lesson of economics is scarcity. There is never enough of anything to satisfy all those
who want it. The first lesson ofpolitics is to disregard the first lesson of economics.

Thomas Sowell (1930- ), American writer and economist

Taken from Is Reality Optional?: And Other Essays (1993)

Welcome to the fascinating world of economics. You might not notice this right away,
but each of the conversations in the opening vignette in one way or another illustrates
the idea of scarcity—a foundational economic concept. We have all heard that “a good
man is hard to find,” or that there is not enough time in the day, or that we need more
government funding. All of these conversations say something about what is scarce.
Let’s look more closely at this idea.

8
 Chapter 1: It’s All about Scarcity 9

A “Stones Story”
Suppose that, like Diane Keaton’s character in the movie Something’s Gotta Give, I
enjoy meandering along a deserted beach and collecting perfectly flat, round, white,
smooth stones. What if, on one particular occasion, I dig up 10 stones with an unusual
black stripe down the middle and am so enraptured with them that I decide to bring them
along to the party I attend that evening. Suppose that, while at the party, I feel generous
and offer them to anyone who wants one, but to my surprise no one does? This exercise
reveals to me that even though the stones are available in a finite number (10), they are
not—and I repeat, not—scarce. Apparently I was the only one who thought the stones
were worth collecting. Now, that is not really a big problem except for the fact that I
have to transport them home again and I might feel a little embarrassed that my treasures
were rejected. (I can just imagine the comments when people get home, starting with
“What was she thinking?”)
If, on the other hand, the stones create a sensation and 20 people clamour after the
10 stones, there would be a problem. We would now consider these stones a scarce
commodity, because there are more people who want them than there are stones
available. If 100 people wanted them, the stones would become even scarcer. Therefore,
we can conclude that scarcity is fundamentally a relative term rather than an absolute
one. It captures the idea of limited resources (10 stones) relative to multiple potential
recipients.

The Implication of Scarcity

Find ... sermons in stones, and good in everything.

William Shakespeare (1564-1616), English playwright

Taken from As You Like It

This scenario of stones demonstrates that scarcity creates problems that need solving.
You might ask, “What kinds of problems?” First, we have the problem of who gets the
scarce item. If 20 people want the stones, then of the 20 who ask for one, only 10 will
receive a stone. Second, we have the problem of distribution. There needs to be some
kind of system that gets the stones into the hands of the right 10 people. Given that 1
own these stones, it seems reasonable that I make the decision on the means of distribu¬
tion. But I have options, so there are choices to be made.
I could do any of the following:

1. Hand them out on a first-come, first-served basis (queuing).

2. Put everyone’s name in a hat and draw the 10 winners (lottery).
3. Give them to 10 of my dearest friends or family members (favouritism or nepotism).
4. Set up some kind of contest where the top 10 take the prize (tournament).
5. Ask Miss Manners for advice on who ought to get them (social norms).
6. Auction them to the highest bidder (market).
7. Cut them in half and give a piece to everyone (rationing).
10 Cocktail Party Economics

Or, the matter could be taken out of my hands completely if someone

8. Steals them from me and hands them out in the manner of Robin Hood.

Each method listed above can allocate these scarce stones. Markets are just one method
in this rather long list of choices, yet it is the one allocation method that is most near and
dear to an economist’s heart. Here’s why: The problem is not simply getting the stones
into somebody’s hands, but rather getting them into the right hands. I will talk later about
what “right” might mean, but for now understand that economists generally see markets as
the preferred allocation method because they can perform the task most effectively. This
book unapologetically advocates for markets, but you will have to wait until Chapter 9 to
get “the full Monty” on why economists think markets allocate resources better. This is not
to say that the markets work in every situation. In fact, I devote Chapter 11 to market fail¬
ures and possible solutions. Most of the solutions we prefer as economists are market-
based. Only when functioning markets are not possible will most economists concede that
one of the other methods should kick in and allocate scarce resources.

Gossip Column
Lionel Charles Robbins, or Baron Robbins of Clare Market (1898-1984), was a British
economist of considerable influence. He is famous (among economists) for his classic
definition of economics. Robbins also shifted Anglo-Saxon economics away from
ideas put forth by Alfred Marshall and his followers (see the Gossip Column feature in
Making Introductions) through the various essays he wrote and through his hires at
the London School of Economics and Political Science (LSE) of great economists who
thought differently than the Cambridge group. (He did become friends with Cambridge
academic Lord John Maynard Keynes, or Lord Keynes1, a very famous economist who
changed the way governments spend money, so the issues were differences in views
about how the economy works, not university snobbery. In fact, Robbins wrote a book
titled The Great Depression, published in 1934, that decried the Keynesian stimulus
spending approach. He would later recant his negative views on stimulus spending
and in his autobiography expressed his wish that the book be forgotten. Generally, his
wish has been granted.)
Robbins became the chair of the Economics department at the LSE in 1929, but
was required by the university to resign in 1961 in order to take the positions of chair¬
man of the Financial Times and director of The Economist. It seems that Robbins
thought he could both be chair of the department and work for a newspaper. To his
great disappointment, the university didn’t agree and forced on him this opportunity
cost. Fortunately, Robbins was able to devote his efforts to the paper and gave The
Economist the academic credentials it needed to become the premier economics
magazine it continues to be to this day. Robbins remained committed to the LSE, giv¬
ing public lectures, teaching courses, and acting as the chair of its Court of Governors.
In recognition of his efforts, the LSE named a building after him.

1
Keynes was, like Robbins, a mere baron and would have been addressed as Lord Keynes.
 Chapter 1: It's All about Scarcity 11

Robbins was a man of considerable influence in many spheres of British life.

During World War II he was director of the economic section of the war cabinet offices.
He was also the chairman of the National Gallery and director of the Royal Opera
House and Covent Garden. In 1959, he was given a life peerage (one of the first
offered) and became Baron Robbins of Clare Market in the City of Westminster.2 He
was also responsible for the direction of the British university system because of the
Robbins report (1963). Robbins was an academic economist who had a practical
influence.3

THE CLASSIC DEFINITION OF ECONOMICS

Economics is the science which studies human behaviour as a relationship between given ends
and scarce means which have alternative uses.
Baron Lionel Robbins (1898-1984), British economist
Taken from An Essay on the Nature and Significance of Economic Science (1932)

Although the above definition of economics by Baron Robbins is a classic, it certainly

sounds dull—definitely not something you want to quote at a cocktail party. If you
understand it, however, you will realize that it has profound implications. Robbins points
to scarcity as the key idea in economics since, without scarcity, no economic problem
exists because all people can have as much of everything as they want. (Heaven4, here
we come!) This means that nothing needs to be allocated, making markets, as one
method of allocating things, unnecessary. Scarcity, therefore, sits at the root of all
economics in general and markets in particular. Once something is scarce, it is no longer
free for the taking, which creates an allocation problem that needs solving. Now we are
definitely back on Earth.

So What’s It Gonna Cost?

Where there is no choice, we do well to make no difficulty.
George MacDonald (1824-1905), Scottish author

Anyone who has spent a day at the mall—whether working or shopping—knows that
acquiring things takes time, energy, and resources. Simply put, the greater the scarcity of
something, the more it costs to acquire. Economists want to know what you gave up in
order to acquire a particular item because people usually must give up something in
order to get something else. What you forgo actually reveals the cost of what you chose.
The official term for what we give up is opportunity cost.

2 In the United Kingdom, life peers (as opposed to inherited peers) are created members of the Peerage
whose titles may not be inherited by their children. Life peerages are created under the Life Peerages
Act of 1958, always at the rank of baron, and entitle the holders to seats in the House of Lords if they meet
certain qualifications such as age and citizenship.
3 The Oxford Dictionary of National Biography is a good place to go if you are interested in learning more
about Lord Robbins. It is now available online.
4 Gordon, Scott. (1980). “The Economics of the Afterlife.” Journal of Political Economy, 88 (February):
213-214. In this paper, Gordon argues that scarcity could still exist in heaven.
12 Cocktail Party Economics

Opportunity cost carries with it the idea that every choice you make implies a choice
for an alternative that you did not make. Let me put it this way. If a situation involves a
choice between two alternatives, the choice you finally make means that you have lost or
given up the other possible choice. Opportunity cost is the choice you didn’t make—the
opportunity lost.
Here is an extreme example. In the movie Sophie’s Choice, a sadistic soldier forces
Sophie to choose which of her two children would live and which would die. In a gut-
wrenching scene, Sophie finally chooses that her son live and has to live with that choice
for the rest of her life. The cost to save her son was very real—the death of her daughter.
The moral of the story is this: Every choice involves loss, and that loss is a cost. In
Sophie’s case, the loss was devastating. For most of us, the losses involved in everyday
choices are minor. When I choose to have a coffee, I decide against having a tea. Not a
big cost, but still a cost that represents an economic reality.
Let’s see if we can find a lighter artistic example to illustrate the subject of costly
choices. In Robert Frost’s poem “The Road Not Taken,”5 we find the narrator musing
over the attractiveness of the paths ahead. If an economist attempted to analyze this
poem, he or she would want to put a value on the road not taken in order to determine
the cost for the one taken. Moreover, there is no universal cost to this road because the
road not taken can be different for different people. For example, if I choose a coffee for
my afternoon break, I might be passing up on a tea, whereas someone else might forgo a
soft drink or bottled water. In other words, the personal (opportunity) cost for choosing a
particular road differs from person to person. When observed from the outside, it is often
very difficult to identify the true cost of someone’s choice since most people’s second
option—the road not taken—remains a private matter.
Other times, however, the opportunity costs are quite public for all to see. Such was
the case with two British men who lived around the same time. Each of them made simi¬
lar choices but with very different costs. C.S. Lewis (1898-1963) and King Edward VIII
(1894-1972) were both bachelors who decided to marry divorced women. King Edward
chose to marry Wallis Simpson and willingly gave up his throne because of the laws
surrounding divorce and the monarchy. C.S. Lewis, on the other hand, was required to
give up only his bachelor pad at Oxford University, which he gladly did as well. It may
well be that Lewis loved Joy Gresham as much as King Edward loved Wallis Simpson,
but the truth of the matter is that King Edward paid the larger price for that love. In his
mind, Wallis Simpson’s love was scarce and worth the price.

Time Is Relative
The only reason for time is so that everything doesn 7 happen at once.
Albert Einstein (1875-1955), Nobel Prize-winning physicist

Getting back to the men at our cocktail party, they don’t seem like the kind of guys who
have a lot of time for romantic stories about the scarcity of love in the lives of King
Edward VIII and C.S. Lewis. These men care more about the scarcity of time. They all

' Robert Frost (1874—1963) published the poem “The Road Not Taken” in 1916 in his collection Mountain
Interval. It was the first poem in the book and the first poem he printed entirely in italics.
 Chapter 1: It's All about Scarcity 13

agree on that. After all, who can argue with the facts that there are only 24 hours in a day
and that death is 100 percent certain?
Even though we can agree that time is limited, that doesn’t mean that the level of
scarcity of time is the same for everyone. In other words, individuals have different
opportunity costs for time. For instance, retirees who often talk of having a lot of time on
their hands are much more willing to wait at the doctor’s office than people who have to
take time off work to do so. Some teenagers and young adults will camp out for days
to get tickets for a concert or the latest game consoles, whereas busy executives might
pay someone else to stand in line to purchase these items for them. Busy people look at
time as a series of costly choices. Bill Gates captured this idea when he said, “Just in
terms of allocation of time resources, religion is not very efficient.6 There is a lot more I
could be doing on Sunday morning.”7
Bill Gates is right in stating that religion takes time away from an activity that makes
him a lot of money. Anything other than work can be expensive to pursue if you earn a
high salary. Research has shown that men with higher-paying jobs work more and sleep
less then men with lower-paying jobs.8 Economists explain this phenomenon by saying
that men with high-paying jobs have greater opportunity costs for a little “R and R” than
men with low-paying jobs. For them, it is a costly decision to not be working. A big
paycheque is a form of “golden handcuffs” that keep well-paid men chained to their
desks.

Cocktail Party Etiquette

Dear Miss Manners: What about Easter? I suppose you have etiquette rules that apply to
Easter Day?
Gentle Reader: Certainly, and when the Day of Judgment comes. Miss Manners will have
etiquette rules to apply to that, as well.
Judith Martin (1938- ), American writer
Taken from Miss Manners' Guide to Excruciatingly Correct Behavior

For any of you who have resorted to multi-tasking as a time management solution,
here’s the skinny. You can’t really do two competing9 things at the same time. You

6 Now that Bill Gates has retired from Microsoft and technically has more time, he can rethink his Sunday
morning activities, but even when he was running Microsoft it still might have been “efficient” to go to
church. Part of efficiency is how much Gates values the experience compared to how much time he has
available. The quotation simply reveals that Gates doesn’t value religion enough to use his scarce time in
that way. A change in his values would change what choice is deemed “efficient.” See Chapter 2 for more
on this topic.
7 Time, January 13, 1996.
8 Biddle, Jeff E., & Hamermesh, Daniel S. (1990). Sleep and the allocation of time. The Journal of Political
Economy, 98(5), 922-943. Approximately one-third of adult life is spent sleeping, but these numbers are
not the same for everyone. Biddle and Hamermesh found evidence that there is some variability in who
sleeps how much. Women, on average, sleep 20 minutes less per night than men do. Higher wages reduce
sleep time for men but small children reduce sleep time for women.
9 Strayer, David L., Drews, Frank A., & Crouch, Dennis J. (2006). A comparison of the cell phone driver
and the drunk driver. Human Factors: The Journal of the Human Factors and Ergonomics Society, 48(2),
381-391. Chewing gum and walking are not competing activities. On the other hand, driving and using a
14 Cocktail Party Economics

might think you can, but you can’t. The amount of time you give to one activity simply
means that there is less time for the other. Because time is scarce, you must make
choices and these choices are going to cost you. The minute you spend on your smart
phone costs you a minute of meaningful face-to-face conversation with the person
beside you. The cost of face-to-face interaction is the text message you didn’t read in
that moment. The choice is very simple but meaningful in terms of understanding oppor¬
tunity costs.
Now, here is the test. Tell me what you should do when a call comes in on your
BlackBerry during a party. Do you take it or continue with your conversation? Which
activity gets your precious time? Unfortunately, markets can’t provide you with the solu¬
tion in a social setting like this. Fortunately, someone like Miss Manners10 could help
solve this dilemma with one of her Gentle Reader answers. Of all of the allocation
methods available to solve this particular time problem, I’m afraid that only social
norms have a fighting chance of optimally allocating your time.
Here is some advice that Miss Manners would probably give: A cocktail party is just
that—a party. It is a social thing, so you should keep it social. When you go to a cocktail
party, don’t be like the men in our story who are trying to talk and text at the same time,
because you will end up doing neither very well. As Eckhart Tolle would say, “be in the
moment” so the party doesn’t turn out to be a boring, collective waste of time for every¬
body. Turn your ringer off and resist answering if you can. (Unless, of course, your wife
is going into labour and needs to contact you.) This is the polite thing to do. Thank you.
Thank you very much.

Single, Educated Female Looking for Soulmate

God give me a rich husband though he be an ass.
Thomas Fuller (1654-1734), English preacher, physician, and writer
Taken from Gnomologia (1732)

Now that we have dealt with the conversationally challenged men in our story, let’s turn
our attention to the well-dressed women who felt that all the “good ones” were taken.
Are they? Well, given what these women might define as a good man, it is probably
true.
Research has shown that educated women can be somewhat picky when it comes
to finding a suitable marriage partner. In general, they want a man who has as much
or more education as they do." You’ve heard the phrase beggars can’t be choosers?

cellphone seem to require the same faculties. Researchers found that using a cellphone while driving was
similar to driving drunk.
10 Recommended reading: Miss Manners' Guide to Excruciatingly Correct Behavior, Freshly Updated by
Judith Martin (1938- ). See the chapter on Electronic Communication. It should be noted that Martin’s
father was an economist with the United Nations.
11 Susan Lewis and Valerie Oppenheimer, in their paper “Educational Assortative Mating across Marriage
Markets,” found that, in the United States from 1979 to 1992, 64 percent of “marriageable” women
married. Of the women who married, 70 percent married “up” in terms of education. In areas of the United
States that were more “thin” on educated men, women were more likely to marry “down,” especially as
they aged. In areas where men were not as scarce, women were more likely to wait for the right “educated”
guy-
 Chapter 1: It’s All about Scarcity 15

Well-educated women don’t have to be beggars, because they tend to be financially

independent and can afford to wait for Mr. Right or choose to stay single. However, if
they have some urgency regarding marriage (saying that they are “desperate” to get
married doesn’t quite sound right), then the numbers don’t work in their favour. On
average, the college and university student population is about 60 percent female.12
Furthermore, should our well-educated women require additional qualities in terms of
height, religion, race, or other important traits, the search for Mr. Right gets even
tougher. So it is true: A particular type of good man is hard to find; in fact, he is quite
scarce. What do these women do when they want to marry an educated man? Can
markets help? Let’s find out.

Make Me a Match, Find Me a Find, Catch Me a Catch

Someone interesting ...
Taken from Fiddler on the Roof (1964)

Usually, when women want to get married, they put great effort into meeting men.
Attendance at cocktail parties is one way to do this. I guess the hope is that, once they
meet someone, sparks will fly and a match made in heaven will transpire. However, it’s
not always that easy. The scarcer these men become, the greater effort a woman must
put into searching for them. Consequently, she must give up something of value in order
to make this effort, which means that this effort has an opportunity cost. She can take
her valuable time and go where the men are (which is like a queue) or join some kind of
dating service to have it search for her (a market). Either way, it is costing her time
and/or money.
If she thinks that the search for Mr. Educated Right is too expensive (i.e., the oppor¬
tunity cost is too high), she can opt out of the market altogether and stay single or simply
change markets and go after less educated men who are more abundant. Don’t take this
the wrong way, but these men are easier (and economists would say cheaper) to find.
Essentially, these women find themselves engaged in what is called a marriage market,
which has all of the usual features of markets. This market allocates scarce men to
women who will pay the price to find them. It gives a whole new meaning to the term
meat market, doesn’t it?

The Politics of Choice

Real politics are the possession and distribution of power.
Benjamin Disraeli (1804-1881), British prime minister

When General John Vessey, Jr. served as the chairman of the Joint Chiefs of Staff under
U.S. President Ronald Reagan, he commented that a “resource-constrained environ¬
ment” was really another way of saying there wasn’t enough money to go around.
Vessey’s observation still captures the economic tension involved in political choices
and explains why the “suits” at the cocktail party in our opening story end up arguing
about politics. Once a government has set its budget, it must still divide that budget

12 Christofides, Louis N., Hoy, Michael, & Yang, Ling. (2006). The Gender Imbalance in Participation in
Canadian Universities (1977-2003). University of Guelph discussion paper.
16 Cocktail Party Economics

between competing recipients. Supplying one rifle to one soldier might mean that an
elementary school class doesn’t get the publicly funded swimming lessons it wants. If
that is how the government decides to slice the cake, the cost of the rifle can be meas¬
ured in terms of swimming lessons not given. If you are a kid who wants to learn to
swim, the cost is very disappointing. But it goes both ways. When a soldier faces an en¬
emy, the government’s decision to allocate funds to a classroom of 10-year-olds instead
of arming her with a weapon becomes a very significant cost to her.
The reality is that government officials, who may or may not represent your personal
wishes, make these spending decisions all the time. It’s no wonder that government
budgets get people riled up. They cause voters in democratic countries to support politi¬
cal parties in the hope that, upon a party’s victory, their elected leader will represent at
least some of their interests. Although this is an indirect way of getting what you want,
sometimes getting involved in politics is the only alternative.
Governments use most of the allocation methods mentioned above to distribute the
scarce resources they manage. They do everything from organizing people into queues
in emergency rooms to rationing supplies during natural disasters. They are involved in
market activities when they collect tolls on roads. Sometimes they employ nepotism,
which tends to generate a flurry of letters to the editor from those who are “shocked and
appalled” once it is uncovered, which is why politicians try so hard to cover this type of
thing up. In less democratic countries, bribes and payoffs are the cultural norm in
allocating scarce resources to particular people. Although this is a backhanded type of
market, it is still a market.
Generally, governments tend to get more involved in the areas where markets don’t
seem to work well. In Chapter 11, the problem of market failures will explain why gov¬
ernments are necessary to provide the optimal allocation of scarce resources when
unregulated markets cannot.

SO, HOW DOES ONE GET A DRINK AROUND HERE?

Be careful to trust a person who does not like wine.
Karl Marx (1818-1883), German philosopher, political economist, and revolutionary

Finally, you have made it to the bar! I think it’s fair to assume that if alcoholic bever¬
ages were free, the number of drinks that people would want would exceed the number
of drinks available. Wine, beer, and other spirits would therefore be scarce. This is just
a more complicated version of the “stones story” earlier in the chapter. Allocating
these drinks to drinkers now becomes the challenge. Let’s look at some possible solu¬
tions.

1. If the party has an open bar that serves drinks on a first-come, first-served basis until
they run out, the allocation method would be a form of queue where the early birds
get the brew. I hate to tell you this, but in this situation you really will need to get in
line and pay for that drink with your time.
2. If the establishment hands out one drink ticket per person (even to the non-drinkers),
we have a rationing system. If at this point you happen to want two drinks, you had
better try to find some abstainers and convince them to give you their drink ticket.
 Chapter 1: It's All about Scarcity 17

Here, you pay with the time it takes to search for these people and the effort it takes
to negotiate with them.
3. It may be that Miss Manners has decreed that only one drink is socially acceptable at
this kind of cocktail party. A social norm of this type will ensure that there’s enough
to go around as long as no one cheats. Here, you pay with guilt if you cheat—and, in
that case, shame on you! For those who come to the bar and find the drinks are all
gone—tough luck and don’t get too angry about it.
4. The owners of the bar might randomly draw names from a bowl of business cards
(lottery); only the winners get to drink, while the losers get to watch the winners
drink. Here, it pays to be lucky.
5. The bartender serves drinks only to friends (favouritism). In this case, you might
want to be friendlier to the bartender. (As a woman, I don’t really want to think
about it!)

While each of these methods offers possible solutions for allocating drinks and a few of
them are quite common at social settings such as a retirement party or a wedding, this
book is all about how markets can allocate the drinks among the drinkers.

Getting to the Swizzle Stick

When you go to a party that has a cash bar, you find yourself in a market setting. If you
want a drink, you must take something of value to the bar and exchange it for your
desired libation. This is not a good time to forget or lose your wallet. If you have nothing
of value to bring to the bar, you will not get a drink even if you are desperate for one.
This is the downside of markets, which will be dealt with in Chapter 9. For those of you
who have the money for drinks, when you go to the bar you need to realize that what¬
ever you offer to the bartender will no longer be available for you to purchase something
else. Therefore, each drink has an opportunity cost.
Ultimately, it is a matter of personal choice whether you decide to buy a drink or not.
Each of us must assess the subjective value of the drink relative to its opportunity cost. If
the personal value of the drink is more than its opportunity cost (something you could
have used the money for instead), you buy. If it’s not, you don’t bother. In other words,
in order for you to buy a drink there has to be nothing else you would rather do with
your money at that moment than to buy that drink. Again, if it isn’t worth the opportu¬
nity cost, you will pass.

Pricing Policy
Flying might not be all plain sailing, but the fun of it is worth the price.
Amelia Mary Earhart (1897-missing July 2, 1937), American aviation pioneer and author'1

The illustrations discussed in this chapter show that scarcity causes everything to have
an opportunity cost associated with it, against which you must compare your subjective

13
Earhart was the first woman to receive the Distinguished Flying Cross because she was the first female
pilot to fly solo across the Atlantic Ocean. She set many flying records and wrote two books about her
flying experiences, one of which is called The Fun of It, published in 1932.
18 Cocktail Party Economics

values. Notice that markets have conveniently put numbers on the opportunity costs,
which gives you a reference point when making choices. We call these numbers prices,
and they are found everywhere and anywhere a market exists. Because the concept of
value is related to the concept of scarcity and affects the outcomes of markets, it gets its
own chapter. It’s time to think about what it means to get some satisfaction.
Value: Where Emotions and
Economics Collide
What is a cynic? A man who knows the price of everything and the value of nothing.
Oscar Wilde (1854-1900), writer of plays, short stories, poems, and novels

The journey to the bar was a long one. The day had progressed as a series of unfortu¬
nate events. First thing this morning, you were on the phone with a major client. He
refused to pay his bill because he didn’t feel your work was “worth it.” Your boss found
out and became irritated with you.
Mid-morning, your brother called to let you know that your annoying sister-in-law, an
art history major, thinks she bought a Jackson Pollock painting at a garage sale over the
weekend.1 An older couple hadn’t known what it was and didn’t like it. It was taking up too
much space in their small house and they were happy to get rid of it. Gritting your teeth,
you insincerely say, "That’s great. Wow. Congratulations. Hope she’s right.”
In the middle of the afternoon, you heard more bad news. Your recent round of in
vitro fertilization had not worked, and the gynecologist wants to schedule next month’s
treatment. You think, I don’t want to live through that again.
By the end of the day, you felt bagged and just wanted to go home and change into
some comfortable clothes. It is just your luck that the CEO dropped by your office and
said, “I committed to going to a networking cocktail party, but a client has just invited me
to an NBA playoff game, so you will have to go to the party for me.” You think, Why does
this guy deserve to earn 200 times my salary when all he does is go to sporting events
with clients and watch athletes make mega amounts of money for having fun?
Later, while slouching at the bar, you wonder about what makes something valuable.
Why is the Pollock painting more valuable than the work you did for your client? Why is the
CEO's and the star athlete’s time more valuable than yours? These questions are quickly
drowned out by the bigger, more personal, questions. Given that it doesn’t seem to be work¬
ing, is it worth all the money you are spending on in vitro, and when is it time to stop trying?

IS ANYTHING PRICELESS?
Honest disagreement is often a good sign of progress.
Mohandas Karamchand Gandhi (1869-1948), Indian political and spiritual leader

When it comes to what we value highly, we sometimes feel that it is in poor taste to put
an explicit price tag on it. Those famous “priceless” MasterCard advertisements support
our emotional sense that some things are beyond valuation. But 1 have to disagree. I’m
probably going to offend a few people when I say this, but to most economists nothing is
truly priceless.

1 It might be far-fetched to think that an original painting could make its way into a garage sale, but some¬
times it happens. Who the #$&%> Is Jackson Pollock? is a documentary about a woman named Teri Horton,
a 73-year-old former truck driver who may have purchased a Jackson Pollock painting from a thrift shop
for $5. Some in the art community question the painting’s authenticity.

19
20 Cocktail Party Economics

Someone might protest: “Who can put a number on the value of a human life?” Be
aware that human lives are reduced to a number every day, and rightly so. Authorities
often call off searches for missing persons because they can no longer justify the cost of
their effort. Doctors, in consultation with family members, pull the plug on patients in
hospitals because it is too costly (on many levels) to keep them alive. Lawyers recom¬
mend living wills2 precisely because family members may not see the value of your life
in the same way you do. Even if your family is unified, the hospital may take the matter
to court because it values your life differently. Ultimately, value is a number3 and that
number is not infinity. The question remains: “Whose number do we use?”

Value Is Subjective ... It’s Personal

Things only have the value that we give them.
Moliere (1622-1673), French actor and playwright

Just like fingerprints, the preferences, desires, and things that are appreciated differ from
one person to the next. This means that people have different trade-offs they are willing
to make for just about everything. You, for instance, might be willing to pay for some¬
thing I wouldn’t take even if it was offered to me for free. It seems to me that sometimes
the fate of a particular item—be it a couch, bicycle, or teacup—depends on whether a
family wants to go through the hassle of having a garage sale to get rid of it. I would
much rather just put the item on the curb the night before garbage day in hopes that it
“disappears” into a good home.
The older couple in our story obviously thought the Jackson Pollock painting was a
problem and they wanted to get rid of it. They knew they didn’t value the painting as a
work of art in its own right. What they didn’t know was how much others would value it.
Consequently, not knowing has cost them money. But once things are bought or sold in a
market, some of their hidden values are revealed. Prices play a role in separating people
who have a high value for something from those who have a low value for it. In the case
of the Pollock painting, a series of markets will eventually enable the individual who has
the highest valuation for it to actually acquire the painting. The first market (the garage
sale) allows the annoying sister-in-law—who values the painting more than the retired
couple—to obtain it, but she will resell it to someone else who wants it even more than
she does. The final buyer in this chain of markets will keep the painting because he or she
values it so much. Without these markets, each person’s value for the item remains hid¬
den; however, once someone pays a price, some minimum value can be seen.

... It’s More Than Personal

The people who make up various societies and cultures have strong opinions about what
we ought to value, and this is expressed in our religions, morality, and cultural norms.
However, each cultural group in the world may emphasize some values over others. For
instance, some groups place a high value on the life of the unborn child while others

2 A document, made by a person when still legally fit to do so, expressing the desire for types of medical
intervention when the person is no longer fit to express his or her preferences.
3 The U.S. Environmental Protection Agency set the value of a “statistical life” at US$6.9 million in May 2008.
 Chapter 2: Value: Where Emotions and Economics Collide 21

place a high value on nature in terms of the environment or animal rights. Each group
will work tirelessly to promote its causes or values. This is why we see boycotts of
existing markets for such things as cosmetics tested on animals or products made in a
particular country where people’s labour is deemed exploited.
Cultural norms, morality, and even religious convictions can change over time and,
with them, so can our values. When societal values change, what we are willing to buy
and sell also changes. For example, to people who live in the free world, the idea of
owning another human being is morally repugnant. We cannot imagine how anyone
could have thought that slavery—the buying and selling of human beings—was a good
idea. However, 200 years ago, some seemingly decent individuals in the southern United
States had no qualms about owning slaves. Fortunately there has been a shift in values
prompting economic change as well.

Answering Questions That Have Answers

It is the business of economists, not to tell us what to do, but show why what we are doing
anyway is in accord with proper principles.

Joan Violet Robinson (1903-1983), British economist

Taken from Economic Philosophy (1962)

Economists can say a lot about what individuals and societies value, but they have little
to say about what should be valued. They are very good at holding up a mirror to society
and showing it what it really looks like, but they rarely comment on the beauty of the
reflection. From an economist’s perspective, the main point is this: If you want a picture
of what people value, check out their markets. The market tells the truth. You may or
may not like that truth but it doesn’t change how the real world works. Yes, CEOs of
corporations and top athletes do earn “obscene” amounts of money compared to the
average person’s “pittance” of a salary. Paintings by famous artists do sell for “outra¬
geous” prices while no one would pay a dime for one that looks similar if painted by
your beloved child. You can’t get away from it. Markets reveal all and serve as exposes
on our collective values. Most economists see their role as one that uses market analysis
to explain why something is valuable and to explain what forces are at work to change
the revealed value, which is known as price. (Also, most economists would never use
words like pittance, obscene, or outrageous to describe a price.)

SCARCITY REVEALS VALUE

In every child who is born under no matter what circumstances and of no matter what parents,
the potentiality of the human race is born again, and in him, too, once more, and each of
us, our terrific responsibility toward human life: toward the utmost idea of goodness, of the
horror of terrorism, and of God.

James Rufus Agee (1909-1955), American author

If I were to ask parents to put a dollar figure on how much they love and value their
children, they would probably be offended. I can see how my question would be
offensive to them. Of course, parents think their children are priceless. But when we
look at how most parents acquire children, we can see that they have not actually paid
22 Cocktail Party Economics

very much to get them. (In fact, the encounter that produced these children could have
been quite pleasant!) So, before I begin an analysis of the value placed on babies (and
before anyone sends me an angry email), let me state that I agree with the obvious pla¬
tonic4 idea that things can have intrinsic value. That value is not infinite, however, but it
can certainly be very high. I accept the fact that parents love and value their children. 1
just think that “high value” means different things to different people. When markets
become part of the process of acquiring a child, let’s say through adoption or in vitro
fertilization, the bottom end of how high parents are willing to go to acquire a baby
becomes exposed. Hidden values become public because of monetary transactions.
Let’s look at couples who have been diagnosed with infertility (my husband and I are
included in this group). For us, the normal way of conceiving and having a child doesn’t
seem to work. To put it bluntly, for infertile couples like us, babies are scarce. The good
news is that an initial diagnosis of infertility may not necessarily lead to childlessness.
There are ways of acquiring a child, but because of the scarcity problem it will cost us to
do so. Infertile couples pay in terms of time as they wait for appointments with doctors,
in terms of discomfort as they endure painful medical procedures, and in terms of money
as they have to pay medical specialists. If more and more couples experience infertility,
the increased demand on a doctor’s time drives up the cost to see that doctor. In the
United States, which has a private health care system, infertility specialists’ fees will
rise; in Canada, which has more public health care system, couples will wait longer to
see these doctors. These couples pay either with time (queue) or with money (market).
Therefore, the value that potential parents place on a biological baby becomes evident to
those around them as they pay, pay, and pay some more.
If medical science cannot produce a baby for these couples, they may shift their
efforts toward adopting a child. Essentially, this is a shift to a substitute market. The
couples pay even more, both with time as they wait on various adoption lists and with
money for adoption services either at home or abroad. In fact, they end up giving money
to everyone in the adoption process except the woman who actually gives birth to the
child. Ironically, if a couple actually did pay the birth mother directly to give them her
baby, many people would become morally offended since, in their minds, it turns babies
into a commodity that you can buy or sell. (In some places, surrogacy has created a way
for a woman to get paid to have a baby, although it is not legal everywhere.5)
Every time a couple pays something to acquire a baby, they reveal how much this
child is actually worth to them. Each of these payments is the result of the scarcity of
babies to infertile couples. As babies become scarcer, the opportunity cost to acquire a
child goes up. If it costs more and you pay the cost, then you reveal to those around you
that this child is worth at least this much to you. If the child had not been worth the
higher opportunity cost, you would have opted out of the market and not paid the price.
Economists call this revealed preferences. We now have more information about how

4 Plato (428/427-348/347 BC) was a Greek philosopher. He studied under Socrates and was a mentor to
Aristotle. In this example, the value of a child is said to be of universal, not just particular, value.
5 Surrogate mothers sometimes provide the egg, but other times they simply “rent out the womb” to a
fertilized egg. If they provide this service for free it is called altruistic surrogacy. Commercial surrogacy
provides the surrogate mother with an income for her actions. This is illegal in Canada but not in India,
which is now the world leader in surrogate services.
 Chapter 2: Value: Where Emotions and Economics Collide 23

highly these parents value their children. For some families, babies are the “pearl of
greatest price.”6
I don’t think infertile couples are necessarily people who value children more than those
for whom pregnancy and childbirth is easy (although “easy” is not how most women would
describe the birthing experience). It is just that, for most couples, babies are not hard to
acquire and so these couples don’t end up revealing their preferences. On a personal note,
both Martin and I are very thankful that we adopted our two sons. On a financial note, we are
also thankful that we didn’t have to mortgage our entire future to do so.
Acquiring children is one thing; raising them is another matter. With the advent of birth
control, the decision to have another baby has come to depend on the value of that addi¬
tional child to the parents and the opportunity cost to raise him or her. For both fertile and
infertile couples alike, scarce resources must be used to raise a child. This is probably why
most parents do not choose to keep having children until it is physically impossible to do so.

Valuing a Jackson Pollock

I can't change the fact that my paintings don’t sell. But the time will come when people will
recognize that they are worth more than the value of the paints in the picture.

Vincent van Gogh (1853-1890), Dutch painter

A Jackson Pollock painting sold in 2006 for more than $100 million. Wow. This is partly
because Pollock died in 1956 and is obviously no longer painting. The number of Pollock
paintings is fixed, although a new one could pop up in someone’s storage locker.7
However, the concept of scarcity is driven by more than some fixed quantity available.
Scarcity also captures the idea of how many people want or value an item. Jackson
Pollock was recognized as someone who played a significant role in the development of
American abstract art. Museums, galleries, and private collectors would all jump at the
chance to get one of his paintings. The value of a Pollock painting has to do with the
individual valuations placed on it by the potential buyers. Market value is about both
sides of the fence: the quantity available and the valuations placed on that quantity. It is
possible that Pollock’s work could, at some time in the future, fall out of favour. If this
happened, the quantity of paintings would not change but their market value would. The
paintings have value only because someone wants them and, given the current market
price of a Pollock, someone wants them pretty badly.

Put Your Money Where Your Mouth Is

In 2006, record executive David Geffen put Pollock’s No 5, 1948 up for sale.
The painting sold in a private deal for $140 million. What does the final price of
$140 million tell us, and what does it not tell us, about the value of the painting?

6 Jesus tells a story in the Gospels of a man who discovers a pearl in a field. The man then sells everything
he has to buy the field in order to make the pearl his own. Giving everything you have for something is
about as close to priceless as economists are willing to go. Those with more resources have more that they
can give up in order to get what they want.
7 In May 2005, NPR reported that 32 unknown works were discovered in a storage locker belonging to
Pollock’s friend Herbert Matter.
24 Cocktail Party Economics

To begin with, it tells us that no one else was willing to top this price,8 and therefore
no one else valued this painting at the SI40 million mark. It also tells us that the
Mexican financier who bought the painting valued the painting for at least that amount.
He might have been willing to pay even more for it, but that wasn’t necessary. We also
know that David Geffen did not value this painting for more than $140 million or he
wouldn’t have sold it. Economists often equate the price of anything, in this case the
painting, with its value. Although this is not strictly true, it isn’t a bad approximation.
The price paid for this item is called its market value and is about as good an approxi¬
mation for the true worth of the painting as we can get. The subjective value that the
buyer has for the painting is at least equal to the market value, but it could very well be
more. Markets only reveal so much.
—

Gossip Column

Karl Heinrich Marx was born in 1818 in Trier, a part of the Kingdom of Prussia. He
died in London, England, in 1883 and is buried in his wife’s Highgate Cemetery grave.
Marx was both a scholar and an activist. As a political economist, sociologist, political
theorist, philosopher, and revolutionary, Marx is often called the father of communism.
This doesn’t resonate well with most economists, although his ideas have found a
home in what is called Marxian economics. He proposed that the market value of a
good should be based on the quantity of labour used to make it. This is in contrast to
the idea put forth in this chapter that market value is a matter of scarcity.
When Marx died, he was essentially penniless (net worth of £250), but he left
behind his ideas in Das Kapital. Only the first volume was published in his lifetime. The
remaining two volumes were published posthumously by his good friend Frederick
Engels. Engels was a very good friend, indeed. He supported the financially strapped
Marxes (ironically using funds from the Engels family cotton mills) and even went so
far as to claim paternity of a child—Henry Fredrick—born to the Marxes’ housekeeper
Helene Demuthin in order to keep Marx's wife, Jenny, from finding out the child was
actually Karl’s. Marx had six named children (one died before receiving a name) with
his wife, and each of four girls was named Jenny, after their mother. Fortunately, they
didn’t go by Jenny. Imagine the confusion. At least two children, a boy (Henry Edward
Guy) and a girl (Jenny Eveline Frances), died a year after birth, which must have been
heartbreaking to the parents. Marx had to beg money (£2) from a friend to purchase a
coffin for one of these children. The grief and marital tensions must have been
unbearable, and this may explain how Henry Fredrick came into existence.
Through Das Kapital and The Communist Manifesto (co-authored with Engels),
Marx’s influence has been enormous. In scholarship, his work has appeared more
frequently in the index of the International Encyclopedia of Social Sciences than

It is possible that someone who values the painting more didn’t know about the sale, but 1 doubt it. The
“big money” art community is pretty small.
 Chapter 2: Value: Where Emotions and Economics Collide 25

anyone else’s. As well, within 50 years of his death, about a third of humanity was
ruled by governments devoted to Marxism.9
While I cannot claim sympathy with Marx's ideas, I do have sympathy for him (and
the Jennys), especially since he named one of his daughters the same name as me.

WHEN PLAY BECOMES WORK:

SPORTS AS A BUSINESS
Golf may be played on Sunday, not being a game within the view of the law, but being a form
of moral effort.'0

Stephen Butler Leacock (1869-1944), Canadian economist and author

Armed with ideas about value and scarcity, lets look at why sports stars (or any kind of
star, for that matter) make so much money. Most obviously, the number of very talented
people at the very top of a field is small. There are only so many athletes like golfer
Tiger Woods" or basketball player LeBron James out there. That’s half of it. The other
half is explained by the excitement factor, which affects the size of the audience watch¬
ing. Big salaries and endorsements go to sports stars who are successful at popular
sports. They generate a lot of value because they have so many fans, who are each will¬
ing to give up something else to watch them and to buy a product they endorse. The
sports star may be only marginally better than another athlete, but that’s all it takes to
create a following.
Athletes such as Tiger Woods and LeBron James have negotiated some of their
value into their own pockets. They actually might be worth more than what they are paid
but they are certainly not worth less, even though some critics may think so. Each team
or company that employs these stars has a maximum price it is willing to pay them
depending on how much it estimates the players will generate in revenue for the fran¬
chise or company. By the same token, the star has a minimum number he or she is will¬
ing to receive depending on what others have offered to pay. These other offers are an
opportunity cost for making a deal with one particular organization. The market value
for a player is usually some number in between the player’s minimum and an organiza¬
tion’s maximum. These deals are usually negotiated, so it helps to have a good agent
working for you to get the highest salary possible.
(By the way, if you have a bad season, you will be re-evaluated, so make sure to play
well and not get injured. If you need a clean-cut image to be worth something in
endorsements, don’t commit marital infidelity. Notice that I didn’t say don ’t get caught.
If you are a star, you will get caught! As Tiger Woods found out, your downfall has
value in other entertainment markets, most notably the gossip tabloids.)

* Even though Marx was bom in Germany, he spent much of his life in England. This explains why he has a
biography in the Oxford Dictionary of National Biography, just as the Marshalls and Robbins do.
10 It used to be common for a Christian culture to abstain from working on Sunday. Thus, if golf were work,
it would have been forbidden.
11 In 2007, Tiger Woods had the highest endorsement income of any athlete, earning $100 million. LeBron
James’s endorsement income was third at $25 million. Woods would go on to be the first athlete to earn
$1 billion.
26 Cocktail Party Economics

From the perspective of free market economists, these top athletes are worth every
penny they receive. The market has brought together those who value the athlete’s
performance and those who can perform. Everyone is happy until they start talking
about salaries over a beer.
On the other hand, Marxist economists see the value of a worker as something intrin¬
sic to being classed as labour, and no one labourer deserves this level of remuneration. It
should be clear why most top athletes want to live in a free market economy.

THE SPECIAL CASE OF THE CEOS

My problem lies in reconciling my gross habits with my net income.

Errol Leslie Flynn (1909-1959), Australian-born actor

To many economists, CEOs are just another example of highly specialized talents that
get the big bucks for being marginally better than anyone else in creating value for their
shareholders. These economists believe that slight increases in the scarcity of executive
ability elicit huge gains for these CEOs.12 Other economists aren’t convinced that execu¬
tive compensation is an issue of simple scarcity and put forth alternate theories to
explain the multi-million-dollar salaries given to top executives (mainly in the United
States). Most of these theories have to do with the incentive structure of various com¬
pensation packages and how they motivate managers to behave in ways that increase the
profits paid to the shareholders.13 This example demonstrates that while the simple idea
of scarcity is foundational in economics, sorting out what is actually going on with
executive pay is matter of debate.
During the fall of 2008, U.S. President George W. Bush convened an emergency
summit to look at a $700 billion bailout for American firms in the financial sector. The
Emergency Economic Stabilization Act of 2008 limits the amount of compensation these
failed companies can give their executives. Wall Street’s mantra of “pay for perform¬
ance” raises questions about how much pay the top executives deserve for really poor
performance and why these bright (scarce) and mostly male executives in the financial
sector got it so wrong.14

The Not-So-Special Case of You

Here is the depressing news: If you have a set of relatively common skills and you are not
the topic of conversation at the annual shareholders’ meeting, you are not particularly
scarce. Unfortunately, your salary will reflect that fact. What can you do to change this?
A good way to increase your salary is to try to show your boss that you are valued
elsewhere. Getting another job offer and then having a meeting with your boss about it
might be a good way to stay at your current firm but receive higher pay. This tactic is a
bit risky if you don’t really want to leave your job because, while your boss may be

12 See Gabaix, Xavier, & Landier, Augustin. (2008). Why has CEO pay increased so much? The Quarterly
Journal of Economics, 123( 1), 40-100.
13 See the chapter titled “Why Your Boss Is Overpaid” in Tim Harford’s book The Logic of Life.
14 Andrew Ross Sorkin’s book Too Big to Fail is a fascinating read about the main characters in this saga.
The salaries earned by these executives were in the tens of millions of dollars.
 Chapter 2: Value: Where Emotions and Economics Collide 27

sorry to see you go, he or she will also help you take your things to the door if the com¬
pany’s value for your services is not as high as your other offer.
Another thing you can try is to make yourself more extraordinary and your skills less
common. That will up your value in the labour market. By improving your education or
work experience, your services become a scarcer commodity. If you can develop a skill
that makes clients love to pay you because “you are so worth it,” your compensation
package should reflect that unique ability. Sometimes it also helps to play golf with cli¬
ents. Whether you should win or lose the game is a decision you’re going to have to
make for yourself. Again, think about the opportunity costs.

THE PARADOX OF VALUE

When the well’s dry, we know the worth of water.

English proverb

So far, we have looked at the price of things as telling us something about value.
Economists call the price of something its marginal value or incremental value rather
than its total value. The idea of margin or increment means that you are looking at items
one at a time and treating them separately, as opposed to cumulating their values over all
products in a category. Price is the marginal value of one painting, one athlete per sea¬
son, a paid sexual encounter, or your services per paycheque. It is not, for example, the
total value of all Jackson Pollock paintings. If Jackson Pollock had lived longer and
painted more (and nothing else had changed), the price of one of his paintings would be
less but the total value of all of his paintings would actually be higher. More people
would get pleasure from his canon of work and society as a whole would be better off,
even though the price per painting would be lower. Economists call this the paradox of
value. The more abundant something is, the less we pay for it but the greater overall
total value it has in the economy. One star athlete is paid a high salary but his or her
overall contribution to society is much less than an army of daycare workers who each
earn minimum wage. Adding up the value of low-paid individuals would result in a
number higher than the sum of a few individuals who make a high income.

Of Cabbages and Kings: Value and Price

“When / use a word, ” Humpty Dumpty said in rather a scornful tone, “it means just what I
choose it to mean—neither more nor less. ”

Charles Lutwidge Dodgson, pen name Lewis Carroll (1832-1898), English author
Taken from Through the Looking-Glass (1871)

People usually want the total value of a good or service to be reflected in its price. This
is understandable, because it feels fairer to them. After all, important things should cost
more and reflect their true value, shouldn’t they? But prices are simply measures of rela¬
tive scarcity—its marginal revealed value—and become a mechanism to get people to
use those scarce resources wisely. Only those individuals who value a particular thing
above its price will actually purchase it. Prices are not measures of total significance.
Child care, the water we consume, and the cabbages we eat are cheap to buy, not
because they are unimportant in the scheme of things but because babysitters, water, and
28 Cocktail Party Economics

cabbages are relatively abundant. The abundance of something may have large societal
benefits overall, but its price reflects the fact that there is a lot of that thing to go around.
In many ways, it is good that important goods and services like babysitting, water, and
cabbages are so abundant and cheap to purchase. Think about what life would be like if
or when they became very scarce. Who would look after our kids? What would we
drink? Where would we get our cabbage rolls?15

TRADING VALUES
These first two chapters have given you the basics to understand how trade works and
why so many people are willing to engage in it. When people have different values for
scarce goods, trade is the next logical step. Let’s take that step into the next chapter.

15 On a less sardonic note, when natural disasters occur often the basics of life—clean water, first-aid
supplies, and batteries—become quite scarce and cause untold heartache to those involved.
Exchange: Supply and Demand,
Take One
If economists could manage to get themselves thought of as humble, competent people on a
level of dentists, that would be splendid.

Lord John Maynard Keynes (1883-1946), originator of Keynesian economics

With glass in hand, you saunter toward a group of men chatting and overhear one dad
say, “What a night. I didn’t realize how tricky Halloween could be when kids are different
ages. My oldest son wanted to run and get to as many houses as possible. He was so
frustrated with his kid sister who couldn’t keep up with him, we finally decided that he
would do both sides of the street and my daughter and I would only do one. He got twice
as much as she did but they both seemed happy with it. Thankfully, it wasn't raining and
my part was over by 9 p.m. It sure wasn’t over for the kids, though. By the end of the
night, their rooms looked like the floor of the New York Stock Exchange used to look after
a day of heavy trading.1 What a mess, and I hate to think about the dentist bill.”

A NIGHTCAP ... I MEAN, RECAP

Teach a parrot the words “Supply and Demand’’ and you've got an economist.

Thomas Carlyle (1795-1881), Scottish historian

The road from scarcity to markets is surprisingly short—a hop, skip, and a jump, really.
We have seen that scarcity leads to an allocation problem. Markets offer a great system
to allocate goods. (The fact that markets are often the best solution to the allocation
problem will be explained in Chapter 9.) The concept of scarcity combines the ideas of
both subjective values and availability. When these two team up, choices need to be
made. Scarcity makes decisions costly and markets conveniently put a numerical value
on those costs. It’s called price.
Suppose that someone gives you a gift certificate for a jewellery store. At the jewel¬
lery counter, you see a watch and a ring that would look just terrific on you. However,
you discover that your gift certificate can buy only one of them. Don’t you just hate it
when reality hits and you realize that you can’t have both the watch and the ring? You
have to choose. How do you make the final decision? It all depends on your answers to a
couple of simple questions. First, what are the costs? Second, what are the benefits? This
is the classic cost-benefit analysis you often hear about. The (opportunity) costs in this
story are easy. If you get the ring, it will cost you the watch; if you get the watch, it will
cost you the ring. The benefits depend on your subjective values. Between the two
accessories, you will buy the one that has a subjective value greater than the (opportu¬
nity) cost. If things are close, you will stand at the counter for a long time, potentially
making the jeweller more and more nervous as the Mozer mantel clock ticks on.

I
All trading is now done electronically.
30 Cocktail Party Economics

Costs and benefits bring us to the concept of supply and demand, the buzzwords of
economics. There are two ways to look at this topic. The first is a top-down approach and
the second is (surprise, surprise) a bottom-up approach. This chapter provides a top-down
broad overview of why markets usually work. For the bottom-up approach. Chapters 6 and 7
break supply and demand down into its component parts and look at them in nitty-gritty
detail. Chapter 8 puts it all together and the supply and demand framework will be used to
tell some stories that illustrate these market concepts. In particular, I will focus on auto
sales and the housing market to help you see how supply and demand works.

The Basics Are Surprisingly Simple

Things should be made as simple as possible, but not any simpler.

Albert Einstein (1879-1955), German-bom theoretical physicist

When you give something up, you are supplying or selling it.
When you get something, you are demanding or buying it.
Sometimes money is involved. Sometimes it isn’t.

WHAT IS A MARKET?
Never underestimate the determination of a kid who is time rich and cash poor.

Cory Doctorow (1971-), Canadian author

Taken from Little Brother (2008)

On October 31 of each year, children in North America scurry through the streets, going
door to door to collect junk food. It’s called Halloween, and it can be a lot of fun. Just
make sure you don’t get between the kid and the candy. That’s when you will see the
real ghouls come out! On this night, you will find junior entrepreneurs working at
the most organized form of begging there is. The evening rewards the swift because the
window of opportunity (dictated by social norms) runs from about 6 p.m. to 9 p.m. and
then it is all over for another year.
What a joy it is to dump the haul on the floor and begin the ritual sorting. Chocolate
bars2 in one pile. Chips* 1 in another. Finally, candy in a third. (Apples are tossed before
they make it into a pile. Halloween is about basic food groups, and fruit isn’t one of
them!) The compulsive child will refine the sorting into even more piles ... and probably
even record them on some sort of spreadsheet.
Happy is the child who has siblings, because the evening’s business then goes into
overtime with major wheeling and dealing. Despite the differences in wealth (some kids
cover more ground and hence have more loot), trading has its benefits. For instance, sup¬
pose that one child doesn’t like chocolate but is addicted to chips and candy and that the
other child likes everything. It makes sense that the first child would propose a mutually
satisfying trade to the other, saying, “How about two chocolate bars for one bag of chips?”

: The Hershey company and Mars Inc. are the largest manufacturers of chocolates in the world. Nestle and
Lindt are also big players. Mars Inc. is owned by members of the Mars family, making it one of the largest
privately held companies in the United States.
1 Potato chips account for approximately one-third of the total savoury snacks market.
 Chapter 3: Exchange: Supply and Demand, Take One 31

“It’s a deal,” the other child agrees. These two rational children (and all children are
rational when it comes to candy), with their different value systems, engage in complex
trade negotiations to improve their own personal situations. After all, no one freely trades
something they like for something they hate ... unless, of course, we are talking about a
mother trading with her children! Economists call the benefits of a mutually satisfying
trade the gains from trade. Markets or exchanges4 are simply the mechanisms that allow
such improvements in happiness to occur. It is as old as civilization itself.5
After all of the trades are completed for the night, we can figure out the real price of
a bag of chips for these children. We saw that one bag of chips traded for two chocolate
bars. Therefore, we can conclude that the price of a bag of chips is two chocolate bars
and, conversely, that the price of one chocolate bar is a half a bag of chips. (I hope you
now recognize that these prices are opportunity costs for chips and chocolate.) Due to
the nature of barter,6 each player must be in two markets simultaneously (both the chips
and the chocolate markets). One child cannot buy chips without selling chocolate bars. If
one of the children didn’t want to trade (we have all heard of some kid sister who refuses
to deal), then neither the chocolate market nor the chips market would exist in that
household. Markets require the willingness of both players to exchange something of
value at a price they can agree upon.

Adding Money
All government—indeed, every human benefit and enjoyment, every virtue and every prudent
act—is founded on compromise and barter.

Edmund Burke (1729-1797), Irish statesman

The concept of barter (for example, the exchange of chips for chocolate bars) is simple
to understand, but what happens when we add the real-world complication of money?
Money exists because societies may want to engage in wider trade beyond two parties.
Let’s look at a complicated trading scenario: Wilma wants what Barney has,
Barney wants what Fred has, and Fred wants what Betty has. Finally, Betty wants
what Wilma has (and it’s not Fred!). In order for barter to work here, as in the
Halloween story, you would need to have all of these players in the same room doing
some pretty complicated trade negotiations. From The Flintstones, we know that these
people are couples and best friends, so barter would probably work. But what if the
people are unrelated?

Actual or Potential?
Money is only as good as what you buy.

Gilbert Van Sligtenhorst (1934-), Eveline Adomait’s dad

4 For example, stock markets are also called stock exchanges. In the United States, commodities are listed on
the Chicago Mercantile Exchange (CME).
5 Trade of commodities seems to date back to least 5000 BC between the Mesopotamian and Indus
regions.
6 Barter is the trade of real things for real things. No money is involved. If someone agrees to babysit a child
in exchange for a toilet installation, he or she would be bartering services. If both sides agree to this
exchange, they are both getting a good deal.
32 Cocktail Party Economics

Let’s see how money can help. Suppose that Wilma sells her stuff to Betty, who pays
her in money. Money then acts as a type of holding tank of potential buying power.
Economists say that money is functioning as a store of value. This store of value
(money) can sit in Wilma’s purse until it is convenient for her to meet up with Barney
and buy what she wants. However, once Wilma purchases something, she converts what
is potential value into actual value. Her money buys something real that she can use.
Barney, on the other hand, has given up something actual or real (which he values) in
return for money, which hopefully retains its value for as long as he has it. This money
now gives him potential value or buying power to be used to obtain what he wants when
it is convenient for him to do so. He must use his money to buy something in order to
experience the actual value of a dollar.
Money allows these Stone-Age characters to make trades without having to be in the
same room together. As long as money holds its store of value, these players can take
their time to make a purchase. Thus, complicated deals become much simpler. In addi¬
tion, money allows people to be in one market at a time rather than require them to be in
two simultaneously, as is the case with barter.
The simplicity of using money makes it seem as if money is actually real in and of
itself. The use of money disguises the fact that all markets are eventually about real
things changing hands, not about money. Money is just a way of storing value until it
is convenient to purchase something real. For most people, the real trade is labour
hours supplied in exchange for goods and services demanded. It could be a T-shirt
slogan:

Life is simple:

Work {real)

Get paid (money)

Buy stuff (real)

The Real World

All perception of truth is the detection of an analogy.

Henry David Thoreau (1817-1862), American author

Halloween is a perfect illustration of real trade. The kids who work the streets have piles
of junk food to either consume or trade. They trade (or supply) a part of their stash if
they can get back (or demand) something they like better. If all kids do this, the world is
a better place by the end of the evening. I can almost hear you now: “All of this stuff
about The Flintstones and Halloween is kids’ stuff. I get what you are saying about trade
at this level, but how does this relate to the real world of international trading arrange¬
ments? Can this help me understand how countries trade with each other?” In the
vernacular of Fred Flintstone—yes, it yabba dabba does!
For starters, it is a misnomer to say that countries trade with each other. Rather, indi¬
viduals in countries trade with each other, and countries keep track of the numbers that
move in and out of their borders. The governments of various countries are not major
trading participants. An international story comparable to our Flintstones example goes
 Chapter 3: Exchange: Supply and Demand, Take One 33

something like this: The American company Walmart7 buys clothing from manufacturers
in China. With the money the Chinese companies are paid, they buy oil8 from Canada.
The Canadian shareholders of the oil companies use some of the money from the sale of
oil to purchase Californian wine.9 Finally, the workers at the winery buy clothes at
Walmart that were manufactured in China. It’s Wilma, Barney, Fred, and Betty over
again. The situation only looks more complicated because we have added borders, three
currencies (monies), and people who never meet.
While governments provide the environment that makes trade easy or difficult for
the average citizen to engage in, they usually aren’t big players in the actual buying and
selling of goods themselves.10 This fact can be lost when people talk about countries
such as the United States, China, or Canada trading with each other. It is easy to think
that presidents and prime ministers are trading clothes for wine, when in reality they are
not. (They simply go to cocktail parties with each other.) Trade agreements set up the
terms and conditions that allow citizens in their respective countries to negotiate these
trades.

Getting into the Game

There are two great rules of life, the one general and the other particular. The first is that
everyone can in the end get what he wants, if he only tries. That is the general rule. The par¬
ticular rule is that every individual is, more or less, an exception to the rule.

Samuel Butler (1835-1902), British author

Some look negatively on markets and point out that not everyone participates in markets
and therefore cannot benefit from free trade. This is the big criticism from the political
left,” which is usually suspicious of free markets. (A communist approach would ration
goods equally to all citizens.) Economists have to admit that market economies imply
that only those with something to trade can reap the rewards. Let’s take a careful look at
our Halloween analogy to see who doesn’t engage in trade and identify what they repre¬
sent in the global economy.
First, children without brothers or sisters have no one to trade with. They still have
their piles of goodies, so it is hard to feel sorry for them. However, if they could easily
trade with someone, they would be better off. They could trade something they “sort of’
like for something they really like.

7 Walmart accounts for about 30 percent of all buying power in China and about 10 percent of all U.S.
imports from various countries.
8 China is the second largest consumer of oil in the world. Since 2005, China has been buying into Canadian
oil companies in order to secure a stable supply of oil.
9 In 2007, 95 percent of U.S. wine exports were from California and totalled $951 million in value. Canada
bought approximately a quarter of those sales.
10 When governments purchase items from other countries, they are engaging in trade but acting like any
other player. For example, the LCBO (Liquor Control Board of Ontario), an agency of the Ontario gov¬
ernment, is a big buyer of alcohol on the world market and a big seller of alcohol to Ontarians. Sales in the
2007-08 fiscal year were $4.1 billion.
11 The term political left originates from the French Revolution and had a lot to do with the seating
arrangements of the political parties. The nobility sat on the right of the president’s chair and the liberal
deputies sat on the left. The French assembly still seats its representatives from left to right in terms of
their politics.
34 Cocktail Party Economics

Any country that produces goods and services but doesn’t trade with the outside
world would be in this situation. This is called autarky, which means self-sufficiency.
China was close to an autarky from around 1950 to 1978 because of policies established
by Mao Zedong. Since 1978, China has steadily increased its use of markets and
subsequently has more to trade. Also, with its accession to the World Trade Organiza¬
tion (WTO) in 2001, the volume of trade has increased significantly so that China is now
the fifth largest exporter in the world.'2 Whether these gains translate into general
increases in the standard of living for all of China’s citizens is a question of some
debate. It appears that urban13 and younger people receive most of the gains from trade.
Second, sick children generally do not trade. This situation is sad. Through no fault
of their own, these children cannot bring anything of Halloween-generated value to the
economic table.
Similarly, countries that have had natural disasters, famines, wars, or epidemics have
a smaller pile with which to trade. While free trade can take a terrible situation and make
it slightly better, it cannot fix the underlying production problems.14 For instance, the
United Nations has set specific goals to reduce poverty in the world by 2015. However,
these goals look unattainable for the continent of Africa due to civil wars, the HIV/AIDS
pandemic, malevolent dictators, and drought. The situation in many African countries
appears to be much more complicated than a simple trade problem.
Third, kids whose parents oppose “trick or treating” and prohibit this activity have
nothing to trade. For religious reasons, some parents prevent their children from going
out on Halloween night. Other parents inspect their children’s stash for anything they
consider really bad (although most of it is bad for you). Many dentists recommend that
parents remove the candy or “buy it back.” This kind of trade is usually not negotiated
but rather imposed by the parent. In other words, it is forced trade rather than free trade.
These kinds of actions represent government policy, and international trade policies
affect the ability of citizens, both at home and abroad, to trade with each other. Coun¬
tries, through their laws and institutions, influence the environment within which mar¬
kets operate. For example, the United States currently forbids any trade with Cuba due
to ideological and political differences. Even when a country is a friendly trading part¬
ner, a single event can block trade. In 2003, the United States banned imports of
Canadian beef due to one case of mad cow disease. Before the ban, Canada was the third
largest exporter of beef in the world; trade was valued at $4.1 billion, with 90 percent of
it going to the United States. After the ban, exports dropped to virtually zero. You can
image the devastation this caused to the beef industry in Canada.
Finally, kids whose candy gets stolen unfortunately don’t get to trade either. Think
of it ... all that hard work was for nothing. Trade or markets have no power to get back
people’s loot. What is needed is a system that protects private property, preventing theft
from happening in the first place. On Halloween night, when there are tricks as well as
treats, protection may come in the form of a parent or older sibling accompanying the
child on his or her route, thereby protecting the goods from other unscrupulous imps.

12 In 1980, China’s volume of trade was valued at US$38 billion. In 2002, the volume had grown to
US$620 billion. Over a period of 20 years the trade balance had doubled at least three times.
13 In 2005, the growth in income was 8.3 percent in urban centres and 3.8 percent in rural areas. These
numbers have been adjusted for inflation.
14 See Chapter 4 for issues facing developing countries.
 Chapter 3: Exchange: Supply and Demand, Take One 35

On a grander scale, governments play a role in setting up and policing the legal
systems that protect property from transnational theft. The Paris Convention for the
Protection of Industrial Property is the most widely adopted international treaty in the
world. This convention seeks to protect the holders of patents (and other intellectual
property) from losing income due to theft and was first signed in 1883. Today, 173
countries have signed the treaty, giving a legal framework to the rights of patent holders.

Gossip Column

Adam Smith15 was probably born in June 1723 (the month and year of his baptism),
approximately six months after his father died. He was therefore raised by a single
mother and was quite close to her, living with her when not at university or travelling. He
entered Glasgow University at the age of 14 and, while he was there, won a scholarship
to Balliol College, Oxford. At Oxford, it appears he may have suffered a nervous
breakdown because he left before his scholarship was over. From then on, Smith
maintained Glasgow’s intellectual superiority over Oxford16 as an academic institution. In
1751, he earned a professorship at Glasgow University, giving lectures in the fields of
ethics, rhetoric, jurisprudence, political economy, and “police and revenue.”
Smith was the stereotypical absent-minded professor who dressed strangely, spoke
to himself, and collected books. (Sounds like a typical prof to me.) He loved his work and
apparently was popular with students as well. In 1763, Charles Townshend made Smith
an offer he couldn’t refuse: to tutor and travel with Townshend’s stepson Henry Scott,
the Duke of Buccleuch. Smith resigned his university post in the middle of term and
attemped to return the students’ fees, but the students refused to take the money back.
Smith authored two historically important books: The Theory of Moral Sentiments
(1759), which is based on his lectures at Glasgow, and An Inquiry into the Nature and
Causes of the Wealth of Nations, commonly known as The Wealth of Nations (1776),
which, interestingly enough, came out in the birth year of the United States. (In The
Wealth of Nations, Smith refers to the American Revolution as “present
disturbances.”) In a letter to friend David Hume, Smith wrote that he had started to
write The Wealth of Nations while touring “the Continent” with young Henry Scott
because he needed something to pass the time in Toulouse, France. It took him more

15 There are 20 pages written on the life and works of Adam Smith in the Oxford Dictionary of National
Biography.
16 Smith believed that universities and colleges should receive some of their funds directly from students
(Glasgow type) rather than rely on endowments (Oxford type) because it puts the incentives in the right place.
It forces the professor to care about the student when preparing course lectures. In The Wealth of Nations,
Smith has a whole chapter on the education of youth. He writes, “In some universities the salary makes but a
part, and frequently but a small part of the emoluments of the teacher, of which the greater part arises from the
honoraries and fees of his pupils. The necessity of application, though always more or less diminished, is not
in this case entirely taken away. Reputation in his profession is still of some importance to him, and he still has
some dependency upon the affection, gratitude, and favourable report of those who have attended upon his
instructions; and these favourable sentiments he is likely to gain in no way so well as by deserving them, that
is, by the abilities and diligence with which he discharges every part of his duty.”
36 Cocktail Party Economics

than a decade to finish it. Once published, it was an instant success and the initial
print run sold out in six months. Smith planned to write more books but died in 1790
after a painful illness. He ordered any of his writings that he considered unpublishable
destroyed, which is truly unfortunate. On his deathbed he expressed regret that he
had not achieved more.
Smith is known for his explanation of how rational self-interest and competition,
operating in a social framework (which ultimately depends on adherence to moral
obligations), can lead to economic well-being and prosperity. He used the phrase the
invisible hand to illustrate how all of these ideas work together. Contrary to the way he
is often portrayed, he wasn’t a free market absolutist and did recognize some role for
government.
Smith is ranked at number 30 in Michael H. Hart’s list of the most influential figures
in history. To honour Smith, the Bank of England put his portrait on £20 notes
beginning March 13, 2007; he is the first Scotsman to be given this honour. Most
economists point to Adam Smith as the granddaddy of modern economics.

LAYING BLAME
No society can surely be flourishing and happy, of which the far greater part of the members
are poor and miserable.
Adam Smith (1723-1790), moral philosopher and political economist
Taken from The Wealth of Nations (1776)

While each of the situations discussed

above place markets in a global context,
markets are really about individuals, of
any age, trying to improve their situa¬
tions. However, when bad things hap¬
pen, markets often get blamed for the
outcome. 1 hope, from these examples,
you can see that the existence of trading
relationships is not the real issue. Blam¬
ing poverty, social unrest, and political
upheaval on the market economy is like
shooting the messenger rather than deal¬
ing with the root causes.
In the next chapter we will take the
first step in helping us to sort out how
societies create something of value and
what players need to do to get into the
game. Just as problems have root
causes, so does wealth. I hope you will
find the next chapter “a treat” rather
than “tricky” to read.
Producing Wealth
It is not wealth one asks for but just enough to present one's dignity, to work unhampered, to
be generous, frank and independent.

William Somerset Maugham (1874-1965), English writer

Taken from Of Human Bondage (1915)

A line of partially filled bottles obscures a part of your reflection as you stare into the mir¬
ror behind the bar. A quick shake of the head and you are out of your silent reverie. You
raise the glass that was resting on the coaster in front of you to your lips. The first sip of
the Cabernet Sauvignon is wonderful, rich and mellow with a hint of smoke. After a sur¬
vey of the room, you realize that the conversations haven’t changed much since you last
eavesdropped, and you aren’t really interested in joining any of them. Today was not a
good day. Your computer crashed and all of this week’s work was lost. You can't believe
that you didn’t back up your files, which is your normal practice. Your boss doesn’t know
about the fiasco yet and is going to be livid. Even though you are here to connect with
potential clients, you feel sorry for yourself and brood at the bar, nibbling on peanuts1
instead of networking.
The bartender catches your attention by vigorously shaking up two martinis. A waiter
orders six different cocktails: a Bloody Mary, Singapore Sling, Manhattan, Fuzzy Navel,
Daiquiri, and Margarita. Without moving from her position, the bartender swiftly grabs the
appropriate bottles and pours and mixes the drinks apparently without much thought. You
are fascinated by her speed and dexterity.
“You have all those drinks memorized?” you ask, attempting to make conversation.
“Yes, I took a bartending course and work here part-time. I have done this job so
long that I can make these cocktails in my sleep!” she replies, happy to have someone
engage her.
“So what do you do when you’re not working here?” you continue.
“I’m a university student finishing up a degree in languages and linguistics. I couldn’t
get a student loan so I bartend to pay my way through school.”
“Good for you!" you exclaim. “So what does a person do with a degree in languages
and linguistics, anyway?”
“I speak four languages fluently and hope to work as a courtroom interpreter at some
point. I’m also doing a minor in cultural studies, which should help me understand the
immigrants who find themselves in court. Working here is great! I have made really good
contacts with lawyers and a few judges. A couple of them said that they would be willing
to give me a reference when I need one.”
Another waiter comes with an order and the bartender quickly loads the tray with
drinks. You think to yourself, What an accomplished person she is. She will go far. As
she walks to the fridge, you notice that one of her shoes has a much bigger heel than the

On July 13, 2005, while a guest on The Tonight Show with Jay Leno, Johnny Depp claimed that a study on
bar peanuts had revealed 27 different types of urine mixed in with the nuts. He used this evidence to
explain why he doesn’t eat them. I have to admit that, even though this might be an urban myth, 1 am
inclined to not eat them as well.

37
38 Cocktail Party Economics

other and that she walks with a decided limp. Your admiration for her rises even more
and you quickly decide to end your private little pity party. With your wineglass fully
loaded, you do an about-face. It’s time to work the room.

THE WEALTH OF NATIONS

We cannot seek or attain health, wealth, learning, justice or kindness in general. Action is
always specific, concrete, individualized, unique.

John Dewey (1859-1952), American philosopher, psychologist, and educational reformer

In our society, we can easily assume that an individual or a country blessed with an
abundance of natural talent or resources will inevitably be very rich. But this is not nec¬
essarily the case. We all know that there are many people who possess knockout good
looks and are very intelligent but don’t do much with their lives, whereas other people
live with some sort of handicap and go on to do great things.
Countries aren’t much different. Let’s compare Japan and Zimbabwe. Both countries
are about the same size, but that is about all they have in common. Japan lost World War
II and has little in the way of natural resources, whereas Zimbabwe has fantastic natural
resources and won its independence in 1980. You would think from this information that
Zimbabwe should be the wealthier country. Au contraire. The United Nations reports
that in 2007 the per capita income in Zimbabwe was US$261, while Japan’s per capita
income was US$33 632. Furthermore, the Japanese have the highest life expectancy in
the world at close to 83 years, whereas Zimbabweans’ life expectancy is close to
38 years. The numbers tell a different story.
While this chapter looks at the resources used to make goods and services, we need
to remember that these resources are not enough to predict the standard of living in a
country. Wealthy nations are not lucky countries but rather are productive ones. They
take the inputs available to them, whether small or great, and efficiently make outputs
from them. Economists call this the production process, where productivity is the key to
a growing economy. Think of productivity as the conversion factor that translates inputs
into outputs. For example, a bartender’s “drinks served per hour” is one measure of how
productive that bartender is. Another measure may be the aesthetic quality of the cock¬
tails’ presentation. (Who knew all those cute little umbrellas holding fruit on top of
brightly coloured drinks could be called productive?) Whatever the productivity meas¬
ure, it is still true that more inputs produce more wealth because they create more of
something to value. If more goes in, then more comes out.

SO, WHAT ARE WE WORKING WITH?

God creates everything out of nothing—and everything which God is to use he first reduces to
nothing.

Soren Kierkegaard (1813-1855), Danish philosopher and theologian

Anything that makes something else is called an input. Inputs can be complicated or
very simple. For example, growing a tomato requires dirt, sun, rain, and seeds—the
good stuff. We can make it more complicated by adding fertilizer, greenhouses, and
genetically modified seeds. When brought down to the most basic level, inputs are
 Chapter 4: Producing Wealth 39

resources, and these separate into broad categories, which we will look at in turn. Before
we begin looking at each basic input type, let me make a few general comments.
First, most resources on earth are now relatively scarce and have an opportunity cost
associated with using them. Second, each category of resources calls its opportunity
cost or price by its own special name. Furthermore, inputs are typically sold in markets
and as the level of scarcity changes, so do their prices. Third, the quality of an input is
not necessarily uniform across any one category. This affects its opportunity cost.
Fourth, inputs often need to be combined with each other to actually produce something.
“No input is an island entire of itself’2 and all that.
Let’s look at the possible building blocks to obtain a high standard of living. (There
is one resource that won’t be discussed below but can be “relatively’’ important in terms
of living well: your parents. You might want to think about treating them as valuable
resources.) This chapter will feel a bit like reading an encyclopedia; I’m sorry about
that, but it can’t be helped. Understanding the basic terms goes a long way in terms of
holding your own in any meaningful conversation about economics. It’s hard to sound
intelligent if you don’t know the vocabulary. Here we go.

1. Land
Buy land, they 're not making it anymore.

Mark Twain (1835-1910), American humorist, writer, and lecturer

Because historically the wealthy were mainly landowners, land was written about as a
resource by all of the early economists. While it may seem obvious that land is a scarce
resource because it has a fixed quantity,3 it is not the finiteness of the quantity that actu¬
ally makes land scarce. If the amount available exceeds the amount that people want,
then land is actually not scarce. In fact, land across the plains of North America felt end¬
less to the early pioneers. As they headed west, land was essentially free and there for
the taking. This is not the case anymore. Somebody owns all of the land in North
America; if you want it, you’re going to have to pay for it. What you will pay varies
depending on how scarce the land is, which also includes the scarcity of certain qualita¬
tive features. For instance, land in cities is scarcer and therefore more expensive than
land out in the boonies. Swampland differs from areas with fertile soil. Land in
the desert is different from a property with a lake or ocean view. In other words, as the
cliche goes, land costs are about location, location, location, which is really code for
scarcity, scarcity, scarcity.
When considering land as an input or resource, it does not always progress from
abundant to scarce. When areas like those during the Gold Rush that were once booming
become ghost towns,4 land becomes relatively abundant again, enabling people to find a
cheap place to rent or buy. However, it can be tough to find a job working for ghosts.

2 “No man is an island entire of itself’ is a line from John Donne’s (1572-1631) Meditation XVII. The first part
of the line—“No man is an island”—is cleverly but falsely attributed to Bon Jovi in the movie About a Boy.
3 Although we’ve said that land is a fixed quantity, the Netherlands did reclaim land from the sea. Due to a
system of polders and dikes, approximately 27 percent of the Netherlands is actually below sea level. More
than 60 percent of the country’s population of 15.8 million lives in this area.
4 There are at least 180 ghost towns and historic places in the United States.
40 Cocktail Party Economics

Economists call the opportunity cost of the land you use in the production of goods
and services rent. You might say, “Hey, wait a minute, 1 don’t rent my land. I bought it.”
That may be true, but if you write off your land as a business expense, or give up the
opportunity to rent it out, economists call the cost of using the land in production the
rental cost, even if you are paying rent only to yourself.

2. Raw Materials
One cannot fix one's eyes on the commonest natural production without finding food for a
rambling fancy.

Jane Austen (1775-1817), English writer

Taken from Mansfield Park (1814)

Raw materials are inputs that we need to put some effort into getting, but usually they
are not fundamentally created by people. The best examples are wood, water, oil, metals,
and minerals. Sometimes farm products like rice, coffee, wheat, and pork bellies (think
bacon) are put into this category. They are essentially commodities. These commodities
are priced according to their level of scarcity. Prices of raw materials are usually quoted
as a price per barrel, bushel, tonne, etc., which we now know to be its opportunity cost.
Again, as with land, the level of scarcity of raw materials can change over time. For
example, fresh water, which for hundreds of years was considered abundant on the west
coast of the United States, is now starting to become scarce.* * 5 Saudi Arabia can produce
high-quality oil by basically sticking an oil well in the ground whereas the tar sands of
Alberta6 require a major expenditure of resources to get the same quality of crude oil out
of them. This means that the tar sands are a viable source of oil only if the scarcity price
is high enough. Given the huge swings in oil prices, we can safely say that the level of
scarcity of oil is not constant.

3. The Environment
Swigert: Okay. Houston, we’ve had a problem here.
Duke: This is Houston. Say again please.
Lovell: Houston, we've had a problem.

Apollo 13 (said April 13, 1970)

Whether it immediately comes to mind or not, the environment is a resource. Out of all
of the scarce resources in this chapter, the environment raises some of the biggest
concerns for humanity because it seems that many people feel it is being used in a com¬
pletely irresponsible way. However, the economics of environmental problems is not
simple. We will deal with environmental problems in Chapter 11, but for now let’s just
mention the environment’s biggest complexity.

Seventy-one percent of the world is covered in water; however, 97.2 percent of it is salt water. Polar ice
accounts for another 2.15 percent, which leaves less than 1 percent that is fresh water. Taken from Bjorn
Lomborg’s The Skeptical Environmentalist (2001).
6 Tar sands are found in extremely large quantities in Canada and Venezuela. Oil sand is often referred to as
non-conventional oil or crude bitumen, in order to distinguish it from the crude oil traditionally produced
from oil wells.
 Chapter 4: Producing Wealth 41

The biggest problem is that no one owns the environment. This phenomenon is known
as the tragedy of the commons.1 Because no one is directly responsible for the environ¬
ment, people treat this scarce resource as if it were abundant. Consequently, no one pays
the true price for using it. Most people don’t purposely mess up the environment. They are
essentially reasonable people acting in their own personal interests in a way that ends up
destroying the planet, which of course is not in the collective interest of humanity.7 8
Markets handle most other scarce resources effectively, but the environment is not
marketable ... to its peril. However, if someone did own the environment, he or she
would ensure that all who used it paid the true opportunity cost. When we treat some¬
thing that is actually scarce as if it were free, we run the risk of overusing it or degrading
it to the point that it is no longer worth anything. Unfortunately, doing nothing makes
things worse, but it is Iogistically difficult to do what needs to be done to make things
better because of this lack of ownership.

4. Physical Capital
Capital is that part of wealth which is devoted to obtaining further wealth.

Alfred Marshall (1842-1924), British economist

Capital is made when some inputs are used to make machines or buildings. One input leads
to another one. Usually, these machines or buildings are only useful in producing something
else and are not consumed by people for pleasure. After all, most of us would never drive a
tractor to the movies or live in a factory as a home; they are used to create or produce other
things. Of course, there are exceptions to this generalization. The same kind of car can be
both an intermediate capital good (taxi used to generate cab rides) or a final consumption
good (family vehicle). Many small business owners have a home office, which is analogous
to a factory. This space may be the only room in which they live, but technically it’s a work¬
space when they are working and a home space when they are not working. This is starting to
feel like a home and garden channel. They always call rooms “spaces.”
Capital also has a quality aspect to it. Top-of-the-line machines differ from basic
models. In addition, capital depreciates when machines wear out and buildings run
down. Rusty, broken-down trucks and vacant, dilapidated bams no longer function
as useful capital. Furthermore, technological advancements can make certain kinds of
capital worthless unless they’re in a museum. For instance, we generally no longer use
typewriters, even if they are in mint condition. The typewriter has become an obsolete
technology replaced by computers and printers.

Costing Capital
If it isn 't the sheriff, it's the finance company; I've got more attachments on me than a vacuum
cleaner.

John Sidney Blyth Barrymore (1882-1942), American actor

7 “The Tragedy of the Commons” is an article written by Garrett Hardin and first published in the journal
Science in 1968.
8 Elinor Ostrom, the first woman to win the Nobel Prize in Economics (2009), does outline eight design
principles that can stabilize the management of a common property. Needless to say, these principles are
easier to achieve on small local problems than big global ones.
 42 Cocktail Party Economics

When economists speak of capital, we usually mean physical capital such as machines,
inventories on hand, and buildings. These are the things that can actually produce goods.
They are real. However, when we hear the term capital markets in the business news or
issuing from the lips of pundits,I * * * * * * * 9 it is usually associated with paper assets such as stock
bonds, loans, or mortgages rather than the real assets such as machines, buildings, and
inventories. Economists call paper assets financial capital.
Why the confusion in the use of the word capital? It has to do with the connection
between physical capital and financial capital. In order to purchase a machine or build a
factory, business owners usually borrow10 * money. The “borrowed” funds generate a
paper trail in the form of stocks, bonds, mortgages, and so on, to keep track of the finan¬
cial arrangements. On the flip side, people’s savings represent the funds that are avail¬
able to lend in financial capital markets. These funds search for good investment"
opportunities, and these opportunities are found in real capital making real products.
Here is a concrete example: Canadian company Research In Motion (RIM) created a
great product called the BlackBerry. In order to get the device to consumers, RIM needed
to pay developers, marketers, retailers, and whoever else could make this happen. RIM’s
owners didn’t have the funds to do this on their own and basically had two alternatives for
funding: They could either borrow the money or issue some stock in the company. If the
funds came as a loan, the lender would get signed loan papers with a payment plan that
specified a certain rate of interest. If the company sold stock, the buyers of that stock
would get a piece of paper that represents their part ownership of the business. These
papers keep track of the sources of funds and remuneration required to take an idea and
make it a reality. Start-up companies usually have difficulty convincing a bank to lend
them money and therefore rely heavily on equity financing. Without a doubt, RIM’s early
stockholders are very happy that they parked their financial capital with that company.12

Touched by an Angel

The four most dangerous words in investing are “This time it's different. ”

Sir John Templeton (1912-2008), American-born British financial investor and philanthropist

Essentially, financial capital acts as the grease that keeps the gears of real capital turn¬
ing. The funds provided by those with savings purchase the real assets sitting on the
factory floor, which generate the real goods. Without these angel investors,13 many small
businesses wouldn’t have enough financial capital to get their product to market. A
credit crunch occurs when no one wants to provide the funds that business owners need,
therefore restricting their ability to generate real goods and services. No angels for them.

I The term pundit originates from a Sanskrit word meaning learned and is first found in English in 1672. The
term’s contemporary usage may have its origins in a Yale University society known as The Pundits
founded in 1884.
10 1 use the term borrow loosely and, some would say, incorrectly. Borrowing is strictly about debt financing,
which stocks are not. A stock is part ownership of a firm but is still a source of funds that require a
repayment of sorts. Either way, the business owners are using funds that don’t belong to them.
II Technically, businesses invest (real capital) and people save (financial capital).
'* RIM was originally financed by Canadian institutional and venture capital investors. In 2008, RIM was
worth close to US$6 billion.
1 Angel investors typically invest their own funds, whereas venture capitalists manage the pooled money of
others in a professionally managed fund.
 Chapter 4: Producing Wealth 43

This was the big concern during the global financial crisis of 2007 to 2009. Central
banks around the world worked hard to keep bank credit as a source of funds flowing
precisely because it is so connected to the real economy. Chapter 12 will look at the
financial crisis in some detail, but for now I want to make sure that capital—both physi¬
cal and financial—gets its rightful place when the credits start to roll on any production.

I Owe, I Owe
Ambition is an illness in Italy, and no one wants to catch it.

Marlena de Blasi, American-bom Italian writer

Taken from A Thousand Days in Venice (2002)

The vocabulary of high finance can leave one bewildered, but many of these words find
their roots in how early entrepreneurs thought about their businesses, especially their
machines and buildings. Suppose that you borrow $1 million (a nice, round, big number)
at 10 percent interest per year to buy a machine. In order to get the cool million, you
have to sign a piece of paper called a contract that commits you to give the bank
SI00 000 per year in interest payments and to some repayment plan for the principal.
With sweaty hands, you sign the papers. After a brief panic attack, you rush back to the
factory and march down to that new piece of machinery. Once there, you stare into its
expensive blinking lights and think, You had better be worth it!
So, what will make this machine worth it? Simply put, if the 10 percent interest you
must pay to the bank (which is called the cost of capital) is less than the return on
investment (sometimes called the rate of return) of the machine, then you’re good. In
other words, if the machine makes you more money from what it produces than the
money you have to pay to use it, then all is well. If not, you will live with a few regrets,
not to mention some sleepless nights.

A Capitalist?14
The rate of interest acts as a link between income-value and capital-value.

Irving Fisher (1867-1947), American mathematician and economist

What if I already have the money and don’t need to borrow funds to buy the machine?
Does that mean I don’t have any costs and the revenue the machine makes is all gravy?
No, it doesn’t. Why? Because the money is not free. Remember when we talked
about opportunity costs earlier? When I use my own money, I am—in a real sense—
lending the money to myself; this implies an opportunity cost, because I could have
loaned the money to someone else just as easily and made interest income. Therefore,
even if 1 use my own savings, I need to think about such things as the interest rates that
the banks are paying when I make an equipment purchase. Whether 1 borrow from an
outside source or from myself, the equipment needs to make a rate of return at least
equal to the rate of interest to be a worthwhile investment.

14 The word capitalist was minted by William Thackeray in the sense of one who owns capital and was more
precisely defined by Karl Marx in Das Kapital as one who owned working capital, including machinery, and
made money by letting others work on those machines. Here is what Marx said about capital (I couldn’t resist
including it): “Capital is dead labour, which vampire-like, lives only by sucking living labour, and lives the
more, the more labour it sucks.” You have to admit, he certainly had a flair for the dramatic!
44 Cocktail Party Economics

However, there are a few positives with respect to lending the money to myself, and
they shouldn’t be discounted. I am unlikely to foreclose on myself if I get behind on the
payments, and I require a lot less paperwork. This is probably why so many corporations
like to use their own money (called retained earnings15) to finance capital expenditures
rather than go to the bank or stock market for the funds.

5. Going into Labour

Opportunity is missed by most people because it is dressed in overalls and looks like work.

Thomas Edison (1847-1931), American inventor and businessman

The concept of labour, the human sweat portion of production, is self-explanatory so 1

won’t bore you with the obvious. However, I do want to point out that working to feed
your family is just that: working. It is not slavery, even if it sometimes feels like it.
While you may feel you do not have a real choice about whether to work, most of you
do have some choices with respect to employment. Slavery offers no choices because
the slave is the property of someone else. Now, if someone is forced to work at gun¬
point, we can safely assume that the person is no longer a worker but a slave. However,
if a person is a free agent, he or she would be classified as a worker and not a slave
whether the work that he or she does is enjoyable or not. That person may also feel
underpaid and overworked. This is still not slavery.
So, why all this melodramatic talk of slavery, and how does it relate to the way most
of us think about employment? I’ve noticed that, once we start to compare working con¬
ditions around the world, the phrase slave labour is thrown around quite a bit. While
there are real human rights issues when it comes to working conditions around the
world, wage differentials between developed and less developed countries have nothing
to do with the concept of slavery. The fact that a worker in a developing country makes
less than a worker in an industrialized country does not make that worker a slave. If they
voluntarily show up for work, put in a long, hard day, and take home a paycheque that
feeds their families, they are workers and not slaves.

Slavery, properly so called, is the establishment of a right which gives to one man such a
power over another as renders him absolute master of his life and fortune.

Charles-Louis de Secondat, baron de La Brede et de Montesquieu (1689-1755), French social

commentator and political thinker

Child labour is one of the most complicated labour issues we face today, stirring up
powerful emotions and moral indignation. Due to extreme poverty, children all over the
world are forced by their parents to work in what many refer to as “sweatshops”—jobs
where the children work in difficult conditions and have no choice in the matter.
The children are, for all intents and purposes, slaves who work in order to generate an
income for their parents. For those of us who live in the developed world, it is an
unthinkable reality and something that most of us would like to see ended. However, it is
not a simple matter of closing down these sweatshops. Poverty is a symptom of a greater

15
In Canada, even in a recession, at least 40 percent of corporate capital needs are met with internal funds.
In most years the number is higher than 60 percent. See Chapter 8 of Principles of Macroeconomics, 2nd
edition, by Frank, Bemanke, Osberg, Cross, and MacLean (McGraw-Hill).
 Chapter 4: Producing Wealth 45

problem that requires something other than simply shutting down “the corporation” in
that country. This sort of “feel good about yourself in the West because you joined a
campaign to shut down the big boys and did something” solution usually reduces the
options of the impoverished individuals involved and can actually cause circumstances
to go from bad to worse for a child. There is no doubt that sweatshops are abhorrent, but
this is a complex issue. One thing is certain: Removing the productive capacity of a
developing county will not make its people better off.
We need to get away from our Western assumptions for a moment. Contrary to what
we might think, most parents in developing countries love their children, but economic
survival can take its toll. We need to remember that these parents are not forcing their
children to give up playing with Lego in order to work in a sweatshop. Playing with
Lego was never a viable alternative. These children have to work because, without their
income, the whole family would be in dire straits. It turns out that when sweatshops are
shut down, these children often end up as prostitutes, maimed beggars, or even dead—
not exactly what human rights-minded individuals hope will happen and certainly not
good news for the children or their parents. Removing a place of employment doesn’t
free them to a better life. Don’t get me wrong: I would love for these children to be free
to play with Lego all day without any economic responsibilities. The best way to
accomplish that is to make their countries more productive with more alternatives in an
economic sense. The richer a country becomes, the better the lives of its children are.
That means encouraging economic growth. What we think of as childhood is really a
phenomenon found in the world’s richest countries. Maybe corporations, who know
something about producing, can be part of the solution.

Quality Assurance
Education alone can conduct us to that enjoyment which is at once best in quality and infinite
in quantity.

Horace Mann (1796-1859), American education reformer and politician

Labour also involves the issue of quality. Highly skilled workers are different from low-
skilled workers. Economists talk about acquiring human capital16 through education,
experience, and networks. It is both who and what you know that pays. When people
invest in their education, they earn a rate of return on that investment. However, because
that education becomes embodied in a person who usually cannot be repossessed17 as a
machine can be, borrowing to fund educational pursuits can be difficult. In economist
speak, the credit market to acquire human capital is incomplete.111 Remember that the bar¬
tender in the opening story was working her way through university because loans are
tough to get. Despite the difficulties, she strategically invests in her education in hopes that
her future will be brighter because she will know something that others don’t know or have
skills that others don’t have. After all, not many people can speak four languages as she
does. The fact that she is also establishing a Rolodex of contacts will help her become

16 The term human capital first appeared in a 1961 American Economic Review article titled “Investment in
Human Capital,” by Nobel Prize-winning economist Theodore W. Schultz.
17 In previous times, a person could be repossessed and put in debtor’s prison or taken as a slave.
18 When markets are “thick,” there are a lot of buyers and sellers. When markets are “thin,” they can some¬
times be incomplete with one side—either the buyer or the seller—missing.
46 Cocktail Party Economics

more valuable to the marketplace. Employers love workers who can connect people to
save them money or who can enhance business opportunities for the company.
However, human capital can also depreciate. This means that the quality of labour goes
down. For instance, leaving school to work at a job for an extended period of time before
returning for postgraduate education is not normally a good idea, because you naturally
forget what you learned the longer you are away from it. My advice to students is to keep
going until you are ready to stop formal education for good. Alas, sometimes breaks are
unavoidable. For example, maternity leaves take women out of the workforce for a time. If
the woman’s job relies heavily on business contacts or if some new technology transforms
the industry while she is away raising kids, then coming back to work can be daunting. She
can feel both unappreciated and depreciated when she is passed over for promotion.
Workers can also get sick, retire (someday), or die (hopefully not too soon). All of
these events affect the quantity and quality of labour available at any given time. Both
Japan and Zimbabwe have declining numbers of workers. However, the reasons for
those declines are very different. For instance, Zimbabwe’s problems are due to the fact
that AIDS/HIV and other diseases have decimated the workforce, whereas Japan’s prob¬
lems are due to an aging population because of declining birth rates and tough immigra¬
tion laws. Japan’s decline signals a looming problem for that country’s future.

Getting Paid

The misery of being exploited by capitalists is nothing compared to the misery of not being
exploited at all.

Joan Robinson (1903-1983), British economist19

Taken from Economic Philosophy (1962)

Labour is generally paid in the form of wages, salaries, commissions, and bonuses.
However, these wages have meaning only in relation to what those wages can buy, which
economists call earning real wages. For instance, if a worker in another country earns a
low wage but those low wages provide an adequate or even good standard of living in that
person’s country, then the real wage is great. International comparisons between countries
are only sensible if we take both wages and prices into account. Here is how it works:
Suppose that I live in a country that pays $100 per day but where bread costs $10 per loaf.
Now suppose that you earn $10 per day but bread costs $1 per loaf. While my income is
supposedly 10 times yours, it has the same purchasing power—10 loaves of bread per day.
We both earn the same real wage.20

6. Entrepreneurial Ability
A gardener, who cultivates his own garden with his own hands, unites in his own person the
three different characters, of landlord, farmer, and laborer. His produce, therefore, should
pay him the rent of the first, the profit of the second, and the wages of the third.

Adam Smith (1723-1790), Scottish moral philosopher and political economist

19 It is thought by many economists that Joan Robinson should have been the first woman to win the Nobel
Prize in Economics.
Usually international comparisons are made in purchasing power parity, or PPP U.S. dollars. Purchasing
power parity is an attempt to get at the idea of real standard of living.
 Chapter 4: Producing Wealth 47

There are basically two ways in which someone can own a company. The first seems
obvious: A person starts a business. This entrepreneur combines all of the resources we
have discussed previously, takes the risk of bankruptcy, and runs a business hoping for
big returns. He or she gets whatever is left over after everyone else receives payment.
These returns are called profits, and profits are the only cost of doing business that can¬
not be written off as a business expense.
Let me underscore an important point. Economists have the concept of what is called
normal profits. These profits are the amount needed to convince entrepreneurs to start a
business. Depending on how much the entrepreneur could make elsewhere, the level of
normal profits varies from individual to individual. This is where accountants and
economists differ. Suppose that an accountant told a client who gave up a job making
$50 000 working for someone else that they made profits of $30 000 in a given year.
An economist might frame it differently to the same client, “Sorry, but you actually lost
$20 000.” Economists always see profits in terms of opportunity costs.
The second way for a person to own a company is less obvious but really important
nonetheless. A group of shareholders can hire managers to act on their behalf. They do
this when they buy stock in a company. These individuals provide the funds for the
managers to work with, and in turn they require a return on their investment. This return
is paid out of profits in the form of dividends. If you happen to think that the amount of
profits should be legislated downward and get upset at reading headlines about a particu¬
lar company making obscene profits, consider this: Without the ability to make profits,
our society does not provide an environment to promote entrepreneurship or give people
a reason to save. Business owners and their investors are the backbone of what most
people think of the free enterprise system and the productive engine of our economy.
These individuals are the risk takers and will take those risks only if the rewards (which
come in the form of profits) are high enough.

Gossip Column

Wassily Leontief (1906-1999) was born to a Jewish family and raised in Russia. His
father was an economist and Wassily must have been a natural, because he finished
the equivalent of a master’s degree in economics by the time he was 19. At the end of
his studies, he opposed communism and spoke out for free speech and academic
autonomy. The KGB detained him several times because of his views, and he was
able to leave Russia in 1925 only because of a medical misdiagnosis. He then went to
Germany, where he earned his Ph.D. at the University of Berlin in 1928.
In 1932, Leontief went to work at Harvard University in the Economics department.
It was there that he finished his work on the input-output tables that won him the
Nobel Prize in 1973. These tables were generated by a series of mathematical equa¬
tions that modelled the U.S. economy in what economists call a general equilibrium
framework. Using real data and the newly invented Harvard Mark II computer,21 he

21
The Harvard Mark II was a computer built at Harvard University under the direction of Howard Aiken and, fortu¬
nately for Leontief, finished in 1947. Like many high-tech inventions, it was funded by the United States military.
48 Cocktail Party Economics

was able to provide empirical evidence for his theoretical ideas. Leontief was funda¬
mentally against “theoretical assumptions and non-observed facts” and he believed
that economists should get their hands dirty with real numbers. This input-output
approach has been used by Western, socialist, and developing countries alike as they
engage in economic planning. Leontiefs ideas sit on the shoulders of other great Jew¬
ish economists, namely David Ricardo, Karl Marx, and Piero Sraffa.

DOTTING THE I S: INVENTION, INNOVATION,

AND THE INDUSTRIAL REVOLUTION
Invention is the mother of necessity.

Thorstein Bunde Veblen (1857-1929), American economist and sociologist

For most of human history, economic growth, in terms of output, was miniscule. There
was subsistence living for a very long time. But somewhere around 1750, all that
changed with the arrival of the Industrial Revolution. At that time, human beings had
accumulated enough knowledge and capital to reach a critical mass, which caused an
explosion in practical inventions—things like the steam engine, weaving machines, and
electricity. Finally, Mother Necessity could give birth to her inventions. The world
hasn’t looked back since and now takes rapid technological growth for granted.
Technology has progressed to the point where one thing is for sure: Education is at
the heart of any future advancement. Education is what trains the brains (human capital),
which in turn invent the equipment (physical capital) that fuels our economy. For exam¬
ple, Intel’s Andrew Groves earned a Ph.D. in chemical engineering from the University
of California (Berkeley) in 1963. Under Grove’s leadership, Intel became one of the
world’s key players in microprocessors. All that math training was good for something!
It helped him to multiply Intel’s value from $18 billion to $198 billion.

Patiently Crossing the T’s

With inventions came patents ... and patent lawyers. The thinking behind the establish¬
ment of patents was that patents would give the originators of ideas a temporary return on
all of their hard-earned thinking. However, intellectual property is not like physical prop¬
erty in that it is less tangible and therefore it is harder to catch and punish those who steal
it. The arts industry has been trying to prevent illegal downloads of music, films, and pic¬
tures without much success. Intellectual property is also not like physical property in that
society as a whole benefits from these inventions when they are “stolen.” This might seem
like an odd thing to say, but consider generic drugs. Once a drug is out of patent, that
helpful drug can be made cheaply and distributed to people who need it. Patents limit the
production of socially beneficial products. I’ll discuss intellectual property in a different
context in Chapter 11 but, for now, it’s easy to see why individual inventors would want
tough patent laws and why society might not want those laws to be quite so ironclad.”

22
Malcolm Gladwell, in his book What the Dog Saw, provides what I think is a very cogent argument for
why society would not want to stifle creativity with strict copyright laws in the chapter titled “Something
Borrowed.” I must confess that he is one of my favourite authors.
 Chapter 4: Producing Wealth 49

The Domino Effect

Contrary to popular opinion, society’s “middlemen” do serve a useful function. They
provide convenience to the customer, saving time or offering specialized skills in the
production process. Intermediate companies take the outputs of a supplier as an input
to their own businesses, add value to it, and then sell it to the next player in line. For
example, a chemical company sells silicone gel (input) for a breast implant (output)23
to the plastic surgeon, who performs the breast augmentation (input) on a movie star
(output), who wants to have big breasts to improve her career. The movie star takes
her new body (input) and gets a lead role in a new film (output). Theatres get the
rights to show the film (input) and display it on opening weekend (output). I don’t
think eliminating the “middlemen” would be a very good thing in this case. Slapping a
glob of silicone gel on a movie screen would not look very appealing without all of the
steps in between.

Beyond the Basics

The test of our progress is not whether we add more to the abundance of those who have
much; it is whether we provide enough for those who have too little.

Franklin Delano Roosevelt (1882-1945), American president

All of the scarce resources or inputs we have discussed in this chapter, when used in
combination with each other, produce things. Economists call this thing output because
this word captures the idea of both a physical product such as silicone gel and a service
such as plastic surgery. People buy these outputs and experience the standard of living
that these “things” bring.
Fundamentally, there are only a few ways to get out of poverty and into a decent
standard of living:

1. Find more inputs to use. The recent discovery of new oil resources off the coast of
Brazil is a good example of this effort.
2. Improve the quality of the inputs.24 For example, labour can improve through educa¬
tion, training, or better health.
3. Change technology25 and use existing inputs better. Improvements in agriculture
labour productivity due to advancements in fertilizers, machinery, and genetic modi¬
fication of foods are good examples.

23 In 2009, Americans spent a total of approximately $10.5 billion on cosmetic procedures. Of that number,
$6 billion were spent on surgical procedures and $4.5 billion were spent on non-surgical procedures (data
from the American Society for Aesthetic and Plastic Surgery).
24 Sandra Black and Lisa Lynch in “Human-Capital Investments and Productivity” (AEA Papers and
Proceedings, May 1996), found that development of computer skills significantly increased productivity.
(Remember, this was the 1990s.)
25 The paper “The Economics of Has-beens,” co-authored by Michael S. Weisbach and Glenn MacDonald,
appeared in the February 2004 issue of Journal of Political Economy. In their study, the researchers argue
that while experience may offer the older worker a certain amount of income protection, technology
advances “always turn them into has-beens to some degree.” Unless older workers can easily update their
skills, new technologies will tend to depreciate their labour value.
50 Cocktail Party Economics

4. Get government to administer effective programs. From a strictly economic point of

view, let alone from a humanitarian one, it makes perfect sense that countries
educate children and immunize them against debilitating diseases. These public pro¬
grams produce a high-quality labour force; since each highly skilled, healthy worker
produces more output than a low-skilled, sick one, this is a good idea. In contrast,
the AIDS pandemic has devastated developing countries because it kills off the most
productive workers, leaving behind a population consisting of the very young and
the very old, who are unable to produce enough to sustain a decent standard of
living, not to mention invest for the future.

Researchers Sheggen Fan and Neetha Rao, in their paper “Public Spending in
Developing Countries: Trends, Determination, and Impact,”26 conclude that not all gov¬
ernment spending has the same impact on growth and poverty reduction. In developing
countries globally, the best thing to spend money on is agricultural research, education,
and roads, whereas the worst thing to spend money on is defence. In Africa, spending on
agriculture and health has the biggest impact.
While inputs are the building blocks for generating wealth, there is still the question
of what you should make with the inputs you have. The next chapter will revisit trade;
but instead of looking at what gains can be made from trade, we will look more closely
at who should produce what in order to have something to trade. Given that individuals
can use their inputs to make different outputs, we need to figure out what people should
do for a living.

26 Fan, S., & Rao, N. (2003). Public spending in developing countries: Trends, determination, and impact.
EPTD Discussion Papers 99. International Food Policy Research Institute.
The Absolut(e )1 of Comparative
Advantage
There is hardly anybody good for everything, and there is scarcely anybody who is absolutely
good for nothing.

Philip Dormer Stanhope, 4th Earl of Chesterfield (1694—1773), British statesman

From the bar, you see a flurry of activity at the door as a group of Shakespearean actors
walks in, high on the evening’s performance. This was the opening night for a production
of Hamlet,2 and the audience showed their appreciation with multiple standing ovations.
At the encouragement of the host, the actors head straight to the bar for a celebratory
drink. It seems that a patron of the theatre has already instructed the bartender to give
the actors a drink ...on him.
The actor who plays Horatio orders in a suave manner: “A Black Dane, please.” His
colleagues roar with laughter.
Once everyone has a drink, “Hamlet” raises his glass to make a toast. “May plays
always be the thing!”
“Hear, hear!” the thespians agree.
You overhear “Laertes” comment to “Ophelia”, “To think that my parents wanted me
to have a normal job. An accountant, actually, but as I always say, To thine own self be
true.'3 It looks like my hard work is paying off. I just got a major role in a movie.”
“Ophelia" displays a slight sadness as she tries to gather up a big smile and con¬
gratulate “Laertes.” In the back of her mind, she wonders where her own career is going.
That very morning she took a pregnancy test and the result was positive. She and her
husband are ecstatic about the news, because they really want children, but the rational
part of her is already wondering how this is going to affect her career. One thing is cer¬
tain: Now is not the time for her to audition for a role in a movie.

SO, WHAT DO YOU WANT TO BE (OR NOT TO BE)

WHEN YOU GROW UP?
My mother had a great deal of trouble with me, but I think she enjoyed it.

Samuel Langhome Clemens, pen name Mark Twain (1835-1910), American writer

If you want to spark fear in a helicopter parent,4 suggest that his or her child could grow
up to be a failure. The parental drive to produce successful children has caused many

1 In 2008, Absolut vodka was sold by the Swedish government to the French company Pernod Ricard.
Absolut is the third largest brand of alcoholic spirits in the world after Bacardi and Smirnoff. More than
40 percent of the imported vodka in the United States is Absolut.
2 William Shakespeare wrote more than 40 plays. Hamlet is one of his most recognizable.
3 The following lines are from Hamlet: “to thine own self be true,” “the play’s the thing,” and the suicidal
“to be or not to be.”
4 Helicopter parents hover over their children.

51
52 Cocktail Party Economics

a concerned mother and father to buy all manner of books and computer programs
guaranteed to raise their child’s IQ.5 It has also driven much of the participation in such
worthy activities as swimming lessons, music lessons, and sports teams, all with the goal
to produce a very successful, but some would say hurried,6 child.
For an individual, the decision about what to be when you grow up is an important
one. For a country, these individual decisions are important as well. Countries are, after
all, made up of many individuals. Once we know what the majority of a country’s citi¬
zenry is doing, we can predict what that country will be known for when it comes to
production. Why do some countries produce furniture7 while other countries produce
university8 degrees? Let’s take a look.
We have already looked at the benefits of free trade, but they are worth revisiting
here. Anyone can be better off if he or she trades something from his or her own pile of
goods for something in another’s pile of goods if he or she happens to like the other item
more. Trade assumes that the pile of goods is already accumulated. In our Halloween
story a few chapters ago, the night’s “trick or treating” was over before the trading
began. On Halloween, the pile you have to trade with depends on how fast you move,
luck, and finding a great neighbourhood in which to trick or treat. Sort of like life, don’t
you think?
So, what really determines the contents of the pile of goods sitting in front of you?
To answer that, we need to back up a bit. Normally when economists talk about trade,
they include the word specialization before the word trade. This pair of terms rolls off
economists’ lips like the names Rosencrantz and Guildenstern9 do off the lips of a
Shakespearean scholar. Most people produce specialized goods—a pile of goods that is
limited in variety—and use those goods to trade for a wider variety of goods that they
want or need. For example, a dairy farmer will sell milk to buy such items as pants,
shirts, bread, and meat. Essentially, the farmer trades the milk he or she produced
(actually, the cows did the producing) for food and clothing he or she didn’t produce.
Once an individual specializes in the production of one or a few items, he or she
becomes dependent on others for what he or she wants but did not make—hence the
need for trading partners.

SPECIALIZATION IS SPECIAL
One man cannot practice many arts with success.

Plato (427-347 be), Greek philosopher

5 The term IQ, from the German Intelligenzquotient, was coined by German psychologist William Stern in
1912. The average IQ score is 100.
6 Elkind, David. (2001). The Hurried Child: Growing Up Too Fast Too Soon, 3rd ed. New York: Perseus
Publishing.
7 From 1985 to 2006, China’s furniture industry grew an average of 15 percent. China now ranks first in the
world for furniture production. This sector employs approximately 13 million Chinese workers (China
Building Decoration Association).
8 Of the top 10 universities in the world (by most rankings), the United States has six of them. The other four
are in Britain.
9 Rosencrantz and Guildenstern are characters in William Shakespeare’s Hamlet. Rosencrantz and
Guildenstern were common Danish family names in the sixteenth century.
 Chapter 5: The Absolut(e) of Comparative Advantage 53

Why specialize? Why put yourself into the position of needing others? To be blunt, indi¬
viduals who specialize can make more money10 than those who do not. Economists think
that the phrase Jack of all trades but master of none is true. We know that while many of
you could do most things that you set your mind to, it is not possible with scarce
resources to actually do everything your mind thinks about doing. You have to make
choices, and those choices have opportunity costs. (This refrain might be starting to
sound like a broken record, but it’s important to be constantly reminded that all eco¬
nomic choices are based on scarce resources resulting in opportunity costs.) Everyone
doing a little of everything will produce less with the same resources than everyone
doing one thing and trading with others for what they did not make. Specialization
allows us to do more with what we have. Here is the best part: More production leads to
more consumption.

A Tale of Two Writers

I specialize in murders of quiet, domestic interest.

Agatha Mary Clarissa Christie (1890-1976), English crime author

Taken from Life magazine (May 14, 1956)

We can now think about who specializes in what. When you specialize, you are choos¬
ing to do something. The flip side is also true. You are choosing not to do something
else. This choice is not random but based on a number of factors such as individual pref¬
erences, abilities, and opportunities.
To make things concrete, let’s consider the writing histories of two people: Paul
Krugman" and myself. As an economist, Krugman’s career stands head and shoulders
above my own. He has won a Nobel Prize in Economics and is very famous. I know who
he is, but he has never heard of me. In addition to his academic publications as an
economist, he is an accomplished writer, with a number of textbooks, popular books,
and New York Times columns under his belt. I have never written a textbook or even
penned a letter to the editor of a newspaper. So, what am I doing writing a book called
Cocktail Party Economics? Why isn’t Krugman writing this book if he is superior to me
as both an economist and a writer? The answer to this question should bring hope to
everyone. For you see, Krugman, like all of us, has only 24 hours in a day. He has
to make choices like the rest of us about what to do with his time. He can spend his day
enjoying various leisure activities, consulting, teaching courses, or writing. However,
every time he chooses one activity, he cannot do another one. This fact presents him
with a problem about what to do with his time.
Now, suppose that Krugman chooses to spend his time writing. There are still more
choices to make. When he puts pen to paper (or should I say fingers to keyboard), the
words that flow out of him must have a destination, and he has many great destinations

10 I am reluctant to use the word money. Money isn’t real but stands in for real things. Essentially, the
specialist can make more money because he or she can make more outputs.
11 Paul Robin Krugman (1953- ) is an American economist, columnist, and author. He is a professor of
economics and international affairs at Princeton University and a columnist for The New York Times. In
2008, Krugman won the Nobel Memorial Prize in Economic Sciences “for his analysis of trade patterns
and location of economic activity.”
54 Cocktail Party Economics

to choose from. Let’s see ... where can these words end up? A peer-reviewed journal, a
New York Times column,12 an economics textbook, or a popular economics book? Which
should he choose? My guess is that since Krugman is a rational economist, he will go for
the option that will give him the most satisfaction overall, which is probably connected
to increasing his lifetime income as well. We know he hasn’t written the kind of book
you are holding (yet), and therefore he must feel that his words work harder for him in
other places. Voila, he has left a book for me to write. Not to be overly modest, but I
have been teaching introductory economics to young minds for more than 20 years.
Helping people understand economic ideas is something I do rather well according to
my student course evaluations. While 1 might be less talented than Krugman in many
areas, in this one area we might (and I stress might) be pretty close. The moral of the
story is this: Never feel that, because you are less talented than others, there is nothing
for you to specialize in. You just have to find the right spot to fill.

Getting Technical
If Shakespeare had been in pro basketball he never would have had time to write his solilo¬
quies. He would always have been on a plane between Phoenix and Kansas City.

Paul Westhead (1939- ), American basketball coach

Taken from The 2548 Best Things Anybody Ever Said (2001)

Economists would say that while Paul Krugman has an absolute advantage in all
economic writing, I have a comparative advantage in writing a fun-filled, chatty-type
economics book. Krugman has comparative advantage in the other types of economic
writing (and he has written a lot!). Absolute advantage or overall talent will make you
very rich because you are good at whatever you do. But absolute advantage will not
indicate which activity made you rich. For that, we need to know what you have a
comparative advantage in. So, what determines comparative advantage? To the general
public, the answer that economists give sounds a bit like jargon but here goes: Whoever
has the lowest opportunity cost in a particular activity has comparative advantage in that
activity.
O, woe is you! Why are we back to opportunity costs? Well, the problem for very
talented people is that everything they choose to do will incur a huge cost in terms of a
forgone alternative. Given all of his writing options, it is very costly for Paul Krugman
to write the kind of economics book you are holding, and to date he hasn’t. I, on the
other hand (now that my kids are older), gave up domestic chores to write this book ... a
price I am willing to pay! My costs are definitely lower, and therefore 1 have the advan¬
tage for writing this type of book.
What matters is not what you excel at or what your competitor excels at. What matters
is the relative difference. Paul Krugman is better than I am at all things economics, but he
can’t do everything. He is far better than I am at writing newspaper articles, but he may be
only a little better than 1 am at writing a book of this type. Therefore, he focuses on what
he is much better at doing and forgoes a book that is best written by me and only me.
Hallelujah! While it is possible to have absolute advantage in everything, it is impossible
to have comparative advantage in everything—unless, of course, you are God.

12
Many of Krugman’s popular books are collections of essays or columns that he wrote for other sources.
 Chapter 5: The Absolut(e) of Comparative Advantage 55

Career Counselling
To all of you young people, here is my advice: Go after your comparative advantage
dreams. If you happen to be the best at everything, then lucky you. Go for the career in
which you clearly dominate. (I never really understood why Michael Jordan13 switched
from basketball to baseball. As an economist, I feel there must be more to this story.
Fortunately, he returned to his real area of strength.) For the rest of you in the cheap
seats who may not clearly dominate in any area, you don’t have to be the best to enjoy a
successful career. When you compare yourself to others, go for the close-second option.
There is something significant for you to do. Having said this, I think it is also important
to give you a reality check: Don’t bang your head against a wall if there is no hope. If
you are not even close to succeeding, try something else. For example, if you are 5 feet
tall and want to be an athlete, you are unlikely to have a comparative advantage in bas¬
ketball,14 but other sports may fit the bill. You might consider gymnastics,15 for example.

Pro Choice

Why in almost all societies have married women specialized in bearing and rearing children
and in certain agricultural activities, whereas married men have done most of the fighting and
market work?

Gary Becker (1930-), American economist and Nobel Prize winner

Taken from “The Economic Way of Looking at Life,” Nobel lecture printed in Economic
Sciences (1992)

Differences in comparative advantage also describe and predict how families function.
Economic models based on the theory of comparative advantage take into account how
men and women make free choices as they try to be as happy as possible given their
circumstances. For many women, who due to biological16 reasons have the comparative
advantage in child rearing, the clear choice is to stay home to care for their children
and households rather than to have a career. They do so because the opportunity cost of
having a career is high. Often, the wages they would earn are not enough to justify the
hassle and emotional cost inherent in the choice to get a job.
For many feminists,17 basing the decision to stay home on the idea of opportunity
costs does not sit well because they believe that traditional women’s roles are a form of
oppression or a social construction rather than the free choice of rational women. How¬
ever, as a feminist myself, I consider research into the economic factors related to social
structures as critical if social change is going to happen. It highlights the importance of
the economic constraints that women face as they rationally make choices. For example,
Patricia Apps and Ray Rees18 found that the kind of help governments gave families

13 Michael Jordan announced his retirement from the Chicago Bulls in 1993 but returned in 1995 and helped
the Bulls make the playoffs.
14 The shortest player in the NBA was Tyrone “Mugsy” Bogues at 5'3".
15 The average height of a gymnast is less than 5'6".
16 Recovery time needed from pregnancy and the ability to breastfeed.
17 Betty Friedan’s book The Feminine Mystique (1963) criticized the idea that women could find fulfillment
only through child-bearing and homemaking. Friedan’s obituary in The New York Times described The
Feminine Mystique as one of the most influential non-fiction books of the twentieth century.
18 Apps, Patricia, & Rees, Ray. (2004). Fertility, taxation and family policy. The Scandinavian Journal of
Economics, 106(4), 745-763.
56 Cocktail Party Economics

changed the degree to which women participated in the workforce. Governments that
had individual taxation and publicly supported child care had more women in the labour
force than those that had joint taxation (sometimes known as income splitting) and child
payments. From a public policy point of view, if you change the opportunity costs, you
change behaviour.
On a personal note, there are reasons why I have waited this long to write a book.
When my children were small, I chose to spend my time on other activities. 1 confess
that I was guilty of being a helicopter parent, and it took up a lot of my time. In my
mind, the opportunity cost of writing a book was just too high. Fortunately, kids grow
up. I’m happy that writing is not necessarily a young person’s sport.

Gossip Column

David Ricardo (1772-1823) was born in London, England,19 to a rich Jewish family,
the third of 17 children. At 14, he began to work at his father’s stock brokerage busi¬
ness. At 21, he eloped with Priscilla Anne Wilkinson, a Quaker, and together they
raised three sons and five daughters. (Obviously not trying to keep up with his
parents. Or maybe Ricardo limited the number of children because he heeded the
warnings of his close friend the Reverend Thomas Robert Malthus [1766-1834] about
the perils of overpopulation.20)
Due to his non-Jewish marriage, he became estranged from his family and aban¬
doned Judaism to become a Unitarian. Once disinherited, Ricardo set up his own
business similar to that of his father. A very clever man, he made a fortune as a dealer
of government securities, so much so that he retired at age 42 to Gatcombe Park21 to
pursue intellectual interests including economics.
Ricardo was the first to systematize economic theories and, in 1817, he published
his ideas in Principles of Political Economy and Taxation (catchy title!). His most
famous contribution is the theory of comparative advantage, where Ricardo argued
that highly skilled and low-skilled labourers could benefit from trade with each other if
they concentrated on the correct activity. He argued that the same thing could be
applied to countries.
Ricardo pursued a career in politics, taking the easy way to Parliament. He was
“elected” in 1819 as member of Parliament in Westminster for an Irish rotten borough22
that had perhaps a dozen voters. He never visited it. However, his analysis of the
world led him to argue for free trade and against the British Corn Laws, which proba¬
bly would have been helpful to his electorate. The Corn Laws instituted tariffs that

19 I highly recommend the book The Worldly Philosophers by Robert L. Heilbroner if you wish to know more
about Smith, Marx, Ricardo and Malthus as well as many other interesting if not unusual economists.
20 An Essay on the Principle of Population, through its six editions, was published from 1798 to 1826.
21 Gatcombe Park was bought by Queen Elizabeth II in 1976 and is the home of her daughter, Princess Anne.
22 A rotten borough was a parliamentary constituency in the United Kingdom that had a very few voters. It
was an easy way for a rich person to get a seat and therefore achieve an unrepresentative influence in
Parliament. The Reform Act 1832 disfranchised the 57 rotten boroughs that existed and redistributed repre¬
sentation in Parliament to more populated areas.
 Chapter 5: The Absolut(e) of Comparative Advantage 57

protected landowners-politicians from cheap foreign grain. This made bread very
expensive for the poor workers. In an essay Ricardo published in the year the Corn
Laws were instituted, he suggests that their abolition would put profits into the hands
of the worker and industrial class and take it from the landowners. Despite being a
landowner himself, he felt that would be a good thing.
Due to poor health, Ricardo retired from Parliament in 1823 and died in the same
year. He was only 51. Much modern economic methodology dates from Ricardo.
It’s been said that Ricardo’s greatest contribution to economics is the phrase let us
assume.

THE BASIS OF COMPARATIVE ADVANTAGE

The raw fact is that every successful example of economic development this past century—
every case of a poor nation that worked its way up to a more or less decent, or at least
dramatically better, standard of living—has taken place via globalization, that is, by produc¬
ing for the world market rather than trying for self-sufficiency.

Paul Robin Krugman (1953-), American economist and Nobel Prize winner
Taken from The Great Unraveling: Losing Our Way in the New Century (2003)

The basis of comparative advantage goes beyond personal choices to national trade pat¬
terns. In fact, Paul Krugman was given the Nobel Prize for his work on trade models.
Before him, David Ricardo had explained that trade between countries was due to the
fundamental differences between those countries. For instance, it is easy to see how a
country rich in natural resources will sell them to other countries that don’t have those
resources. In the same way, it is not hard to imagine that a country with a long growing
season and fertile soil will produce food and sell it to countries that need it. Countries
with very cheap labour have advantages in producing goods that are labour-intensive,
whereas countries with highly educated populations have advantages in the knowledge
economy. Each country, with its relative strengths, specializes in specific activities, and
the direction of the flow of exports and imports is easy to guess. Ricardo provided the
basic rationale for these trading relationships between countries that are very different
from each other.

Same Difference
But what about the case of countries that are very similar to each other? History has
shown that they still trade with each other. Take, for example, Sweden and Germany.
Both of these European countries have educated, relatively well-paid labour forces and
similar political systems. How does one explain the trading pattern between these coun¬
tries given that there are no fundamental differences between them? To illustrate the
point, let’s look at cars. Sweden produces Volvos and Germany manufactures BMWs,23
both of which sell in similar car markets. Both countries export their cars to the other
country. Until Krugman looked at this issue, old trade theories had a tough time explain¬
ing why both countries produced similar products. Krugman combined two ideas that

23
Volvo means “I roll" in Latin. BMW stands for Bavarian Motor Works.
58 Cocktail Party Economics

became the basis of what is called New Trade Theory. First, he incorporated the concept
of economies of scale. This means that as a company produces more and more of some¬
thing, the average cost of producing that item goes down. It pays to be big. Second,
Krugman added the idea that people prefer a variety of products of the same type. These
two concepts, building on the basic idea of comparative advantage, predicted that both
countries would continue to produce cars but different brands. Specialization is now at
the brand level.

Bumper Sticker Protectionism

Out of work yet? Keep buying foreign.

Bumper sticker

When people oppose free trade, they tend to focus on the loss of specialized jobs to
another country. The bad news is that, for some people (because of their age or apti¬
tude), the ability to shift to another line of work is nearly impossible. They have personal
reasons to be against free trade that make sense for them. Because of those personal
reasons, these people will, of course, lobby for protectionism. However, in terms of the
bigger picture, we need to answer an overarching question before we decide whether
protectionism is warranted: How does protectionism in one sector affect the country as a
whole?
But first, how does one protect? Essentially, protectionism tries to eliminate any
comparative advantage of another country by “levelling the playing field.” These poli¬
cies might include

1. Tariffs (think taxes) on imported goods to make them more expensive to buy
2. Quotas that allow only a limited amount to enter the country
3. Rules and regulations that make it difficult for a foreign firm to sell its product in the
importing country
4. Government subsidies and tax breaks (sometimes known as handouts) to firms who
cannot compete with foreign companies

The problem with protectionism is that once we level the playing field (this phrase is
uttered a lot by those who favour protectionism), there is no benefit to trade. In other
words, if everyone’s opportunity costs for identical items are the same, no one will ever
trade with anyone else. There would be no point.
Let’s explore protectionism further by looking at an example. 1 currently live in
Canada, which does not normally grow oranges. I really like oranges and buy them regu¬
larly from the grocery store for what seems to be a reasonable price. They are
transported by truck to Canada from Florida. 1 have a question for you: Why should my
government block the flow of oranges from Florida to Canada just because someone has
decided to produce expensive oranges in a Canadian greenhouse? Some may argue that
these Canadian jobs at the greenhouse need to be protected at all costs. The employees at
the greenhouse may not be able to find a job with as good a paycheque anywhere else.
But let’s pull back from the situation for a minute and think about this. By protecting the
Canadian orange sector, we remove any advantage that the sunny Florida weather has in
producing oranges inexpensively. If Canada restricts Florida oranges, the price of
 Chapter 5: The Absolut(e) of Comparative Advantage 59

oranges will be driven up so that it is equivalent to its Canadian counterpart, and it is

very costly to produce oranges in a Canadian greenhouse. Because oranges are now
expensive, orange-loving consumers like me will reduce the number of oranges they
purchase, although a good portion will now be made in Canada. Is this scenario worth it?
I hope you are saying to yourself, “I don’t think so.”
Here is the big picture on protecting existing jobs: Domestic producers that compete
with importing firms will gain from protectionism, but the consumer of those products
will end up losing. I can’t really prove to you here the relative sizes of the losses and
gains. That would require more detailed analysis, which is beyond the scope of this
book, but I can let you know the end of the story and hope that you believe me. Here is
the scoop. When industries are protected in order to save jobs, the consumers lose more
than the producers and workers gain. It is therefore not good for the entire country to
protect any one industry just because it is in decline.
In our example, the protection of Canadian oranges24 would generate a huge loss in
terms of a drop in orange consumption. Oranges are, after all, good for you and valued
by the consumer. The benefit to the Canadian producers of oranges in terms of jobs
saved will never come close to the value of the losses of all consumers. In reality, it
would be cheaper to pay the workers who cannot move to another position a pension
than to protect their jobs to keep them from unemployment. Protectionism of this sort is
a trap that decreases the overall value to all citizens as it tries to help a few of them.
This may sound bad, but it gets even worse. Protecting Canadian oranges causes
scarce resources to stay in an uncompetitive industry and prevents them from naturally
moving somewhere else in the economy. For example, the energy needed to keep the
greenhouses warm could be used to heat homes. Furthermore, this affects our children,
who grow up desiring and training for jobs in this industry because the wages are arti¬
ficially high. Because they end up working in the Canadian orange industry, they
don’t do something that society really needs them to do. Protection has long-term con¬
sequences.

Dynamic Change
Instead of this absurd division into sexes, they ought to class people as static and dynamic.

Evelyn Arthur St. John Waugh (1903-1966), British writer

Taken from Decline and Fall (1928)

Just to make life confusing (isn’t that always the way?), protectionism for dynamic rea¬
sons might be the way to go, especially if you are a developing country. The criticism of
protectionism above is based on a static model of economic production. In other words,
comparative advantage is a given and isn’t going to change. In our example, Canada will
never be as warm as Florida, so it is unlikely to ever have comparative advantage in
growing oranges. Protecting Canadian orange producers is a bad idea. But sometimes,
for whatever reason, things can change.

24
I do not believe that any oranges are produced in Canada for commercial reasons. This example is meant to
be completely ridiculous, but the underlying principle is not. I chose this example because it focuses on the
opportunity cost argument for free trade. I find that if I use a real-world example, the underlying idea gets
lost in the heat of very real emotions.
60 Cocktail Party Economics

For example, in the 1960s, the World Bank did a feasibility study for South Korea with
respect to steel production and declared it a premature venture. This is a nice way of say¬
ing, “What a dumb idea!” It turns out that South Korea did not have the required raw mate¬
rials and domestic market for the product. The country did not appear to have a possible
comparative advantage in steel production. Nevertheless, in 1973, the South Korean gov¬
ernment founded the Pohang Iron & Steel Co. Ltd. and provided the necessary funding to
ensure its success. By 1985, the company was one of the lowest-cost producers of steel in
the world (about two-thirds of the cost of steel in the United States). By 1988, the company
was the eleventh largest steel company in the world. How did a country with absolutely no
comparative advantage in steel production become a world leader in steel?
For some countries, temporary protectionism gives a reprieve from the winds of
competition in order for them to get up to speed. These countries develop a comparative
advantage where none existed, and this new comparative advantage becomes a source of
wealth for those countries—thus the term dynamic comparative advantage. This reason
for protectionism is called the infant industry argument because it supposes that the
industry needs protection much like a child does in his or her early years. Economists
get a little worried about using this argument to justify protectionism, because it is pos¬
sible that the baby will never grow up. If protectionism remains permanent, we go back
to our previous discussion. Then, it is basically a bad idea. Fortunately, for the Pohang
Iron & Steel Co. Ltd, the South Korean government began the process of privatization in
1997, and the company was completely private by 2000. It continues to stand on its own
feet and do well. In 2006, it was ranked the number two producer of steel in the world,
just behind Arcelormittal.25 Temporary protectionism actually produced a comparative
advantage in this case. You’ve come a long way, baby.

National Sacrifice
You can t learn too soon that the most useful thing about a principle is that it can always be
sacrificed to expediency.

William Somerset Maugham (1875-1965), English writer

Taken from The Circle (1925)

There is another argument for protectionism that makes good sense to many (even to some
economists). This involves national security of some sort, whether it has to do with
defence, food, water, or energy—the essentials of life. People who support protectionism
for security reasons—whether it be food security, water security, or national defence—feel
that the country should have production in these areas no matter what the cost. Unfortu¬
nately, the costs are great. The country will pay for that security with a lower standard of
living overall, because it is not producing in the area of its comparative advantage.
Some people may be able to sleep better at night if they know that their country’s
defence system is in-house and that none of its fighter jets were imported. (In June 2009,
IDG News Service reported that sensitive documents belonging to an American contractor
were found on a hard drive in a market in Ghana. It seems that exported computer garbage
may be more of a security problem than imported fighter jets.) At a more basic level, many

Arcelormittal was formed in 2006 by the merger of Arcelor and Mittal Steel and has its headquarters in
Luxembourg. It ranked thirty-ninth on the 2008 Fortune Global 500 list.
 Chapter 5: The Absolut(e) of Comparative Advantage 61

individuals favour some food or energy production in the event that all other countries stop
selling them food or oil for some reason.26 From an economist’s perspective, as long as the
price tag for this security is clear, a meaningful debate can occur about what level of secu¬
rity is essential. The security argument is kind of like the argument for insurance. Yes,
those without fire insurance have a higher standard of living because they don’t have pre¬
mium payments, but what happens if their houses catch on fire? However, if you happen to
live in a fireproof house, you may not need insurance. Maybe a basic insurance plan is
good enough, rather than going for the deluxe coverage? In the same way that households
need to analyze their home insurance needs, countries must figure out how risky their trad¬
ing relationships are and then protect themselves accordingly.

UNDER THE INFLUENCE

If I have seen further it is only by standing on the shoulders of giants.

Sir Isaac Newton (1642-1727), English scientist and mathematician

The theory of comparative advantage, and all it implies, is one of the most influential eco¬
nomic theories affecting trade policy around the world. It turns out that David Ricardo, the
father of free trade, became interested in economics at age 27 because he read a book
while on vacation—not just any book, but The Wealth of Nations by the great economist
Adam Smith. He did what Google Scholar tells its searchers to do: Stand on the shoulders
of giants. Essentially, Ricardo’s idea of comparative advantage predicts who will supply
what in the market. The next chapter will explore one of the natural consequences of com¬
parative advantage: supply (in the first of the Venti27 chapters). If economics is known for
anything, it is certainly known for the words supply and demand.2*

26 On October 17, 1973, Arab states placed an oil

embargo on the United States (and later on
Japan and the countries of Western Europe) as
a punishment for its decision to supply Israel
during the Yom Kippur War. The price of oil
quadrupled by 1974. This control of a vital
commodity became known as the “oil weapon.”
27 Recall that the Venti designation means that
a little math is going to be thrown in. Don’t
despair. You can do this.
28 The phrase supply and demand was first used
by James Denham-Steuart in his Inquiry into
the Principles of Political Economy, published
in 1767. Adam Smith used the phrase in his 1776
book The Wealth of Nations, and David Ricardo
titled a chapter of his 1817 work Principles of
Political Economy and Taxation “On the
Influence of Demand and Supply on Price.”
 CHAPTER

Supply Side (A Venti Chapter)

If you have great talents, industry will improve them; if you have but moderate abilities,
industry will supply their deficiency.

Sir Joshua Reynolds (1723-1792), English painter

The sun has a warm glow as you look across the eighteenth hole to the fairway beyond.
From your comfortable chair situated just outside the clubhouse, you have a tranquil
view. Furthermore, the beer is cold and your muscles are relaxed as you stretch your
legs out and cross them in front of you. The world feels like a great place at this moment.
Laying your head back, you close your eyes.
From a nearby window—open to enjoy the late afternoon air—you hear bursts of
laughter. From what you can tell, these folks have just finished a car rally and the winners
are receiving their prize: a gift card for a free tank of gas.
“Let’s go out on the patio and get a drink," says the winning driver.
“Great idea,” the rest concur.
After rearranging tables to accommodate the group, the waiter takes their drink
order. Easy conversation flows. It is the kind found among friends who have known each
other for decades.
With mischief in her eyes, one of the women says, “So, what's this week's topic at
the Old Boys’ Club?”
A distinguished man with grey hair looks at her in mock horror. “The Retired
Business Men’s Association [said with emphasis] has an auto sector1 analyst coming to
talk about what is going on.”
Another man with typical male-pattern baldness pipes up. “Good. Maybe the news
will be better. All I know is that right now they’re killing my pension income. I need it—
especially because they are raising the green fees at the club.”
The other men look shocked. “What?” they exclaim.
The man continues. “Yeah. I was talking to the manager. I guess the grounds crew
all got raises, and the price of fertilizer is up. They have to raise the fees to cover the
cost.”
“Poor you,” says a woman who appears to be his wife as she rolls her eyes and pats
his arm.
A tall, athletic man gazes longingly at the golfers and asks, “So, who is in
charge of organizing next month’s activity? How about a golf tourney before the
fees go up?”
“No. No. We agreed we would go the opera next month,” asserts a woman with
coiffed silver hair. The men all groan in a good-natured way.

In 2008, the year the financial crisis took hold, U.S. auto sales dropped to 13.2 million units from
16.1 million units in 2007. According to data from Edmunds.com, the Detroit Three also lost 3.7 percent
of market share over that year. Chrysler went from 12.9 percent in 2007 to 11 percent in 2008.
GM went from 23.8 percent to 22.4 percent, and Ford went from 15.5 percent to 15.1 percent of the
market.

62
 Chapter 6: Supply Side 63

SEPARATED BUT NOT DIVORCED: SUPPLY + DEMAND

I am like any other man. All I do is supply a demand.

Alphonse Gabriel “Al” Capone (1899-1947), American gangster

We will cover supply and demand much like the front nine and back nine of a golf
course. In this chapter, we discuss supply and, in the next chapter, demand. In Chapter 8
we will bring them together and hopefully get a clearer picture of how the game of eco¬
nomics really gets played.
At first, some of the concepts we deal with will be challenging. Not only that, the
media often oversimplify these ideas or confuse the concepts, which doesn’t help matters.
Getting back to the golf analogy, it may look easy to hit a little white ball into a little black
hole, but a lot of physics and good technique are required to make sure your game goes
well and you don’t end up tossing your clubs into the pond on the seventh hole. Think of
reading this chapter as if you are practising your putting on a green or hitting a bucket
of balls at a driving range. There, you learn important fundamental skills, but it’s still not
the same as playing an actual game of golf. The road to understanding can seem tedious at
times, but the tedious part lays down important building blocks for a good grasp of
real-world events. So hang in there—you don’t have to be a great economist to enjoy
recreational economics, but the better you play, the more fun it is.

THE BASIC SWING OF THINGS

You have to learn the rules of the game. And then you have to play better than anyone else.

Albert Einstein (1879-1955), Nobel Prize-winning theoretical physicist

Before we start this training session, let’s reiterate the key points made in the previous
chapters.

1. People produce things with scarce resources.

2. Scarce resources mean there is an opportunity cost to use them.
3. The most efficient way to make a good2 is to use the inputs or resources that have
the lowest opportunity cost associated with them first.
4. The owners of low-cost inputs—whether labour, land, or capital—are said to have a
comparative (or its synonym: competitive) advantage in the production of goods pre¬
cisely because of their low opportunity costs.

These are pretty broad economic concepts, and so far I’ve been able to get away with
using only words to talk about them. I hate to tell you this, but things are about to
change as I get more precise. I’m going to use some graphs to explain things. While 1
was tempted to write a book without them, in the end I just couldn’t do it. Here is why:
Economists find that graphs effectively help us to tell the backstory that makes sense of
the many comments and conversations about economics that often crop up at places like
cocktail parties. Without these structured diagrams, economic words—which are rich in

2 I know this might seem a bit weird, but economists refer to anything made that is a good thing as a “good.”
This is in contrast to something negative that gets produced (such as pollution), which we call a “bad.” It
might sound as if we’re a bunch of 2-year-olds, but it works for us.
64 Cocktail Party Economics

meaning—become jargon with no precise meaning at all. These visuals help us to pic¬
ture the economic models thought to be running behind the scenes.* 3 Without them, this
book would be like golfing with a terrible stance, a bad grip, and the wrong clothes. Sad.
So, put on your thinking caps, because it is time to be a little more analytical4 than
we have been so far. If you get bogged down, don’t worry about it. Stay with me and
keep going. Try to get the gist of the entire chapter. You can always reread the tougher
parts later—that is, if you want to. However, I won’t be offended if want to mix a dry
martini instead.

Gossip Column
i

Johann Heinrich von Thunen (1783-1850) was a German landowner-agriculturalist

whose book The Isolated State (1826) was really the first to put forth an economic
model that could be solved with mathematical tools. His model is the first example of
marginal analysis (marginal cost is an example of marginal analysis), and while his
book was devoid of graphs, it had many equations and tables that were even more
daunting. The Isolated State was a serious treatment of spatial economics with
predictions about land use around cities due to transportation problems and costs.
Furthermore, von Thunen substantiated his ideas with empirical data, keeping meticu¬
lous records, thereby connecting theory with facts. This book is really the beginning of
economic model building, which is the foundation of all modern economic thinking.
Alfred Marshall (see the Gossip Column in Making Introductions) said that von
Thunen was one of his favourite historical economists. Paul Samuelson, the winner of
the second Nobel Prize in Economics, declared von Thiinen’s work a “magnificent
edifice of general equilibrium.” This edifice is worshipped by location theorists, geog¬
raphers, and Nobel Prize winners alike. Only ordinary economists have undervalued
his contributions. This may be due to the fact that some of his ideas have not stood
the test of time. For instance, von Thunen had some ideas about labour theory and
was convinced that an important relationship was found in a particular wage equation.
This equation was so important to him that he requested it be put on his tombstone. It
reads A = yfap, where the natural wage, A, is the square root of ap, where p is the
worker’s product and a is the worker’s subsistence requirements. This is an unfortu¬
nate use of tombstone space. The equation is really neither here nor there in
economic theory, but von Thunen’s location model is definitely on the academic map.
More importantly, his way of thinking about theory was revolutionary. Unfortunately,
spatial economics5 is a specialized topic not found in most introductory economics
texts and von Thunen's contributions to the discipline as a whole are often missed.
Thankfully, Nobel Prize winners mention him from time to time.

1 In Geoff Colvin’s bestselling book Talent Is Overrated, Chapter 7 makes the point that elite performers in
any field think in terms of models, not just facts.
4 You will need to activate the left side of your brain in this chapter.
5 For a clear lineage from Johann von Thunen to Paul Krugman. who was featured in the previous chapter,
see Fujita, Masahisa. (2010). Evolution of spatial economics: From Thunen to the new economic
geography. Japanese Economic Review, 61( 1), 1-32.
 Chapter 6: Supply Side 65

WHO IS MAKING YOUR CAR?

Any customer can have a car painted any color that he wants so long as it is black.
Henry Ford (1863-1947), founder of the Ford Motor Company
Taken from My Life and Work (1922)

Essentially, economists picture the production of any good, whether a physical product
or a service, as if it were one of many identical items in a line. For now, just imagine a
line. Fortunately, 1 have one handy for you in Figure 6.1.
Let’s take fuel-efficient cars—perfect for the afternoon car rally in the opening
story—as an example. The line starts on the left with a point that represents the car that
costs the least to make. Next in line, we picture another small fuel-efficient car that has
the second-lowest cost of production. We continue this process until we place all cars of
this particular type somewhere along the line in ascending order according to their
opportunity costs.

FIGURE 6.1 Ordering of small fuel-efficient cars

<s>
g Third-lowest s
s
✓
y
s
" cost s
s
s
'c s
^ Second-lowest s
/
✓
cost ✓
✓
Q. ✓
✓
Lowest cost - ✓

i-r
Car 1 Car 2 Car 3

Visualizing a line (or lineup) of products like this helps us to keep our perspective
straight when thinking about markets because it reveals what economists believe is the
most important characteristic in the production of any good: opportunity costs. You see,
economists sort companies by opportunity costs rather than by some other metric such as
age or size, because ultimately only relative costs will determine which companies make
the cars we drive. A business might be the “golden oldie” in the auto market, but if it
spends more to make a car than the new company on the block, it gets sent to the end of
the line or to the top right of the graph. This line is no “stairway to heaven.” Car compa¬
nies would actually prefer to be at the bottom end of this ascending cost line and will do
whatever it takes to stay there. It appears that low costs are much like low golf scores.
It’s how you win the game.

Different Players, Same Game

There is one rule for the industrialist and that is: Make the best quality of goods possible at
the lowest cost possible, paying the highest wages possible.
Henry Ford (1863-1947), founder of the Ford Motor Company
66 Cocktail Party Economics

The big idea from this upward-sloping line of cars is that just because the cars are
almost identical to each other, that doesn’t mean their production costs are necessarily
the same—and these differential costs matter. Just ask a representative from the
Detroit Big Three about the impact of higher retiree6 expenses on the price of their
cars when compared to the Japanese Big Three.7 * Even though the cars produced by
each of the companies may look equally attractive to the consumer, the underlying
costs to make the cars may be radically different. This difference determines which
company sells more cars and makes more profits in the auto sector irrespective of its
long and glorious history.
Let’s compare the costs incurred by foreign* and domestic car companies in North
America. Both have similar hourly wage costs for their workers. So, that’s not the
difference. Aha, here it is: the cost for employee benefits! Until the most recent restruc¬
turing of the Detroit-based car manufacturers, the employee benefits gap sat somewhere
between $25 and $309 per hour. This means that, in 2007, it cost approximately $2000
more for these companies to produce a car than it did for a rival Japanese car company.
There is a price to be paid for having a long and storied history. Older companies such
as General Motors, Ford, and Chrysler simply have many more retired employees with
ongoing health coverage and pensions. Since Japanese manufacturers are relatively new
as employers in North America, they have fewer retired workers, hence lower costs—a
definite advantage.
Although it’s admirable that the North American car companies have been socially
responsible10 to their employees over the years, the harsh reality is that all that grey hair
among their former workers moved them to the higher end of the opportunity cost line.
It’s not a good spot to be in when the demand for cars tanks. “Restructuring” in this
industry has been partly about addressing this retiree problem. In the opening story, the
auto analyst who is coming to speak to the retired businessmen will probably tell them
much of what I have just told you. Not good news for the old boys’ pension funds.

Lining Up the Usual Suspects

I will not go so far as to say that to construct a history of thought without profound study of
the mathematical ideas of successive epochs is like omitting Hamlet from the play which is
named after him ... But it is certainly analogous to cutting out the part of Ophelia. This simile
is singularly exact. For Ophelia is quite essential to the play, she is very charming—and a
little mad.

Alfred North Whitehead (1861-1947), English mathematician and philosopher

6 Toyota, with few retirees in the United States, spends less than $300 per vehicle on health care costs, com¬
pared to GM’s more than $1600. Of course, the motor vehicle recalls that began in November 2009 and
carried over into the next year raised costs significantly for Toyota.
7 The Detroit Big Three are General Motors, Ford, and Chrysler. The Japanese Big Three—Toyota, Nissan,
and Honda—all gained a higher percentage of smaller global sales. Thus, market share went up for them.
* The distinction between foreign and domestic has to do with head offices rather than the location of manu¬
facturing or shareholders.
g White, Joseph B., Stoll, John D., & McCracken, Jeffrey. (2007, September 27). GM labor deal ushers in
new era for auto industry.” The Wall Street Journal.
10 This probably has more to do with the negotiation skills of the United Auto Workers (UAW) union and the
Canadian Auto Workers (CAW) union than with the kindness of the car companies.
 Chapter 6: Supply Side 67

Now, let’s take that line of goods that we ordered according to opportunity costs and
finally convert it to a typical economics graph. I can almost hear you saying, “Finally!”
Remember that a picture is supposedly worth a thousand words. Well, I hope it’s worth
at least a few hundred to you, because the supply and demand framework is really the
visual workhorse of depicting economic thought, so we are going to spend a bit of time
on it. Hopefully it won’t feel like I’m beating you over the head with a dead horse. (How
do you like that for some mixed metaphors?) If you understand this way of thinking, you
will be a long way down the yellow brick road.
If you talk to an economist about an economic problem, invariably he or she will pull
out a pen and paper to graph what we call supply and demand curves. Economists do
this over and over again. To the casual observer, it can feel like the movie Groundhog
Day. However, these supply and demand curves are more than just pretty pictures; they
tell stories. Now, don’t be alarmed if you see a line rather than an actual curve.
Economists call supply and demand illustrations “curves” even if they look like straight
lines. Straight lines are easier to draw if you are artistically impaired ... and most
economists are.
Let’s first take a look at the supply curve in Figure 6.2. The supply curve captures, in
a systematic way, the behaviour of all businesses as they react to a change in the price
that is charged for their product. To illustrate, let’s look at the behaviour of three car
companies that at this point we'll call companies A, B, and C. In the graph, we will order
all of the small cars they make according to their opportunity costs. To make the exam¬
ple easier to follow, I have shown all of the low-opportunity-cost cars as if they were
produced only by company A on the left and all of the high-opportunity-cost cars as if
they were produced only by company C on the right. In the real world, costs never sepa¬
rate out this neatly.

FIGURE 6.2 Supply of small fuel-efficient cars

68 Cocktail Party Economics

If we replace the term opportunity cost with the term price, the line is called a long-
run" supply curve and typically slopes upward from left to right. It slopes upward
because usually prices start low and end high as more products are produced and sold in
a market. Why is that.’ It’s time to connect the dots between opportunity costs and
prices.
Let’s say that the price for a new fuel-efficient car is low—say, $10 000. According to
the ordering of opportunity costs, we begin with Company A, because Company A and
only Company A can cover its costs of production at that price. Since it is the only one that
can survive by making cars at this price, only what it produces will be available to the
marketplace, which means that the total number of cars on the market will be low. How¬
ever, once people start buying more fuel-efficient vehicles, Company A becomes maxed
out in its production capabilities. At that point, the cars have to come from another com¬
pany and Company B is next in line, albeit with higher production costs. Higher costs
mean that the price that Company B must charge needs to be higher as well.12 Because all
car prices are now higher, the executives at Company A think this is fantastic. They can
now make more profit due to the difference between what it costs their company to make
the cars and this new higher price—which, of course, they do charge! In contrast, Com¬
pany B finds the price just high enough to get by on. Unfortunately for Company C, it
needs a price of at least $30 000 to be a player in this market. It waits in the wings.
With a little extension of the logic, we can see that the price required to make a nor¬
mal profit is the same as the opportunity cost of production. This shouldn’t be surprising
if you recall from Chapter 4 that economists assume that some level of profit is part of
the cost of doing business. An important thing to keep in mind here is that the price of a
car in the market is really a reflection of what it costs to make a car for the last company
to enter the market. In our graph, $30 000 reflects Company C’s costs of production,
including the distribution of normal profits to shareholders.

No Longer Nameless
Experience teaches slowly and at the cost of mistakes.

James Anthony Froude (1818-1894), English writer

Economists distinguish between short-run and long-run supply curves. The only difference between the
two is the following: In the short run, the number of firms is fixed and the entry of a new firm is an
increase in supply. In the long run, the number of firms is flexible and the entry of a new firm is considered
to be a movement along a much more responsive supply curve. The supply curves in the short run and long
run therefore have different slopes. For the purposes of this book, I don’t think it’s worth getting bogged
down in this kind of detail. I am sticking to an upward-sloping long-run supply curve and ignoring the
short run.
It is worth taking a little detour to explain the difference between a firm’s view of costs and the market’s
view of costs. When an auto manufacturer builds a plant, the first car off the line is the most expensive. All
of the overhead is on that one car. As more cars leave the plant, the cost per car falls. This seems like a
contradiction to what is said in the text, but in reality it is not. When a car manufacturer plans to make cars,
it does not intend to make just one. The plant has an optimal production quantity that minimizes the cost of
building cars. The market sees the cost around the optimal production point rather than on the cost of the
first car. In reality, the production of only the first car is never going to happen and its high cost is irrele¬
vant to the market. Even if the plant decided to decrease production, it would never make just one car. It
would close up shop long before production got that low. Therefore, the market is concerned only with the
lowest cost of producing cars for a particular manufacturer that really happens.
 Chapter 6: Supply Side 69

In our automobile example, the Japanese Big Three—Honda, Nissan, and Toyota—
occupy the first three low-cost spots on the small car supply curve while the Detroit Big
Three—Ford, GM, and Chrysler—are further along the curve at higher opportunity
costs. (I think this was the correct order in 2007, but I wouldn’t stake my life on it.) This
ranking indicates a kind of “survival of the fittest” should the price for small fuel-
efficient cars take a nosedive. Consequently, it was no surprise during the economic
downturn of 2008-2009 that GM ended up in bankruptcy protection while Honda did
not. Honda simply had the lower opportunity costs and could endure the lower prices
better than GM. This is not to say that Honda’s executives were happy about the lower
prices, but the company was better able to absorb the brunt of the drop in car sales.

Picky Differences
The first day of spring is one thing, and the first spring day is another. The difference between
them is sometimes as great as a month.

Henry van Dyke (1852-1933), American author, educator, and clergyman

When economists talk of supply, they usually are not referring to the particular number
of units sold in the market. That number is called the quantity supplied, not supply. The
idea of supply embodies much more than that. Sometimes people are confused by this
distinction because supply and quantity supplied sound similar but are not the same
thing. In Figure 6.2, supply basically is the line. On this supply line, we can have many
quantities supplied, depending on the particular price point. Moving up and down the
line changes the quantity supplied but it doesn’t change the overall supply.
Maybe a golf13 analogy will help to drive things home. There are a couple of ways to
move a ball different distances down a fairway. One way is to use a particular club but
change the force of the swing. The other way is to use the same force but change the
club you use, because each club has a fundamentally different makeup. In our economic
model, the distance the ball travels equates to the quantity produced and the force
equates to the price. A change in force (price) changes the distance (quantity supplied),
whereas changing the clubs—let’s say using a pitching wedge instead of a 3-iron—
represents a change in the overall supply. A change in supply happens only due to a fun¬
damental change or shift in the way things are done—much like using a new club.
Failure to keep supply and quantity supplied distinct leads to incorrect conclusions
when people discuss real-world markets, just as confusing a golf sw ing with golf clubs
makes explaining a golf game difficult. In terms of market analysis, people most often
get caught in vicious circles of logic. They say stuff like this: “An increase in demand
leads to higher prices, which lead to an increase in supply only to see prices fall again,
which leads to an increase in demand and prices are up again, which leads to an increase
in supply ...” Round and round she goes, and where she stops nobody knows.
This particular circle would have been broken long ago had the concept of move¬
ment along a curve (or change in quantity supplied) been used at least once. Instead,
people litter their explanations with the S word and the D word and the conversation gets
messy. Ultimately, you can’t tell market stories that make sense without being careful

13
The modem game of golf probably originated in Scotland around the twelfth century, with shepherds
knocking stones into rabbit holes on the current site of the Royal and Ancient Golf Club of St. Andrews.
70 Cocktail Party Economics

about supply/quantity supplied and its counterpart, demand/quantity demanded, any

more than you can comment on a golf game without differentiating between the golfer’s
swing and his or her clubs. However, in economics you don’t have to whisper.
How do you straighten out faulty economic statements? Well, we need to look
closely at the role that price plays in the scenario. Does a price change motivate a change
in the quantity supplied, or does some other change motivate a new price? The golfing
commentator would ask the following question: Did the force change the distance the
ball travelled, or did a change in golf clubs change how much force was needed? Once
we sort out this confusion, we will also sort out whether it is a movement along a supply
curve or a fundamental shift in supply.

Full Range of Movement

If I have done the public any service, it is due to my patient thought.

Sir Isaac Newton (1643-1727), English scientist and theologian

We begin with a movement along the curve or a change in quantity supplied.

Essentially, this implies that if the price of a product goes either up or down, a company
reacts to that price change by changing its production levels. It’s like changing the force
in your golf swing. Price and only price motivates the change. The arrows in Figure 6.3
indicate that the actual quantity supplied by a company changes when the price drops
from $30 000 to $10 000 per car. In response to the price drop, companies drop the
quantity they will make from 13 million cars to 9 million cars. Price changes motivate a
change in the quantity supplied, but the fundamental supply stays put. (Just to keep this
golf analogy going, the distance you hit the ball decreases if you use less force in your
swing, but you are still using the same club.)

FIGURE 6.3 Moving along the supply curve

Quantity of cars (in millions)

The arrows on this graph just happen to show quantity decreasing rather than increas¬
ing because the example is about prices falling. However, if you flip the arrows around,
you can show the quantity supplied increasing from 9 million cars to 13 million cars when
 Chapter 6: Supply Side 71

prices rise from $10 000 to $30 000 per car. (However, the adage what goes up must come
downu is not true in markets. Unlike for gravity, there is no law that says prices and quan¬
tities have to fall. It is entirely possible that they can keep going up and never come down.)
In the real world, when prices fall, companies that at one time produced their wares
profitably cannot do so anymore (which probably stresses out the executives quite a bit).
They now have to decrease the quantity they supply and have some options to accom¬
plish this. For instance, they can downsize their workforce to get “leaner and meaner,”
thereby reducing opportunity costs. Or, they can simply go bankrupt and leave the mar¬
ket altogether. Either reaction is a response to lower prices in the market and from a
long-run perspective is called a drop in the quantity supplied to the marketplace.

Another Cost by Any Other Name Is Still a Cost

We do not think good metaphors are anything very important, but / think that a good meta¬
phor is something even the police should keep an eye on.

Georg Christoph Lichtenberg (1742-1799), German scientist and satirist

Next, we look at how we represent a business reaching—metaphorically speaking—for a

new club. It is time for a shift or change in supply. This occurs when a business experi¬
ences fundamental changes to its costs that ultimately affect the price that must be
charged for a product. In Figure 6.4 we see two different supply curves: one labelled
Initial supply and the other labelled New supply. This figure is kind of like a before and
after picture for the shift in supply.

FIGURE 6.4 Decrease in supply of cars

New supply Initial supply

Quantity of cars (in millions)

14
Attributed to Sir Isaac Newton as a reference to the law of gravity.
 72 Cocktail Party Economics

On the initial supply curve, at a price per car of $20 000 the company could produce
11 million cars. When costs rise, there are two perfectly legitimate ways to explain what
the company can do in response. The company could continue to make 11 million cars
but it must charge more than $20 000 per car. Or, the company could accept the same
price ($20 000) but produce fewer cars (9 million) at that price point. We visually repre¬
sent the increased costs as a leftward shift of the supply curve along the X-axis. In this
case, supply is said to have dropped because overall opportunity costs have risen. The
car company is visually operating on a new supply curve and—yes, go ahead, you can
say it supply is down. Once it is on this new supply curve, the company can of course
move up and down it to change the quantity supplied.
Essentially, supply and quantity supplied are all about opportunity costs. Therefore, com¬
panies care about anything that changes the cost of doing business. It doesn’t matter if it is
motivated by a movement along a supply curve or by a shift in one. When companies engage
in cost-cutting they aren’t usually being mean-spirited.15 Often it’s a matter of survival.
Furthermore, an analyst who digs into the inner workings of a company or investigates
industry-wide trends before making market predictions in the media isn’t just a Nosy
Parker. He or she cannot predict anything without knowing the details of what happened to
costs and why. The next section will dissect the possible reasons why supply curves shift
one way or another changes that will motivate new prices—and you will see that each
scenario can be reduced to a change in the opportunity cost of doing business.

Business Fundamentals
We all, according as our business prospers or fails, are elated or cast down.

Publius Terentius Afer, known as Terence (195/185-159 BC), Roman playwright

Taken from Hecyra (165 BC)

Let s look more closely at what changes the overall opportunity costs for companies and
thus shifts the industry supply curve to the right or left. What big issues worry company
presidents other than market demand? (Demand will be covered in the next chapter.) If
you end up at a cocktail party with business people, they tend to complain about a num¬
ber of things: their employees, the rising cost of raw materials, the weather, and the gov¬
ernment. Why is that? Well, each affects their businesses’ bottom lines by raising costs.
Economists illustrate this idea by shifting supply to the left.
There are five main categories of factors that shift supply:
1. Government involvement
2. Productivity changes
3. Prices of inputs
4. Weather

5. Technological advancement through innovation, invention, and production

improvements

In the 2005 film Kinky Boots, the owner, Charlie Price, describes the times he laid off workers as some of
the worst of his life. To save the company he stops producing staid menswear and begins producing kinky
boots for men. The supply of staid men’s shoes decreased and the supply of kinky boots increased. Fortu¬
nately, this change in supply saved the company and the workers’jobs.
 Chapter 6: Supply Side 73

1. Government Involvement
A government that robs Peter to pay Paul can always depend on the support of Paul.

George Bernard Shaw (1856-1950), Irish writer and Nobel Prize winner in Literature

Since people love to complain about government, it gets the top spot. What are the major
“sins” of governments? They tax and regulate businesses. (Sometimes, creating really
complicated tax laws can feel like a combination of these!) Taxes take money out of the
pockets of a company, and regulations force the company to jump through costly com¬
pliance hoops. Complicated tax laws require that companies hire expensive accountants
in order to figure out legal ways to avoid paying the piper. Clearly, governments can
increase the opportunity cost of doing business.
But governments giveth as well as taketh. They can do things like deregulate and
subsidize, both of which benefit companies. Business leaders usually don’t complain
about these things at a cocktail party unless they occur in some sector other than their
own. Then, you hear a lot of grumbling about how unfair the government is, which tends
to put a negative spin on the party. May I suggest you introduce these folks to one of
your lobbyist friends? If you don’t think they can afford a lobbyist, how about buying
them another cocktail and trying to redirect the conversation?

2. Productivity Changes
Jesus is coming. Look busy.

Bumper sticker and T-shirt slogan

How many times have you heard someone say that you can’t get good help these days?
Employers tend to complain a lot about the work habits of their staff. If an employee
makes a lot of mistakes, arrives late, works slowly, leaves early, makes many personal
calls during work hours, visits colleagues at the water cooler, searches the web all morn¬
ing,16 and takes twice as long to do something than anyone else does, then you can be
sure that management is keenly aware that the cost figures are climbing along with their
blood pressure. Low-productivity workers who happen to earn the same wage as high-
productivity workers raise the cost of what is produced. They do “less with more”—that
is, they produce less than they potentially could for the same cost. This reduction in pro¬
ductivity decreases or shifts supply to the left.
Remember, if you are ever at a cocktail party with employers who have “slackers” in
their companies, don’t get them started the topic of “good help.” Believe me when I say
the conversation can only go downhill. As an employee myself, I find it helpful to at
least keep up the appearance of high productivity. That way, management stays happy
with me. (By the way, if any of my employers happen to be reading this book, I hope
you bought 10 copies—just kidding.)

3. Prices of Inputs
I can make more generals, but horses cost money.

Abraham Lincoln (1809-1865), American president

16
Lim,Vivien K.G., Teo, Thompson S.H., & Loo, Geok Leng. (2002). How do I loaf here? Let me count the ways.
Communications of the ACM, 45( 1). These authors quote internet productivity losses between 30 and 40 percent.
 74 Cocktail Party Economics

Supply can decrease or increase if input prices go up or down. Labour is generally the
most important input in the production process, so don’t mention the dreaded word
union to a manager during a cocktail party, especially if that manager is also the owner.
You don’t want to be responsible for a coronary. In a nutshell, unionization causes
higher wages, salaries, and benefit packages—although, to be fair, it does tend to raise
productivity as well—just not enough to cover the extra costs. On net, unions raise the
cost of production and reduce supply.
The idea of scarcity also comes into play with labour because the scarcer particular
types of employees are, the more employers will have to pay to hire and retain them,
which can really “shift your curve.” For some owners and managers, the old saying is
really true: It is hard to get good help these days, at least at the desired price point.
In our modem technological world, labour usually works in tandem with physical
capital. In the auto sector, some state-of-the-art factories cost more than a billion17 dol¬
lars to build. As labour becomes more expensive (even non-unionized shops become
expensive if they match wages to keep unions out), machines become a viable substitute
for workers. In countries with cheap labour, there is less pressure to mechanize.
Next to labour and capital, oil is probably the third most important input for North
American production. As oil prices rise, so do the costs to make most goods.18 Most
tangible goods are physically transported in some way or involve plastics of some sort.
Furthermore, industrial machines need oil to keep them humming. Increases in the price
of oil cause the supply curve of most products to shift to the left, indicating a decrease in
supply.

4. Weather

Just for the record, the weather today is partly suspicious with chances of betrayal.

Charles Michael “Chuck” Palahniuk (1962—), American writer

Taken from Diary (2003)

Not all business people complain about the weather, but the ones who do probably rely
on a particular kind of “good" weather. Ski resorts need it to be cold, road workers need
it to be dry, and airlines need it to be safe. Farmers get the award for complaining the
loudest about the weather. But we won’t hold it against them since they depend a great
deal on the vagaries of the weather. One bad drought, flood, summer hailstorm, or
tornado can wreck a whole growing season, not to mention a farmer’s day. Enough said.

5. Technological Advancement

A bore is a person who opens his mouth and puts his feats in it.

Henry Ford (1863-1947), founder of the Ford Motor Company

Bosses don’t usually complain about the latest technology when they are at parties. If an
employee invents some labour-saving device, the company can produce goods less
expensively. It doesn't even have to be a monumental change. Simply tweaking (or the

In 2008, Toyota opened a $1.1 billion assembly plant outside of Woodstock, Ontario, that employs about
1200 people.
Oil-based products include such things as plastics, cosmetics, pharmaceuticals, and construction materials.
 Chapter 6: Supply Side 75

more sophisticated and substantive word innovating) existing processes can often
increase productivity, which increases supply and makes management very happy.
Henry Ford is a good example of an innovator. He not only fathered the concept of
the assembly line used to mass-produce his Ford Model Ts—an idea adopted by manu¬
facturers around the world—but also developed the dealer franchise system. This
allowed every city in the United States to have access to brand spanking new, yet rela¬
tively inexpensive. Ford Model Ts. Technology improvements and innovative business
practices will increase or shift supply to the right, which contrasts with some of the more
gloomy scenarios we have discussed so far.

CREATING LINKS19
One cannot be a good historian of the outward, visible world without giving some thought to
the hidden, private world of ordinary people; and on the other hand one cannot be a good his¬
torian of this inner life without taking into account outward events where these are relevant.
They are two orders of fact which reflect each other, which are always linked and which
sometimes provoke each other.

Victor Hugo (1802-1885), French writer

Congratulations, you have finished the front nine of the course and (said with a Scottish
brogue) it’s time for a wee break. You deserve it. The inner workings of business aren’t
always obvious, but hopefully you have a better idea about the crucial role that costs
play in determining a company’s supply and quantity supplied. In the next chapter, we
switch gears from supply to demand. Fortunately, since we are all consumers, you
should be able to identify with the concept of demand (and quantity demanded) more
easily, and you should find the next chapter a quicker read. Cheers!

ship
ret au°n
andthe
Ju the f**
< due to e es$.
con fo fd°ir,g
ihe coSt °

19
A links is the oldest style of golf course.
 Demanding Clients
(A Venti Chapter)
The demand that 1 make of my reader is that he should devote his whole Life to reading
my works.

James Joyce (1882-1941), Irish writer

There is a buzz in the air as you enter the foyer of the opera house. Can you believe it?
The group of retired folks you saw at the golf course is here as well! You move closer to
eavesdrop on their animated conversation. The women sparkle from the silver of their
carefully coiffed hair to the gold of their shoes. All of them still wear their fur coats and
they are sorting out what to do with them. Should they check their furs or keep them
because of a chill in the foyer? For now, it looks like they’re going to keep them on.
“The Marriage of Figaro is my favourite opera!" exclaims one woman.
“I am just glad it’s a comedy. I don’t really want to watch people die tonight,” pipes in
the balding man.
“Maybe you ‘old boys’ can pick up a few tips on how keep your women. After all, for
most of us it has been only 40 years,” quips the woman with dancing eyes.
The men roll their eyes as they grin at each other. One of them smiles, wiggles his
eyebrows like Groucho Marx, and says, “That’s easy. Just keep her in expensive1 chocolates.”
As you watch these friends banter, you think to yourself: Retirement looks like a lot of
fun if I can stay as active as these people. You remind yourself to buy some of those anti¬
aging vitamin supplements from a health food store that you recently saw advertised on TV.

IF I SUPPLY, WILL YOU DEMAND?

But the bounty of capitalism has at least one downside. It does not automatically produce
what people really need; it produces what they think they need, and are willing to pay for ... if
they are also willing to pay for snake oil, it will produce snake oil.

George Arthur Akerlof (1940- ), American Nobel Prize-winning economist, and Robert James
Shiller (1946-), American economist
Taken from Animal Spirits (2009)

If the supply side of markets has to do with opportunity costs, then the demand side is all
about what buyers value—what gives them pleasure or happiness. Let’s take a quick look at
the psychology of the consumer. Have you ever been in a department store and heard some¬
thing like this over the loudspeaker? “Attention, shoppers. Chocolates will be marked down
50 percent for the next 20 minutes in aisle 3!” If you have, you will notice that suddenly, with
an almost herd-like movement, shoppers rush to buy the chocolates they may have previ¬
ously passed over as “not worth it.” Why did the mention of this price drop suddenly make
those chocolates oh, so worth it? Was it the sultry voice of the announcer? I don’t think so.

1 Fritz Knipschildt is the mastermind behind the most expensive chocolate in the world and is sometimes
called the Willy Wonka of Connecticut.

76
 Chapter 7: Demanding Clients 77

The explanation is all about marginal value. In Chapter 2, we discussed the concept of
value in more detail, but here is a brief recap. Marginal value is the personal value to the con¬
sumer of an item when considered one item at a time. Here is the important idea: As the
number of items purchased by the consumer increases, the value of each item in the psyche
of the consumer tends to decrease. Think of it this way: The first chocolate goes in your
mouth and gently melts. Mmm ... fantastic! Better than sex, some would say.2 You take a
second chocolate. Again, you experience pleasure. However, it’s never really as good as the
first one. By the seventh chocolate you feel guilty (but who can resist the eighth!).
Economists think of the chocolates as items along a line where the first chocolate has
the greatest marginal value and each successive one has a lower marginal value. It is pos¬
sible to have so many chocolates that we wouldn’t take another one even if it were free. In
other words, the “good” has become a “bad” for you, and its marginal value has gone from
a positive one to a negative one. Just because the individual chocolates look the same on
the outside, they are not equal in value in the eyes of the consumer. It all depends on where
that chocolate sits in the line in front of your lips ... not to mention around your hips.

Looks the Same on the Outside

All animals are equal, but some animals are more equal than others.

Eric Arthur Blair, pen name George Orwell (1903-1950), English author
Taken from Animal Farm (1945)

Let’s visualize this with—what else?—a line on a graph. In Figure 7.1, on the left side of
the graph, we have higher marginal values that can be translated into dollars and cents.
In this case, the price is $20 because of the low quantity (two) available. If we move
from the left side down toward the right, the quantity available goes up. This means that
we are willing to pay the most for the first item in the line because we value it the most.
As we consume more chocolates (six now, instead of two per month), the price we are
willing to pay falls from $20 to $5 because our marginal value for that chocolate—given
that we have already had a few—drops.
Economists call the entire downward-sloping curve (all of the possible prices and
quantities) the demand curve, or demand for short. This curve plots the customer’s will¬
ingness to pay for different quantities of the same good. This curve also tells us how
consumers behave when the price of chocolates changes. Again, as with the idea of sup¬
ply, we need to hold constant everything else that could affect the consumer’s desire for
chocolates in order to sort out how price motivates consumption. All other relevant
factors will be represented by shifts in the demand curve.
Just as we did with supply and quantity supplied, we need to keep the distinction
between demand and quantity demanded crystal clear. To illustrate the idea of demand
and quantity demanded, let’s look at two ways to increase the quantity bought. The first
way is for the consumer to experience a price drop. In this case, the demand curve
remains the same but, due to a price decrease, the quantity demanded increases. The

2 Salonia, A., et al. (2006). Chocolate and women’s sexual health: An intriguing correlation. The Journal of
Sexual Medicine, 3, 476-482. This study found that women who ate chocolate did have higher Female
Sexual Function Index (FSFI) scores. However, younger women tend to eat more chocolate than older
women, and once the data were adjusted for age the chocolate wasn’t important anymore. Too bad.
78 Cocktail Party Economics

FIGURE 7.1 The demand for “good” chocolates

The demand curve shows the

customer’s marginal value for
0)
CO chocolates, or willingness to
O \ pay for them, goes down as
O
o $20- s
-C X. N more is consumed. This is an
o
R N increase in the quantity demanded.
o Demand remains the same.
U)
$10- s
2.
d) \
o SA
Q_
$5- ^ Demand

1 1 1
2 4 6
Quantity of “good” chocolates per month

second way is for something fundamental to occur that changes the consumer’s values
and willingness to pay for the item. These are shifts in demand and we will look at the
big shifts later in the chapter.
Let’s look at a change in quantity demanded first. Actually, we have already done
most of this in the chocolate sale example. Basically, when prices change, buyers com¬
pare their marginal values (or willingness to pay) against what they have to pay to
consume. Lower prices mean that marginal values can be lower, which only happens at
higher quantities. Therefore, as prices fall, the quantity demanded increases.
When people hear about a special sale on chocolates in the department store, their
brains (if they like chocolate, that is) may calculate that this new price is now below
their internal “willingness to pay” value, which makes the chocolates worth purchasing
when before they were not. Their brains also tell them to hustle over and buy some
chocolate before it is all gone. As they buy more, their brains recalculate the new drop¬
ping marginal values of each successive package of chocolates until the last box’s mar¬
ginal value matches the sale price. The greater the drop in price, the more chocolates it
takes to reach psychological equilibrium. The quantity demanded is up, but it is rare for
a shopper to clear out a whole bin.
However, the consumption of chocolate can go up because of factors other than choco¬
lates going on sale. For example, Halloween, Christmas, and Easter all seem to involve an
unhealthy amount of chocolate. (I’m sure kids wish that back-to-school sales had choco¬
lates as part of the tradition!) In Figure 7.2, we represent this kind of change in consumer
behaviour with a shift in the demand curve. There are two stories that can make sense. One
way to look at it is to say that, for the same price (say, $10), people are willing to buy more
chocolates. In other words, their value for chocolates goes up during certain holidays. The
quantity purchased at $10 goes up from the initial two to the new three chocolates per
month. But another way to look at it is to say that people are willing to pay more to main¬
tain current levels of chocolate consumption. Notice in the graph that, at two chocolates
per month, people value chocolate at more than $10 per box. Either way, this scenario
looks like a rightward shift of the demand curve, which is called an increase in demand.
 Chapter 7: Demanding Clients 79

FIGURE 7.2 Shift in demand for “good” chocolates

Quantity of “good" chocolates per month

There are many more things that can change how consumers feel about chocolates. Here
is an adult example: Suppose that a new study somehow proves that chocolate increases
libido in women. I think most of us would predict an increase in the demand for boxes of
chocolates. However, it is hard to say if women would buy the chocolates for themselves or
if men would purchase the chocolates as an aphrodisiac ... I mean gift.1 In the end, it doesn’t
much matter to Charlie and his chocolate factory as long as things are looking up.

Gossip Column

Sir John R. Hicks (1904-1989) was the eldest son of a newspaperman and a noncon¬
formist3 4 minister’s daughter. He won a mathematics scholarship to attend Baltiol College,
Oxford, but was not content with mathematics and after one year switched to the new
Philosophy, Politics, and Economics (PPE) school, also at Oxford. Things did not go
well, partly because he was “not well taught” in economics.5 He finished with a second-
class degree and no real qualifications in any of the three subjects,6 even though it was
evident to his fellow students and tutors that he was a very gifted person.
Hicks tried to follow in his father’s footsteps as a journalist, but that didn’t go well
either. Fortunately (as he says in his own words during his acceptance speech for the
Nobel Prize), economists were scarce, and he took a temporary lectureship at the

3 Valentine’s Day week accounts for 5 percent of total annual chocolate sales, according to Neilson.
4 A nonconformist is an English or Welsh Protestant of any non-Anglican denomination, chiefly advocating
religious liberty.
5 See the Oxford Dictionary of National Biography by R.C.O. Matthews. This is the same college that Adam
Smith expressed critical views about.
6 Hicks’s autobiography for the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred
Nobel 1972.
 80 Cocktail Party Economics

London School of Economics (LSE) during the time of Lord Robbins (see Gossip
Column in Chapter 1). He started as a labour economist doing descriptive work on
industrial relations (the economics of unions). At the time, Robbins was revitalizing the
LSE with European, non-British economists. This was in direct contrast to
Cambridge’s Anglo-Saxon feel. The Continental economists (Austrians, Swedish,
French, and Italians) were formative in Hicks’s intellectual development partly because
he was so good at languages and could read their non-translated works.
Hicks was at the LSE for approximately four years but it changed him forever. For
one thing, he met and married his wife, another economist named Ursula Webb. They
were rarely apart and completely devoted to each other until her death in 1985. As
well, he was so affected by his lack of success at PPE that he questioned and worked
through everyone’s theories from first principles. This trained his mind to see major
concepts and connections. Furthermore, the LSE at that time was inspirational, with
such great economists as Fredrich von Hayek.* 7 When Hicks won the Nobel Prize, he
gave the money to the library at the LSE in appreciation. He was the first British
economist to receive the award.8
Hicks is described as the economist’s economist, creating theoretical tools for others
to use. His influence was transformative and felt in almost all branches of the economics
discipline. It is difficult to narrow down what he should be known for. For the purposes of
this book, I will tell you that most second-year economics students will recognize the
terms income and substitution effects in the creation of demand curves. These are the
basic tools taught in all economics programs. What most students wouldn’t know is that
Hicks developed these constructs ... and many others. (Unfortunately, textbooks don't
usually name-drop and ideas appear as if they always existed. To counteract this prob¬
lem, when Hicks taught a course he always made the students read the original papers.)
Ultimately, Hicks received the Nobel Prize for his work9 on general economic equilibrium
theory (more on that in the next chapter) and welfare theory.
Hicks spent the last 35 years of his career as a Fellow of All Souls College, Oxford
... the place where he failed a fellowship examination many years earlier. At All Souls,
Hicks was an active delegate of the Oxford University Press. Any early failures were
completely forgiven and forgotten ... on both sides.

CONSUMER BEHAVIOUR
In opera, as with any performing art, to be in great demand and to command high fees you
must be good oj course, but you must also be famous. The two are different things.
Luciano Pavarotti (1935-2007), Italian opera singer
Taken from My World (1995)

In studying consumer behaviour, there are four main categories that can fundamentally
shift consumer demand:

Hayek (1899-1992) won the Nobel Prize two years after Hicks.
* This was partly because the Cambridge greats—Marshall and Keynes—had died. The Nobel Prize must be
given to a living economist.
9 The award was shared with another great economist, Kenneth Arrow.
 Chapter 7: Demanding Clients 81

1. Consumer preferences
2. Consumer income
3. Prices of related products
4. The number of buyers in the market

1. Consumer Preferences
In the affluent society, no sharp distinction can be made between luxuries and necessaries.

John Kenneth Galbraith (1908-2006),10 Canadian-born economist

Taken from The Affluent Society (1958)

Tastes can and do change—sometimes voluntarily, sometimes with a little help from
societal pressure. For instance, when I was a university student, I didn’t dare wear fur on
campus, even in the coldest weather, for fear that some animal rights activist would
spray my fur with a hair removal product. As a meat eater, I didn’t see the problem with
wearing farm-raised mink (after all, they’re not an endangered species and I really like
the feel of fur, not to mention its warmth in the winter). However, back then, I suc¬
cumbed to peer pressure and didn’t buy a real fur coat. Alas, I’ve had a succession of
fakes ever since. This type of societal pressure was very tough on the fur industry for a
time. Fortunately for them, some famous hip-hop artists started to wear fur, which
helped turn things around, especially among style-conscious younger men tuned in to
that genre of music. Mink farms think that demand has now shifted in the right direction.
Retail clothiers make every effort to understand consumer preferences. They know
that customers usually buy summer clothes before the summer starts and winter clothes
before winter begins. There’s a rhythm to many markets according to the ebb and flow
of what customers want and when they want it. These preferences change not only with
the annual seasons, but also with the seasons of life. North America has an aging popula¬
tion and many members of that population are fighting back, causing the anti-aging* 11
market to grow steadily. I have tried an anti-wrinkle cream myself but unfortunately it
“anti-aged” my skin so much that I got acne again.
Advertising powerfully taps into consumer preferences. Sometimes it’s just a matter
of informing customers about products they are unaware of or drawing attention to de¬
sirable features of the ones they do know about. Most of today’s grocery stores abound
with food labels that contain terms such as no trans fats, light, organic, local, and fair
trade, precisely because today’s consumers prefer or demand these kinds of products.
If you want to sell, say, a new line of clothing, it pays to let potential customers
know that a member of the U.S. president’s family wears your line. In addition to having
great sway over teams of photographers, “First Families” seem to have great power to
induce consumer demand. From Jackie Kennedy’s simple suits, sleeveless A-line
dresses, and pillbox hats to Malia and Sasha Obama’s cute J. Crew inaugural dresses,
inquiring minds want to know where these clothes or similar knock-offs can be pur¬
chased. Getting the word out can increase demand.

10 Galbraith did his undergraduate studies at the University of Guelph, which is where Eveline Adomait
works.
11 The U.S. market for anti-aging products was approximately $20 billion in 2008.
82 Cocktail Party Economics

Advertisers also seemingly create demand where none existed before. Theologians
call this ex nihilo, or “out of nothing.” It turns out that human demand is rooted in some¬
thing—desires and wants—that marketing departments are trying to attach a product to.
For instance, love and fidelity has a stone. It’s called a diamond,12 and we all know it’s
“forever.” Why is that? Couldn’t love just as easily be symbolized by a hunk of quartz?
In the minds of most women, you can almost hear, “You’ve got to be kidding. Those
days are over!” The marketing brilliance of the “diamond is forever” advertising cam¬
paign forever changed how young men propose to their prospective fiancees. Unfortu¬
nately for the men, a cubic zirconium simply will not do.

2. Consumer Income
A large income is the best recipe for happiness I ever heard of.

Jane Austen (1775-1817), English novelist

Taken from Mansfield Park (1814)

Everyone loves getting a raise. I once had my salary almost double overnight and I can’t
describe to you the euphoria I felt at the time. I know money isn’t everything, but it sure is
something. The reality is that most people do buy more stuff when their income increases.
In my case, I no longer thought twice about the cost of a caffe latte. Economists call items
that respond positively to an increase in income normal goods. Being normal sounds like a
good thing. However, when you are in the middle of a recession, it’s not that great to be
“normal,” as the auto manufacturers discovered. We would classify most cars, including
SUVs, minivans, and luxury cars, as normal goods. When income is up, demand is up.
However, the reverse is also true. When income goes down, demand goes down as well.
The most recent global recession caused the demand for cars to go down in most parts of
the world because normal goods simply go with the income flow.
We cannot classify all products as normal goods, however. Products like canned
meat, macaroni and cheese, and rice and beans all do well when incomes fall because
they are “belly-fillers.” But these foods don’t sell as well when incomes rise. Economists
call these products inferior goods. (As you can tell, this term predates the era of political
correctness.) You might be interested to know that in Birmingham, Alabama,13 the ballet,
the symphony, and the opera all experienced increased attendance during the 2008-2009
recession. I will let you make your own conclusions about how “normal” opera is!
Lastly, some products seem immune to income swings. We consider these kinds of
products as necessities or the kinds of products you would buy only in limited quantities.
These include such items as insulin, table salt, toilet paper, and cookies. I don’t know
too many diabetics who would go on an insulin spending spree after winning the lottery.
Insulin purchases relate to a person’s state of health rather than to his or her income
level. Another example is ordinary table salt. I can assure you that the last time my
income increased, I didn’t go out and purchase copious amounts of salt. (Although,
come to think of it... margaritas, anyone?)

In 2000, Advertising Age named “A Diamond Is Forever” as the best advertising slogan of the twentieth
century. “A Diamond Is Forever”: How Four Words Changed an Industry. Voanews.com. March 22, 2007.
13 From the summer of 2008 to the summer of 2009, Alabama Ballet attendance grew 26 percent, while
Opera Birmingham gained 21 percent and Alabama Symphony gained 13 percent.
 Chapter 7: Demanding Clients 83

3. Prices of Related Products

/ sometimes wonder whether all pleasures are not substitutes for joy.
C.S. Lewis (1898-1963), British scholar and novelist
Taken from Surprised by Joy (1955)

A price change for one good can influence the demand for another. For example, when oil
prices rise, drivers begin to search for more fuel-efficient vehicles. This means that oil
prices directly increase small car sales and decrease the demand for gas guzzlers. Also,
most North Americans borrow money to purchase or lease a vehicle. This means that the
availability of credit also directly relates to the demand for cars, no matter what type. For
reasons too complicated to outline in this book, Japanese car manufacturers enjoyed a
comparative advantage in the small car market and focused production on them. In con¬
trast, American car companies produced gas-guzzling SUVs and consequently took a sub¬
stantial hit14 when oil prices spiked above $100 a barrel. All car companies, however,
experienced the collateral damage inflicted on the auto sector during the credit crunch.
Both oil and credit are examples of products that go together with gas-guzzling cars and, to
a lesser degree, fuel-efficient cars. They are called complements in consumption.
You can buy many products separately, but most people can easily see the pairings:
hot dogs and buns, shampoo and conditioner (I always finish shampoo before the condi¬
tioner, which is annoying), peanut butter and jam. If the price of a complement goes up,
the quantity that consumers buy of its paired product falls even though that product’s
price hasn’t changed. Voila—a shift in the demand curve to the left on the graph.
Products also exist as substitutes for each other. Think about brands. If, for instance,
one brand of toothpaste goes on sale and is available in a bin at the end of the aisle at a
drugstore or grocery store, I guarantee that eventually you will find many tubes of the
competing brands mixed in that bin as well, and someone’s going to have to put them
back in their rightful place.
Here’s what happens: Customers walk through the aisles of their local store and pick
up a higher-priced tube off the shelf because it’s on their shopping list. However, as they
get to the end of the aisle, they notice a bin with some other brand of toothpaste on sale.
If they have no particular brand loyalty, they pick up the cheaper tube and leave the
higher-priced one in the bin instead of returning it to where it belongs. Annoying, I
know, especially if you take the wrong tube out of the bin only to find out it is not the
brand on sale at checkout! To many people, the opportunity cost in terms of time to
return the unwanted tube to its rightful place just isn’t worth it. In the end, you have a
bunch of competitors’ products mixed together in the sale bin. This must irritate the
store managers to no end. Now they have to restock the toothpaste. (Just so you know, I
always make my kids return the higher-priced product to its rightful spot. 1 am not
overly concerned about the opportunity cost of their time. However, I wish I was as suc¬
cessful at making them floss more regularly! That is a battle 1 don’t always win.)
Consequently, if a company has a product priced slightly higher than its competitors,
it must do everything in its power to demonstrate that its product is different in some
meaningful way from the others on the shelves. It must be “new and improved” or have
“magic crystals” with divine power to give you that “angelic smile” you need to impress

14
The Economist. (2009, January 17). The big chill.
84 Cocktail Party Economics

that special someone. It must set itself apart from the crowd because, if the consumer
perceives that all products of a certain type have identical value, the low price wins. This
means that as the price of a substitute goes down and customers decide to buy the
cheaper product, the demand for all competing product lines takes a hit and goes down.
There also exists a particular type of substitute that, at first glance, doesn’t really feel
like a substitute to most people. It is the exact same product made by the same manufac¬
turer but at a different point in time. I know this is kind of a Back to the Future idea, but
a company can compete with itself. What? For instance, if you are a consumer in the
market for a car and you know that a car will have a $4000 factory rebate starting next
month, you will probably wait out the month and buy it later. The car today is a substi¬
tute for the same car one month from now. Today’s market and next month’s market15
for the same car are actually different markets but very close substitutes. This means that
when consumers expect prices to fall, they often defer their purchases. By the same
token, if buyers expect prices to go up, they generally feel a sense of urgency to buy
now. Businesses know this and don’t want people to put off their purchases if they can
help it. Therefore, businesses might mitigate customer concerns about future price drops
by offering time-limited price guarantees. It could be something like “We will refund the
difference if the price falls in the next 30 days.” This guarantee helps to make a sale.
Furthermore, stores know that the time cost to get the refund is often more than the price
saving, and therefore many people can’t be bothered to return to the store. Personally, I
can never find the receipt to get the better price, even if I wanted to.

4. The Number of Buyers in the Market

Just because your friend decides to jump off a cliff doesn 7 mean you have to.

Margo Van Sligtenhorst (1939-), Eveline Adomaif s mother

Simply put, if the number of buyers in a particular market goes up, the demand goes up
as well. This might seem obvious but it’s an important factor to consider when talking
about demand. For example, baby boomers have made a huge impact on markets16 in
Canada and the United States, and they will continue to do so until they are gone. (Alas,
I am one of these baby boomers.) For instance, as the first wave of baby boomers
reaches retirement age,17 economists expect the demand for health care services to
increase. For some industries this will represent a huge opportunity, but for others it will
be a challenge. Here’s a hot tip for you: Many of these baby boomers will give up
bungee jumping, so if you happen to own a bungee jumping company you might want to
target the Echo generation in your advertising.
Sometimes, the number of buyers in one market can change due to circumstances or
policies directed at other markets. For example, to deal with labour shortages over the

15 Markets are always for a specific period of time, for example, the market for apples in a particular fall
season.
16 See Boom, Bust & Echo by David Foot.
17 For a more fulsome analysis of the Canadian context, see the work of Professor Chris Regan in “Two
Policy Implications Driven by Population Aging,” Policy Options, October 2010, pages 72-79. He features
a startling graph that shows that folks in their eighties spend four times more on health care than do those
in their sixties.
 Chapter 7: Demanding Clients 85

years, both the Canadian and the U.S. governments have turned to immigration as a
solution. New blood in the form of immigrants can radically change demand patterns for
various products. For example, immigrants to North America from Northern Europe have
generally been milk drinkers. In contrast, immigrants from Asia and Spanish-speaking
countries have not been milk drinkers. As immigration from non-milk-drinking countries
increased, the demand for milk turned sour. Furthermore, teenagers drink soft drinks and
energy drinks rather than milk while on the go. Dairy producers would have been in real
trouble if it weren’t for two things that increased demand again: universal love for cheese
and the celebrity-stacked “Got Milk?” advertising campaign.18 Both of these factors made
the low dairy-product consumers into higher dairy-product consumers, shifting demand
to the right on the graph. Today, the fortunes of dairy farmers are looking up. Milk
consumption is now a middle-class status symbol in emerging economies, which is driving
up demand in countries such as China, India, and those in Latin America. Milk should
continue to be like liquid gold as long as the melamine19 stays out of it.

MEETING OF THE LINES

The meeting of two personalities is like the contact of two chemical substances; if there is any
reaction, both are transformed.

Carl Gustav Jung (1895-1961), Swiss psychiatrist and psychologist

You may not have “got milk,” but you do have the basic skills to put supply and demand
together. Like golf—or marriage, for that matter—your technique will improve if you
practise. Just remember that supply is represented by a curve that slopes upward and
demand is represented by a curve that slopes downward. The next chapter will explore
the meeting of sellers and buyers in markets. The game should be fun. Oh, by the way,
good job on finishing the second Venti chapter!

18 “Got Milk?” is a campaign designed by the

advertising agency Goodby, Silverstein &
Partners for the California Milk Processor
Board in 1993.
19 Sanlu, the Chinese state-owned company, knew
that its milk powder was contaminated with
melamine, a chemical that causes kidney stones
in young children. Babies who had ingested
Sanlu’s milk powder became ill with kidney
problems in early 2007.
 CHAPTER 8

Market Forces: A Beautiful Kind

(Venti with an Extra Shot)
Order is not pressure which is imposed on society from without, but an equilibrium which is
set up from within.
Jose Ortega y Gasset (1883-1955), Spanish philosopher

From centre stage, a female singer croons “Crazy." The thought, She’s no Patsy Cline
but she’s not bad, flits through your mind. At that same moment, the double doors burst
open, pushed by a group of rowdy college guys, shattering the melancholy mood. It’s
obvious that they're out for a night on the town. Each of them grabs a chair at the beat-up
table near you, and they motion for the server to come to them. A beautiful young wait¬
ress makes her way over. After the requisite flirting and beer and food orders, she leaves
the table and walks toward the kitchen. Their eyes track her steps. Once out of sight, the
young men turn to survey the room. Their collective gaze lands on a group of 20-year-old
women in the corner... who covertly return the favour.
You think, This should be interesting. Ludi incipiant1!
Holding court at a corner table is a beautiful blonde with four brunette girlfriends.
It's obvious from the conversation you can overhear that the young men are all
attracted to the blonde and each would like to get her attention.
You think, / hope they have watched the movie A Beautiful Mind2 because they
look as if they are about to make a fatal error by giving all of their attention to the
same girl. One of the young men mentions this fact, but he doesn’t seem to be taken
seriously.
Who knows how this game will eventually play itself out?

LOVE AT FIRST SIGHT

I had become interested in economics, an interest that was transformed into a lifetime dedica¬
tion when I met with the mathematical theory of general economic equilibrium founded by
Leon Walras...

Gerard Debreu (1921-2004), French mathematician and economist

Taken from Debreu’s autobiography on the Nobel Prize website

1 Latin for “Let the games begin.”

This example is not meant to be stereotypically sexist. Rather, it mirrors a pivotal scene found in the movie
A Beautiful Mind. This movie features the life of the mathematician and economist John Forbes Nash, Jr.
(1928- ), who developed what is called the Nash equilibrium (NE). The NE states that a position is stable
if there is no incentive to change one’s strategy given that a player knows what everyone one else is doing.
In the movie, the behaviour with respect to the blonde is not actually an NE. If one of the young men
knows that all of his friends are going for the brunettes, then he should go for the blonde if she is really the
prize. Therefore, everyone going for the brunettes is not an NE. It just goes to show that film producers
never let a few facts get in the way of a good story. Nash received the Nobel Prize in Economics for this
idea.

86
 Chapter 8: Market Forces: A Beautiful Kind 87

I know for many of you this is hard to believe, but some people actually love mathemat¬
ics. 1 mean, really love it. They see the elegance of the language and can wax eloquent
about it for hours. 1 work among these math-aholics in addition to being married to one.
(Martin’s other love—other than me—is chemistry. He routinely buys books with such
riveting words as volatile organic compounds' in the titles, whereas my purchases are
along the lines of Men Are from Mars, Women Are from Venus.*) At a recent department
Christmas party, I found myself headed toward Martin and two colleagues engaged in an
animated conversation. When I discovered that they were discussing the finer points of
eigenvalues,3 4 5 I veered toward the buffet table instead. While it is true that I avoided dis¬
cussing mathematics that evening, it is virtually impossible to teach (or learn, for that
matter) economics without using some math tools. This chapter will use the simplest of
diagrams to show the mathematical concept of equilibrium. You will be happy to know
that we will leave matrix algebra for another type of economics book!

SIMULTANEOUS EQUATIONS
I’m very well acquainted too with matters mathematical,
I understand equations, both the simple and quadratical.
About binomial theorem I'm teeming with a lot of news—
With many cheerful facts about the square of the hypotenuse.
Sir William Schwenck Gilbert (1836-1911), English librettist, and Sir Arthur Seymour
Sullivan (1842-1900), English composer
Taken from The Pirates of Penzance (1879)

We captured the concepts of supply and demand in the last two chapters by visually
representing them as two lines on a graph. Economists use the supply and demand
framework to illustrate and make sense of how buyers and sellers play in the market.
(Hopefully, they play nicely together.)
We saw in the demand chapter that price must fall to motivate additional purchases
of an item. This is due to the fact that people drop the marginal value they place on
something with each successive item available. In other words, the price people are will¬
ing to pay for something is dependent on how much is available. If we don’t know how
much of the product is available in the market, then we have no idea what consumers
will pay (or what their marginal value is) and the whole demand curve is fair game.
On the supply side, we saw that as the quantity produced increases, the price the
companies in a particular industry need to charge goes up as well. It must go up because
the opportunity costs for the new entrants in the market are higher than the costs of the
firms currently in production. Again, the price the industry as a whole needs to charge is
uncertain until we know how much is needed and how many companies are active in the
market.
This chapter takes the next step and nails down the price that will be charged and the
final quantity that will be bought and sold in any particular market. All points on the

3 As it ages, all paper emits a complex mixture of organic compounds. This contributes to the familiar “smell
of old books.”
4 Written by John Gray and published in 1992.
5 Eigenvalues are often introduced in the context of linear algebra or matrix theory.
88 Cocktail Party Economics

supply and demand curves are reduced to a single actuality in the marketplace when
these curves get together. You might be thinking, How can markets be about curves
getting together? Well, these curves, in a rather simple way, represent rational behaviour
on the part of both companies and their customers. 1 know some people aren’t too
rational around curves, but rationality6 seems to be a fairly good assumption to make
about how people behave in markets.
How are the possible prices and quantities located on the individual supply and
demand curves narrowed down to one actual price and one quantity? Take a look at
Figure 8.1 and you will see that, mathematically, at some point these curves cross each
other, and not in a Catholic sort of way.

FIGURE 8.1 Market equilibrium

o Observed
03

price

Observed quantity in the time period

This crossing point is called the equilibrium intersection. This means that one and
only one price-quantity combination simultaneously satisfies both the buyer’s curve and
the seller’s curve. (For all of you married folks, simultaneous satisfaction matters only in
supply and demand interactions.) As long as the supplier’s production possibilities over¬
lap with the buyer’s preferences, real exchange is possible and it can generate real num¬
bers—actual figures that you have probably heard on business news networks or read in
the financial section of the paper. This is no longer hypothetical supply and demand but
real quantities supplied and real quantities demanded.
We will see in the next section that both sides of this market naturally gravitate to
this equilibrium point. It is truly amazing that the amount that consumers want to buy is
exactly the amount that producers make and there is no economic disagreement about
the price. Sure, people on both sides of the transaction can complain about prices, but if
they voluntarily exchange cash for the goods, then they are (as far as the economist is

6 Nobel Prize-winning economist Herbert Simon (1916-2001), in his book Models of Man, points out that
most people are partly rational and partly irrational. This concept is known as bounded rationality. This
irrationality can be due to the fact that individuals have limited information, limited time, and limited
ability to make complex decisions. Most economists believe that, on average, rational models are predic¬
tive of reality. Others—behavioural economists, in particular—worry about the “bounded” part and make
modifications to their models to incorporate this fact.
 Chapter 8: Market Forces: A Beautiful Kind 89

concerned, complaints or no complaints) agreeing with the prices. Adam Smith called
this “the work of the invisible hand.”
Observers of markets see only the equilibrium results—the final price and the vol¬
ume of reported sales—and never get to see the underlying supply and demand curves.
You can’t go to consumers and companies and say, “Show me your curves.” That
information remains behind closed doors, deep in the psyches of consumers and the
thinking of profit-minded owners and managers. Fortunately, knowing how the underly¬
ing model works means we don’t need to mess with their minds to make sense of what is
going on behind the scenes. Furthermore, if anything changes in their particular world,
we can be armed and ready to make market predictions.

Getting Closer to Equilibrium

The faults of husbands are often caused by the excess virtues of their wives.

Sidonie-Gabrielle Colette (1873-1954), French novelist

In order to see why markets are driven to one magical price and quantity combination,
let’s first look at what happens when prices are above or below the equilibrium price. If
the price isn’t right, what forces the market into equilibrium and to a specific price and
quantity combination that is stable?
To illustrate the concept of equilibrium, let’s continue with our car7 analogy from
Chapter 6, only we will extend the analysis to all passenger vehicles, including light
trucks. Figure 8.2 shows the starting point of vehicle prices that are too high. American
consumers will not buy very many—only 9.8 million passenger vehicles. (I know this
doesn’t seem low, but for auto sales in the United States, it is.) On the other hand, at this
price auto manufacturers would love to sell a lot of vehicles. They produce the large

FIGURE 8.2 Market pressures if vehicle prices are too high

7 While the figures used in these examples are realistic for both the American and Canadian car markets, the
use of them is not. Check out the report published by Scotiabank Group for the real story. It can be found at
www.scotiacapital.com/English/bns_econ/bns_auto.pdf
 90 Cocktail Party Economics

amount of 14.1 million units. Hopefully, you can see that this is a problem. Auto manu¬
facturers will actually make more vehicles than consumers want to buy. This is an
expensive mistake. These car companies now find themselves in a situation of excess
supply (the difference between 14.1 million and 9.8 million, which is 4.3 million vehi¬
cles), resulting in numerous car lots containing unsold stock.
Once management realizes what is happening, it usually calls an emergency meeting
of its high-level executives and quickly changes the company’s plans. The company
doesn’t want to have excess inventory piling up. (In fact, many car companies have
just-in-time8 delivery to prevent big inventories of the parts used to make the vehicles as
well.) Unwanted inventories decrease the value of a company’s bottom line.9 Most
likely, the company will make the reasonable move to put its vehicles on sale and cut
further production. This action decreases the price and ultimately—due to the production
cuts—decreases the quantity available. In other words, the car manufacturer moves
downward along its supply curve toward the crossing point. Prices will be lower than the
original sticker price and the quantity of cars produced is no longer the overly optimistic
14.1 million vehicles.
As prices fall, consumers who previously didn’t want a car at the higher price now
decide to buy at the lower “on sale, factory rebate, employee discount” price. Similar to
our chocolate analogy, the vehicle becomes more “worth it” and the consumer moves
along the demand curve to the crossing point. Prices are lower than the original price,
but the quantity of passenger vehicles bought is higher than 9.8 million units. Eventu¬
ally, the quantity that consumers want to buy equals the quantity that dealers want to
sell, and the price stops dropping. Buyers and sellers meet at the intersection of supply
and demand. In other words, the market is in equilibrium with a price lower than the
original price of $29 000, and the number of cars bought and sold is somewhere between
9.8 million and 14.1 million units, the original quantity positions of the buyers and
sellers, respectively.
Notice that the behaviour of the buyers and sellers is represented by the movements
along their specific lines with a starting point and an ending point. Just connect the
dots and, voila, we have supply and demand curves for all to see. You are a forensic
economist!
If prices get too low, we find a similar situation. In Figure 8.3, Canadian consumers10
can’t believe how cheap cars are. As a group, they want to buy a lot of cars (1.51 million
vehicles) at $24 000 per car. On the car manufacturers’ side, only companies with very
low opportunity costs can produce at this price point and still make a profit. They make
only 1.45 million vehicles. This is a situation of excess demand—the difference between
1.51 million and 1.45 million, or 60 000 vehicles. Now we find barren car lots with

This technique was first used by the Ford Motor Company. This statement also describes the concept of
“dock to factory floor,” in which incoming materials are not even stored or warehoused before going into
production. The concept requires an effective freight management system (FMS), which Henry Ford
describes in Today and Tomorrow (1926).
The bottom line is the last line on an income statement. Income statements start with revenues and then
subtract expenses. The difference is accounting profit. As we saw in Chapter 4, economic profits are even
less, because some profits are needed to be in the business and are therefore a cost as far as economists are
concerned. For example, if an entrepreneur gave up a job with an income of $40 000 per year to run a busi¬
ness, then accounting profits of $30 000 are really an economic loss of $10 000.
10
Canadian markets are usually one-tenth the U.S. markets. Passenger vehicles follow this trend.
 Chapter 8: Market Forces: A Beautiful Kind 91

lineups, waiting lists, rain checks, or whatever method best keeps track of unsatisfied
customers. Whoever comes to a dealership after car number 1.45 million is sold will not
be able buy one. Existing auto companies (or new ones waiting in the wings) realize that
this is a profitable business opportunity and take the plunge to produce more vehicles,
even if it costs more to do so. Thus, the quantity produced increases, but because of
higher costs so do the price tags. The car industry moves along the supply curve toward
the crossing point. The price rises above the original price of $24 000, and the quantity
produced exceeds 1.45 million units.

FIGURE 8.3 Market pressures if vehicle prices are too low

Consumers, however, now must pay more for vehicles, which causes some to decide
not to purchase. People want to buy less because of the higher price. Therefore, consum¬
ers move along the demand curve toward the crossing point. As the disequilibrium dis¬
appears, prices rise higher than the original price, and the overall quantity that all con¬
sumers want to buy—although some were unable to buy—is lower than 1.51 million
vehicles. Once we reach the crossing point, the market is in equilibrium. Therefore, if a
market has an excess demand for cars, we can predict that car prices will be higher than
the original price, and the actual number of vehicles bought and sold will be somewhere
between 1.45 million and 1.51 million units after adjustments.

What Drives Equilibrium?

Drive thy business or it will drive thee.
Benjamin Franklin (1706-1790), American politician and polymath

When I told the story of reaching equilibrium in the car market, I hope you got the subtle
message that, in either case, it is the car company who reacts to the consumer and solves
the disequilibrium problem. These manufacturers, motivated by profits, change their
production levels to strategically eliminate any excess supply or demand. (Of course, as
a result of the manufacturer’s responsive behaviour, the price that consumers must
actually pay for the car changes as well.) We know that markets are in equilibrium when
 92 Cocktail Party Economics

the quantity desired by buyers equals the quantity sellers want to sell. This matching of
quantities happens at a common price point.
Profits are the force that drives markets and brings them into equilibrium. When
organizations that produce things don’t care about profits, such as with the communist
central planning system under the former USSR, then it’s quite possible to have a ware¬
house full of rotting vegetables that no one does anything about. Furthermore, without
profits guiding production decisions, we can experience grocery stores with perpetual line¬
ups, which can become a way of life. In a market economy, profit-minded entrepreneurs
remove these excesses as soon as possible. Ultimately, consumers get what they want, but
the motivation comes from the desire by business people to make the largest profits they
can possibly make. If you have ever met a real go-getter entrepreneur, you would know
what I mean when I say that excess demand situations excite them like no other.
Sometimes, excesses can occur, but due to these market forces they are usually
short-lived. For example, during Christmas of 2007, the Nintendo Wii was in short
supply. This market was clearly in some sort of disequilibrium. I know this because I
searched everywhere to buy one for my younger son as a Christmas present. To actually
get one, I had to know someone who knew someone else who happened to be in the
store when a shipment came in. Stores weren’t putting people on waiting lists, so Wii
consoles were allocated to the lucky. This situation was very annoying. At the time, a
rumour floated around that Nintendo had orchestrated this situation in order to drive up
demand, but I don’t buy it (actually, I did buy the Wii, just not the conspiracy theory).
This miscalculation of demand cost Nintendo profits during the Christmas rush. My
guess is that Nintendo was having production problems that prevented it from meeting
the unexpected worldwide demand for this ingenious product.11 As of 2008, production
had increased enough such that the Wii was no longer difficult to buy, and it remained
the top-selling console in the world for some time.

Gossip Column

The biggest influence in Leon Walras's (1834-1910) life was his dad. His father, a
French economist, made his living as a school administrator because economics was
not highly regarded as a separate profession in the French educational system. To
please his parents, Walras applied to the £cole Polytechnique in Paris but failed the
entrance exam twice due to his math skills. He then enrolled in a mining engineering
school in Paris but didn’t like it and spent his time having a really good time (some
would say with a bohemian lifestyle) writing novels and critiquing art. His father
convinced him to give this up to pursue economics, but because Walras did not have
formal economics training (he was taught by his father or self-taught), he could not get
a job as an academic.
Some of his father's socialist values and ideology must have sunk in because
Walras then formed a cooperative bank with his friend Leon Say. In their opinion, the

II
According to NPD Group, the Wii sold more units in the United States in the first half of 2007 than the
Xbox 360 and PlayStation 3 combined.
 Chapter 8: Market Forces: A Beautiful Kind 93

cooperative movement seemed preferable to revolution. They also published a journal

espousing similar ideas to Walras’s father about nationalizing land and tax policies.
Unfortunately, approximately two years after inception, both the cooperative and the
journal failed, but fortunately, Walras was offered the position of chair of political
economy at the Academy of Lausanne in Switzerland. It was there that he combined
his economic ideas with rigorous mathematics (whatever deficiencies he’d had earlier
were eliminated) and wrote Elements of Pure Economics. This book took economics
to new mathematic levels and he, along with William “Stanley” Jevons (1835-1882)
and Carl Menger (1840-1921), are called the authors of the marginal revolution. Fur¬
thermore, Walras is often considered the father of general equilibrium theory, which
was a new mathematical approach to establishing equilibriums in all markets at once.
It appears that he is the founding father of much of modern mathematical economics.
Realizing that real-life markets might not solve themselves with nifty mathematical
models, Walras developed a way for markets to clear called tatonnement, which is
French for “groping toward." Sounds interesting, but it’s not what you think. Buyers
and sellers call out prices and quantities. Most combinations lead to excesses, but the
market will grope its way to equilibrium by decreasing subsequent excesses.12
At one point, Walras thought he was worthy of the Nobel Peace Prize (1906) and
wrote his own nomination, which friends submitted. He felt his work in mathematical
economics, which scientifically supported free trade, would lead to world peace if
adopted. Unfortunately for Walras, Teddy Roosevelt won that year.
Walras wrote all of his works in French, and he was not recognized as an eminent
economist until after his death, when William Jaffe (1898-1980) translated and
published his works into English in 1954. This lack of academic recognition was very
disappointing to Walras and he spent the last decade of his life frustrated, bitter, and
sliding into senility and mental illness. It’s too bad he never knew how famous his
ideas would be among economists. Furthermore, he inspired great economists—
specifically, John Hicks, Kenneth Arrow (new to us but important because he shared
the Nobel Prize with Hicks), Gerard Debreu (who, along with Arrow, developed the
modern-day general equilibrium theory), Piero Sraffa, and Wassily Leontief—to extend
his ideas and make them usable. Sometimes fathers do not know they have children.

Curves Ahead
When producers want to know what the public wants, they graph it as curves. When they want
to tell the public what to get, they say it in curves.

Herbert Marshall McLuhan (1911-1980), Canadian professor and media theorist

Taken from Off-the-Wall Marketing Ideas'*

12 Walras’ Law states that when we are looking at the economy as a whole, all excesses over all markets sum
to zero. Therefore, if one market goes into disequilibrium, it will force other markets—through spillovers
and market linkages—to go into disequilibrium as well. This keeps the sum of the excesses equal to
zero. Economists assume that if a particular market goes into disequilibrium, the individual players in that
market react to remove it, thus all markets are also in equilibrium. Walras’s general equilibrium theory is
about both the sum of all markets and individual markets in equilibrium.
15 Off-the-Wall Marketing Ideas: Jumpstart Your Sales without Busting Your Budget, by Nancy Michaels and
Debbi J. Karpowicz.
94 Cocktail Party Economics

When the market forces have done their work, disequilibrium (the state where the quantity
demanded doesn’t match the quantity supplied) gives way to equilibrium (the state where
quantity demanded and supplied now match perfectly). The best way to find out whether
markets are in equilibrium is to check inventory numbers. If the numbers are too high, the
market has an excess supply; if they are too low, the market has an excess demand.
Once a market is in equilibrium, it can theoretically stay at this particular price and
quantity combination forever, provided nothing causes either the supply curve or the
demand curve to shift. But what are the odds of living in a world where nothing affects
either the consumer or those who produce the goods? Basically, zero. Therefore, when a
change occurs, we should to be able to predict what will happen in any particular mar¬
ket. We want to mind our Ps and Qs, or prices and quantities. What is the point of an
economic framework if it can’t predict anything useful when change happens?

SHIFTS HAPPEN
The network economy is founded on technology, but can only be built on relationships. It
starts with chips and ends with trust.

Kevin Kelly (1952- ), American editor and publisher

Taken from New Rules for the New Economy: 10 Radical Strategies for a Connected World
(1999)

In the previous two chapters, we analyzed the supply curve and the demand curve sepa¬
rately. Specifically, we looked at the various stories that would shift supply and demand
curves either to the right or to the left. Here is a quick review. A change in underlying
production costs is represented by a shift in the supply curve. These include changes in
productivity, input costs, or technology, which all impact the quantity businesses wish to
produce at a particular price level. On the other hand, demand shifts represent changes in
the consumer’s experience. Changes in preferences, income, and expectations about
future prices all change what people are willing to pay today and therefore can be illus¬
trated by a shift in demand.
This chapter takes the next step to help you understand that these curves are not isolated
from each other. If car buyers now prefer flashy cars, then car manufactures “experience” the
increase in demand for flashy cars through market disequilibrium and will fix the problem. If
steel costs suddenly rise, car manufacturers change the price of a vehicle and consumers
“feel" the bad news and change how much they buy. In other words, we can represent these
stories as one curve shifting and the other curve experiencing something moving along it.
The supply and demand framework is very valuable in forecasting price and sales volume
should something affect either the consumer or the producer of a product. Many real-world
economic stories can be analyzed in this theoretical way.

Telling Stories That Make Sense

There are one-story intellects, two-story intellects, and three-story intellects with skylights. All
fact collectors with no aim beyond their facts are one-story men. Two-story men compare rea¬
son and generalize, using labors of the fact collectors as well as their own. Three-story men
idealize, imagine, and predict. Their best illuminations come from above through the skylight.

Oliver Wendell Holmes (1809-1894), American author and physician

 Chapter 8: Market Forces: A Beautiful Kind 95

Basically, there are only four stories that can happen if one curve shifts about. These
stories have completely predictable consequences with respect to the ultimate price
charged and the numbers of goods sold. We can picture them in the following four
graphs. Let’s keep it simple, shall we? Think of these as cheat sheets that we will use in
the next section when we discuss ticket prices. You might want to keep your finger on
this page as we proceed with the next section.

Q Q

Q Q
A. When demand increases, quantity supplied rises; quantity is up and prices are up.
B. When demand decreases, quantity supplied falls; quantity is down and prices are down.
C. When supply increases, quantity demanded rises; quantity Is up and prices are down.
D. When supply decreases, quantity demanded falls; quantity is down and prices are up.

Now you can chat about economics like a pro at a social gathering. Maybe you should
draw these graphs on a cocktail napkin and take them with you to your next party. Once
you know the initial trigger for change, you can sort out which player’s curve must shift
and in what direction. Then you can confidently make your prediction on what will happen
to prices and sales volumes in that particular market. Conversely, if you know what
happened to price and quantity, then you know which shifting curve did the deed and
which one got moved along. Once you know which curve shifted, you can look at the list
of possible reasons for the shift and find the culprit. It is elementary, my dear Watson.

Irresistible Force
It was a marriage of love. He was sufficiently spoiled to be charming; she was ingenuous
enough to be irresistible.

Francis Scott Key Fitzgerald (1896 -1940), American author

Taken from Tales of the Jazz Age (1922)
96 Cocktail Party Economics

Suppose that we hear a story that the demand for some show in a big venue has gone up.
It could be tickets to a sports team that miraculously starts to win games after a losing
streak, or to some famous musician on a new concert tour. What can we predict will
happen if nothing occurs to shift the supply of tickets at the same time as this increase in
demand happens? To see what will happen, let’s look at the state of the market before
demand went up. In Figure 8.4, we see that if the ticket company gets it right, then all of
the seats will be sold at the listed price. There’s nothing ugly about this “before” picture.
Now, let’s see what happens when the new increased demand for those seats occurs.

FIGURE 8.4 The “before” market for tickets

CD
O

CD
Q.
CD
Listed
O
ticket price

Tickets per concert

For starters, at current prices the demand is now higher and, for the particular price
printed on the ticket, a company selling tickets for this venue will sell out of its stock in
a matter of minutes. The market has an excess demand for tickets at that price point.
Profit-minded individuals will try to correct this excess demand and some of the previ¬
ously bought tickets will be resold for the true higher price in some other ticket resale
market. Figure 8.5 illustrates this situation.
While a few consumers react to the higher price by angrily opting out of the market and
complaining to their politicians, many customers are happy to buy a seat even at the elevated
price. They would much rather get a ticket at a higher price than get nothing at all. This ex¬
plains why people willingly pay scalpers more than the price printed on a ticket. Overall, if
there is a fixed number of seats to be sold, an increase in demand will cause ticket prices to
rise. Therefore, if you read a news story stating that an event now has higher ticket prices and
that the performance has been sold out, you know that it must have been due to an increase in
demand. You’ve solved the case! And another thing, just so you know, in the opinion of
many economists the ticket resale market or the act of scalping shouldn’t be a crime. It’s just
one more way in which the market corrects the initial disequilibrium problem.
 Chapter 8: Market Forces: A Beautiful Kind 97

FIGURE 8.5 Resale or “scalping” of tickets

Quantity of tickets per event

In contrast, suppose that the demand curve is the stable factor and supply shifts to the
right. We get a different outcome, as illustrated in Figure 8.6. Recall that the usual
reason the supply curve shifts to the right is because of a decrease in the cost of doing
business. Suppose that the costs to put on a show fall because the rent for large venues is
down—maybe due to real estate woes or to the building of another venue. As a result,
the producers of these big shows decide to put on more shows and lower the price in
hopes of expanding market share. After all, with lower rental costs, profit margins are
now bigger. When the entertainment industry reacts to the lower rental costs by increas¬
ing the number of shows it wants to put on, the quantity of tickets available increases
and the price per ticket falls. In essence, the decision to increase the number of available
tickets shifts the supply curve to the right, which forces them to move along the existing
demand curve for this particular live performance. More tickets on the market mean that
many consumers value these tickets less. The only way that producers can actually sell
these new tickets is to lower the price. In other words, an increase in supply leads to an
increase in the quantity of tickets demanded. We know the story ends with ticket sales
up and ticket prices down. Usually, no one complains about this situation to his or her
legislators.

Home Inspection
An architect's most useful tools are an eraser at the drafting board, and a wrecking bar at the
site.
Frank Lloyd Wright (1867-1959), American architect, interior designer, writer, and educator
98 Cocktail Party Economics

FIGURE 8.6 Increase in supply of tickets

Supply 1 Supply 2
one show two shows

Quantity of tickets per tour

Most business articles give you a lot of facts and figures. The framework I have just used
can help to explain how those figures come about. For example, in an article published
in January 2009, the BBC reported that U.S. housing prices were down 15.3 percent in
December 2008 when compared with prices in December 2007. Furthermore, the
number of houses sold in 2008 was down 13.1 percent—the worst year in 10 years.
What happened? The only story that predicts why both price and quantity were down is
called a decrease in demand story. Demand must have shifted to the left. The article
went on to explain that the credit crunch in the fall of 2008 made it difficult for borrow¬
ers to get mortgages to pay for new houses. (In Chapter 7 we saw that a change in the
price of a complementary product can change demand. In this case, a mortgage is a
product that is complementary14 to houses because you usually need a mortgage to buy a
house. When mortgage rates rise or mortgages become difficult to qualify for, this
decreases the demand for houses.) Sure enough, this decreased the demand for U.S.
houses in the fall of 2008. The economists quoted in the article were hopeful that
dropping interest rates (the price of a mortgage) would cause demand to rebound.
Of course, predicting market results can get a little trickier if two shifts happen at
once. Have no fear—just add the individual effects together. Suppose that we want to
predict what will happen in the new housing market if interest rates go down at the same
time that large tracts of timber are destroyed due to raging forest fires across North

Recall that if the price or availability of one good changes the demand for another good, these goods are
related to each other. They are either substitutes or complements. In this case, the availability of mortgages
decreased, which decreased the demand for homes bought on credit. Since mortgages and houses are
bought together, these goods are complements.
 Chapter 8: Market Forces: A Beautiful Kind 99

America. Lower interest rates should increase the affordability of building a new home
and increase the demand for new houses. Given that lumber is a major component in
new home construction, the new scarcity of lumber should increase the cost of building
houses and cause the supply of new homes to go down. As shown in Figure 8.7, the
interest rate change increases demand and the scarcity of lumber decreases supply. What
happens to the price and quantity of new home construction?

FIGURE 8.7 The market for new housing construction

Quantity of new homes built per quarter

Using our cheat sheets, let see what happens.

• The increase in demand leads to higher prices and higher quantity.

• The decrease in supply leads to higher prices and lower quantity.

Overall, the price effects are additive, so prices are up but the quantity changes are
moving in opposite directions. Therefore, we cannot predict what will happen to the
number of new housing starts until we know which effect—supply or demand—is bigger.
Hopefully, I have given you a few tools to use when trying to understand business
articles that can sometimes be intimidating or when listening to a business analyst drone
on about what is happening in the stock, currency, car, housing, clothing, or whatever
market they happen to be droning on about. The next time you are ensnared in a convo¬
luted economic discussion, simply pull out pen and paper, cut though the clutter with a
graph, and let the picture do the talking.
100 Cocktail Party Economics

PLAYING GAMES
Economists try to predict outcomes of market interactions by modelling participants in
markets, both buyers and sellers, as if they’re playing a market game15 under the
assumption that each employs reasonable strategies to get what they want. The name of
the game for those who produce the goods is called “How to Maximize Profits.”
Consumers play “Buy Me as Much Happiness as Possible.”16 The next chapter looks at
why these strategies are good for society as a whole and how markets may be the best
way to guarantee the most winners.

\
$s 0w’HerS

c“' 1 of ^ Tice
If supl’ arket P"c

qtK»r,t,I>

15 Many board games are based on economic principles. One such example is the game “Settlers of Catan”
designed by Klaus Teuber. This game requires resource management due to scarcity and trading skills that
give gains from trade. It was first published in 1995 in Germany by Franckh-Kosmos Verlag (Kosmos)
under the name Die Siedler von Catan.
16 Economists would say that consumers want to maximize their utility subject to a budget constraint,
which sounds a bit strange to the general public. The word utility has its roots in the 1800s. According to
utilitarians such as Jeremy Bentham (1748-1832) and John Stuart Mill (1806-1876), society should aim to
maximize the total utility of individuals, aiming for “the greatest happiness for the greatest number.”
Society now uses the word happiness or satisfaction in place of the word utility.
 CHAPTER

The Pursuit of Happiness:

Efficiency and Equity
(A Venti Chapter)
In this work I have attempted to treat economy as a calculus of pleasure and pain.

William Stanley Jevons (1835-1882), English economist

Taken from The Theory of Political Economy, 2nd edition (1879)

The great guacamole dip gets totally ignored in the last few minutes of a very close
game. Everyone sits glued to the TV, holding their beers tightly as they wait for the final
play. Even though this party is held at someone’s home, each person is dressed in team
colours and holds team paraphernalia. They’ve even painted their faces. These folks are
true fans. They stayed with the team during the rebuilding years, rejoiced when strategic
trades were made, and hoped it would all be worth it. The coach makes some mysterious
signals to the quarterback, who nods back his acceptance. The players come out of the
huddle and everyone in this home audience holds their collective breath. Sssswhirlllll.
The ball is in the air and the pass is good. Pandemonium breaks out, and normally
reticent men hug each other, shouting and pounding each other on the back.
Hard-earned victory is sweet.

WE HOLD THESE TRUTHS TO BE ... UNDENIABLE

The truth is we are all caught in a great economic system, which is heartless.

Woodrow T. Wilson (1856-1924), American president

It has come to my attention—repeatedly, in fact—that many individuals think econo¬

mists are not nice people. Somehow, our commitment to the concept of free markets has
marked us as heartless souls who only live for the almighty dollar, euro, or yen. While
I’ll admit that there’s probably the occasional jerk among us (which profession doesn’t
have at least a few?—although, come to mention it, I have never met a kindergarten
teacher who wasn’t a sweetheart), many of us are some of the nicest people you will
ever meet. Really. We raise lovely families, volunteer in our communities, pay our
taxes, and vote anywhere from the socialist left to the conservative right. Our conviction
that self-interest1 can be a good thing doesn’t mean that we are necessarily more selfish
than anyone else. Let me defend my profession and my colleagues2 by explaining why
we think the way we do about free and competitive markets and why that doesn’t neces¬
sarily make us mercenary, capitalist pigs.

' The concept of self-interest comes from a quotation from the father of economics himself, Adam Smith: “It
is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from
their regard to their own interest.”
2 See Inside the Economist's Mind: Conversations with Eminent Economists, edited by Paul Samuelson and
William Barnett (Blackwell Publishing, 2007).

101
 102 Cocktail Party Economics

Be Seriously Happy: Optimizing Utility

1 have arrived at the conviction that the neglect by economists to discuss seriously what is
really the crucial problem of our time is due to a certain timidity about soiling their hands by
going from purely scientific questions into value questions.

Friedrich August von Hayek (1899-1992), Austrian economist and philosopher

Published in A Conversation with Fredrick A. von Hayek: Science and Socialism (1979)

Up to this point, I have explained how markets work—the mechanics of the market, so
to speak. Now I will explain why economists think markets are the way to go. Our
support of free markets all boils down to how we think about cost, benefits, and the
optimal allocation of resources in our society when faced with the scarcity problem. In
truth, cost-benefit analysis gets at the heart of the matter as we look for the answer to the
question, “How can people be as happy as possible given that we live in a world of
scarce resources?”
We start by assuming that the benefit of anything to society comes from the happi¬
ness (or, in economist jargon, utility* * 3) it brings to the individual enjoying it. A cool
drink, a good game of football, or a great novel—all of these give people pleasure.
That’s enough for economists to say that these things have “value.” Moreover, econo¬
mists do not (when speaking as economists) generally make moral judgments about
what makes people happy. As long as a person’s activities don’t spill over onto other
people who have no choice in the matter,4 we treat individual tastes and preferences as
sacrosanct and as our starting point.
Basically, from an economist’s perspective, if you want to read a killer thriller,5 so be
it. Who are we to censor your reading habits? If you want to watch a big-screen TV on
game day, dress in oversized team jerseys, paint your face, and wave giant foam fingers
... whatever turns your crank. However, if your reading or TV habits6 cause you to stalk,
kidnap, or hurt someone, then economists would say you should read less graphic
material or watch less violent TV; your demand for certain types of entertainment has a
negative spillover effect, and society cares—and should care—about what you are
consuming. Chapter 11 will deal with this issue more thoroughly. For now, let’s talk
about markets where the social impact is limited to those who make the decision to
consume or produce in the first place.
Once an economist knows that something will make people happy, we say there is a
legitimate demand for this thing—whatever it is. Economists leave the establishment of

As we saw in the previous chapter, utilitarians such as Jeremy Bentham (1748-1832) and John Stuart Mill
(1806-1876) believed that society should aim to maximize the total utility of individuals, aiming for “the
greatest happiness for the greatest number.” Another theory forwarded by John Rawls (1921-2002) would
have society maximize the utility of the individual receiving the minimum amount of utility.
4 Chapter 11 will look at the cases of positive and negative spillovers in consumption or production. These
are called externalities.
Stephen King has written a great book called On Writing, in which he questions the notion of writing only
about “what you know.” Given his genre of books, writing “what you know” would be a little scary. To be
honest, this is the only book of his I could actually read.
In the Annual Review of Public Health (Vol. 27, pp. 393-415, April 2006), researchers L. Rowell
Huesmann and Laramie D. Taylor found that fictional television and film violence contributes to an
increase in aggression and violence in young viewers in both the short term and the long term. They
consider violent TV, video games, and films to be a public health issue.
 Chapter 9: The Pursuit of Happiness: Efficiency and Equity 103

those tastes and preferences—in other words, what ought to make you happy—to the
theologians,7 moral philosophers,8 and advertisers. This can seem like a bit of a cop-out,
but in our professional lives economists avoid moralizing whenever possible. Our
private lives are, of course, another matter. Once a group of economists has a few drinks,
they can moralize with the best of them.
So, here is a common starting point for economists. Things can make people happy.
Eating is better than starvation. Shelter is better than privation. A winning team is better
than a losing one. But to what degree are these things better? And how do we compare
happiness levels between people? You see, if we could quantify how much value a
particular item has for different people, we could begin to answer the really important
economic question of “If more people want something than is available, who in the
group should get it and who should miss out?”

Pick Me, Pick Me!

Before we set our hearts too much upon anything, let us examine how happy those are who
already possess it.

Francois de La Rochefoucauld (1613-1680), French author

Let’s go back to the “stones story” I used in Chapter 1. Hopefully you remember that I
showed up at a party with 10 stones that I was willing to distribute. Let’s suppose that
20 people want the stones. Who should get them? It’s time to get a little philosophical
here and provide an overarching principle to which we can adhere.
Economists want the stones to go to the individuals who would appreciate or treasure
them the most. I don’t think this is unreasonable. Economists think there is a difference
between a recipient tossing the stone in ajar on the kitchen counter when he or she gets
home and someone wearing it as a necklace near his or her heart. Asking your mother
for advice is different from getting unsolicited advice. Therefore, if we could somehow
measure the happiness experienced by the 20 individuals due to the stones, we believe
that society’s happiness as a whole would be maximized if those individuals who value
the stones most highly got them.
Wait a minute. Haven’t we talked about value somewhere before? Guess what? The
demand curve does that. It ranks items according to the marginal value each item
gives—from high to low marginal values. It is the story of our chocolates in Chapter 7.
The demand curve tells us something about what makes society (a collection of
individuals) happy. We now have a tool to help us answer the first part of the question
that was asked earlier in this chapter: “How can people be as happy as possible given
that we live in a world of scarce resources?”

7 For example, the Reformation theologian John Calvin (1509-1564) wrote, “God wishes his gifts to be
valued by us at their proper worth. The more precious they are, the baser is our ingratitude if they do not
have their proper value for us.”
8 To be fair, Adam Smith was primarily a moral philosopher and then a political economist. Most modem
economists worry about two issues: equity and efficiency. Many might consider these very moral issues.
For a terrific explanation of welfare economics, see Economics as a Moral Science by A.B. Atkinson. 1 am
using morals in terms of individual behaviour rather than overall philosophy.
104 Cocktail Party Economics

Productive Practices
The major incentive to productivity and efficiency are social and moral rather than financial.

Peter Ferdinand Drucker (1909-2005), Austrian-bom writer

Taken from The New Society (1950)

Now, on to the part about scarce resources. Society cares, or should care, about how its
scarce resources are used. We want to use our limited resources wisely and not waste
them on producing the wrong thing. I’ll illustrate this concept with an example. Suppose
that I had 10 jobs that needed doing and 10 workers to do them. Who should get which
job? I think it should make some sense to most people that I interview them to figure out
how well they would be able to do the various jobs I need done. Economists would
never want a neonatal brain surgeon to pick pecks of pickled peppers for a living. That
would be a waste of scarce brain power. This, of course, is a very different philosophy
from the communist system of Mao Zedong,9 who intentionally assigned highly skilled
people to low-skill jobs.
Because the most talented among us can to do many things, this means that if I put a
talented person on one job, he or she is not available for another one. I need to consider
this when I allocate workers to positions. “Wait another minute,” you say. “This is
sounding a lot like opportunity cost and comparative advantage again.” Correct you are!
Essentially, companies with comparative advantage have the lowest opportunity
costs. We saw that the supply curve conveniently orders producers according to their
opportunity costs from low to high marginal costs. This was the message of Chapter 6.
Therefore, supply tells us something about what it costs society to produce goods and
services given that these resources are scarce. By producing goods as cheaply as possi¬
ble, we ensure that resources aren’t used on the wrong thing. The neonatal brain surgeon
cuts heads, garment makers cut cloth, electricians cut wire, and poets have cutting wit.
Well, folks, we now have the tools to solve the question, “How can people be as
happy as possible given that we live in a world of scarce resources?” Supply is about the
wise use of scarce resources, and demand tells about our collective happiness. Let’s get
to work and use these tools to find the right answer.

There Are Limits

Maybe you have to know darkness before you can appreciate the light.

Madeleine L’Engle (1918-2007), American writer

Taken from A Ring of Endless Light (1980)

The dark side of the question “How can people be as happy as possible given that
we live in a world with scarce resources?” implies the following reality: There is not
enough to go around for everybody to be completely and utterly happy. Happiness has
limits. Therefore, some tough questions will need answers and some difficult choices

Critics blame many of Mao’s socio-political programs, such as the Great Leap Forward and the Cultural
Revolution, for causing severe damage to the culture, society, economy, and foreign relations of China, as
well as probable deaths in the tens of millions. Mao closed the schools in China, and the young intellectu¬
als living in cities were ordered to the countryside. They were forced to manufacture weapons. It is only
now that China is market oriented that it is truly taking a "great leap forward.”
 Chapter 9: The Pursuit of Happiness: Efficiency and Equity 105

will need to be made. Some of the basic economic questions that must be answered by
society are these:

1. Given that we can’t make everything our hearts desire, what should society make?
2. Who should make the goods? How should they produce the goods, and what tech¬
nology should they use? Where in the world should these companies locate?
3. Who should consume how much of these goods?

I’m sure you agree that these are pretty big questions whose answers have life¬
changing consequences for many individuals. The answers affect whether head-office
executives locate in Singapore or San Francisco, whether the steel for an overpass comes
from India or Italy, and whether your parents vacation in Florida or Fiji.
Fortunately, economists offer a method that helps to make good decisions—cost-
benefit analysis, which is rooted in supply and demand analysis. In fact, these are the
same thing. Demand tells us about the benefits to society of something and supply tells
us what it will cost to make it. This approach helps to answer the questions of who,
what, where, when, why, and how about any situation that involves choice.

FIGURE 9.1 Economic surplus

Quantity of the thing per unit of time

Another graph should help to clarify things. In Figure 9.1, we plot two lines.
Demand is the marginal benefits side of the story and tells us about the relative happi¬
ness an item can give to those who consume it. On the demand curve, all individuals
who highly value the thing (whether it is steel, vacations, or poems) occupy the front of
the line on the demand curve (top left). Supply reflects the incremental or marginal costs
of producing a product due to limited resources. All of the companies that can produce
the thing cheaply sit at the front of the line on the supply curve (bottom left).
Drum roll, please! As long as the value of the thing to consumers exceeds the cost to
make it on the production side of the economy, the thing should be made. Economists
106 Cocktail Party Economics

call the difference between the marginal benefit of the item and the marginal cost to
produce it economic surplus. All items at the front of each line to the left of the crossing
point generate surplus. Any items to the right of the crossing point do not generate
economic surplus but rather put the economy into a loss position.
We now have a general principle for evaluating whether something should be made
or not. If its marginal benefit exceeds the marginal cost, it should be made. If its mar¬
ginal benefit does not exceed the marginal cost ... don’t bother. If each and every item is
subject to the rigour of cost-benefit analysis, then the economic surplus is the greatest.
Voila—the most happiness possible given scarce resources.

Getting It Right: Marginal Analysis

1 knew once a very covetous, sordid fellow [perhaps William Lowndes l0J, who used to say,
“Take care of the pence, for the pounds will take care of themselves. ”

Lord Chesterfield (1694-1773), British statesman

At optimal Q, or quantity, the cost to make that particular item is equal to its benefit.
This unit (and only this unit) has no surplus but also incurs no loss. The optimal quantity
is therefore the great divide that separates making too much from making too little. Like
the story of Goldilocks and the three bears, only one quantity of anything is “just right.”
In terms of economic crimes, there are two great sins that economic systems can
commit. One is a sin of commission (producing too much) and the other is a sin of omis¬
sion (producing too little). Producing too much of a particular good is a “sin” because it
redirects resources from other, more valuable goods and services. For every unit
produced and consumed past the crossing point, the cost to make it is higher than is its
value to consumers. It most certainly is possible to make too much of a good thing.
Society as a whole incurs economic losses" when this happens. Producing too little is
also a “sin” because society values the product more than it cost to make it. The world
would be a better place if more of this product saw the light of day. In this case, the
economic surplus isn’t as large as it could be. The difference between actual production
and optimal production is also called an economic loss.
Here’s an example that might bring this issue to someone’s head. Suppose that the
medical system decided to train doctors only to be brain surgeons. This means that the
only thing doctors would know how to do is operate on heads. Now, suppose that a
patient breaks a bone, gets cancer, or has a heart attack. Brain surgeons do what they
know how to do and operate on the patient’s head. It should be apparent that this does
not result in an optimal level of brain surgeries (not to mention that it causes needless
pain!). Instead, the medical system should redirect valuable young minds to another
branch of medicine—maybe cardiology—that society values more highly. This example
illustrates the concept that an overproduction of brain surgeries can lead to an underpro¬
duction of heart transplants. Think of it as simultaneous sinning!

10 William Lowndes (1652-1724) was Secretary to the Treasury of Great Britain under King William III and
Queen Anne. Lowndes was married four times and had children with each of his wives, 25 children in all. I
wonder if he took care of his pence!
" Economists have a catchy name for this economic loss. We call it deadweight loss, probably due to some
morbidity on our part.
 Chapter 9: The Pursuit of Happiness: Efficiency and Equity 107

A Kind Solution
When we risk no contradiction, It prompts the tongue to deal in fiction.

John Gay (1685-1732), English poet and playwright

Taken from Fables (1727)

One method of allocating goods would be a system in which a benevolent social plan¬
ning department decides who should make an item and who should get it. All the
planners would need to do is ask people to tell them their marginal values for the item
and then rank individuals in descending order. I could have done the same thing with my
stones, if I had quizzed the 20 people to try to ascertain who really, really wanted them.
On the production side, the planners could then ask firms what it would cost to pro¬
duce these items and again rank them in order of ascending costs. Once marginal costs
equal marginal benefits, production and consumption levels get set. The companies then
produce the goods and hand the items over to the customers. Seems simple, right?
It’s time for some reality. What do you think will happen if all that’s required is for
consumers and companies to reveal their relative values and relative costs, respectively?
I hope you are thinking what I am thinking. I think a little lying would result ... okay,
let’s just say that exaggeration would occur. Consumers would be tempted to claim that
they want something more than they really do in order to move up the line. They don’t
want to be past the cut-off point and lose out. As well, firms might understate their costs
just to get the business. Only later will they surprise the planners (the government) with
an extra bill to cover their extra costs.
Planners have no way to distinguish between those who really value something and
those who don’t and between those who can make something cheaply and those who use
highly skilled resources on a low-skill job. Counting on an honour system to allocate
scarce resources doesn’t have much hope of working, given the incentives inherent in
this kind of system to be less than honest. Is the optimal solution remotely possible? For
the good news, keep reading.

Free Market System

A person who is gifted sees the essential point and leaves the rest as surplus.

Thomas Carlyle (1795-1881), Scottish writer

When those who produce and those who consume meet in the marketplace, the intersec¬
tion of supply and demand generates something magical. It’s called price. Prices are
magical because, in most markets, they will guarantee that the optimal Q (quantity) will
automatically happen. Markets force supply (marginal costs) to equal demand (marginal
benefits) at the market price. This is why economists love free markets so much. We
believe12 that, in free markets, the right firms produce the right stuff, which finds its way
into the right hands. It works better than most allocation systems to maximize the
surplus and minimize the fuss.
So, why do market prices make society better off? In a free market, the equilibrium
price that results when supply equals demand turns out to be a very important dividing

12
Given certain criteria that will be addressed in the next two chapters.
108 Cocktail Party Economics

line. Notice in Figure 9.2 that the final market price of this thing equals optimal Q’s
marginal cost and benefit. Anyone who values this thing (it could be an apple, a hot tub,
or a root canal) more than its market price is on the part of the demand curve before
optimal Q and buys. The marginal benefit to these buyers exceeds the price they need to
pay for it. (I know it seems hard to believe, but I willingly paid an unbelievable amount
of money to have a root canal done.) However, anyone who doesn’t value it as much as
the price is to the right of optimal Q on the demand curve. These folks will not buy,
because it isn’t worth it to them. The price exceeds the personal benefits of consuming
the thing. Markets force consumers to reveal the truth about their real values. There’s no
need for lie detectors. The right people get the goods.

FIGURE 9.2 Economic surplus in a free market

c
3
g Market price

Quantity of the thing per unit of time

There is a similar situation for supply. If a profit-minded company can sell the things
they make for a price that is more than the marginal cost of making them, they go ahead
and make them. These owners go to bed with visions of profit margins dancing in their
heads. These companies produce the quantity on the left side of the supply curve up to
optimal Q. If the marginal costs exceed the price, these firms don’t enter into the market
because to do so would generate losses for the owners. These are the companies on the
right side of the supply line. Again, markets force businesses to face the truth about their
costs, and the right companies end up making the goods.
Because market prices exist, each market participant automatically and intuitively
performs a cost-benefit analysis for himself or herself. It turns out that this personal
analysis produces the best results for society as a whole as well. Market price acts as a
reference point to separate those who should from those who shouldn’t.
Let me repeat this important result. When all is said and done, only people who
value things more highly than the market price pay the price to buy the goods, and only
companies that have low costs of production actually produce the goods to eam the
 Chapter 9: The Pursuit of Happiness: Efficiency and Equity 109

market price. Markets can maximize the surplus fairly easily without the need for
benevolence. Self-interest works to enhance the interests of society as a whole.

Message in a Price Tag

You know, Foley, I have only one eye—■/ have a right to be blind sometimes ... 7 really do not
see the signal!

Vice Admiral Horatio Nelson, 1st Viscount Nelson (1758-1805), British naval officer

Prices also serve the important function of publicly announcing society’s marginal costs
and benefits. Economists say that prices act as accurate signals, communicating valuable
information to the other market participants. For instance, when the price called “sala¬
ries” for particular jobs climbs, this informs young people that certain jobs are in
demand by society. Depending on their individual preferences, these young people now
have the opportunity to make intelligent career decisions based partly on the potential to
make a good salary if that is important to them. If entrepreneurs see high prices for
certain goods and services, they can take that information and start companies to provide
those goods and services. Innovators invent products that provide value because of the
profits they expect to make. They tend to use the prices of comparable products as
signals in making their decision to go forward. Prices are a much more efficient way to
transmit information to all of these players than any government commissioned report.

Gossip Column

Friedrich August von Hayek (1899-1992) was born in Vienna into a line of scholars
and minor nobility. During World War I he was stationed on the Italian front, and this
experience caused him to worry about the damage that political organizations could
do. He vowed to make the world a better place and decided to become an academic.
He thought and wrote about the role that socialism played in fascism and how collec¬
tivism (even when done in a voluntary way) usually leads to totalitarianism. (That’s a
lot of -isms.) During his life, he saw it all and came out in support of a laissez-faire
(free and decentralized) system.
Von Hayek attended the University of Vienna, where he earned two doctorates, in
law and political science, but he also studied philosophy, psychology, and economics.
For a short time, he studied at the Institute of Brain Anatomy, which led him to think
about economics systems in the same framework as neurological ones. He was truly a
well-educated Renaissance man.
His influence on economists was extensive. He was one of the most important
members of the Austrian School of Economics and was scooped by Lord Robbins to
join the London School of Economics (LSE). He is the second most frequently cited
economist (after Kenneth Arrow) by other Nobel Prize winners in economics when
they give their Nobel lectures.
Von Hayek's impact hit the political streets when conservative politicians took his
ideas and ran with them. Margaret Thatcher is said to have slammed Hayek's book
 110 Cocktail Party Economics

The Constitution of Liberty13 onto a table during a party meeting,14 saying, “This is what
we believe." Students of von Hayek became part of Ronald Reagan’s administration.
(Maybe von Hayek sensed that he could be hijacked, because he wrote an essay titled
“Why I Am Not a Conservative” found in the appendix of The Constitution of Liberty. Von
Hayek identified his political stance as basically a classical liberal or libertarian one. For
subtle reasons, he disliked using either term and preferred to be called a “Burkean
Whig,” which definitely clears up matters.)
Von Hayek became good friends with Karl Popper, one of the most influential
philosophers of the twentieth century, also from Vienna and also a professor at the
LSE. It is unclear who influenced whom, but each dedicated books to the other in
appreciation of their respective influence.
Last but not least, Jimmy Wales, the founder of Wikipedia, credits Hayek’s work on
prices (as signals) and his thoughts on decentralized information in “The Use of
Knowledge in Society” as central to Wales’s thinking about how to manage the
Wikipedia project.15
For a long time, von Hayek had more influence among political scientists than
among economists, but lately there has been a bit of a revival of the ideas of the
Austrian school with which he was associated.
He shared the Nobel Prize in 1974 with the Swedish socialist Gunnar Myrdal, who
said that the fact that the prize was given to von Hayek and Milton Friedman showed
that it should be abolished.
When one considers the impact of the man, it is worth quoting von Hayek’s
intellectual archrival, Lord John Maynard Keynes (1883-1946):

The ideas of economists and political philosophers, both when they are right
and when they are wrong, are more powerful than is commonly understood.
Indeed the world is ruled by little else. Practical men, who believe themselves to
be quite exempt from any intellectual influence, are usually slaves of some defunct
economist.

EVEN STEVEN
There are two ways of being happy: We can either diminish our wants or augment our
means—either may do—the result is the same and it is for each man to decide for himself and
to do that which happens to be easier.

Benjamin Franklin (1706-1790), American statesman, philosopher, printer, writer, and

inventor

It’s time to pull back and think about why certain people consume more than others.
How do economists deal with the issue of fairness? Much of what we think depends on
the source of the differences in consumption. For starters, people are different and have
different wants and wishes. Free markets work well in this case because they get stuff

This book is number nine on the list of the 100 best non-fiction books of the century.
Ranelagh, John. (1991). Thatcher's People: An Insider's Account of the Politics, the Power, and the
Personalities. London: HarperCollins, p. ix.
15 See the June 2007 issue of the libertarian magazine Reason.
 Chapter 9: The Pursuit of Happiness: Efficiency and Equity 111

into the hands of people who actually value the items and keep stuff out of the hands of
people who don’t value them. For example, one of my sons would never thank me if I
made him Brussels sprouts, whereas my other son really likes them. If I dole out the
sprouts equally to both of my sons, it would not be true to say that I have maximized
their joint happiness. (However, it might make me feel like I’m a good mother if I force
these little cabbages down my older son’s throat. This is the idea of externalities, which
we will look at in the next chapter.) This type of uneven consumption is not really a
problem.
Well-functioning free markets typify the concept of freedom. Individuals have a free
choice to go to the market and buy what they want. Firms have a free choice to produce
and sell what they want with the available methods that work best for them. This free¬
dom to buy and sell leads to economic efficiency. Scarce resources are allocated in such
a way as to make the products that society wants with as few resources as possible.
When free markets do this, it makes a lot of people really happy.
However, global differences in standard of living are about more than differences in
people’s wish lists. Willingness to pay also embodies the idea of ability to pay. Obvi¬
ously, there are many people in the world who, through no fault of their own, have little
to bring to the table. They could be children, elderly, disabled, uneducated, or politically
oppressed. They have little ability to pay, which also makes their willingness to pay less.
The hard, cruel facts are that markets are about exchange, and you have to sell some¬
thing to buy something. For most people, the most important thing they have to sell is
their labour. However, some people just can’t work. Others work hard, but their work
doesn’t pay enough. There is a fundamental difference between people who choose to
work less and therefore make less money and those who work very hard but whose type
of labour is relatively abundant. Abundant labour is typically of low value, which leads
to low remuneration. Consumption can be down for either reason—diminished income
or diminished wants. One is a problem of fairness and the other is not.
Differences in consumption can also be due to systemic unfairness. Some folks are
just lucky. They may be lucky enough to have inherited wealth, which is the reward of
an ancestor’s labour. These idle rich can conspicuously consume.16 Others may have
won the genetic jackpot and are more talented, beautiful, or intelligent, which increases
their odds of bringing something to the market table.
A more common good-luck story would be that children are bom into a middle-class
family that has resources and chooses to invest them in these children. This increases
what these lucky kids bring to the table in acquired human capital. Their parents endow
upon them all manner of lessons, skills, and good health, which benefits them (and
which they hopefully appreciate once they are older). This is not true for most children
in the developing world. These children inherit wars, displacement and refugee camps,
dysfunctional despotic governments, and all manner of diseases. Certain rights are inal¬
ienable, but to be lucky isn’t one of them.

16
The term conspicuous consumption was introduced by economist and sociologist Thorstein Veblen in his
1899 book The Theory of the Leisure Class. Veblen used the term to depict a specific behavioural charac¬
teristic of the nouveau riche, a class emerging in the nineteenth century as a result of the accumulation of
wealth during the Second Industrial Revolution.
112 Cocktail Party Economics

Ignorance Is Bliss
All you need is ignorance and confidence and the success is sure.
Samuel Langhome Clemens, pen name Mark Twain (1835-1910), American author and
humorist

The unfairness of it all has philosophers and economists alike thinking about
how to set up a fair or just system of distribution. The famous and influential
philosopher John Rawls, in his book A Theory of Justice, argued that systems
should be set up as if they were designed under a veil of ignorance. In other
words, imagine what a system should look like if you get to pick a system to live
in but you know nothing about your final place within it. Most of us, for reasons
of self-interest, would then care about how low the bottom of the totem pole is and
want it raised.
Nobel Prize-winning economist Amartya Sen thinks about equity issues in
terms of an individual’s capability to be and do what he or she wants to be or do.
His argument is that it is not enough that an individual has the right to do some¬
thing. The individual must also have the capability of exercising that right. He
calls this effective freedom and advocates policies aimed at removing obstacles
(economic or otherwise) and giving individuals the capability of achieving their
human potential and dignity. For example, a woman may have the right to own a
business but if she, for cultural reasons, never qualifies for a loan, then this pre¬
vents her from exercising that right. This capability approach is very much behind
using something like the Human Development Index rather than a poverty line to
measure poverty.
In developed countries, governments (and their armies of economists) have taken
on greater roles in achieving equity between their citizens. Normally, this involves
taxes and spending programs. With equity as the backdrop, economists favour meth¬
ods of redistribution of resources that do not change the incentives to behave
efficiently. Let me illustrate the problem. Suppose that someone has decided she
likes leisure more than goods, and she is willing to consume fewer goods to have
more free time. Suppose that another individual wants to have a higher standard of
living in goods and works long hours to achieve this. Then, suppose that a govern¬
ment decides that this is not fair with respect to consumption (it does not believe
that anyone would actually value leisure and instead believes that the first individual
is unable to find work). The government then taxes the hard-working person and
redistributes the income to the leisure-loving person, who will of course take the
money. It shouldn’t take much to see that there is little incentive to be a hard¬
working person.'7 Overall, consumption and happiness will go down. This is viewed
by economists as an economically inefficient outcome because individual behaviour
is changed or distorted by the government’s tax policy to equalize what is, in this
case, a free choice in consumption.

17
From the hard-working person’s vantage, it doesn’t matter if the recipient didn’t want to work or
couldn't work. Taxing hard-working people reduces their incentive to work and therefore leads
to economic inefficiency. The reasons why the recipient isn’t working only matter from the vantage
of equity.
 Chapter 9: The Pursuit of Happiness: Efficiency and Equity 113

eTrade-offs
... the conflict between equity and economic efficiency is inescapable. In that sense, capitalism
and democracy are really a most improbable mixture. Maybe that is why they need each
other—to put some rationality into equity and some humanity into efficiency.

Arthur Okun (1928-1980), American economist

Taken from Equity and Efficiency: The Big Tradeoff (1975)

Equity and efficiency issues are in tension. Efficiency tries to create as big a cake as
possible, and equity tries to keep the pieces of the cake to a similar size. The problem is
that once everyone knows how you are going to cut the cake, it changes how big that
cake is actually made. Economists think of equity and efficiency in terms of trade-offs.18
This is especially true for government “tax and spend” programs. It is virtually impossi¬
ble to find one of these programs that doesn’t affect incentives and lead to economic
inefficiency. All public servants can do is try to minimize the damage of going one way
or another. Here, you get many differences and much debate between economists about
what is the best thing to do and about which side—fairness or efficiency—is the better
one on which to err.

Death and Taxes

"If they would rather die," said Scrooge, "they had better do it and decrease the surplus
population. ”

Charles Dickens (1812-1870), English writer

Taken from A Christmas Carol (1843)

I just can’t resist belabouring the point of how hard it is for governments to get economic
policy right. Here’s a complicated example that illustrates the point. At first blush, an eco¬
nomic policy that appears less distorting is death taxes (a.k.a. inheritance taxes or estate
taxes). After all, this type of tax shouldn’t change your ability to work hard and enjoy the
fruits of your labour during your lifetime, because it only happens once you are dead. It
also equalizes wealth to the next generation, reducing the dynastic buildup of wealth into a
few hands (more on this in the next chapter). However, once people know that this is the
policy, they can change their behaviour. They can spend every dime of their wealth before
they die, leaving little savings, or financial capital, to the next generation. This could lessen
the productive capacity of the economy and possibly reduce everyone’s consumption—not
exactly what the government wants to happen. Others employ very expensive accountants
to look for ways around the death taxes. This is a waste of good brains on a non-productive
activity. Finally, it is possible to buy such a big life insurance policy that you effectively
pass on the wealth anyway. When if comes to not paying taxes, the adage if there is a will,
there is a way could never be more true.

18 My esteemed colleague Atsu Amagashie has pointed out that I am a bit “old school” in my thinking here.
While this trade-off is true for industrialized countries, it may not be true for countries with large dispari¬
ties between the rich and the poor. In that case, it is possible to make a change in equalizing standards of
living and actually see production (efficiency) go up. The problem with big disparities between the rich and
the poor is that the odds that the poor will revolt rises. Civil unrest cuts down on production as well as on
rich people’s heads.
114 Cocktail Party Economics

What if governments try to equalize things by spending on public education? This

partially evens out the human capital across rich and poor families, which enables poor
children to get ahead. However, public funding of education never fully levels the play¬
ing field because rich families can invest more in their children’s education by buying
into neighbourhoods with better schools or better extracurricular activities. In practice,
no public policy is perfect, and sometimes you are just plain lucky to be bom into a
well-off family in a great country; other times you hope your luck changes, and you
become a slumdog millionaire.

Capitalist Tools
The meaning of economic freedom is this: that the individual is in a position to choose the way
in which he wants to integrate himself into the totality of society.

Ludwig Heinrich Edler von Mises (1881-1973), Austrian economist

Taken from Economic Policy: Thoughts for Today and Tomorrow (1979, based on lectures
given in 1959)

Free and competitive markets are often called efficient markets and usually work well to
make a big cake or an economic surplus. Creating equity involves losses in efficiency,
but economists (to varying degrees) see that as being worth it. This does not mean we
abandon markets. Au contraire, we usually support policies that enter the market to fix
the problem rather that those that do not.
The next two chapters explore the times when free markets do not work. There are
many and sundry reasons why markets produce inefficient—never mind inequitable—
results. Economists call these situations market failures. It is not precise to say that mar¬
kets aren’t working. It is more correct to say that they aren’t working correctly. Know¬
ing where the problems are can lead to solutions, often market-based ones.

\
In
 CHAPTER

The Name of the Game

(A Skinny Venti Chapter)
When a man tells you that he got rich through hard work, ask him: Whose?

Donald Robert Perry Marquis (1878-1937), American writer

The stag and doe' is in full swing when you arrive. With the wedding a mere three weeks
away, you have heard rumours that tensions are running high in the family. In the corner
of the room, the groom (egged on by the groomsmen, of course) downs shots in quick
succession. He seems quite willing to let any problems go for the night. You wonder if the
bride is able to do the same.
Sure enough, you discover that the bride is not having as much fun as her husband-
to-be. Near the back door, the maid of honour wipes the bride’s mascara-stained cheeks
and comforts her with these words: “Don’t worry. I’m sure your family's department store
will be fine. You know those big-box stores can’t give service the way a small family-
owned business can.”
The bride responds: “All I know is that Dad and Mom have been walking around as if
someone has died since they found out the town gave the approvals. Lately, every time a
bill comes in for the wedding, they look worried. I wish I wasn’t having such an expensive
wedding. If I had known this was going to happen, I would have gone simpler.”
“Listen there is nothing you can do now but really enjoy your wedding. It won’t make
your parents happy to see you miserable. It will make paying for the wedding feel worse.
Who knows, maybe you can use some of the money raised tonight toward the cost. Let’s
get out of this drafty hall and have some fun.”
“Okay, I guess you’re right.”
As they walk toward the party room, with the maid of honour’s arm firmly around the
bride’s shoulder, you think, That's what friends are for.

COMPLICATING THE PROBLEM

In short, competition has to shoulder the responsibility of explaining all the meaningless ideas
of the economists, whereas it should rather be the economists who explain competition.

Karl Heinrich Marx (1818-1883), German political philosopher, political economist, and
social theorist
Taken from Das Kapital, Volume III (1894)

Congratulations, you have done most of the heavy lifting in this book! There are a few
more ideas that require a little graphing and grappling, but they build on what you have
already learned. Hopefully, they won’t seem too complicated.
Let’s briefly summarize the basic concepts of a free market before we add another
complicating layer. We know that, in markets,1 2 sellers and buyers meet to voluntarily

1 A stag (male) and doe (female) is a party given before a couple gets married.
2 These markets could be garage sales, bazaars, auctions, eBay, online orders, the classified ads in newspa¬
pers, or stores. Any forum that connects buyers with sellers is a market.

115
116 Cocktail Party Economics

exchange something—it could be a good, service, or resource. When markets are in

equilibrium, these buyers and sellers agree to buy and sell a particular amount of a thing
for a particular price per unit. In equilibrium, that price is equal to the marginal cost and
benefits of the last unit made. Should either the buyer’s or the seller’s situation change,
then demand and supply analysis helps us to predict how the price of the item and the
quantity changing hands will change as a result of the new economic scenario. The new
equilibrium prices and quantities are simply the logical consequences of the underlying
costs of production and consumer preferences. This means that prices can’t be too high,
too low, outrageous, exorbitant, gouging, a pittance, or whatever other emotional,
morality-laden word people like to throw around. Prices are simply the fallout of what
people want and the underlying opportunity costs to provide for those wants. Furthermore,
these prices act as signals that help the system to maximum economic surplus. The mar¬
ket price is right... except when it’s not.

What Can Possibly Be Wrong?

In economic life competition is never completely lacking, but hardly ever is it perfect.

Joseph Alois Schumpeter (1883-1950), Austrian economist

Taken from Capitalism, Socialism and Democracy (1942)

As I said. I’m going to add a complicating factor, one that directly affects the young
bride in our story and the reason for the tears. This chapter will look at the role that the
number of buyers and sellers plays in setting prices and determining the quantity of
goods bought and sold. It turns out that a decrease in the number of players in the market
can change the quantity available from economically right to socially wrong. Chapter 9
explained what economists mean by the concept of the socially optimal amount. We
found that anything that alters the quantity changing hands from the optimal quantity to
one that is either too high or too low decreases the economic surplus and is, in a socio¬
economic sense, wrong. This chapter will look at the situation where the quantity of
something in the marketplace is consistently “incorrect” or just plain “wrong” economi¬
cally due to the ability of one player to “comer a market.” We will compare that “incor¬
rect” quantity with what would occur if there were a multitude of independent buyers
and sellers.

A Numbers Game
What is the greatest number? Numbe*one.

David Hume (1711-1776), Scottish historian and philosopher3

Let s look at the first extreme. The lowest number of buyers or sellers possible in a mar¬
ket is one. It turns out that if you are the only buyer or seller in a market, you are in a
very powerful position. We have names for each of these players and they all start with
the prefix mono- (which sounds like a disease—however, the economic type of mono I
would love to catch!). We call a single seller of anything a monopoly and a single buyer
in a market a monopsony. The “anything” in question here can be a good or a service on

Adam Smith and David Hume (who was a decade older than Smith) were friends and collaborators.
 Chapter 10: The Name of the Game 117

the output side or a resource on the input side. So, what is the power of being the one
and only? Well, basically, you get to see the other player’s curve and pick where you
want to be on it. In other words, monopolies can choose their optimal price-quantity
combination on their customer’s demand curve and monopsonies can cherry-pick their
optimal spot on the seller’s curve.

Getting a Clue
We must recognize that as the dominant power in the world we have a special responsibility.

George Soros (1930- ), Hungarian-bom businessman

Taken from The Age of Fallibility: The Consequences of the War on Terror (2006)

Let’s begin with the monopolist. If you are the only seller in a market, then every
price-quantity combination on the entire demand curve is yours—all yours—to choose
from. Economists would say that the monopolist is a price setter. Once it sets a price,
only one quantity on the demand curve matches that price, so essentially it is a quantity
setter as well—but economists never call a monopolist that. Setting the price is a very
important decision for a company to make, both for itself and for society as a whole. The
company determines the quantity produced and consumed of something, which we know
has social ramifications. Unfortunately, it makes more sense for monopolists to pick a
price that maximizes their own profits than worry about picking one that maximizes the
economic welfare of society.
In contrast, a competitive firm is one among many firms selling in a crowded market.
Any one company in a particular sector that sells basically the same thing as everyone
else doesn’t really have the ability to change the overall market price. Rather, a competi¬
tive company looks at the price that everyone else charges and charges the same. A
competitive business has no reason to do otherwise. After all, if it sells something at a
slightly higher price than its competitors, customers can simply buy from the competi¬
tion. If it slightly underprices the competition, it will get a lot of business but cut into its
profit margins and not make enough income to cover its opportunity costs. More to the
point, it doesn’t need to charge a lower price to get all of the customers it wants. Thus,
competitive companies tend to charge what everyone else charges, and economists call
them price takers. As we saw in the previous chapter, the price they “take” maximizes
the economic surplus in the system.
In the real world, very few perfectly competitive markets exist. This category of
market requires the existence of identical—not just similar—products with many sellers
in play. Commodities would be the best example of such a market. After all, a tonne of
wheat from one farm looks a lot like a tonne of wheat4 from another. Therefore, when
wheat farmers sell their identical wheat on commodity exchanges, they get identical
prices to each other during a given round of trading. Individual farmers can’t manipulate
the price of wheat on the big electronic board by changing how much they decide to sell
because they just aren’t big enough to make a difference. For these competitive sellers,
the reaction to the posted price is really a case of “take it or leave it.”

4 Wheat is a grass that originated in the Fertile Crescent region of the Near East. It is one of the top three
cereals produced worldwide. The other two are com and rice.
 118 Cocktail Party Economics

For this reason, the markets for commodities such as wheat, oil, milk, and poultry are
also the markets where producers try to organize in order to get a higher-than-
competitive price. These organizations are usually called marketing boards and their
purpose is to act as monopolies and get monopoly prices for their members. While
examples of perfect competition are going the way of the dodo bird, many products are
similar enough and the number of sellers in those particular markets is big enough that
the markets exhibit qualities close enough for us to consider them relatively competitive
markets. Economic models don’t have to be perfect to be close enough for economists to
find them useful.

Analyze This
Concern for man and his fate must always form the chief interest of all technical endeavours.
Never forget this in the midst of your diagrams and equations.

Albert Einstein (1879-1955), German Nobel Prize winner in Physics

In order to see what price monopolists will set, let’s review what a demand curve
looks like and sort out what this shape means for revenues. Recall that market demand
curves slope downward. The monopolist pretty well owns the whole curve and sees
every part of it. (Believe me, the big monopolies have entire departments that try to
figure out exactly what their demand curve looks like. This process is called forecasting
and can be done by economics units if the company is really big5 or by marketing
departments.)
A couple of things would be clear to anyone analyzing the market data: In order to
induce consumers to buy more, the monopolist would need to lower prices. Furthermore,
the revenues generated by a sale are the combination of the price of the product multi¬
plied by how many items were actually sold. In this case, both the price and the quantity
change as the monopolist moves down the demand curve. Therefore, for the monopolist,
this means that revenue has two opposing forces. By lowering prices to sell more units,
the monopolist decreases the amount of potential revenue on the units at the front of the
line. However, by selling more product, they can make more revenue on the additional
units even if the price is lower. In other words, making more output has revenue trade¬
offs that monopolists need to consider. They lose potential revenue on the price drop but
gain revenue on the quantity increase. Monopolists take these trade-off considerations
seriously when they make production decisions.
The owners of competitive companies face no such trade-offs. For a given market,
demand, and underlying costs, these owners don’t really change prices. Recall from ear¬
lier chapters that if these companies decide to raise the price, they will end up losing
customers. Conversely, they don’t need to lower the price to keep their customers. Prices
are set by the overall market activity, where everyone basically charges the same
amount. Competitive companies can’t increase revenue by changing the market price
because they are too small to make any real impact, but they can increase their revenues
by selling more products.
This is not to say that prices never change in competitive markets. They change
if everyone’s costs change or if the market demand changes. This would happen on a

5 For example, Hal Varian (1947- ) is the chief economist for Google.
 Chapter 10: The Name of the Game 119

market-wide scale and would have an impact on everyone in a sector. While market
prices can change when everyone independently acts in the same way, they do not
change because one competitive owner wakes up one morning and decides to change the
price. No one player has that kind of power, and sometimes the market prices can appear
very random to the business owners involved.
Okay, so let’s say that you own a monopoly. What price-quantity combination is
optimal? We can safely say that it is probably not the quantity of zero (unless, of course,
costs are so high that it isn’t worth it to produce the product at all. In that case, who cares if
you have a monopoly over your product? You are not in the market. This explains why a
monopoly over eight-track cartridges isn’t worth much today. You still need demand to make
monopoly power meaningful.) As we travel down the demand curve (see Figure 10.1), we
start with high prices and low quantities and end with high quantities and low prices.

FIGURE 10.1 Demand and total revenue

120 Cocktail Party Economics

Revenue is calculated by multiplying the price of the product and the quantity sold. It turns
out that revenues first rise, reach a maximum, and then fall as quantity increases.
Notice that at quantities 10 and 40 units, the revenue for this firm is the same at
$1000. At the lower quantity (10 units) the price is higher ($100), and at the higher
quantity (40 units) the price is lower ($25). When these different prices and quantities
are multiplied together, we get the same total revenue ($1000). However, because the
higher-quantity production level will cost more to make, 10 units is preferred to 40 units
in the monopolist’s mind. From Figure 10.1, it should be obvious that no right-thinking
monopolist wants to produce more once its revenue starts to fall—ever. Therefore,
production beyond 30 units is out of the question. To the monopolist, only the top half or
higher-priced part of the demand curve is relevant.

Competitive Comparisons
Less is more.

Robert Browning (1812-1889), English poet and husband of Elizabeth Barrett Browning
Taken from Andrea del Sarto

The bottom line is that competitive markets produce more output at lower prices than
monopolies do. Why? Because monopolists have the unique ability to see the entire
demand curve. Each additional item they sell lowers the price not only of that item in
and of itself, but also of all items before it in line. In other words, producing less allows
the monopoly to charge a higher price for the group as a whole. Therefore, each item has
huge revenue ramifications. The monopolist has the incentive to operate on the low
quantity end, which means that prices are higher.
In competitive markets, firms have no control over the market price. They could be
producing anywhere on any given demand curve depending on where the industry sup¬
ply curve crosses it. The industry supply curve is not limited to the top end of the curve.
Competitive companies are price takers, and the price they take is lower than the one a
monopoly sets. Cartels are good examples of competitive firms colluding to try to get at
these monopoly profits. (Obviously, they wouldn’t form a cartel if being competitive
was so great.) Cartels raise prices by imposing production quotas on all members of the
cartel; in other words, supply is orchestrated to go down. This generates a higher price
and lower overall quantity of product than would exist if markets were competitive.
Furthermore, it turns out that the competitive supply curve is the “true” measure of
marginal costs to society. Competitive companies price their products using the real
opportunity costs of the resources, whereas monopolies strategically pick a price point.
Therefore, competitive firms all together produce the optimal social quantity; monopo¬
lies acting alone do not.
The major sin—from society’s perspective—committed by the monopolist is not that it
overcharges for its products, but that it underproduces in order to maximize its profits.
Society as a whole would benefit from more production of the item because the marginal
cost of the production of an item is still below its marginal benefit. While it is easy to see
that consumers would benefit from lower competitive prices, the individual monopolist
does not benefit from producing this extra quantity and it (no surprise here) doesn’t usually
do so. When monopolists hit their optimal price-quantity combination, they tend to sit on
it since it is their gravy train and they have no incentive to get off. Historically, most of the
 Chapter 10: The Name of the Game 121

richest people in the world had some sort of monopoly power. Needless to say, the ride for
them was first class. In the case of monopoly production levels, it is justified for society to
act through its governments to trade off the interests of the monopoly in favour of the
interests of the society. In other words, governments try to maximize the overall economic
surplus. This will probably mean taking away some of the monopoly’s power.

Monopoly Money
It's possible, you can never know, that the universe exists only for me. If so, it's sure going
well for me, I must admit.

William Henry “Bill” Gates III (1955- ), American business magnate, philanthropist, and
author
Taken from Time magazine (January 13, 1997)

The source of monopoly power can take various forms. Looking at the all-time richest self-
made men6 in North America, we can see a variety of sources to choose from. For instance,
John D. Rockefeller (1839-1937), the all-time richest self-made man, bought up the com¬
petition until his company. Standard Oil, gained control over the North American oil
market. To a lesser extent, Andrew Carnegie (1835-1919), the second richest self-made
man, did the same thing in steel. Sam Walton (1918-1992), ranked in the top 10 richest
self-made men, went into small-town America, which had room for only one discount
store, effectively gaining a monopoly in those towns. By the time the other discount stores
realized the benefit of Walmart’s strategy, they were behind the eight ball. It then became
a race to see who could open a discount store in the next small town first. Cornelius
Vanderbilt (1792-1877), ranked in the top five, was philosophically opposed to the
government-formed monopoly in the New York steamship industry and competed with it
anyway. By undercutting prices, he made a hefty duopoly profit.7 * He then went on to form
13 railroad lines, with monopoly control over those routes. (It just goes to show that what
you say and what you do can be very different.) Fredrick Weyerhaeuser (1834—1914)
bought up huge tracts of timberland, gaining control over this natural resource. He is also
in the top 10. In the top five, John Jacob Astor (1763-1848) created the first business trust*
in the United States, from which he operated his fur, real estate, and opium businesses. He
also benefited from protectionist trade policies, which prevented outside competition in the
fur trade. Marshall Field’s (1834-1906) wholesale9 business (where he made his big
money) provided goods to other merchants in the central and midwest United States.
Chicago’s rail and shipping hub made this (and his place in the top 10) possible.
Bill Gates, through Microsoft, owns valuable patents. This puts him in the top five10
all-time richest self-made men in North America.

6 Unfortunately, there aren’t any women in the top echelons of self-made money. Hopefully that will change
in the future.
7 This market structure has two firms. The chapter’s Gossip Column economist, Antoine Cournot, showed
that the quantity produced in the market by two firms is less than competition and more than monopoly.
The profits are in-between as well.
* Trusts were set up with the intention of creating monopolies, restraining trade, and fixing prices. Antitrust
laws came into effect to combat these businesses. Standard Oil was also a trust.
9 His retail store was the precursor to Macy’s.
10 This rank can change depending on the value of his stocks.
122 Cocktail Party Economics

Anything that keeps the competition out effectively gives monopoly power to a
company, along with the associated profits. Right now, the music industry is lobbying
for tougher rules on illegal music downloads precisely because unenforced monopoly
power is no power at all. Currently, Disney’s11 patents on cartoon characters maintain
monopoly profits for Disney.

Mickey Mouse is, to me, a symbol of independence. He was a means to an end.

Walter Elias “Walt” Disney (1901-1966), co-founder of Walt Disney Productions

Taken from Organisation and Complexity: Using Complexity Science to Theorise Organiza¬
tional Aliveness (2004)12

While enforcement of creative rights can look like a simple case of theft prevention,
we saw in Chapter 4 that society may want a statute of limitations on licences,
copyrights, and patents. Society benefits when songs become part of the public domain
and can be used to create something new or just enjoyed because they are old. However,
society also benefits from the creation of intellectual property in the first place. Further¬
more, the incentive to create may be connected to the creator’s ability to extract
monopoly profits. In other words, the creator supplies something that didn’t exist before,
but only if he or she has monopoly control over it. This implies trade-offs. Society cares
about both sides of the market and tries to reach a compromise.
Recent requirements administered by the World Trade Organization mean that a copy¬
right extends for a minimum of 50 years after the death of the author, which seems quite
long enough to extract monopoly profits for the creator and his or her descendants while
guaranteeing that the creation will at some point become part of the public domain.

Gossip Column

Antoine Augustin Cournot (1801-1877) was born in the small town of Gray, now part
of France. He was educated in local schools until age 15 and then worked as a clerk
in a lawyer’s office for four years. He studied law and philosophy on his own, reading
such works as those of the famous mathematician Pierre-Simon Laplace. He realized
that he needed more schooling to do what he wanted to do and enrolled in a math
prep school. He then won entry to a school in Paris when he was 20 years old. Two
years later, the school was shut down due to political reasons and he transferred to La
Sorbonne, obtaining a licentiate13 in mathematics. He then got a job as an adviser to
Marshal Gouvoin Saint-Cyr and as a private tutor to his son. This job gave Cournot a
lot of time to pursue his studies. He would work for Gouvoin Saint-Cyr for 10 years.
(I guess the son finally grew up.) At age 28 he earned a doctorate in sciences,
focusing on mechanics and astronomy.

11 The Copyright Term Extension Act (CTEA) of 1998 extended copyright terms in the United States by 20
years. This law is known as the Sonny Bono Copyright Term Extension Act, the Sonny Bono Act, or the
Mickey Mouse Protection Act.
12 By Jacco Van Uden, page 43. You have to admit, the book has a memorable title.
13 Licentiate (from the Latin licentia docendi, meaning “permission/right to teach”) is the title of a person
who holds an academic degree called a licence.
 Chapter 10: The Name of the Game 123

Cournot’s thesis caught the attention of the mathematician Simeon-Denis Poisson,

who would prove to be a faithful mentor and friend to him as he managed his way
through the halls of academia. Poisson helped Cournot, then aged 33, find a
permanent appointment as professor of analysis and mechanics in Lyon. A year later,
Poisson found him a rectorship at the Academy of Grenoble. At age 37, Cournot was
called to Paris as Inspecteur General des Etudes because of the behind-the-scenes
workings of Poisson. It was in this year that he published his economic masterpiece,
Recherches (1838). This work was largely ignored by economists because it was so
mathematical to read. He rewrote it twice to make it more palatable to readers, but it
was never a success in his lifetime. (I really hope that doesn’t happen to me.)
Cournot was the first to mathematize economics and should be looked at as the
godfather of mathematical economics, predating Leon Walras14 and Stanley Jevons by
one generation. In fact, Cournot attended school with Walras’s father, and Walras
credits Cournot as inspiration for his work. (Much later, John Forbes Nash would
rework from first principles the duopoly [two firms] solution that Cournot had
developed decades earlier in Recherches. Nash did not know of it at the time. The
equilibrium would become known as the Cournot-Nash equilibrium.) Much of
Cournot’s economic work was dismissed by the academics of his time, leaving
Cournot crushed. On a brighter note, his philosophical writings were highly regarded in
that community of French scholars. He did live long enough to see his economics
work vindicated by Walras and Jevons and was very grateful when Walras went to the
Institute de France and accused the economic academics of injustice toward Cournot.
Cournot died later that year.15

Unions and Other Professional Associations

If I went to work in a factory, the first thing I'd do is join a union.

Franklin D. Roosevelt (1882-1945), American president

When labour acts with one voice, it becomes the only legal seller of labour to a
company. This ability requires legislative power to maintain. Employers have incentive
to try to break a union because unions fundamentally raise production costs. Unions act
as agents for workers in negotiations with management and usually bargain for higher
wages, better benefits, and increased health and safety requirements; as well, they insti¬
tutionalize in the workers’ collective agreement practices such as featherbedding.16 All
of these factors increase the cost of doing business for the company. The early history of
the labour movement is filled with companies so intent on preventing a union from
forming or on destroying an existing union that workers were actually killed. (There is
no fury like management under the threat of unionization.) Therefore, governments must

14 The subject of Chapter 8’s Gossip Column.

15 See www.newworldencyclopedia.org/entry/Antoine_Augustin_Coumot and www.economyprofessor.com/
theorists/antoineaugustincoumot.php for more on his life and work.
16 Featherbedding is the requirement of more workers per job than would normally be necessary. For exam¬
ple, the requirement of a minimum of three firefighters on a fire truck would be featherbedding. This
requires a minimum of three workers on every truck when two could do the job.
 124 Cocktail Party Economics

create laws to prevent companies from engaging in violent17 (and not-so-violent) union-
busting practices, which hopefully prevents tempers from flaring and things from getting
out of control. In general, once a union forms, it will most certainly use its new-found
monopoly power. This increases the cost of production, which in turn ends up decreas¬
ing the number of workers the company hires. I hope you recall from Chapters 6 and 9
that this means that the supply of output and the economic surplus are both down.
Join the union, girls, and together say Equal Pay for Equal Work.

Susan Brownell Anthony (1820-1906), American civil rights and women’s rights leader

Professional associations (medical, accounting, law, and engineering groups) and

non-professional organizations (technicians and trades) exist as another form of labour
monopoly, particularly when they restrict entry into their organizations through unneces¬
sarily tough educational requirements. Non-professional licensing for individuals, such
as cab drivers or buskers, also controls who can legally offer services.
The law acts as the enforcer, maintaining monopoly power by requiring a certain
designation or licence in order to practise or operate a service. Workers inside an organi¬
zation make it hard for outsiders to get in, usually by hiding behind the guise of needing
to keep standards up. This practice is not necessarily in the public’s interest. If these
licences or designations truly limit entry into these markets (in contrast to handing out
licences to anyone who applies), then society will enjoy fewer health care services, cab
rides, and juggled balls than what society deems optimal. Again, supply and economic
surplus are both down.

Cartels and Collusion

The strong equilibrium point f just described is one of "unrelenting ferocity ” against offend¬
ers. It exhibits a zeal for meting out justice that is entirely oblivious to the sometimes dire
consequences to oneself or to the other faithful—i. e., those who have not deviated.

Robert John Aumann (1930- ), Israeli-American Nobel Prize-winning mathematician

Taken from “Acceptable Points in General Cooperative n-Person Games” (1959)'*

Cartels are groups of producers that agree to not exceed certain production quotas in
order to keep market prices up. They are essentially co-operating with each other to meet
a common goal of making more profits. Individually, each member must voluntarily
restrict its individual supply, which decreases the overall supply. The Organization of
the Petroleum Exporting Countries, more commonly known as OPEC, represents a good
example of a cartel. Each member country has a limit it can sell on the world oil market.
However, cartels like OPEC have unstable monopoly power because of an individual
member’s incentive to say it is keeping to its quota while in reality it is sneaking more
output onto the market through the back door in order to make more profits. (OPEC
has big problems with members cheating on quotas, precisely because detecting and

1 Baldwin-Felts Detective Agency was known for violently attacking labour union members in such mining
areas as Ludlow, Colorado, and Matewan, West Virginia, on behalf of employers. The Ludlow Massacre
involved three coal mining companies, one of which was owned by the Rockefellers.
In Contributions to The Theory of Games IV, Annals of Mathematics Study 40, edited by A.W. Tucker and
R.D. Luce.
 Chapter 10: The Name of the Game 125

punishing a cheating OPEC member is virtually impossible. Oil looks like oil and isn’t
distinguishable by member state.) Once many countries cheat, the world price of oil
drops to competitive prices. (That is how all other members know someone is cheating.
They just can’t prove who.) This on-again, off-again quota system helps to partially
explain the wild gyrations in oil prices as they swing between monopoly and competitive
levels.
Other examples of cartels are the milk and poultry marketing boards'9 found in
Canada. These farm cartels continue to exist because the government imposes trade
restrictions on these particular foodstuffs and enforces strict food safety laws. Let’s take
the dairy market as an example. It is very difficult for Canadian milk producers to cheat
on their quotas when it is clear which dairy farm shipped the milk to the milk processing
plant. Any producer that ships more than its quota is fined. Furthermore, it is illegal to
sell unpasteurized milk (and any farmer caught doing this is charged), thereby removing
any alternative markets to sell in. Not only that, but there are stiff tariffs on imported
milk, and foreigners don’t really sell in the milk market except for specialty products
like cheese. As a result, the dairy cartel is very stable and profitable. This is good for
dairy farmers but not so good for society. Milk production and economic surplus are
down.
Both OPEC and quota-enforcing marketing boards are examples of legal cartels.
Usually, cartels are illegal precisely because they decrease production and lower eco¬
nomic surplus. Therefore, most countries have laws against colluding behaviours such as
price fixing or bid rigging. In Canada, everything from driver education schools to waste
disposal companies has seen criminal convictions for illegal monopolistic activities. As
you can see, the role that government plays in terms of competition policy can seem a bit
two-faced. Sometimes governments support monopolies and other times they nail them.
For example, Bill Gates has spent many years fighting various U.S. governments
over the issue of monopoly power. The many plaintiffs alleged that Microsoft abused its
monopoly power when it bundled Internet Explorer with Microsoft Windows, prevent¬
ing real competition from other firms. In 2001, the U.S. Department of Justice reached a
settlement with Microsoft that, in part, required Microsoft to share its application
programming interfaces with other companies who could then use them to compete in
similar markets. I’m sure that the thought of being forced to break Microsoft into many
little companies as a worst-case scenario kept Bill Gates up at night and that the final
settlement brought him some relief.

MONOPSONY
People will buy anything that is “one to a customer. "

Sinclair Lewis (1885-1951), American writer

We have seen that, if you are the only seller in a world with many buyers, you are a
monopoly. In contrast, if you are the only buyer in a world with many sellers, then the
buying power is in your hands. You have what is called a monopsony. In this case, you
get to see the entire supply curve, and you decide how much you want to pay when

19
Not all marketing boards restrict production. In order to be a cartel, production restrictions must be in
place.
 126 Cocktail Party Economics

you buy. So, what is the rationale behind the process of picking the monopsonist’s pre¬
ferred price? Because supply curves usually slope upward as the monopsonist buys more
of the seller’s product, it has to pay more for the entire lot. This means not only that
every additional purchase costs more in and of itself, but also that all previous units will
now be priced higher. Stopping at a lower quantity enables the monopsonist to suppress
the price per unit on all units purchased. Big buyers, therefore, stop buying at lower
quantities than would be bought if there were many buyers in a competitive market.
Because less is bought, the price paid to suppliers is lower.

Trouble
Two wrongs don’t make a right, but they make a good excuse.

Thomas Stephen Szasz (1920- ), Hungarian psychiatrist and academic

Taken from The Second Sin (1973)

Our opening story showed a young woman worried about her parents’ retail business. A
big-box store is moving in and her parents are stressed out about it. Do they need to be?
Maybe. One feature of big-box stores is that they are big buyers of merchandise. They
pay less for their products than small buyers, which allows them to underprice smaller
stores. In addition, large players can access suppliers who are further away at lower
costs than a small firm can. We already saw in Chapter 3 that Walmart is a big buyer of
Chinese goods. Economists call the cost savings of buying in bulk economies of scale.
For any store that imports heavily from developing countries, its monopsony buying
power along with economies of scale are usually what gives it monopoly power on the
home front. This is all very bad news before a wedding. It is quite possible that the
bride’s parents will be driven out of business.
Labour markets also have big buyers. Small towns with one major employer often
experience low wages and employment levels. Because of this, these employers are ripe
for unionization. Most of the early history of unions appears to have occurred in this
kind of situation,20 whether it is a mining company or one major manufacturer in a small
town. From the vantage of the public interest, unions together with monopsonies can be
a good thing. Not only are working conditions more humane, but employment can actu¬
ally go up. (Proving this point is beyond the scope of this book, but I couldn’t help but
mention it. It appears that two wrongs can make a right.)

Sports Channels
A sportsman is a man who, every now and then, simply has to go out and kill something.

Stephen Butler Leacock (1869-1944), Canadian economist and writer

Professional sports are also full of these monopsony-union combos. The owners (acting
as one) have monopsony power over whoever plays in their league. If a hockey,

20 Most miners also lived in company towns, where everything was owned by the company and the workers
were paid in company money called scrip. This became a very oppressive environment. Colorado’s legisla¬
ture passed laws to outlaw scrip as well as mandate other improvements to life in these mining towns, but
these laws were poorly enforced. To get a picture of life in these towns, I recommend watching the movies
October Sky and Matewan.
 Chapter 10: The Name of the Game 127

baseball, soccer, football, or basketball player wants to play professionally, there are
very few places to do so, and for many young men it is a dream come true to play and
get paid at the same time. Therefore, the owners have an incentive (given the monopson-
ist’s ability to see the entire supply curve) to keep salaries low and the league small.
Once a union comes in, salaries go up. Depending on how much incomes are raised, it is
actually possible for employment in the league to go up.
This was certainly true of the National Hockey League. In 1967, the NHL Players’
Association formed. Salaries increased, but not to the levels seen in other sports. That
year, the league expanded from the original six21 teams to twelve teams. Over time, the
league has grown to 30 teams. (Note: Some players tried to unionize in 1957-1958 but
the union was busted when the owners either traded the problem players or sent them
back to the minors. The union was able to form only because of the role played by the
Ministry of Labour in Ontario and the commitment by the union’s first president, Bob
Pulford, to not go on strike in the first contract.) This example illustrates the point that,
when a monopsony’s labour force is unionized, not only wages but also employment
goes up. Society and my brothers-in-law are better off because they get to watch more
hockey.

Creative Destruction22
As a matter of fact, capitalistic economy is not and cannot be stationary. Nor is it expanding
in a steady manner. It is incessantly being revolutionized from within by new enterprise.

Joseph Alois Schumpeter (1883-1950)

Taken from Capitalism, Socialism and Democracy (1942)

Most industries live between the extremes of pure competition and monopoly. Think of
it as a continuum with relative firm power changing over time. Let’s look at the auto
sector to illustrate this point. The Detroit Big Three had significant market control until
the advent of free trade. They were closer to the monopoly end of the spectrum. Because
these firms were so profitable, unions had something to fight over. (Monopolies tend to
find each other.)23 Add together the impact of oligopolistic24 car companies, which on
their own raise prices together with unions that further raise prices, and it is safe to say
that cars were priced on the higher end. Furthermore, government-enforced trade barri¬
ers kept cheaper cars out of the market. Once Japanese firms decided to locate in North
America to get around these protectionist practices, the Detroit Big Three were in
trouble. More firms were competing with each other, moving the North American car

21 These six teams (Montreal Canadiens, Toronto Maple Leafs, Detroit Red Wings, Chicago Blackhawks,
Boston Bruins, and New York Rangers) are collectively known as the Original Six.
22 Joseph Alois Schumpeter (1883-1950) was an economist and political scientist bom in Moravia, now the
Czech Republic. He popularized the term creative destruction in economics. The basic idea is that monop¬
oly profits aren’t so bad because they create an incentive for companies to come up with some other way to
provide a similar product, thus destroying the monopoly power of the original company.
23 Walmart is a big seller in small-town America and a big buyer of product from various Chinese firms and
has managed to stave off unions. On the other hand, the Liquor Control Board of Ontario (LCBO) is a big
buyer of alcohol from around the world and a big seller in the province. It is both a monopsony and a
monopoly. By the way, its employees are also unionized.
24 A few companies. Not quite a monopoly, but not competitive either.
128 Cocktail Party Economics

manufacturers further away from the monopoly end toward competition. Their ability to
raise car prices was diminishing. Furthermore, these new foreign car companies weren’t
unionized, which gave them cost advantages.
The Detroit car manufacturers made monopoly-type profits for a long time.
Whenever there is a lot of money on the table, some bright person is going to figure out
some way to get his or her hands on it. It doesn’t require a degree in rocket science to
see why foreign companies found ways to get around this little trade problem. The moral
of the story is this: If there are monopoly profits25 to be had, people are going to go for
them. It is only a matter of time.

LOOKING FOR THE RIGHT ANSWERS

Right or wrong, the customer is always right.

Marshall Field (1834-1906), American businessman and philanthropist26

Monopolies (unions are an example of a labour monopoly) charge more and sell less
than competitive suppliers. Monopsonies buy less and pay less then competitive buyers.
Both of these monos decrease economic surplus because they underproduce and are
therefore free market failures. The next chapter will look more carefully at all kinds of
market failures, with a view to providing solutions to these problems.

You can t stop innovation if there is money to be made. When phone companies had monopoly power, in
came the cellphone.
The Lniversity of Chicago was founded by both Field and New York's John D. Rockefeller to rival nearby
Evanston s Northwestern University. Field is number seven on the list of all-time richest self-made men.
Rich people are usually friends with each other.
Getting an F: A Look
at Market Failures
We have forty million reasons for failure, but not a single excuse.

Rudyard Kipling (1865-1936), British author bom in India

The weather this afternoon is perfect. Friends and family arrive en masse bearing gifts,
and make their way to the festively decorated backyard. After years of childlessness, the
happy couple has finally adopted a little one. The bailiff served the court papers this very
week. From beginning to end, what felt like an endless process took a little over three
years. The star of the show—a little boy—sits on the ground surrounded by young would-
be mothers, all trying to get his attention. He starts to cry, and his mom picks him up and
soothes him. Everyone smiles.
As if on cue, the hired wait staff bring out trays holding flutes of champagne for the
adults and sparkling juice for the younger guests. The boy’s dad, looking a little
emotional, raises his glass to propose a toast. At that moment, the quiet is shattered by
the sound of a chainsaw next door. It seems that the neighbour who borders on the back
of the property has chosen this moment to cut down an old maple tree to make way for a
swimming pool. The noise is deafening. Awkwardly, the dad walks to the fence and asks
for a reprieve. Unfortunately, due to scheduling issues, the man is unwilling to change his
plans and the noise will continue. There is no choice but to herd everyone indoors.

MODEL OF PERFECTION
Trifles go to make perfection and perfection is no trifle.

Michelangelo di Lodovico Buonarroti Simoni, commonly known as Michelangelo

(1475-1564), Italian Renaissance artist

The story we just read illustrates a kind of market failure. (Sometimes, when a tree falls,1 2
everyone hears it!) Each individual clearly wanted something specific from the day, but
at least one party walked away unsatisfied with the way things worked out. Economists
today often grapple with the issues of market failures. This means that markets do not
serve society well because they fail to bring about the desired result. While things don’t
always work out neatly in markets, fixing the problem can be complicated. Sometimes
buyers and sellers can solve their own problems, but other times markets are going to
need a little help, particularly from governments, to make them work well. This chapter
will travel into the darkness of failures but, like most economists, I always wear my
miner’s light to look for free market solutions if they are remotely possible.

1 Chapter 11 is a chapter of the United States Bankruptcy Code, which permits reorganization under the
bankruptcy laws of the United States. When a company fails, that does not mean the market does. In
the spirit of Chapter 11, any market failure should be restructured in order to succeed.
2 If a tree falls in a forest and no one is around to hear it, does it make a sound? can be viewed as either a
philosophical riddle about reality (posed by philosopher George Berkeley in 1710) or a scientific observation
about the nature of sound (in Physics [ 1910] by Charles Riborg Mann and George Ransom Twiss).

129
 130 Cocktail Party Economics

Before starting in on the depressing stuff, let’s begin on a positive note. Generally,
markets work well. They almost effortlessly coordinate large groups of people to either
produce or consume goods and services, creating this wonderful thing called economic
surplus. This connecting of buyers and sellers can seem so smooth that it may feel as if
some invisible hand is directing human activity to do the right thing. We know now that
the coordinating function of markets works because of the role that prices play, as opposed
to some big hand in the sky. We saw that prices signal to the various players in the market
useful information about the marginal costs of producing and the marginal benefits of con¬
suming. The market players then make choices based on that information. When the
informational content of prices accurately reflects the true value of the product, the final
quantity produced and consumed is socially correct. Furthermore, this quantity is made by
the right companies and consumed by the right customers. Markets can get a lot of things
right, and economists label the ones that get it right efficient markets.
But what if, for some reason, the information the price conveys is wrong and doesn’t
accurately reflect the true marginal benefits of the product or the marginal cost to make
it? Now is the time for the rest of the story.

Terms and Conditions

Digressions, objections, delight in mockery, carefree mistrust are signs of health; everything
unconditional belongs in pathology.

Friedrich Nietzsche (1844-1900), German philosopher and philologist3

What I am about to tell you does not negate everything I have said thus far about the
efficiency of unfettered free markets. In fact, a competitive free market is normally
the gold standard test4 against which all market activity should be measured. Of course,
we don’t live in a perfect world and so we want to look at why markets fail to live up
to this ideal or why the test itself may sometimes be flawed. Prepare yourself for a
longer than normal chapter, because failure often takes longer to explain than success.
You might want to pour yourself a stiff drink.
Here are the five general categories of problems that lead to market failures:

1. The market doesn’t have enough players in it.

2. Market activity produces either positive or negative spillover effects not taken into
account by the decision makers.
3. Property rights are either unclear or unenforceable.
4. Governments change the price or quantity of something.
5. Some market participants know more than others about what is really going on.

1. MARKET POWER: MADE FROM CONCENTRATE

People of the same trade seldom meet together, even for merriment and diversion, but the
conversation ends in a conspiracy against the public, or in some contrivance to raise prices.

Adam Smith (1723-1790), Scottish moral philosopher and political economist

Philology considers both form and meaning in linguistic expression, combining linguistics and literary studies.
4 In medicine, gold standard test refers to a diagnostic test or benchmark that is regarded as definitive.
 Chapter 11: Getting an F: A Look at Market Failures 131

In the last chapter we looked in detail at markets with only a few players. To recap,
if any buyer or seller has some control over market share and chooses to exercise that
control by limiting quantity, then from society’s perspective that market will not make
enough goods or services. These concentrated markets simply fail to allocate scarce
resources properly. The concentration ratio is often defined at the percentage of the mar¬
ket serviced by the biggest four firms. The bigger the percentage, the higher the concen¬
tration. In extreme cases, only one player—a monopoly, monopsony, or union—is in
control. In each of these cases, what is controlled is very different, but the results are the
same. Each market will result in not enough final output made.
In Chapter 9 we learned that, from society’s perspective, the socially optimal quantity
of a product occurs when the marginal benefit of that item equals the marginal cost to
make it. Moreover, in Chapter 10 we also learned that due to private self-interest, big busi¬
nesses5 have no incentive to provide enough goods in the marketplace. It is more profitable
to restrict output directly, as does the monopolist, or indirectly, as do monopsonies and
unions.6 Large players stop producing when society’s marginal benefit of the output still
exceeds the output’s marginal cost. This presents society with a problem.

Monopoly Power
Power tends to corrupt; absolute power corrupts absolutely.

Sir John Emerich Edward Dalberg Acton (1834-1902), English historian

Any form of concentrated market power can be a problem; however, society tends to
focus mostly on monopolies. There are a number of approaches that can take the teeth
out of a monopolist’s bite, and they all involve the government. The government can do
any of the following:

A. Create laws that encourage competitive markets

B. Regulate the monopoly
C. Own the monopoly

A. Create Laws That Encourage Competitive Markets

As a preventative measure, society tries to solve the monopoly problem by passing laws
that prevent markets from concentrating in the first place. These laws have such winning
names as anti-combine laws, anti-competition laws, or antitrust laws, depending on the
country. These laws usually have provisions that prevent collusion between competitors
or practices that force competitors out of business, Governments also have rules about
how mergers and acquisitions can be done legally.7 The goal of such legislation is to

5 Note that a union is a business just like a monopoly and monopsony.

6 In 1992, the Canadian Radio-television and Telecommunications Commission ended the monopoly of
long-distance phone service by Bell Canada and the provincial counterparts. It used to be quite common for
people to end conversations by saying, “Better get off the phone, this is long distance.” Now, with cheap
phone plans, people don’t mention cost anymore.
7 The banking sector in Canada has seen mergers between types of financial institutions. (For example, TD
Canada Trust is a merged company made from a bank and a trust company. This merger happened in
2000.) However when TD and CIBC applied to merge, the request was denied by the Finance Minister
Paul Martin on December 14, 1998, due to concerns of anti-competition in the Canadian banking sector.
 132 Cocktail Party Economics

make it easier for small players to participate in the market, thereby keeping the numbers
of firms up. For example, most developed countries have laws against predatory pricing.
These laws forbid existing companies from temporarily dropping their prices to prevent
another player from making a profit, thereby driving it out of business or preventing
it from entering the market in the first place. For example, the European Commission
fined French internet service provider Wanadoo millions of euros after finding it guilty
of inhibiting competition in the market for high-speed internet access by charging
below-cost prices. The commission claimed that Wanadoo’s behaviour restricted the
entry of competitors and the potential for competitors to develop. The concern is that
once the competition is wiped out, the prices increase again to monopoly levels.

B. Regulate the Monopoly

Sometimes there just isn’t enough demand to support more than a few companies.
Furthermore, the economic benefits of size (yes, size does matter) can make some firms
a natural monopoly. Governments, in this case, regulate their behaviour in the market.
For example, utilities such as cable companies must petition their particular public utili¬
ties commission before they can change their rates. These companies may be big, but the
government doesn’t want them throwing their weight around.

C. Own the Monopoly

The theory of Communism may be summed up in one sentence: Abolish all private property.

Karl Marx (1818—1883), German author of The Communist Manifesto (1948)

Finally, governments sometimes just decide to own a company or nationalize it. For
example, in Canada, provincial governments own most of the electric power utilities,
usually with the word hydro somewhere in their names.8 Government ownership in
Canadian Crown corporations9 included Air Canada, Canadian National Railway,10 and
Potash Corporation of Saskatchewan until these companies were privatized. Privatiza¬
tion is the act of selling publicly owned companies to the private sector.
Each of these solutions—laws, regulations, and state ownership-—addresses the
issue of market power. The efficacy of these approaches is not the topic of this book,
but in terms of pecking order, free market types prefer laws to regulatory agencies and
prefer regulators to state ownership. Those suspicious of free markets prefer the
reverse order.

2. EXTERNAL RELATIONS: SPILLOVERS

Truth in philosophy means that concept and external reality correspond.

Georg Wilhelm Friedrich Hegel (1770-1831), German philosopher

Hydro-Quebec, BC Hydro, and Ontario’s Hydro One are good examples of this. Canada is the world’s
second largest producer of hydroelectricity in the world (after China) and one of a few countries to
generate the majority of its electricity in this way.
The terms Crown corporations and Crown entities are used by Commonwealth countries to indicate
government-owned corporations.
The Canadian National Railway is now a public company with 22 000 employees and market capitalization
of US$21 billion in 2008.
 Chapter 11: Getting an F: A Look at Market Failures 133

Usually, market prices help people to make good personal decisions because the price
accurately reflects the true costs and benefits of something to society. In this case, the
personal decision to buy and sell matches what society would like to see happen. But
the costs and benefits of the decision maker are only socially correct if they are private.
What do I mean by private? There can be no spillover effects; in other words, whatever a
person does should not have an effect on individuals who have no say in the matter. If
spillovers occur, then the market price is no longer an accurate signal of the true overall
societal costs and benefits. Economists say that these markets have externalities.
Let’s look at our opening story. Because these neighbours live side by side, the
action of one neighbour imposes a cost on the other. The tree-cutting neighbour wants a
pool and has hired someone to take out his tree. The other neighbours want to have
a party to celebrate a significant event in their family. They would like it to be outside in
their backyard and meaningfully quiet. They end up being disappointed by the outcome.
However, the result is not just a personal disappointment, it is inefficient. The tree¬
cutting, pool-loving man did not take into account the negative costs of his actions on
his neighbours. With a little coordination, another suitable date could have been
arranged for either the celebration or the chainsaw massacre. Markets are supposed to
efficiently coordinate people’s activities. Not so in this case. All that the markets
accomplished on this day was to provide the champagne and take out a tree. Markets
didn’t address the crucial point of optimal timing for the day’s events and therefore, as
an effective coordination mechanism, the markets get an F.
Unfortunately, from a market economist’s perspective, the production and consump¬
tion of many products spill over in either a positive or a negative way onto innocent
bystanders. This causes the production levels in the market to be socially wrong. In the
case of negative externalities, more output than is socially optimal happens. In the case
of a positive externality, not enough output occurs.
Let’s start with a positive externality. Professional gardeners often talk of “borrowing”
from the neighbour’s property when landscaping. This means that you take into account
the next-door hedge, gardens, and other attractive features when developing your own
property. I happen to live on a street populated by retired people who love to garden. With
every additional nearby rose garden, my property value goes up, and I did not have to pay
for it. I am enjoying the view as well as a positive externality. However, it wasn’t always
this way. I once lived on a street where a man did oil changes in his front yard. Needless to
say, I didn’t enjoy this view and complained bitterly with the rest of the neighbourhood
about the negative effects his yard was having on our property values.
The existence of externalities explains why neighbours care so much about what pri¬
vate citizens do to their front yards. The front yard isn’t private. My examples may seem
trivial but, as town councils that try to revitalize their downtown cores realize, what the
neighbours do affects both property values and business prospects." This point was
brought home to me when my son took driver’s education. I admit that it gave me pause
as I dropped him off for his first lesson to realize that a massage parlour was in the back
of the building. A worried mom, I of course talked to the owner of the driving school.

11 A new mall always tries to sort out the anchor stores—the large stores that make the mall worth going
to—first before it attracts renters for the rest of the space. Small stores care who the big stores are, as it
affects the pedestrian traffic between them.
 134 Cocktail Party Economics

He assured me that the two groups of customers never crossed paths. I hope so, because
I really didn’t want to think about this particular externality. More importantly, I didn’t
want my son thinking about it.
To solve the externality problem, we need to address the two issues of property rights and
transaction costs. The next section in this chapter will explore property rights more generally,
but it is worth mentioning how property rights play out with respect to externalities. So, I ask
you, who do you think should have had the right to get their way in our opening story: the
tree-clearing neighbour or the celebrating family in the backyard? Once we know who has
the right, it is possible for markets to sort themselves out. Nobel Prize-winning economist
Ronald Coase showed that well-defined property rights could eliminate externality problems
without further government involvement. The parties would simply negotiate a price with
each other to get to a solution because it’s clear who should do the paying. Without property
rights, there are two problems to solve: who should pay who and how much? Two questions
are harder to get answers to than one—especially when emotions are running high.

Gossip Column

Ronald Harry Coase (1910- ) was the only child in a working-class British family.12 His
life story reads like a series of serendipitous events that finally let him to a Nobel Prize
in Economics.
As a young boy, Coase suffered from a weakness in his legs that required him to
wear leg irons. This weakness landed him in a school with other children who had
both physical and mental disabilities, and he took courses in such riveting topics as
basket weaving. Fortunately, he was a reader. For some reason he can't recall, he
missed taking the entrance exams for the local secondary school, which should have
happened when he was 11. His parents lobbied, and he was allowed to write the
exams when he was 12. Fortunately, he was then awarded a scholarship to a good
school. Once at school, Coase wrote the matriculation exam and passed with distinc¬
tion in history and chemistry but, because of the loss of one year from age 11 to 12,
he did not take Latin. Who cares, you say. Well, this ruled out a further degree in
history, which would have been his first inclination. He was left with chemistry, but the
required mathematics proved not to his liking. Finally, he switched to commerce.
Coase took mostly business and accounting courses until his final year, when he
happened to take an economics course from Arnold Plant, who had just arrived at the
London School of Economics. Plant introduced Coase to Adam Smith’s invisible hand
and changed the focus of his life. His intention to this point had been to go into law.
Because of Plant’s recommendation, the University of London awarded Coase a trav¬
elling scholarship, which took him to the industrial heartland of the United States to
study how firms operate. His studies allowed him to ask businessmen why they did
things in-house rather than through contractors, and the answers he got indicated that
it came down to transaction costs. If it was cheaper to do something in-house, a

12
Again, the Oxford Dictionary of National Biography is a great source for information about this British
economist.
 Chapter 11: Getting an F: A Look at Market Failures 135

company did it in-house. Otherwise, it subcontracted. Coase published an article on

this idea in 1937 called “The Nature of the Firm.” This is the first of two papers that
would win him the Nobel Prize. He was only 27 years old.
At age 50, he wrote the other Nobel paper, which looked at property rights and
externalities—the Coase theorem, if you will. The groundwork was done during the
intervening years as Coase studied natural monopolies, especially those in communi¬
cation. He did more thinking about the role that property rights could play in allocating
the radio frequency spectrum and wrote about it in an article. This first published work
outlining the Coase theorem had the exciting title of “The Federal Communications
Commission.” Economists at the time read his conclusions, and many wondered how
such a good economist could get it so wrong. If he was right, the implications would be
quite profound in that the role of government in correcting these types of markets was
much less than previously thought. Government simply needed to assign property
rights, and the market would sort itself out.
George Stigler invited Coase to a workshop in Chicago. During this visit, a number
of big-name economists who thought his ideas were in error invited Coase to expound
on his views. The group took a vote before Coase began and only 1 out of 21 thought
he was correct. After the conversation, everyone thought he was right and encouraged
him to write another paper, which has the better title “The Problem of Social Cost.”
When Coase gave his speech accepting the Nobel Prize, he said that if these econo¬
mists had not encouraged him to write the article, he would not have done so. That
would have been a great loss, because at the time of the Nobel speech it was the
most cited paper in modern economics.
Coase, without mathematics, revolutionized how economists thought about the
role of government and law in economics, and it all happened almost by accident.

Who Could or Should Pay to Solve the Problem?

The physician can bury his mistakes, but the architect can only advise his client to plant
vines—so they should go as far as possible from home to build their first buildings.

Frank Lloyd Wright (1869-1959), American architect

Many of the modem solutions to pollution—a major negative externality caused by

businesses producing goods—are based on the principle of polluter pays. In other words,
society at large retains the right to a clean environment and, in general, holds polluters
responsible for fixing the problem. However, it doesn’t necessarily have to be this way.
We could just as easily make the party experiencing the negative effects of the pollution
responsible for fixing the negative externality they are experiencing. Now, I realize this
may go against your instincts of justice, and you may say, “What? Make the victim pay?
That just isn’t right.” You are correct in saying that this becomes a problem of justice,
but justice isn’t an economic problem. It is an ethical, political, and moral problem. The
big economic problem here is that too much pollution is happening. To solve that prob¬
lem, we don’t necessarily need the polluter-pays principle.
Let me give you an example of a market-based solution where the victim pays to
correct a market failure. It is reported that because he was short, impresario (what a cool
word) Billy Rose made it a practice to buy four tickets when he went to the theatre. Two
 136 Cocktail Party Economics

of the tickets were for himself and his escort. The other two were for the seats directly in
front of him; he would leave these seats empty so he could have an unobstructed view of
the play. Instead of complaining to the theatre or asking the person in front of him to
move his or her head, Billy Rose solved his externality problem himself by paying the
price to avoid the problem altogether. For Billy, this expense was worth it.
Rose’s solution also demonstrates the issue of relative transaction costs when it
comes to externality problems. When transaction costs are low, individuals can find a
solution for themselves. It turns out that Rose could easily solve his problem when he
purchased the two extra seats. This simple transaction involved only him and the box
office. How much longer does it take to say, “Four tickets, please’’ instead of “two tick¬
ets”? The time and money cost of solving this problem are relatively low. I know many
of you might be thinking that theatre tickets are expensive, but this solution is cheap
when compared to going to court or fighting city hall to solve problems. People solve
their own externality problems all the time when they live in expensive gated communi¬
ties, plant trees on the property line, or put up three-metre fences.
Let’s look at a more complicated case that entails huge transaction costs. What if manure
(yuck) from numerous farms located upstream from a town leaches into a river and enters the
water supply downstream? The number of people involved makes it virtually impossible for
each party to negotiate individually with the others to actually solve the problem. While a
solution would highly benefit the entire group of townsfolk, the cost for any one person to
solve the problem would be very high and some would say prohibitive. The townsfolk need
to act together to make the cost worth it. To solve this problem, some level of government
would usually need to take on the issue, but sometimes it can be handled by a concerned citi¬
zens group.13 Now the cost of negotiation is lower because of economies of scale, which
means that the cost incurred by the government to represent one citizen isn’t much different
from the cost to represent thousands. The cost per citizen, however, goes way down.
Once governments decide to act to reduce the sewage (externality) in the city’s water
supply, there is more than one way they can accomplish this goal. The first two solutions
I am going to provide are market based, because they put a price on pollution. The third
solution is outside the market system. Each policy has administration costs associated
with it. If the costs to run any program exceed the benefits of it, the government should
try another plan.
The basic solutions are these:

A. Tax bad behaviour or subsidize good behaviour

B. Cap and trade, which caps the level of pollution by selling pollution permits. Allow
these permits to be traded in an open market.
C. Regulate to reduce bad behaviour

A, Paying for Sins or Providing Rewards for Virtues

You can't trust water: Even a straight stick turns crooked in it.
W.C. Fields (1880-1946), American comedian and actor

13
In 1978, Lois Gibbs, a local mother and president of the Love Canal Homeowners’ Association, began to
investigate why there were many health problems in the area. Gibbs discovered that her neighbourhood sat
on top of 21 000 tons of buried chemical waste.
 Chapter 11: Getting an F: A Look at Market Failures 137

To economists, it doesn’t matter if the environmental program is a carrot or a stick type

of program. (A horse can be convinced to move by either a carrot in the front or a stick
in the rear.) Economists think either approach can work. This is really another way of
addressing who will pay for the problem. For example, on one hand, the government
could charge a pollution tax on the farmers who are polluting. Farmers can avoid the tax
(a stick) by spending money on some system that prevents manure from going into the
river or they can let the manure flow and accept a higher tax bill. Either way, the polluter
is “paying to pollute.” Because it now costs the farmers to pollute, this policy raises the
cost of farming and the supply of animals goes down. Less animals mean less manure,
and no one has to raise a stink.
On the other hand, the government could have a mechanism in place whereby the
victims affected by the pollution pay the polluter through their tax dollars (a carrot) to
pollute less. In this case, the farmers are motivated to reduce their supply of animals
in order to get the government funds. Again, the result is fewer animals making poop.
Each of these approaches ensures that less fecal material makes its way into the water
supply of local homes, although who ends up paying the bill is different. The nature of
the program can be either a carrot or a stick type to get the polluter to co-operate.

B. Permitting Pollution
Another way in which the government can handle this problem is to limit the quantity of
pollution it will tolerate by limiting the number of pollution permits it issues. If the
number of permits is less than the number farmers need, permits are now scarce and they
become valuable pieces of paper that can be bought and sold. The right to pollute will
now cost something. There are a couple of ways to “pay,” depending on who owns the
permits.
On one hand, existing farmers may be “grandfathered” the automatic right to some
of these pollution permits. They still pay to use a permit because it could be sold to some
other farmer. The permit has an opportunity cost. On the other hand, the government
may require every polluter to buy a permit. Then, all farmers pay out of pocket. Again,
permits that have a positive market value raise the cost of production and the supply of
farm animals shifts to the left. To be sure, the grandfathered farmers will be richer than
those who must pay out-of-pocket, but that’s not what is relevant. The reduction in pol¬
lution is the real goal. Either payment plan will achieve this.
Carbon trading14 is an example of a permit-type system whereas a carbon tax is ...
well, a tax. Economists like these approaches because they put the true social cost of
polluting in front of company accountants, who now see pollution as a costly activity due
to either the value of the permits or the cost of the taxes they need to pay. The costs of pro¬
duction are now higher and, as we saw in Chapter 6, higher costs shift the supply curve
downward to a lower quantity. In the end, a reduction in output means less pollution.

C, The Regs
Finally, governments establish laws that regulate spillovers between citizens without
any direct transfers of monies. In terms of pollution, the government may require
manufacturers’ pollution emissions to be under certain numbers. I am pretty familiar

14
This is sometimes called a cap and trade system.
138 Cocktail Party Economics

with this world because my husband is an environmental engineer who works in consult¬
ing. Most of his clients hire him to test their air pollution levels to make sure they are in
compliance with government regulations. It turns out that if you are under the legal lev¬
els by a smidgen, you are fine. If you are over by a smidgen, you are not fine and might
even get fined—and will probably pay more than a smidgen. Of all the methods used to
control pollution, economists like this one the least. Regulations do not take into account
the fact that the cost to comply can be financially painful for some companies but be
relatively inexpensive for others. Economists would like to see the overall level of pollu¬
tion go down but we would prefer to reduce pollution using the least amount of scarce
resources possible. Some companies spend a fortune to get their numbers down only a
smidgen, which doesn’t really help to reduce pollution much at all. Economists prefer
tax and permit type solutions to regulations.
Often at the neighbourhood level, however, market-based solutions don’t seem to
work. The multitude of municipal bylaws speaks to this reality. For example, most urban
centres require citizens to maintain their properties to some degree. This standard may
be as simple as having to mow your lawn once it gets to a certain height, shovel the
snow within a certain amount of time after a snowfall, or stop playing loud music after a
certain time of day. Some municipalities go even further and legislate the colours you
are allowed to paint your heritage house or forbid a clothesline in your backyard or pes¬
ticide use on your front yard. City hall has established these laws in response to some
externality. With regard to the opening story, an applicable bylaw could be established
to ensure that neighbours are entitled to two weeks’ notice before a tree comes down in
their area. Many communities even have laws in place that make it illegal for people to
cut down a healthy mature tree without permission. All of these types of bylaws serve as
non-market approaches to the externality problem.

Good Neighbours Make Good Fences

The Bible tells us to love our neighbours, and also to love our enemies; probably because they
are generally the same people.

Gilbert Keith Chesterton (1874-1936), English writer

The unfortunate externality of the tree clearing in the opening story is similar to something
that happened to me, only it was a hedge rather than a tree. (1 must tell you that I was very
ticked off at my neighbour for doing what he did.) Ironically, it all happened on Good
Friday, 2009.1 can only imagine my neighbour’s conversation with his wife on that fateful
morning. Maybe it was something like, “Hey, honey, today I think I’m going to cut down a
hedge! What better way for the neighbours to experience the true meaning of Easter?”15
Somehow, he was able to borrow a truck and trailer from another neighbour down the
street who happened to be gone for the weekend. (It’s so nice to know that my other
neighbours—friends of my backyard neighbours—knew what was going to happen in my
backyard before I did!) I came home from church only to have him knock on my door and
explain that he wanted to take out the hedge ... as soon as he could back up the truck.

15
Christians mark Good Friday as the day of Jesus’ crucifixion. This Friday is called “Good” because Jesus’
sacrifice was to pay for the sins of the world. Easter Sunday marks His resurrection and the beginning of
new life.
 Chapter 11: Getting an F: A Look at Market Failures 139

The hedge is on his property, so many of you will say, “Tough luck, but it is his
hedge. You should be thankful he told you at all.” You are correct, but this hedge lies
outside his chain-link fence and is not accessible from his yard. (Initially, he built the
fence in front of his hedge because of his Rottweiler, but now he also has a pool.)
Furthermore, our property extends beyond his yard to another neighbour who was not
taking out the rest of the hedge. Once the chainsaw stopped, our backyard looked like
someone had given the hedge a bad haircut. A third of the hedge was cut to the ground
and the rest was three metres tall. To add insult to injury, he asked my husband to move
his truck and trailer so the remains of the hedge could be removed (much more conven¬
iently) through our yard and driveway. When the assault was over, we were left with an
eyesore and no privacy. I quickly made some calls about putting up a wooden fence.
Here is my opinion on the matter, and you can take it for what it is worth. When in
an exchange between neighbours it’s clear that markets don’t work well, I think a little
common courtesy goes a long way in maintaining good relations. I should have been
given at least two weeks’ notice about the hedge coming down. In the end, the only good
thing I got out of the experience was a perfect example of externalities for my book.
Once I realized that, I did smile about the whole thing.

3. PROPERTY LINES
Portia: This bond doth give thee here no jot of blood; The words expressly are “a pound of
flesh. ”

William Shakespeare (1564-1616), English writer

Taken from The Merchant of Venice

My story nicely segues to the problem of property rights that are impossible to establish
or enforce. On Good Friday, my neighbour essentially behaved as if he had all of the
property rights even though, in my mind, the issue wasn’t so clear-cut. According to
Ronald Coase, if the property rights are absolutely clear, then I was not without options.
If my neighbour had the right to do what he did and I didn’t like it, 1 could have kept the
hedge if I was willing to pay him more not to cut it down than the amount he valued it
gone. Unfortunately, the events happened quickly and it was a civic holiday, which
meant I couldn’t make any inquiries into what my rights actually were. If I had wanted
him to be on a sticky wicket,16 I could have said, “Go ahead and take out the hedge but
don’t step one foot on my land,” but that seemed a little too high drama for me. In the
end, I blinked and let him have his way.

Public Property
What happens when property rights are functionally irrelevant? Two pertinent examples
are what economists call public goods and common property. To be a pure public good,
an item must have two salient characteristics: It must be non-rivalrous and
non-excludable in consumption. Huh? Let me explain. Non-rivalrous means that my
consumption of a good does not result in less of it for you to consume, and

16 The phrase sticky wicket comes from the game of cricket. The pitch becomes hardened due to drying rain,
which makes batting difficult.
140 Cocktail Party Economics

non-excludable means that my consumption cannot exclude you from consuming the
item. It may be easier to understand if I give you an example. Suppose that I drive up
and down my street looking for a wireless internet connection for my laptop. When I
find one (and I will). I’ll be able to use the connection without the homeowners knowing
that we are all online at the same time. My internet use does not rival theirs (one extra
user shouldn’t do much to slow things down) and they have not excluded me from their
property. In this situation, the internet connection is acting as a public good. To exclude
non-payers, the internet customer has to install a firewall. The act of my connecting to
an account I am not paying for is called free riding.
Internet service providers have figured out how to get rid of this free rider problem,
but other goods are not so easy in terms of excluding people. If my neighbour decides to
plow our street after a snowstorm, he cannot stop others from driving down the plowed
road. If one shipping company decides to build a lighthouse,17 it cannot stop other ships
from using the light to guide their way. Without government funding, not enough public
goods would be provided, because they are costly to produce and difficult to extract
revenues for. This is why governments in developed countries are in charge of such
things as roads, national defence, and policing. These are public goods, not because they
serve the public but because they are non-excludable yet have a huge value to all who
use them. They are worth publicly funding.

Public Health and Education

Health and education have both a private and a public component to them. Certainly,
the private return on education is high for people, and that is why families scrimp and
save to send their little ones to university or college. But on top of the private benefits,
there is also a public good component to education. The more educated a population,
the greater the engagement in civic duties such as voting and support of free speech,
and the lower the crime rates. Furthermore, fundamental non-commercial research
done by universities and colleges serves the public good. There is nothing to patent
and only a very rich philanthropist or government could pay for it otherwise. Think of
what the world would be like without the foundational work of Max Planck18 or Albert
Einstein!
Public spending on health is another example of a private-public combination.
Immunization programs reduce the number and effects of debilitating diseases.
While immunization benefits the recipient, the negative spillover of infectious
diseases warrants government funding of immunization programs for those who would
not pay for it. A healthier population is a more productive population.

17 Ronald Coase showed that lighthouses in nineteenth-century Britain were privately provided and that ships
were charged for their use when they came into port. Markets seemed to be working for this public good.
Upon further analysis, the truly free market lighthouses didn’t survive long. Only those that the govern¬
ment granted the right to collect a “light due” for did so. Eventually the government bought up the light¬
houses because the private lighthouses started to act as monopolists.
18 Planck was appointed dean of Berlin University, after which it was possible for him to call Einstein to
Berlin and establish a new professorship for him (1914). The two scientists became close friends and met
frequently to play music together. Planck is the founder of quantum theory and won the Nobel Prize for
Physics in 1918.
 Chapter 11: Getting an F: A Look at Market Failures 141

Law and Order

If you 're in the Chicago area anytime soon and you see a red-haired girl driving around—in
the words of Elmer Fudd—be vewy vewy careful.

John Ortberg (1957-), American minister and author

Taken from Everybody’s Normal Till You Get To Know Them (2003)

One public good that is vital if markets are to function properly is a well-defined justice
system. What is the point of working hard if your work is stolen or your employer
refuses to pay you and you have no recourse? What value do property rights have if they
are not binding? Citizens need to know what the rules are and be confident that they are
enforced. These rules should seem fair to most people. This averts revolutions or
strikes19 that can shut down economies completely.
Think of justice as rules of the road. If everyone drives close to the speed limit,
drives on the correct side of the road, and gives the right of way when they should, traf¬
fic keeps moving. Traffic cops help to enforce these rules, which would surely be broken
if it were not for their existence. While a cop on every comer would be excessive, not to
mention expensive, we do want a few of them around here and there. But even with a
decent traffic system, accidents sometimes happen, and markets are no different. If we
notice that a particular intersection has more accidents than “normal,” it might be worth
increasing surveillance of that comer. The same can be said for markets. If one market
fails badly for whatever reason, a small change in government intervention could fix it.
The entire market system doesn’t need to be changed.

The Tragic Commons Revisited

In Chapter 4, I mentioned that the big problem with the environment is ownership. This
is especially true with transnational issues such as global warming or overfishing in the
oceans. In this case, the environment is rivalrous or depletable but not excludable. In
fact, almost every country in the world emits carbon dioxide into the atmosphere, which
depletes environmental quality, and many countries send out fishing trawlers, which
depletes the fish stocks. Without some sort of global property rights system, we are in
big trouble.

4. GOVERNMENT INTERFERENCE
I make a fortune from criticizing the policy of the government, and then hand it over to the
government in taxes to keep it going.

George Bernard Shaw (1856-1950), Irish playwright

So far, I have been extolling the virtues of government intervention in fixing market
failures. I must now switch hats to look at market failures caused by government
programs. Frankly, when governments intervene in a market to change the price or the

19 The largest general strike that ever stopped the economy of an advanced industrial country—and the
first general wildcat strike in history—occurred in May 1968 in France. The prolonged strike involved
11 million workers for two consecutive weeks, and its impact was such that it almost caused the collapse of
Charles de Gaulle’s government.
142 Cocktail Party Economics

quantity for reasons other than externalities or public goods, they mess with the perfec¬
tion of the free market. Usually the government has the best of intentions, but that
doesn’t mean that what it does is right. The government gets it wrong not because it is
evil but because when it disconnects itself from free markets it loses valuable informa¬
tion about what people value or a firm’s opportunity costs. Government policy is a bit
like doing brain surgery while blindfolded. It is really tough to get right.
For instance, the government might think that the rents poor people pay are too high
and decide to legislate rent controls. This has the very bad result of driving owners of
rental housing out of business, reducing the number of rental properties, decreasing rental
quality, and creating a housing crisis. Left-wing Nobel Prize-winning economist Gunnar
Myrdal criticized governments who used rent controls to solve the problem of affordable
housing, characterizing them as bad planners without vision or courage.20 Ouch!
When a government intervenes to change price or quantity to a number other than
the efficient free market amount, economists say that the government is distorting the
market. The price no longer conveys the correct information and distorts the decisions
of the consumers or producers in the market. In the case of rent controls, the landlord
sees low rents and decides to get out of the rental housing market, even though there
are lineups outside the apartment building of people looking for the low-priced hous¬
ing. The price no longer reflects the true demand for the apartment and ceases to
influence the landlord appropriately. Swedish economist Assar Lindbeck went on
to say that rent controls were the most efficient way to destroy a city other than to just
bomb it!
While governments have the best of intentions, almost everything they do to change
the market price—whether it be to raise wages with minimum wage legislation, protect
domestic jobs with tariffs, tax or subsidize consumer products, or pay farmers more with
agricultural price supports—distorts the market and misallocates scarce resources.
In a civilized society, it is virtually impossible to get rid of taxes, so what can be done to
deal with life’s inevitable distortions and failures? Economists Richard Lipsey and Kevin
Lancaster showed that, given an unavoidable failure in one market, it might be worth it to
have a distortion in another market. This is called the theory of the second best. For example,
if a mining company is badly polluting, it might be optimal to let the company become a
monopoly. A monopoly (usually a bad thing) would reduce production, which is good for the
pollution numbers. Or, suppose that a monopsony hires too few workers and pays its work¬
force too little. Then, adding a union could increase not only wages but also the level of
employment. In both stories, two wrongs can make a right. This means that the simple
laissez-faire shoe doesn’t fit all feet. A little analysis might be necessary.

5. I KNOW SOMETHING YOU DON’T KNOW

It is a very sad thing that nowadays there is so little useless information.

Oscar Fingal O'Flahertie Wills Wilde (1954-1900), Irish writer

Myrdal, Gunnar. (1965, August 25). Opening address to the Council of International Building Research in
Copenhagen. Dagens Nyheter, p. 12; cited in Rydenfelt, Sven. (1981). The rise, fall and revival of Swedish
rent control. In Block, Walter, & Olsen, Edgar (eds.). Rent control: Myths and realities, p. 224. Vancouver:
The Fraser Institute.
 Chapter 11: Getting an F: A Look at Market Failures 143

Markets work well when everyone has access to the same relatively accurate informa¬
tion, but once one person knows more than others do, we have asymmetric information
and this can lead to market inefficiencies or, more bluntly, to market failure. In broad
strokes, asymmetric information causes problems because people use the information
strategically while others cannot. When people are strategic, they improve their personal
lot in life, and that may mean they keep some things quiet. Economically, when different
players know different things, it is hard to get those who know more to behave appropri¬
ately with respect to either risk or effort. Usually, this scenario leads to too much risk
and not enough effort.
Essentially, the economic crisis of 2007-2009 had its roots in asymmetric information,
and the buzzwords of this type of problem were thrown around the media as pundits tried
to explain to the public what on earth was happening. The next chapter will look at the
issues of the economic crisis more closely as they relate to financial markets in particular.

Risky Business
As a general rule the most successful man in life is the man who has the best information.

Benjamin Disraeli (1804-1881), British prime minister and novelist

The risk of any decision, when it is accurately known by everyone involved, is not a
problem even if the risk is very high. Risk is not a market failure. Fully informed con¬
senting adults can freely consent. Problems occur when one party either hides the truth
or changes its behaviour, which essentially changes the truth. Economists have great
names for these situations, which make it all sound more formal. Concealing the truth is
called adverse selection; changing behaviour is called moral hazard.
The classic academic paper on adverse selection is George AkerloFs “The Market
for ‘Lemons’.” This paper, for which he won the Nobel Prize,21 set forth the idea that
the person who knows more—the seller of the car—has an incentive to hide the fact
that the car is a lemon from the buyer who knows less about the car. Buying a used car
is therefore a tricky venture. If the market price turned out to be the average between
good cars and lemons, then lemons make a killing and good cars sell below their true
value. Given that the owners of good cars don’t want to sell their vehicles for less than
they think they are worth, only lemons exist in the second-hand market and the price
reflects that fact. This is a bad thing because owners of good cars also want to
sell their vehicles, and buyers would be willing to pay the price if they knew the cars
were good. Essentially, the market for good cars disappears because of asymmetric
information.
Participants in markets can solve this problem. The owner of the car could signal the
worth of the vehicle by offering warranties, guarantees, or endorsements by famous peo¬
ple. The buyer of the vehicle could screen the car for quality by taking it to a mechanic
for a look under the hood, reading consumer reports, or buying only from a friend or
relative. Screening and signalling are expensive, but these methods keep the market for
good used cars alive. As long as the benefit of the solution exceeds the cost of solving
this problem, the world is better for it.

21
Writing “The Market for ‘Lemons’”: A Personal and Interpretive Essay, http://nobelprize.org/nobel_prizes/
economics/laureates/2001/akerlof-article.html
 144 Cocktail Party Economics

The insurance industry worries more about risk than any other industry. Life insurance
companies want to insure healthy people who are likely to live longer lives. Adverse selec¬
tion problems are rife, but insurance companies try to get an accurate risk picture by asking
for medical and lifestyle information during the application process. In other words, they
screen. Once they agree to insure you, the risk isn’t over. Moral hazard problems arise
when people change their behaviour after the policy is issued. Suppose that a policyholder
suddenly decides to take up skydiving or mountain climbing. He might buy a hot little
sports car and drive like a maniac. She might start smoking or drink more heavily. If the
insurance company had known what the policyholder was going to do, the rates would
have been higher to reflect the true risk of this person. The only thing insurance companies
can do is put caveats in the contract that make the policy null and void under certain condi¬
tions. For example, most life insurance policies will not pay out if the person commits sui¬
cide within the first two years. I guess they figure that people who plan to commit suicide
and are thoughtful enough to buy a life insurance policy to leave money for those left
behind will probably change their minds after two years.

E for Effort

Quality is never an accident; it is always the result of intelligent effort.

John Ruskin (1819-1900), English art critic

Adverse selection and moral hazard can also apply to effort. In adverse selection, work¬
ers misrepresent their abilities or skills to get hired. Moral hazard happens if an
employee shirks his or her duties once hired. In these cases, the workers know more
about themselves than the employers do, hence there is an asymmetric information situa¬
tion and, more importantly, a market problem.
Employers try to solve the adverse selection problem through rigorous hiring proc¬
esses. Again, this is screening. They scrutinize cover letters and resumes for any relevant
work experience, education, or typos. This is why recommendations are so important to
the employer and why “who you know” might be more important than “what you know”
in terms of landing a job.
Often, potential employees try to signal their quality to employers. Showing up to
the interview with appropriate attire, a reputable degree, or fantastic letters of reference
signals to the employer that you are not a lemon of an employee.
Once a worker is hired, there is still the problem of moral hazard. Employers can’t
monitor their employees all day long. As the saying goes, When the cat’s away, the mice
wilt play. The market has developed payment schemes to try to solve mediocre perform¬
ances, whether it be through shirking or playing too safe. These are called incentive-
compatible compensation schemes. If you can say that without stumbling, you’re hired!
This could include piece rates, bonuses, commissions, and requirements for billable
hours. You earn more if you produce more. If you become a senior executive, your pay
will include stock options. In other words, you make more income if the company’s
stock does well.
Firms might do as Henry Ford did. He paid higher than market wages, known as
efficiency wages. This removes any desire by a worker to lose a particular job. The
benefit of shirking or absenteeism goes down, and morale goes up. Ford’s chief of
 Chapter 11: Getting an F: A Look at Market Failures 145

labour relations estimated that productivity rose 51 percent after Ford instituted these
higher wages. More importantly, from 1914 to 1919 profits doubled.
These are all market-based solutions to solve the moral hazard problem. They align
incentives with desired results from the employer’s perspective. One thing is certain:
Anything that can get relevant information to the party that needs it is a good thing.
However, none of these complicated, costly compensation schemes would be necessary
if people were fully informed to begin with.

CASING THE POINT

A thinker sees his own actions as experiments and questions—as attempts to find out some¬
thing. Success and failure are for him answers above all.

Friedrich Wilhelm Nietzsche (1844-1900), German philosopher

Congratulations, you have finished reading everything you ever wanted to know about
markets but were afraid to ask! The next chapter will look at financial markets as a case
study. Essentially, everything in this book finds examples in the fascinating world of finance.
 CHAPTER

Numb€rs: Financial Markets

There is no safety in numbers, or in anything else.

James Grover Thurber (1894-1961), American writer and cartoonist

Taken from “The Fairly Intelligent Fly” in the New Former (February 4, 1939)

As you walk into the ballroom of the luxury hotel, the first thing that hits you is the sea of
dark suits—black, navy, grey—on both men and women. The only break in the dark palette
comes from the white shirts and red bowties of the wait staff milling around with trays of
canapes and wine. You are here to celebrate the merger of the accounting firm1 that does
your company’s books with another major player in the industry. Along with entrepreneurs
and industrialists, the guest list looks like a who’s who in the financial sector. Bankers, bond
traders, stockbrokers, and hedge fund managers chat as they enjoy a drink on the account¬
ing firm's dime. The atmosphere is rife with power, importance, and money, and you hope
you don’t say anything that seems remotely stupid2 to anyone. From a passing tray, you
scoop up a glass of Chateau Margaux3 and look for a group to join.

ACCOUNTING FOR THE FINANCIALS

The ease of mathematical manipulation may lead to a neglect of those issues that are hard to
formalize or, equally dangerous, to a distortion in the way we look at those problems ...
Peter Skott, economist
Taken from Mythical Ages and Methodological Strictures: Joan Robinson’s Contributions to
the Theory of Economics Growth (2004)

Before we start looking at the financial sector, I think it would be good if I told you what
is not going to happen in this chapter, just so that those of you who are skipping ahead
to read about Financial matters won’t be disappointed. I am not going to explain what
happened in the financial crisis of 2007-2009 in excruciating detail. That has been
done—with great finesse, I might add—by economist Robert Shiller,4 who has the
comparative advantage in this topic. I am also not going to outline every conceivable
financial product known to man. 1 can’t think of anything more unbearable.
Rather, I am going to describe the economics underlying the financial markets. This
will enable you to understand many details described by other sources, whether they
be books, magazines, newspapers, or Wikipedia. I admit that I picked one of the most

1 The Big Four accounting firms worldwide are PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst
& Young, and KPMG. This group was known as the Big Eight until 1987, and was reduced to the Big Five
through a series of mergers by 1998. The Big Five became the Big Four as Arthur Anderson suffered
irreparable damage following the 2002 Enron scandal. The Big Four “accounted” for close to US$95 billion in
revenues in 2010. This group is thought to be an oligopoly.
The first book in English on stupidity was A Short Introduction to the History of Stupidity by Walter
B. Pitkin (1932).
“Investment wines” are considered by some to be Veblen goods after economist Thorstein Veblen, who
coined the phrase conspicuous consumption. The uninformed (like me) should watch out for scams in this
market. It is highly unlikely that this wine is available at this gathering.
4 The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It (2008).

146
 Chapter 12: Numb€rs: Financial Markets 147

complicated of all market systems as an application, but I think it is particularly impor¬

tant that you understand some of this since it truly affects everyone in the world. I
should warn you that the plethora of names for available financial securities can be
mind-boggling. For some reason, finance types love to make relatively simple things
more complicated than is necessary. Perhaps it’s because this field is dominated by men
who may feel they need to compensate for something.

Cadastral Survey5
Power is the great aphrodisiac.
Henry Alfred Kissinger (1923- ), German-bom political scientist, diplomat, and winner of the
Nobel Peace Prize
Taken from The New York Times (January 19, 1971)

Recall from Chapter 4 that the financing behind buying a machine or piece of property is
called financial capital because it is the paper trail recording the acquisition of the real
capital. For example, a factory matches up with the corresponding mortgage used to buy
that building or with the shares belonging to the owners of the building. The factory or
real asset is paperized.6 However, finance has evolved since the early days. With all of
the exotic names for these paper financial instruments, it can appear that finance is now
utterly divorced from the real economy that produces goods and services—but it isn’t.
You just have to look a bit harder.
There are many ways to slice and dice financial instruments, and I have chosen to
put things into the broadest categories possible. Think of it as sorting the laundry. While
they are all clothes, the darks go in a different pile than the whites or permanent press.
Fundamentally, every financial asset (even those I don’t mention in this book) can fit
into one of the following five categories: money, debt, equity, derivatives, or some
grouping of the first four.
Each of these categories could literally fill a book. In fact, each of them has. My
summary of each type of of asset will be quick and dirty—which probably doesn t fit
well with the laundry analogy.

1. Money
Money is the safe haven for individuals and companies when the real economy looks
scary, because in low inflationary times money keeps its value. In tact, financial inves¬
tors7 often hold money if they think the other categories are going to tank. Nassim
Taleb,8 the author of the bestselling book The Black Swan: The Impact of the Highly
Improbable and one of the few voices to predict the financial crisis of 2007-2009, was

5 Cadastral surveys are used to document the boundaries of land ownership.

6 This is one of the big problems in developing countries. They have either unclear property rights or no mecha¬
nisms to create paper out of real assets. This slows down their growth. See Peruvian economist Hernando de
Soto Polor’s book The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else.
1 I have been careful to use the term financial investor rather than investor because economists separate
investment from saving. Firms invest and people save. The general public, however, doesn t ditlerentiate
between the two so talk about investing their money. I will therefore compromise and add the word finan¬
cial in front of investor.
8 Taleb also recommends in his book to make use of serendipity by going to as many cocktail parties as possible.
148 Cocktail Party Economics

asked in an interview about where he was parking his wealth in light of the recent
financial crisis. Taleb’s reply—“cash is king”—indicated that he wasn’t ready to get
back into other types of paper at that time.
Historically, money has had many forms. These include commodities such as gold or
grain (cigarettes were used as money in German prisoner of war camps), coins, and bills,
but these days the most important form of money is sitting in bank" accounts. Very few
people keep their money as cash10 under their mattress anymore—although I love finding
cash when 1 do the laundry ... particularly bills.
Money acts as grease for the wheels that turn the real economy, helping businesses
to produce and consumers to buy. Grease is a good thing, except when it gets into your
clothes and when companies start to hold lots and lots of money. This is a bad sign
because it means that these companies are veering away from investing in real equip¬
ment, real inventories, and real buildings and choosing instead to hold cash that isn’t
real. Ultimately, money must buy real things to keep the real economy going. Really.
“Does it hurt? ” asked the Rabbit.

“Sometimes, ” said the Skin Horse, for he was always truthful. “When you are Real, you don't
mind being hurt. ”

Margery Williams Bianco (1881-1944), English-American author

Taken from The Velveteen Rabbit or How Toys Become Real (1922)

When an individual, business, or government buys the money of another country, the
currency of the other country is called foreign exchange. While the origins of foreign
exchange markets are found in international trade, the majority of buying and selling of
foreign exchange nowadays is due to the buying and selling of financial paper. If a
European wants to buy an American stock, it must do so with American dollars.
Foreign exchange markets connect buyers and sellers of currency with each other in
order to trade their money." The predominant players in this market are banks and cen¬
tral banks through two electronic networks—Reuters and Electronic Broking Service—
that are computerized systems where dealers post bid (buy) and ask (sell) prices. The
market clears automatically, which means that the computer matches the players who
posted the same bid and ask prices. A minimum trade of SI million of currency is re¬
quired to play in this market, so I think it’s fair to say that leaves most
of us out of it. When the average person buys currency, he or she does so from a bank
that buys the currency in this way.

Greasing the Wheels of Time

The importance of money flows from it being a link between the present and the future.
John Maynard Keynes'I 2 (1883-1946), English economist

I will use the word bank to include institutions that act like banks. These include credit unions, savings and
loans, trust companies, etc.
In Canada, a little over 6 percent of money is in the form of cash when chequing, saving, and cash are
added together. The situation in the United States isn’t much different.
The foreign exchange market is the largest financial market in the world. The daily turnover of currency is
in the trillions.
Keynes is probably one of the most influential economists of the last century. As Milton Friedman said in
1965, “We’re all Keynesians now.”
 Chapter 12: Numb€rs: Financial Markets 149

While money exists mostly in the form of bank accounts, money markets are about the
buying and selling of short-term debt. So, what is the connection between the two? This
might seem strange, but the only difference between them is a matter of time or (in
financial terms) liquidity. Bank accounts—the most liquid of all financial assets—can
usually be accessed 24/7 through the internet or bank machines, whereas money market
debt can be as short as a day but can also be as long as one year. Because these assets are
relatively short-lived and very common, they can be easily sold and converted into bank
accounts. For all intents and purposes, they are as good as money, and economists call
these financial assets near money.
This kind of short-term debt can be issued by governments in the form of Treasury
bills13 or by corporations in the form of Commercial Paper. Banks can also create such
typical money market assets as Certificates of Deposit,14 Banker’s Acceptances,15 or
Repurchase Agreements.16 While this list of financial instruments in the money mar¬
kets sounds quite exotic, don’t be too impressed. For visualization purposes, think of
buyers and sellers exchanging pieces of paper created by governments, businesses, and
banks that need to borrow for short periods of time. The pieces of paper are agree¬
ments to settle up sometime within a year. If people don’t want to wait to settle later,
they can sell the paper now in the money market to someone else who will settle with
the borrower later. When you hear the term money market, this is what they are talking
about. I guess the more accurate near money markets is a too much of a mouthful for
the finance guys.

2. Debt

Creditors have better memories than debtors.

Benjamin Franklin (1706-1790), American politician and polymath

Taken from Poor Richard's Almanac (1758)

Debt is an 10U, or a promise to pay back—typically, with interest. This can be a loan,
mortgage, or bond. Bonds have a term longer than one year and are publicly traded in
bond markets. These are called over-the-counter markets, with market makers in the
middle facilitating the trades. Market makers are usually investment bankers17 in a
brokerage division. In contrast, individual mortgages and loans are usually not negoti¬
ated in publicly traded markets. There are reasons for this that will become clear later in

13 T-Bills are bonds sold with a promise to redeem them for $1000 in a year or less. They are sold at a dis¬
count to make a positive rate of return for the buyer.
14 Certificates of Deposit are different from savings accounts in that a CD has a specific, fixed term (often
three months, six months, or one to five years) and, usually, a fixed interest rate. It is intended that the CD
be held until maturity, at which time it is cashed in for the principal and interest.
15 A Banker’s Acceptance, or BA, is similar to a certified cheque.
16 In a repo, the borrower agrees to sell a security to a lender and also agrees to buy it back from the lender at
a fixed price at some later date.
17 Regular banks are called commercial banks and do the things that economists and the general public asso¬
ciate with banks. They provide the products that allow people to save and borrow. Investment banking
deals only with very large financial investors and does such things as advising on mergers and acquisitions,
underwriting a new stock offering, or speculating with derivatives. Underwriting connects businesses that
need capital with financial investors who have it.
 150 Cocktail Party Economics

the chapter. We will see the vital role that regular banks18 play in bringing borrowers and
lenders together to create such things as car loans and home mortgages.

3. Equity

When I received the Nobel Prize, the only big lump sum of money I have ever seen, I had to do
something with it. The easiest way to drop this hot potato was to invest it, to buy shares.
I knew that World War II was coming and I was afraid that if I had shares which rise in case
of war, I would wish for war. So I asked my agent to buy shares which go down in the event of
war. This he did. I lost my money and saved my soul.

Albert Szent-Gyorgyi (1893-1986), Hungarian physiologist

Taken from The Crazy Ape (1970)

Equity is ownership in a company and can take the form of stocks or shares. If a com¬
pany wants to raise financial capital by selling off ownership, it can list its company’s
stock on a stock exchange. This is done through an investment banker who has a seat on
various stock exchanges. When a company issues stock for the first time, it is said to be
going public with an initial public offering (IPO). If, at a later date, it issues more stock,
these are known as secondary or seasoned offerings. The biggest job of these investment
bank underwriters is to price the stock and facilitate the sale so that the issuing company
will get the financial capital it needs to do its business in the real world.
Stock exchanges19 have requirements for listing, and by necessity the businesses who
list are large companies. It also costs a lot to be a part of an exchange, so only the big¬
gest of these big players list on multiple exchanges. If a company cannot afford to list or
fails to meet the requirements of the exchange, it can still sell shares in the over-the-
counter market. For instance, penny stocks20 are sold in this way. When General Motors
filed for Chapter 11 bankruptcy protection, it was delisted from the various stock
exchanges21 but its stock was still available over-the-counter.
Since 1969, there has been a third option for buying and selling stocks. They now
can be sold through electronic communications networks in much the same way cur¬
rency is traded. A computer automatically matches buyers and sellers who give the same
price. This is done for a small transaction fee.

4. Derivatives

The gambling known as business looks with austere disfavor upon the business known as gambling.

Ambrose Bierce (1842-disappeared 1914), American writer

18 Other institutions offer bank-like services. These include credit unions, trust companies, and savings and
loans companies. Finance companies like those associated with retail outlets (Sears, the car companies)
provide loans without taking deposits. They create debt, then sell it to get the funds to lend.
19 The top eight stock exchanges in the world are the New York Stock Exchange (approximately four times
larger than any other), the Tokyo Stock Exchange, the NASDAQ, Euronext, the London Stock Exchange,
the Shanghai Stock Exchange, the Hong Kong Stock Exchange, and, last but not least (at least from my
perspective), the Toronto Stock Exchange.
~° The terms penny stock, microcap stock, small caps, and nano caps are sometimes interchangeably.
On November 18, 2010, a reorganized GM issued an IPO and was listed again. This allowed governments
to sell off their shares and reduce their ownership of the company.
 Chapter 12: Numb€rs: Financial Markets 151

Derivatives derive their value from some other underlying asset. The most common
types of derivatives available in the market are options, futures contracts, forward con¬
tracts, and swaps.22 Derivatives can be sold over-the-counter like bonds or on special
derivative exchanges23 the way many stocks are traded. The most important role for
derivatives is usually hedging,24 a form of risk minimization. Think of hedging as an
insurance policy against prices not going your way.
But, wait a minute. Aren’t hedge funds partly to blame for the financial crisis? Then
why did something that should reduce risk actually create a financial mess? Well, in
reality, while risk reduction is the goal of hedging, hedge funds actually take the same
derivative products and increase risk to generate above-average returns for their clients.
They are speculators rather than hedgers. They are allowed to do so because only the
very rich can play in this game, and governments don’t regulate hedge funds to the same
degree as other types of financial investments. In terms of regulation, it was felt that the
big boys should be able to take care of themselves. Given the financial mess in hedge
funds and the spillover effects on the economy as a whole, it looks like they aren’t quite
so independent and might need a diaper change. Often these funds borrow money25 to
buy derivatives, a practice known as leveraging, which accentuates the direction of the
gains or losses. Needless to say, in the financial crisis of 2007-2009, it was the losses
that got accentuated.

5. Pooling Assets
Undoubtedly, holding is risky.

Karen Burton Mains, American author

Taken from Comforting One Another: In Life's Sorrows (1997)

Assets can be created by pooling or combining any of the assets discussed above in
some way. Normally, pooling is supposed to reduce risk, but you would never get that
idea from the reporting on the financial crisis. Much of the excitement in the financial
sector has been in this category. Here is where the fortunes of such companies as
Lehman Brothers Holdings Inc. (which went bankrupt—interesting word26), Merrill

22 Options are the right to buy or sell at a certain price some time in the future or to not buy or sell. Futures
and forwards involve the actual buying and selling some time in the future. Swaps trade streams of income
flow but the original assets remain with the original owners. Think of wife swapping: Everyone stays
married to their spouses but they trade services with other partners.
23 The world’s largest derivatives exchanges (by number of transactions) are the Korea Exchange (which
lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such
as interest rate and index products), and CME Group (made up of the 2007 merger of the Chicago Mer¬
cantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile
Exchange).
24 For example, a car company may agree to buy steel from a Chinese company for a particular price with
delivery and payment due six months from now. If that price is quoted in U.S. dollars, the Chinese com¬
pany is subject to exchange rate risk and could lose profits should the value of the U.S. dollar appreciate
against the yuan. It may want to get rid of this uncertainty by entering into a contract that buys the U.S.
dollar for a particular yuan price six months from now. This is called a forward contract.
23 Sometimes called buying on margin.
26 The word bankruptcy is formed from the ancient Latin bancus (a bench or table), and ruptus (broken). A
“bank” originally referred to the bench on which the banker worked in the marketplace. Hence, when a
banker failed, he broke his bank.
152 Cocktail Party Economics

Lynch & Co. (which was bought out by Bank of America), and AIG or American
International Group, Inc. (which needed massive bailout money to survive) played out.
This category saw plenty of action during the fall of 2008.
These gourmet-sounding mixed bags include the following:

• Asset-backed securities, which include such things as asset-backed commercial

paper27 and collateralized debt obligations.28 (I told you: Somebody has to have
issues to make up names like these.) So, what do these things do? These products
convert paper that is not tradable into something that can be traded in a public mar¬
ket. For instance, mortgages negotiated between individuals and their banks are not
tradable but when banks repackage them in groups of mortgages, the mortgage-
backed commercial paper can be sold on world markets. This process is known as
securitization. The bank no longer owns the mortgages even though homeowners
make payments to the bank. The bank services—for a fee, of course—the mortgage
on behalf of the owners and is now just the frontperson. This allows banks that
are heavily regulated to sell locked-in assets like mortgages and convert them to
more liquid funds. The whole subprime mortgage market mess happened in this
category of financial assets.
• Funds, whether they be managed funds, mutual funds,29 investment funds, income
trusts, or pension funds. Fund companies own a variety or portfolio of financial assets
and allow small financial investors to buy units of the entire pool. These financial
investors never directly own the assets in the pool. Rather, the investors are along for
the ride with the fund company—and they hope it is a good one. Funds allow small¬
time investors to spread their wealth out over many assets and “not put all their eggs
in one basket.”

Gimme a Break
There are three kinds of men. The one that learns by reading. The few who learn by observa¬
tion. The rest of them have to pee on the electric fence for themselves.

Will Rogers (1879-1935), American comedian and actor

In terms of broad asset groupings, we have hit most of the lingo found on the front cover
of the business section. I know I have bombarded you with a lot of detail, but it was
really unavoidable. It is precisely because of these minutiae that I find finance a bit
over-the-top, so I can only image what you must be thinking. If you need to take a break,
I completely understand. This is a good spot to do so.

Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized by other
financial assets. In other words, this paper is backed by a collection of other types of paper. ABCP is used
for short-term financing needs.
Collateralized debt obligations are a type of asset-backed security based on a portfolio of fixed-income
assets such as mortgages or car loans.
A mutual fund is a professionally managed investment that pools money from many investors and invests
it in all of the other types of financial assets. These assets can be bought, held, and sold by the fund man¬
ager.
 Chapter 12: Numb€rs: Financial Markets 153

Gossip Column

Merton Howard Miller (1923-2000) was the only child of Joel and Sylvia Miller. His
dad was a lawyer who studied at Harvard, and while Miller followed in his father’s
footsteps by going to Harvard, he studied economics instead of law.
Throughout his academic life, Miller was surrounded by Nobel Prize winners in
economics. Robert Solow (who won in 1987) was in the same introductory economics
class at Harvard. After a career path that involved some government jobs, grad school
at Johns Hopkins, and a brief stint teaching at the London School of Economics, he
joined the faculty at what would become Carnegie Mellon University. It was there that
Miller became colleagues with Herbert Simon (who won the Nobel in 1978) and
Franco Modigliani (who won in 1985).
Merton Miller would see a whole new meaning to his initials, MM. In collaboration
with Modigliani, their ideas about optimal financing of real corporations would become
famous and taught in all corporate finance texts. Modigliani—Miller, known as M&M,
isn’t just candy. Their conclusions were revolutionary. They found that, as long as
governments didn’t distort one type of financing over another, there is no “one size
that fits all’’ when it comes to acquiring financial capital to run a company. This was a
new idea as “case study-type" business schools were teaching optimal debt-equity
ratios on a case-by-case basis. When Miller was asked by reporters to explain why he
won the Nobel Prize in 1990, he gave the following story. After a game, Yogi Berra
was asked if he wanted his pizza cut in quarters or in eighths. Berra answered “in
eighths,” because he was really hungry. This cleverly and clearly demonstrated the
fundamental idea of M&M. Financial assets are just about how you slice the pizza.
This is not where the real action is. The size of the pizza has to do with how the
company is doing as a profitable business.
Miller left Carnegie Mellon to go to Chicago and became colleagues with Milton
Freidman (who won the Nobel in 1976), Theodore Schultz (who won in 1979), and
George Stigler (who won in 1982). As each of these men were avid supporters of free
market solutions to economic problems, Miller fit right in. He believed in the Efficient
Market Hypothesis (more on this theory later in the chapter) and personally held his
wealth in stocks that weren’t actively managed. He did, however, play in the market
from time to time as a gamble.
At Chicago, Merton taught Myron Scholes (who won the Nobel in 1997), who
along with Fischer Black came up with a very mathematical theory for pricing
options—a derivative. Miller also taught Sandy Grossman, who later worked with
Joseph Stiglitz (who won the Nobel in 2001) on the effect that a few investors who
search out information can have on the market as a whole.
Who knows? Maybe hanging out with all of these bright Nobel Prize winners gives
off externalities. I should be so lucky as to catch it.
154 Cocktail Party Economics

IN THE MARKET
Economic life should be definancialized.... Investments should be for entertainment.

Nassim Nicholas Taleb (1960- ), Lebanese-bom philosophical essayist, scholar, and

practitioner of mathematical financial economics
Taken from The Black Swan: The Impact of the Highly Improbable (2007)

Now to the part I like: the underlying economics. It is all comes back to the simple
idea of suppliers and demanders crossing paths in a market. Each of these financial
assets has someone trying to sell or supply the asset and someone trying to buy or
demand it. As discussed earlier in this chapter, they rendezvous in various kinds of
markets, whether formal exchanges, over-the-counter markets, or electronic networks.
The price of the asset changes if more people are selling (price will go down) or if
more people are buying (price will go up). The financial pages of daily newspapers
usually give you the results of the previous day’s stock market trading. They tell you
the opening price, the closing price, and the volume of shares traded for all stocks
listed on the particular exchange they happen to cover. Basically, you are given the
prices and quantities and it is up to you to figure out if there was a supply shift, a
demand shift, or both. Usually, the commentary section will try to explain what
happened that day in terms of what buyers or sellers were doing. Sometimes it will try
to tell you why these participants did what they did. It all makes for interesting reading
if that is what you are into. (I know, I know—some of you are thinking you’d rather
read the obituaries.)
There are some common themes with respect to financial markets, and I’ll give you a
few of them so you see the connection between this chapter and the earlier Venti chap¬
ters—and hopefully you’ll feel as if all of your hard work has finally paid off.
Normally, big buyers of financial assets such as pension funds own something from
each category to get what they feel is a profitable “balanced” portfolio. If anything rele¬
vant changes, it may change the mix they want to hold. For example, if a pension fund
manager wants to hold a few more stocks, he or she may sell some of the bonds to fund
the purchase. Thus, the change in demand for stocks is the direct result of a change in
the supply of bonds. The increase in the demand for stocks (demand shifts to the right)
means that share prices go up. The sale or increased supply of bonds (supply shifts to the
right) means that bond prices go down. If for some reason both stocks and bonds are
unattractive, the managed fund will sell both types of asset and hold cash. This increases
the supply of both stocks and bonds and each sees prices decline. The money market,
however, will see an increase in demand, and those prices will go up. Anything that
makes one type of asset more attractive relative to the others causes this kind of asset
reallocation, which is really about changes or shifts in supply or demand for each type of
asset.

All change is not growth, as all movement is not forward.

Ellen Anderson Gholson Glasgow (1873-1945), American Pulitzer Prize-winning novelist

This switching of assets could be due to a change in how different financial invest¬
ments are taxed or regulated or to a change in their relative risk. If stocks get a tax break,
the demand for stocks is up and the financial company sells bonds to raise funds. A
government may regulate pension funds to hold more bonds, which will increase the
 Chapter 12: Numbfrs: Financial Markets 155

demand for bonds and increase the sale of stocks by pension fund managers. If stocks
are perceived by financial investors to be more risky, the supply of stocks goes up as
they are sold off, and the demand for safer bonds goes up because everyone is buying
them. Prices change until the benefit of switching is gone.
These markets are also affected by the state of the economy as a whole. This could
include expected profits or changes in interest rates. If firms are doing well, they are
issuing stocks and bonds to get the financial capital they need to buy real capital. This
increases the supply of both stocks and bonds. Furthermore, these firms are expecting to
make profits, which will be paid out to their shareholders. This increases the demand for
these profitable stocks. Any bonds outstanding are now less risky because, given the
buoyancy of the economy, the company is sure to pay them back. This will increase
the demand for bonds. Therefore, when economies are growing, the volume of stocks
and bonds traded tends to go up. Prices also tend to rise, which indicates that demand
pressures are more than the supply increases.
On the other hand, if the central bank raises interest rates, this increases the cost of
doing business. As a result, profits go down, and this decreases the demand for stocks. In
addition, the interest payments on older bonds are now not enough to compete with other
interest-bearing assets, so bonds take a capital loss. In other words, bond prices fall due
to a lack of demand. When interest rates increase, the bond and stock markets tend to see
lower prices.
Now that we have all this useful information, it would be nice to do something with it.
(Actually, it can be emotionally fulfilling just to get the information. This is usually only true,
however, if you have the social life of a kumquat.)

Unix Programmer’s Manual

Buyers of these kinds of financial assets want to make informed decisions. Getting
accurate information on a particular stock or bond means knowing details about that
company (or, for some bonds, the government), the industry it is a part of, and the
national and international economy in which it lives. This is a lot of information, but
there are people out there looking for it. As long as the benefits of the information
exceed the cost, analysts are motivated to go after it.

Markets That Get It Right

Where an opinion is general, it is usually correct.

Jane Austen (1775-1817), English novelist

If markets are functioning correctly they are called efficient. This means that the market
price accurately reflects the opportunity costs of both buyers and sellers who know eve¬
rything there is to know. With financial assets, opportunity costs are usually purely
financial rather than mixed with personal preferences. No one in his or her right mind
buys a financial asset because of how pretty the stock or bond looks. Personally, I get
tons of mail from the mutual funds I own and, believe me, I don’t look at all of those
reports as a work of art in their own right. I usually glance at them to see how well my
financial investments are doing and shove the papers in a drawer. (I confess: I some¬
times just stuff the unopened envelope in the drawer.) 1 hold assets now because
 156 Cocktail Party Economics

I plan to sell them later, and later isn’t here yet. Once I sell these financial assets, then I
can go shopping.
The kind of assets people hold is of greatest indifference to most of us, but the return
on those assets is not. This means that everyone wants to buy low and sell really high to
make a big return. If markets are efficient, this should be difficult to do. Why? Well,
let’s suppose that there is this amazing publicly traded stock out there that is currently
undervalued. Once people find out the stock is undervalued, they rush out to buy it.
Normally, because the companies listed on stock exchanges are pretty well known to
those in the business world (who are actively looking for this information), everyone
gets this information at once and the stock price is bid up in minutes. The price is now
“right” and no else will be able to pick this stock as a big “winner.” Now suppose this
happens for all stocks? Then they are all priced right.
If this is true, there are a couple of implications. The first is that you don’t need any
special skills to pick stocks. Pick any one you like. Pick one because you like the sound
of its name. Throw darts on a board. Whatever. If they are all priced efficiently, then a
monkey30 could pick a portfolio and do as well as the average fund manager. Further¬
more, you’d only need to pay the monkey in bananas. Believers in Efficient Market
Hypothesis (EMH) believe that the best financial investments are low-cost index funds
rather than high-cost managed funds. On average, the returns are similar but the costs
are not.
It is hard to imagine that a fund manager who happens to do well five years in a row
is just lucky rather than clever, but it’s possible. Think of stock picking as tossing a coin.
You have a 50-50 chance of heads or tails every time you toss. If you toss a fair coin
and get heads five times in a row, this does not indicate a trend. There is no predictive
power in your tosses. Next time you toss, you are no more likely to toss heads or no
more likely to break the trend and toss tails. A completely random process can toss 100
heads in a row.31 It is therefore possible for a fund manager to beat the average every
year for 15 years, as William Miller did, and for the process of picking stocks be com¬
pletely and utterly random. In fact, probability dictates that out of all the people picking
stocks, somebody should fit this profile.

I Should Be So Lucky
There is no such thing as luck. There is only adequate or inadequate preparation to cope with
a statistical universe.

Robert Anson Heinlein (1907-1988), American writer

Taken from Time Enough for Love (1973)

Others aren’t quite so committed to the Efficient Market Hypothesis. They find it hard
to believe that people like Peter Lynch (who made unbelievable returns when he ran
Fidelity’s Magellan Fund from 1978 to 1990), William Miller, and Warren Buffett are
just lucky fellows. There is some research that indicates that these naysayers might be
right and that strategies do exist to consistently and repeatedly outperform the market.

30 Mr. Adam Monk, the Chicago Sun-Times' stock-picking monkey has beat the market for four years
running.
31
See The Drunkard’s Walk: How Randomness Rules Our Lives (2008) by Leonard Mlodinow.
 Chapter 12: Numb€rs: Financial Markets 157

These approaches tend to fall into three categories, all looking at some part of the
picking process. They include the following:

1. Having a genius or insider as the picker

2. Moving quickly once the information gets out
3. Understanding that smart people have biases and make systematic errors

1. In the Know

Anybody who plays the stock market not as an insider is like a man buying cows in the
moonlight.

Daniel Drew (1797-1879), American financier

Without a doubt, there are some people who as a group consistently outperform the mar¬
ket. They are known as insiders and this is the reason why Martha Stewart32 went to jail.
If you trade on information not yet known to the public, you can do better than the mar¬
ket. However, be careful. It is precisely for this reason that insider trading is a crime in
North America and that CEOs must announce when they are personally buying or sell¬
ing their companies’ stock. In Martha Stewart’s case, it is still insider information if you
get a tip from a broker (Peter Bacanovic) who also works for the CEO (Samuel D.
Waksal) of another company (ImClone). Essentially, insider information is an example
of asymmetric information that causes the market to become efficient once the informa¬
tion is out of the bag and in the public domain.
On the other hand, there may be individuals who are really good at interpreting the
volume of information available on these companies, sorting out what is relevant, and
seeing potential that others don’t see. For example, Warren Buffett bought Coca-Cola
stock in 1988 when it wasn’t doing well. Somehow, he knew that the company had great
untapped potential in overseas markets. He was right and, once Coca-Cola expanded
into other countries, the stock took off. These great minds may exist, but one thing is
certain. They are sort of like sports stars. They are not common, and the odds are that
you and I are not part of that group.

2. A Mover and a Shaker

It is no use to keep private information which you can t show off.

Mark Twain (1835-1910), American writer and lecturer

As I mentioned earlier, if new information comes to light, the market can respond within
minutes. But, for those minutes, the stock is undervalued or overvalued. Some invest¬
ment banks have departments that specialize in fast trading. These traders watch
computer screens for news and are always connected to securities dealers. If something
comes in, they react immediately to make a profit.
Goldman Sachs went further with a computer program that looked for disequilibrium
at the level of the millisecond. In July 2009, when employee Sergey Aleynikov suppos¬
edly stole the computer code, this created a financial sensation for two reasons.

32
According to the U.S. Securities and Exchange Commission, Stewart avoided a loss of $45 673 by selling
all 3928 shares of her ImClone stock. The day after her sale, the stock’s value fell 18 percent.
 158 Cocktail Party Economics

Aleynikov was arrested by the FBI on industrial espionage charges, which is always
titillating news to financial types, but, more importantly, the following statement was
made by Assistant United States Attorney Joseph Facciponti: “There is a danger that
somebody who knew how to use this program could use it to manipulate markets in
unfair ways.” This statement raised the interesting question of whether this practice is
truly ethical. Needless to say, if you and I are leisurely reading the paper, picking stocks
during our morning coffee break, we are a little too late.

3. Disturbing Behaviour

The difference between stupidity and genius is that genius has its limits.

Albert Einstein (1879-1955), German Nobel Prize-winning theoretical physicist

The final criticism of Efficient Market Hypothesis is much more fundamental. This research
maintains that stocks can be overpriced or underpriced for a long time due to human predis¬
positions. Dan Ariely, in his book Predictably Irrational: The Hidden Forces That Shape
Our Decisions, outlines many of the ideas of this school of thought. Most of the applications
to finance have to do with the underlying cognitive biases people may have.
Let me give you a few quick examples from the research:

1. It turns out that people have a very strong aversion bias against loss, even if the loss
has a low probability and the gains are very probable. They are therefore
“irrationally” unwilling to make those profitable investments.53 This may explain
why stocks of small firms tend to make higher returns. Fund managers are unwilling
to hold them because of a fear of any loss, even if the probability of loss is very low.
2. People continue to work on projects doomed for failure if they have already committed
resources to them. People don’t want to lose when they should let it go. For example, a
fund manager may hold a stock thinking it will have to turn around eventually.
3. Individuals have a very high opinion of their opinions. (Most people see themselves
as above average, which of course is impossible on average.) If analysts have
predicted that a stock will do well, they are unwilling to change their minds very
quickly should bad news come in. This means that they don’t react to the change fast
enough and remain anchored to their previous opinion. The stock is not priced
correctly until the anchor gives way.
4. Individuals exhibit an endowment effect. They value what they own more than they
would if they were buying it new. This may keep stocks in a portfolio longer than is
optimal.
5. Cognitive bias can also help to explain herding behaviour, which leads to bubbles. If
everyone is buying, others buy; if everyone is selling, others sell. No one wants to
look like the fool if something is a real trend. Besides, if you are foolish to buy high,
the only ones who will lose are those at the cusp. You may be able to sell to an even
greater fool.

Israeli behavioural psychologist Daniel Kahneman (1934—) won the Nobel Prize in Economics for his work in
this area. His writing partner, Amos Tversky, would undoubtedly have won as well but he died before the
award was given. Nobel Prizes are never awarded posthumously. Both men moved into this area of economics
because of their chance meeting with economist Richard Thaler. I guess you could call that good luck.
 Chapter 12: Numb€rs: Financial Markets 159

The implications of this work are the following. If a computer could be programmed
to overcome these systematic cognitive issues, it should be a better stock picker. Richard
H. Thaler, an American behavioural economist, has done just that, but the jury is still out
on whether this approach does pick better or if it is just randomly lucky in the same way
the monkey portfolio is. We will probably need about 200 years of data to know for
sure.
Phew, here is another spot to stop if you need a break.

TOO BIG TO FAIL

The financial industry had always been intended to be something of an unseen backroom
support for the broader economy, helping new businesses get off the ground and mature com¬
panies adapt and expand. Yet in the years leading up to the crisis, the finance sector itself
became the front room. The goal on Wall Street became to generate fees for themselves as
opposed to for their clients.

Andrew Ross Sorkin (1977- ), American writer

Taken from Too Big To Fail (2009)

As discussed in the last chapter, externalities can cause market failures. This is a big deal
in financial markets because, fundamentally, financial markets are all about the positive
impact of paper markets on real markets. If it weren’t for the positive spillovers that fi¬
nancial capital has on real capital, these paper assets would not have a raison d’etre. It is
precisely because we can’t eat, wear, or live in stocks and bonds that the buying and
selling of paper assets needs to be protected. If you have to choose between saving a
major car company or saving a major investment bank, go for the bank. Cars are real and
don’t need to be saved. Paper, on the other hand, is the grease behind everything real in
the economy. If that grinds to a halt, the entire real economy grinds to a halt as well.
This is similar to the instructions given to parents on a plane. In the case of an emer¬
gency, make sure you put on your own oxygen mask first and then place the mask on
your child.

Calling Information
The study of money, above all other fields in economics, is one in which complexity is used to
disguise truth or to evade truth, not to reveal it.

John Kenneth Galbraith (1908-2006), Canadian-born economist and author

Taken from Money: Whence It Came, Where It Went (1975)

After all this talk of picking good stocks, you would think that stocks are the most im¬
portant type of financial capital used to fund the real economy. Not true. Stocks account
for less than 12 percent of the total funds. I can hear you gasp. So, what is the most im¬
portant source of capital for business in the developed world? Let me give you a hint.
It’s not bonds. Rather, old-fashioned loans and mortgages through a bank (or something
that acts like a bank) account for more than half of financial capital raised. This keeps
the wheels of the economy turning. The question is, why? If stock markets can easily
move funds from savers into the hands of investors, why isn’t it the main conduit for
this process? It turns out that financial markets face asymmetric information issues.
 160 Cocktail Party Economics

transaction costs, and property right issues at every turn—all of the things we discussed
in previous chapters—and that banks or near banks are uniquely positioned to solve
these problems.

Picking a Lemon
/ ’ll be with you in a squeezing of a lemon.
Oliver Goldsmith (1728/1730-1774), Anglo-Irish writer
From She Stoops to Conquer (1773)

So, what are the problems that banks and near banks can solve? Let’s think about the
dilemma of an individual saver who wants to park his or her life savings in order to have
a comfortable retirement. How does one know if the borrower of these savings is good
for the money, especially if he or she is a stranger? If you invest in a company, how do
you know if it is a profitable one? You might pick a lemon and lose everything, or at
least not do very well. This adverse selection problem is so worrisome that the lending
market would be significantly smaller and only limited to large well-known companies
if it weren’t for bank-like institutions. The big companies can signal to financial inves¬
tors across the country their creditworthiness and solve their own adverse selection prob¬
lems. They do this when they hire expensive accounting firms to audit their books
(although, as we saw with the Arthur Andersen-Enron scandal, this doesn’t necessarily
mean anything) and expensive investment bankers to do their IPOs. By law, both ac¬
counting firms and investment bankers must show due diligence as they certify their
clients, thereby solving the asymmetric information problem. However, small and mid¬
size companies cannot afford this signal in order to sell their stock. These companies
may be great investments but, because of “the lemons problem,” private lenders cannot
or will not risk lending to them. This is a loss on the real economy side.
All is not lost, however. Screening of smaller firms can be done fairly cheaply by
banks. Banks can conduct interviews, look at a company’s financial statements, visit its
facilities, and check its credit rating to see if the business is a good risk for a loan. On
the personal side, they can send someone out to see if a house is worth the mortgage
they are putting on it, ask for tax returns, and check personal credit ratings. This allows
individuals to get access to funds to buy a home. It also allows savers to know that their
savings went to a good home.
Furthermore, these banks can use and keep the information private. Stock and bond
markets cannot. For example, if a bond rating agency publishes bond ratings for its cli¬
ent who pays a lot for the reports, they cannot prevent others from free riding on the
information and using it without paying for it. This means that less information gather¬
ing occurs than is optimal in these direct markets. On the other hand, banks have the
incentive to get as much information as they can on would-be borrowers because they
alone profit from that information.

Too Small to Play

A person’s a person, no matter how small.

Theodor Seuss Geisel (1904-1991), American writer and cartoonist

Taken from Horton Hears a Who! (1954)
 Chapter 12: Numb€rs: Financial Markets 161

In terms of saving money, small-time investors (people like me) cannot directly play in
the stock market cheaply. Each purchase or sale of a stock generates a brokerage fee or
transaction fee, and the percentage is bigger the smaller the sale. Furthermore, in order
to reduce risk, it is a bad thing to buy only one stock. (The pension funds of many U.S.
companies have an overemphasis in those companies’ stock. If a company goes bank¬
rupt, this is a very bad thing indeed for its workers.) It is estimated that a person needs to
hold at least 15 different stocks34 in various sectors to minimize his or her exposure to
undue risk. This becomes expensive in terms of transactions fees. Banks, on the other
hand, often provide mutual funds, which are a cheaper way to buy multiple stocks. But
even if they don’t sell mutual funds per se, they hold a portfolio of loans and mortgages
that spreads the depositors’ (lenders’) risk over many borrowers. Thus, banks act as a
go-between for small firms and small financial investors to reduce risk at a low cost.

Hazardous to Your Financial Health

There is danger from all men. The only maxim of a free government ought to be to trust no
man living with power to endanger the public liberty.
John Adams (1735-1826), American president

The other problem that needs to be solved in order for savers to part with their hard-
earned savings is the problem of moral hazard. What if the borrower takes the money
and spends it on jet planes, high-end parties, or expensive office equipment? This will
not generate profits to repay the loan or pay stock dividends. Banks again can monitor
their clients more cheaply than the average person can. They can add legal covenants to
the contract restricting what the borrower can do with the money. If someone borrows
to buy a house, the house is now held as collateral by the bank. To make sure that the
borrower behaves appropriately, banks require the borrower to put in some of his or her
own money in the form of a down payment or ask for a co-signer on the loan. The more
the borrower has at stake, the less likely he or she is to fritter away the funds. (My
parents would have killed me if I had defaulted on a loan they had co-signed.) Banks can
put the incentives in the right place.
Moral hazard also explains why CEOs of large corporations are paid mostly in stock
options rather than a salary. They now have something of theirs in the mix. It also
explains why bondholders place restrictions on corporate boards or even have a seat on
the board. If a board engages in very risky investments with the bondholder’s funds, the
only money it is losing is the bondholder’s. But if things go well, the shareholders get
the entire surplus. Bondholders have to watch for these incentives. Furthermore, share¬
holders are taking their revenge against CEOs who use their money in inappropriate
ways. Canadian media baron Conrad Black was accused of corporate kleptocracy, which
is a fancy way of saying that he personally took funds that belonged to all shareholders.
Fie was charged with fraud and obstruction of justice and sentenced35 to jail in the United
States.

34 See Wagner, W.H., & Lau, S.C. (1971). The effect of diversification on risk. Financial Analysts Journal,
27(6), 48-53.
35 Black appealed the ruling and, as of October 28, 2010, was left with only one count of mail fraud and one
count of obstruction of justice. The court also ruled that he must be resentenced.
 162 Cocktail Party Economics

Law and Order

The world of antitrust is reminiscent of Alice's Wonderland: everything seemingly is, yet
apparently isn’t, simultaneously.
Alan Greenspan (1926- ), American economist and chairman of the U.S. Federal Reserve
Taken from “Antitrust," published in Capitalism: The Unknown Ideal 11961)

Needless to say, given the importance of financial markets and all of the potential for
market failure, financial institutions (banks, in particular) are some of the most regulated
companies in the developed world. This is generally a good thing. Let’s look at each
market failure mentioned in the previous chapter and see what governments are doing
about each.

1. Concentrated Markets
Governments try to keep the industry competitive with strict merger and acquisition
regulations. However, the industry is still marked with TBTF, or the Too Big to Fail
phenomenon.36 In financial crises, governments actually encourage these kinds of mergers
in order to keep the amount of bailout money required to a minimum. For example, in
March 2008, as a result of the financial crisis, the Federal Reserve arranged the takeover of
Bear Steams (which had lost $3 billion in asset-backed securities of subprime mortgages)
by JPMorgan Chase. Normally, banks like to merge because it reduces the cost of doing
business due to economies of scale and scope37 (which is a good thing) and because it gives
them more market power (which is a bad thing). Governments have to weigh the pros and
cons as they approve these mergers and acquisitions.

2. Externalities
As discussed, financial markets are all about positive externalities. If banks fail, the collateral
damage can be horrendous. Even if banks are perceived to be failing, it can result in a bank
run and shove good banks over the edge into bankruptcy. As people rush to get their deposits
out of a bank they fear might fail, it causes that bank to actually fail. Therefore, deposit
insurance is required by law because it gives confidence to savers that their money is fine
where it is. Take a deep breath. There’s no need to have a bank panic attack.

3. Asymmetric Information and Information Gathering

Information is critical to efficient financial markets, but information suffers the problem
of being a public good. On publicly traded assets like stocks or bonds, there is no means
to exclude non-payers from using information once it becomes available. Therefore, not
enough information is collected on the whole. Governments help by legislating
mandatory disclosure laws, forcing the information to be acquired and made public.
These could include standardized accounting practices across the G-10 countries, rules
ot board governance, and requirements for CEOs to publish their trading activites,
including any potential conflict of interests.

First used in 1984 to bail out the Continental Illinois National Bank and Trust Company.
Economies of scale is about producing more of the same thing (e.g., loans) at a cheaper price. For example,
larger banks can have a lawyer on staff to handle all of the mortgages. Economies of scope is about producing
related products (loans, mutual funds, life insurance, etc.) with the same agent. This again reduces the cost.
 Chapter 12: Numb€rs: Financial Markets 163

4. Government-Legislated Prices
Governments can also legislate interest rates. Interest rates are really prices on
borrowing and lending money, so this is paramount to legislating a price. Typically, this
is not a big problem in developed countries because the laws are usually about very
specific unusual loans, such as payday loans38 or loan shark activities. However, the
United States created difficulties for normal banks with Regulation Q,39 which started
out with the best of intentions. This regulation prohibited banks from paying any interest
on chequing accounts. Needless to say, once less-regulated saving alternatives hit the
market, it became hard for banks to get people to save with them, especially when the
competition from money market mutual funds paid interest. Not to be left in the cold,
these banks developed other products that got around this rule. Regulating interest rates
is generally a bad idea.

5. Asymmetric Information and Moral Hazard

We looked at asymmetric information problems extensively already, so I won’t repeat
myself. Here I just want to note that moral hazard can be created by regulations. For
instance, if a bank knows that it is too big to fail or that, if it does fail, deposit insurance
will clean up the mess, it could choose to engage in very risky behaviours. To prevent
this, governments require the banks to hold reserves of cash or other short-term capital.
Furthermore, all financial institutions are monitored by various government agencies and
must submit reports on a regular basis. Governments also criminalize and prosecute
white-collar financial fraud such as Ponzi40 schemes, hiding of losses41 or falsifying
trading records,42 insider information, and conflicts of interest such as front running.43
The hope is that the severity of the punishment will deter others from trying the same
types of fraud. One thing is certain: Even with government intervention, moral hazard is
difficult to eliminate in the financial sector.

Abnormal Behaviour
Every normal person, in fact, is only normal on the average. His ego approximates to that of
the psychotic in some part or other and to a greater or lesser extent.

Sigmund Schlomo Freud (1856-1939), Austrian psychiatrist

38 According to the Criminal Code of Canada, any rate of interest charged above 60 percent per annum is
considered criminal.
39 Regulation Q was put in place by the Glass-Steagall Act of 1933 but phased out by the 1980s. The key
provision of Regulation Q that remains is that banks cannot pay interest on chequing accounts.
40 The term Ponzi scheme is a widely used description for any scam that pays early investors returns from the
investments of later investors.
41 In 1995, Nick Leeson of Barings LLC, without anyone’s permission, started to bet on derivatives. He
hid his activities from his superiors and succeeded in bankrupting the company, but not before he lost
$1 billion. He went to jail and wrote a memoir. He is now out of jail, speaking on the dinner circuit, and is
the CEO of an Irish football club.
42 In 2008, Jerome Kerviel of Societe Generate made bets on the futures market. He falsified documents and
lost the company 4.9 billion euros. He was arrested for fraud.
43 Front running means that a broker buys for himself before he buys for the client whose order is large
enough that it may change the price.
 164 Cocktail Party Economics

In many ways, the subprime mortgage crisis of 2007-2009 is counter to the normal func¬
tioning of banks. This crisis only happened because banks (or near banks) were giving
ninja mortgages (no income, no job or assets) to people who were therefore very risky.
This was partly the result of a political push to encourage home ownership among low-
income earners. Furthermore, the banks were willing to provide these mortgages because
the loans were taken off the banks’ books through the process of securitization, creating
asset-backed securities of these subprime mortgages. The loans were then no longer the
bank’s problem, so they didn’t worry about them. It appears that the scene was ripe for a
little moral hazard. The incentives were huge to provide as many bad loans as possible
because they were so profitable with little liability. Down the line, other international
financial investors bought these asset-backed securities because they were first bought
and then sold by Fannie Mae and Freddie Mac,44 which were receiving affordable hous¬
ing credits from the U.S. government for buying and repackaging these subprime securi¬
ties. Here, the government was trying to increase home ownership in the United States.
Rating agencies perceived the implicitly government-backed securities as very safe and
gave them high ratings.
All was well as long as housing prices continued to rise. The assets backing the
paper were worth something; therefore, the paper was worth something. However, once
housing prices started to plummet, the paper followed suit. That, of course, was bad, but
it gets worse. Hedge funds leveraged themselves to buy these asset-backed securities, so
any decline in value of this paper was magnified. Furthermore, these asset-backed secu¬
rities were downgraded by the rating agencies, which led to the downgrading of AIG, an
American insurance company, on September 16, 2008. AIG, which previously could
engage in the derivatives markets without collateral, was suddenly required to come up
with collateral for all of its deals. Of course, AIG didn’t have it and encountered a
liquidity crisis. To add insult to injury, on October 22, 2008, the creditors of Lehman
Brothers who had bought derivatives (credit default swaps) from AIG to hedge against
a Lehman bankruptcy—settled their accounts when the bankruptcy happened. AIG will
never be the same. All of this happened because the initial bank managers were no
longer left holding the bag. The moral of the story is this: If banks get stuck with bad
loans, they usually solve the adverse selection problem. If the incentives are thoughtless,
moral hazard happens.

Closing Markets
One sees qualities at a distance and defects at close range.

Victor Hugo (1802—1885), French writer and statesman

As I end this chapter, I don’t want to give the impression that financial markets are such
a mess that we should just give up on them. That would be a mistake. Financial markets

The Federal National Mortgage Association, commonly known as Fannie Mae, was founded during the
Great Depression as a government-sponsored enterprise. Its mandate is to keep the number of loans flow¬
ing to the lower-income public by agreeing to buy these loans from the banks, thus removing them from
the banks books. Fannie Mae then repackaged the loans into groups and resold them to investors. These
are called asset-backed securities in general and collateralized debt obligations in particular. Freddie Mac
does basically the same thing but is not constrained to mortgages of low-income families.
 Chapter 12: Numb€rs: Financial Markets 165

are the main reason that the Western world has such a high standard of living, and that
point should never be lost. One of the best things about humans is that we can learn and
make improvements to our systems. Furthermore, small changes can make a big
difference. I am optimistic that the financial crisis of 2007-2009 will result in a few
regulatory changes for the better and that we will weather the storm.
 Conclusions: Tying
Up Loose Ends

It is the loose ends with which men hang themselves.

Zelda Sayre Fitzgerald1 (1900-1948), American writer

The retirement party invitation reads:

Cocktails at 6 p.m.

Dinner at 7 p.m.

You arrive early for the evening’s festivities at 5:35 p.m. In fact, you get there so early
that the room is empty except for the guest of honour—your boss—and his family. After
greeting him, you turn your attention to his entourage. His wife, a banker, looks lovely in
her little black dress and genuine pearls. You can tell that she is pleased and proud that
all four of their children are in attendance. You shake hands with each in turn.
The oldest daughter works in advertising but is currently on parental leave. She
stands beside her husband, who is holding their adopted son. Recalling the numerous
stories of expensive, failed in vitro treatments, a complicated adoption process, and the
mix-up over a neighbour cutting down a tree during their adoption celebration party, you
offer your heartfelt congratulations on the new addition to their family. However painful
the journey to this point has been, they seem to be very happy.
The next oldest—a son—is a partner in an accounting firm. You can tell that he is
very much like his dad in both looks and temperament. Recently, his wife thought she
had discovered a Jackson Pollock painting at a garage sale. So far, no one in the art
community will authenticate the painting, and she continues to work at a local art gallery.
Their two children—a boy and a girl—are in elementary school. The boy appears to be
discreetly putting a spider down his little sister’s back.
The third oldest looks very theatrical ... and very pregnant. You know that this was
not a planned pregnancy and that her career as a Shakespearean actor is on hold for a
while. Looking closely at her face, it appears that she has come to terms with her situa¬
tion. She holds hands with her husband, who is sporting a happy grin. What great teeth.
Of course—he’s a dentist.
Last, but not least, is the youngest son, a boyishly handsome young man. He plans
to squeeze four years into six in order to max out his football eligibility and still get a de¬
gree. His dad worries that he parties a bit too much and studies too little. His date for the
night is the most drop-dead gorgeous blonde you have ever seen, except for maybe in
the movies. He must be doing something right!

' Wife of writer F. Scott Fitzgerald. Theirs was a tempestuous marriage.

166
 Conclusions: Tying Up Loose Ends 167

As the room fills up, the wait staff bring around complimentary glasses of wine.
Should guests want anything other than wine, they can buy it from the bar along the back
wall.
Oh, no! You notice that, in the corner, two senior partners have already started to
talk politics. They can never agree on anything, let alone politics. You make your way
over to save the day but your attempt turns out to be unnecessary. They are interrupted
by a young woman with a prosthetic shoe. She gushes, “Thank you so much for the
scholarship. I can’t tell you what this means to me now that the cost of my final year is
covered. What a luxury to be able to quit my bartending job and focus completely on my
studies. Thank you. Thank you.” The gentlemen are obviously delighted that their contri¬
butions to the linguistics endowment fund are so greatly appreciated. They both reiterate
the sentiment that the money couldn't have gone to a better recipient. You think, wow, at
last, something they agree on!
The cocktail hour is coming to an end and the master of ceremonies issues a call for
guests to take their seats. You quickly and surreptitiously check your BlackBerry for text
messages. There’s nothing important.

A BIG ENDING
What is written without effort is in general read without pleasure.
Samuel Johnson (1709-1784), British writer and lexicographer

We have come to the end of this book, and it is time to retire this baby. According to
websites that specialize in giving advice on how to give a good speech, construct a good
essay, or pen an effective non-fiction book, the conclusion is very important. It should
summarize all of the major points, restate some thesis found in the introduction, and
leave the audience wanting more. In my case, the more would be another Cocktail Party
Economics book. To be honest, I don’t see how repeating myself would make you want
to read another book. It sounds so boring that, frankly, I just can’t bring myself to do it.
So here’s what I’m going to do instead. I will give you what I think are a couple of
major implications of markets. These may seem like new ideas, but hopefully they will
make sense given what you have read so far.

Get to the Points

There ain't no such thing as free lunch.
Taken from Economics in Eight Words2

First, economics is mostly about exchange. This is in contrast to the answer I get when I
ask people: “What do you think economics is all about?” Most people answer “money.”
Granted, money is often involved, but it doesn’t have to be. For example, I don t think
it would be a good idea if, after a pleasant evening spent in bed, the husband or wife
(depending on who “demanded” and who “supplied”) left a little cash on the night table
to finalize their transaction. On the other hand, there is an economic theory postulated by

2 El Paso Herald-Post, June 27, 1938, but often attributed to Milton Friedman.
 168 Cocktail Party Economics

some academics that marriage is an arrangement whereby women and men trade sex for
security. I will leave you to debate who is getting what.3
Furthermore, in a recent book called Catching Fire: How Cooking Made Us Human,
primatologist Richard Wrangham outlines another exchange theory that suggests that the
responsibility traditionally shouldered by women for meal preparation has its roots in an
implicit contract whereby the male protects the food supply of the woman in exchange
for her culinary skills. Today’s markets with explicit prices are just a more sophisticated
version of that exchange. Now the food chain has more complicated contracts between
complete strangers and women who want to eat out.
Second, don’t be scared of markets. They are not inherently evil. Rather, a well¬
functioning or efficient market brings many buyers and sellers together to give every¬
body what they want: a better life than the one they’ve got. In order for life to be truly
better, all individuals must ultimately be consumers. Adam Smith, the granddaddy of
economics, couldn’t have said it better when he wrote, “Consumption is the sole end and
purpose of all production; and the interest of the producer ought to be attended to, only
so far as it may be necessary for promoting that of the consumer.”
Furthermore, virtually all buyers and sellers exchange freely and without compul¬
sion. They do what they do because they want to. Nobel Prize—winning economist
Milton Friedman summarized this point when he said, “The key insight of Adam
Smith’s Wealth of Nations is misleadingly simple: if an exchange between two parties is
voluntary, it will not take place unless both believe they will benefit from it.”4
Third, incentives matter.5 Markets generate prices, and these prices act as reference
points in decision making. For consumers, price represents the opportunity cost against
which they evaluate their marginal values. Only if the marginal value exceeds the price
is the item worth buying. For producers, the price embodies the marginal benefit of
taking their products to market. As long as the marginal benefit covers the opportunity
cost ot production, the firm has an incentive to make it. It doesn’t matter if prices are
explicit or implicit; all exchange is ultimately about opportunity costs and marginal
values. Prices just take the guesswork out of what those final numbers are. As a result,
only those items that have a higher value in the minds of the consumers than the oppor¬
tunity cost paid by the producers actually get bought and sold. This is a good thing.
Society should never use scarce resources to make something if people do not value it
enough. If marginal values or opportunity costs should happen to change ... no problem.
Buyers and sellers will get the message through the price signal and react accordingly.
The system works.
Fourth, markets aren t sacred and therefore shouldn’t be worshipped. Usually,
markets offer a great way to allocate scarce resources, and fortunately they usually get it
right. But and this is a big but, I cannot lie—sometimes markets get it wrong. If a
market can solve its own problems, great—leave it alone. But if it can’t, it is up to gov¬
ernments to ride in on their big horse and save the day. However, governments should be

For an interesting economic discussion about this topic, read Tim Harford’s book The Logic of Life,
page 71.
Taken from Free to Choose: A Personal Statement, by Milton and Rose Friedman. The Economist hailed
Milton Friedman as “the most influential economist of the second half of the 20th century possibly of
all of it.”
This is the main point of the bestselling books Freakonomics and Super Freakonomics.
 Conclusions: Tying Up Loose Ends 169

careful to not create bigger problems than the ones they are trying to solve. They need to
keep in mind the law of unintended consequences. If governments institute policies that,
unbeknownst to them, change either opportunity costs or marginal values, then people
will change their behaviour, and not always in the ways hoped for.
By now, I hope you realize that the discipline of economics is really a way of think¬
ing about anything that involves choice. Most economists aren’t too confident that
governments can come up with a better system than the free market to assist in those
choices. This may be why we are so committed to it.

I'M SO GLAD WE HAD THIS TIME TOGETHER

Oddly enough, it is the market—the least overtly spiritual of concepts—that delivers a
profoundly spiritual message: that it is through exchange that difference becomes a blessing,
not a curse, enrichment, both sides gain.

Baron Jonathan Henry Sacks (1948-), British Chief Rabbi

Taken from The Dignity of Difference (2003)

Well, there you have it. A few big ideas and a lot of small talk about markets. I hope you
feel more confident during cocktail party conversations. Even if these kinds ot conversa¬
tions aren’t your thing and you would rather discuss the latest movie or novel, there are
still some benefits to knowing this material. If you happen to be a woman, remember
that an educated understanding of a subject viewed as a typically male one is like fantas¬
tic underwear. No one has to see it, but you can feel the difference and it changes how
you carry yourself. If you are a man, lightly chit-chatting on these matters with savoir
faire is very attractive, especially if you know when to stop. Remember, the marginal
value of anything—even economics—diminishes.

GOSSIP COLUMN WITH SPECIAL

FEATURES AND END CREDITS
An author who speaks about his own books is almost as bad as a mother who talks about her
own children.
Benjamin Disraeli, 1st Earl of Beaconsfield (1804-1881), British prime minister

Throughout the pages of this book, I have told you a lot about economics and econo¬
mists and a little bit about myself. It’s time to reverse those proportions. Here is my
opportunity to give you a behind-the-scenes look at the creation of this book, as well as
to give credit where credit is due.

Look Who’s Talking

One of the best decisions I made at the absolute beginning of this project was to have a
writing partner who could actually write. Rick Maranta and his wife, Judy, also happen
to be long-time friends of my husband, Martin, and me. One of the amazing things about
working with Rick is his ability to fundamentally change every paragraph of the book,
 170 Cocktail Party Economics

yet keep my voice. When people who know me read the final manuscript, they felt as if
it was me talking.6 / felt as if it was me talking. As the Brits would say, “Brilliant.”
I have to tell you that this book would never have seen the light of publishing day
without my friend Rick. It wasn’t just a comma here and a verb tense there. His editorial
comments made me work twice as hard to get it right. Let me give you one example of a
comment he wrote to me on Chapter 6: "A real-world example of this situation is really
important. You are tending to veer into the abstract without any tangible example that
people can relate to. A book like this must have lots of examples.” Rick improved the
entertainment factor of the book and, because of that improvement, dare I say improved
the educational value of it as well. It is our wish that you can read this book on the
beach, at the cottage, or on public transit.

The Readers
Economists are generally negligent of their heroes.
John Kenneth Galbraith (1908—2006), Canadian-born economist
Taken from The Age of Uncertainty (1977)

I started out with many readers for the first chapter of this book, but the field quickly
narrowed to two women who stayed with me every step of the way. I would like to
express my profound thanks to Patricia Swidinsky and Mary-Jane Davison. Essentially, I
wrote and they read. Furthermore, they were always positive and excited about what I
way trying to do but gently let me know when they didn’t understand what I was saying.
I pictured their faces as I typed on my QWERTY keyboard. Both are intelligent,
educated, and interested in learning more about economics. I couldn’t ask for a better
first audience.
My sister Marian Van Calbi started reading for me near the end of the writing proc¬
ess, but she had great ideas. She asked me to tell her what happened to all of the people
in the various cocktail party vignettes. She wanted to know more about these fictitious
people. This chapter’s opening story is a direct result of that request. I didn’t incorporate
the busy retirees who participated in the car rally and attended the opera. Needless to
say, our guest of honour is a friend and plans to participate in their future adventures. I
haven t sorted out whether his wife is going to take early retirement to join him yet. I
also didn’t know how to tell you that the bride’s family store did go out of business, but
thankfully the dad works as the local store manager for the new big-box store.
I wish to thank my good friend Brenda Murray for her lovely drawings of Rick and
myself. We decided that a book like this needed a bit of glamour and a picture of us
probably wouldn’t “cut it.” Brenda promised to make us look great without the necessity
of surgery!
I would also like to thank my colleagues in the Economics department at the Univer¬
sity of Guelph. Many of them read a chapter in their area of expertise and gave me
valuable feedback. They are Asha Sadanand, Atsu Amegeshi, Michael Hoy,
Laurent C ellier, Francis Tapon, Bram Cadsby and former colleagues Ray Rees, Louis
Christofidies, Graeme Wells, and Merwan Engineer (who saved me from a very

To hear Rick speak in his own voice, please read the Afterword.
 Conclusions: Tying Up Loose Ends 171

embarrassing mistake). Economists can be a picky bunch when it comes to economic

theory and the last thing I wanted was to get slammed by the broader academic commu¬
nity. Therefore, I asked Professor Brian Ferguson to read the gossip columns. Brian is
very much like the featured early economists: well read—his library is legendary and his
memory encyclopedic—and a bit of a quirky dresser. When he wears bifocals, it is really
two pairs of glasses! These economists kept me from sacrificing accuracy in order to
make things readable. Any economic errors are certainly not their fault. On the creative
side, our former graduate secretary Anne Bolger told me that I needed to add a summary
(the napkin notes) at the end of each chapter. Lastly, my chair, John Livemois (who
co-teaches introductory microeconomics), agreed to use this book as part of our curricu¬
lum. To all of them, my fulsome thanks.

Counting the Cost and Paying the Price

A woman must have money and a room of her own if she is to write fiction.

Adeline Virginia Woolf (1882-1941), English writer

Usually, the last individuals to get thanked are family members. Furthermore, they are
usually thanked for enduring all manner of trials and tribulations imposed upon them
during that the writing of the book. While I have things for which I wish to thank my
husband and two sons, in all honesty the price they paid for me to write this book is not
one of them. Let me explain. Martin owns an environmental consulting company and
has a home office in the basement of our house. He has had this home office since our
youngest child was a year old, and that child is now a teenager. Martin works a mini¬
mum of 60 hours a week and, frankly, I don’t think my new busyness really registered
because his nose was to the proverbial grindstone.
Probably my oldest son has the biggest beef with me, but only because the desktop
computer I really like to use is in his room. (We bought him an expensive laptop.) On a
regular basis he would say, “Mom, can I have my room back?” to which I would reply
“Give me 15 more minutes.” I will admit that he was slightly inconvenienced, but I
don’t really think it was that big of a deal.
Last but not least, my youngest son should thank his lucky stars I was so engrossed
in writing this book. I no longer had time to nag him about cleaning his room, practising
his guitar, doing his homework, and wasting countless hours playing video games. (I do
feel somewhat guilty about this lapse in parenting.) Both of us hope—for very different
reasons—that there will be a sequel.
If you have to ask how much it costs, you can 't afford it.

John Pierpont Morgan (1837-1913), American financier and banker

The person who paid the price to write this book is fortunately the person who
economists say should pay if this is an efficient market. That person is me. I paid in
hours and hours of sitting in front of a computer screen, giving up nights, weekends, and
some holidays over what turned out to be a couple of years. There were three costly side
effects. First, I gained 10 pounds. All of my cute little cocktail dresses fit a tad more
snugly and seem a little more revealing. Sigh. Second, my house and garden are a mess.
(In our family, due to differences in marginal values and comparative advantage, Martin
 172 Cocktail Party Economics

does the cooking and I do the cleaning. I think the fact that I don’t clean or garden as
much as I used to may have been a contributing factor to the weight gain.) Third, 1
dropped many of my volunteer activities to focus on writing this book. It is my sincere
hope that what you hold in your hands is worth the price I paid.
So, if they didn’t sacrifice in the production of this book, why am I grateful to my
family? Well, my family believes that I can write a bestseller. My kids say such things
as, “Mom, when you make royalties on your book, can I have ...?” This has been said so
often that I have come to believe that royalty cheques are inevitable. Martin proudly tells
people that I am writing a book. When writing got hard, I partly kept at it because of
their great expectations.

Publishing Phenomenon
One of the most terrifying aspects of publishing stories and books is the realization that they
are going to be read, and read by strangers. I had never fully realized this before, although I
had of course in my imagination dwelt lovingly upon the thought of the millions and millions
of people who were going to be uplifted and enriched and delighted by the stories 1 wrote.
Shirley Jackson (1916-1965), American author
Taken from Come Along with Me (1968)

1 never wanted to self-publish, because as an economist I firmly believe in the vital role
of “middlemen.” The basic tenet of this belief is that publishing houses add value when
they guide the process of getting a book from writer to reader. 1 was right. I would there¬
fore like to express my appreciation to Pearson Education Canada in the person of Gary
Bennett, for saying yes to this book. His “yes” was the critical one 1 needed to get. Even
though I haven t “laid eyes” on any of the people I am going to mention, their eyes have
combed this book many times. Each pass had a slightly different focus, which improved
the quality of the book. Karen Townsend, the developmental editor, decided what stayed
in and what had to go. The nip and tucks were worth it. Susan Broadhurst was both the
production editor and the copy editor, fixing all of the spelling, grammar, and style
errors. Patricia Jones proofread the final pages to make certain that mistakes didn’t make
their way into the published book. If I had self-published, the quality of this book would
not have been the same.
\ ou hold in your hands my book, my baby. A lot of me has been passed on, but so
has something of an economics heritage. 1 hope you found it to be a good read. If not,
remember that it is my baby and you should never tell a mother that her child is ugly ...
at least not to her face. Ciao.
Afterword: Rick’s Postpartum

As Evie has said, in your hands you hold her “baby.” Let me just say that I am honoured
to have been able to participate in its happy delivery. (I’m not quite sure what that makes
me in this analogy, but whatever it is, I want you to know that her husband, Martin, is
okay with it.) As with childbirth, producing a book like this must entail a sometimes
painful process. For me, writing always has its struggles, frustrations, and times of pain
when you want to bang your head on the desk because you just can’t express something
the way you would like to. However, you press on with the thought that hopefully you
are bringing something of value into the world, something that everyone will love as
much as you do. As a writer, before I embark on such a laborious venture I make sure,
like any good economist, to count the costs and insist that there is a good enough mar¬
ginal benefit associated with the effort. I am happy to say that I think Cocktail Party
Economics was well worth the effort it took to write for a number of reasons.
First, whenever you get a chance to write a book with a bright, passionate, Type A
person with something important, entertaining, and interesting to say, you go for it. Evie
is one of those people. She has been a friend of mine for many years, and what I love
about her most is her enthusiasm and willingness to work through things with people,
through good and bad, to get things done. In humility, she realizes the importance of
community and that only by combining the complementary skills of different people can
we achieve something better than what one could have done on our own. Now, she may
say that she is simply being a pragmatic economist, but I don’t think you can get that
sort of wisdom from graphs.
Second, I enjoy the challenge of making a topic that is perceived as complex acces¬
sible to a wider audience. I love the phrase it’s not rocket science because I don’t think
most things really are as complicated as rocket science (however, now I’m really not
sure that rocket science is all that complicated after I read that a father and his son suc¬
cessfully sent their iPhone into space and recorded video with it). In any event, the point
is that sometimes people go out of their way to make things sound more complicated
than they really are. I don’t like that. I never have. I want to help people understand
things at whatever level they are at. I think this book goes a long way toward making the
subject of economics, which touches us all, accessible to a larger audience.
Third, I never turn down an opportunity to appear smarter than 1 am. I am not an
economist by profession, but you know what? After working with Evie to write this
book, I now realize that I am exercising my inner economist every time I choose a Venti
Caffe Mocha instead of a Tall Caffe Latte at Starbucks. It’s all about opportunity costs,
baby, and that’s pretty sweet!
But you know what is even sweeter? My wife, Judy, who enabled every opportunity
for me to work on this book with encouragement and patience. Thanks so much, honey!

173
 Index

A Bear Steams, 162 Christie, Agatha, 53

ability to pay, 111 A Beautiful Mind. 86n Christofides, Louis N., 15n
abnormal behaviour, 163-164 Becker, Gary, 55 Chrysler, 66, 66n, 69
Absolut vodka, 51 n Bell Canada, 13In Clemens, Samuel Langhome, 51, 112
absolute advantage, 54 benefits, 29 Coase, Ronald Hany, 134-135,139,140n
accounting profit, 90n Bentham, Jeremy, lOOn, 102n Coase theorem, 135
Acton, John, 131 Berkeley, George, 129n Coca-Cola, 157
Adams, John, 161 Bianco, Margery Williams, 148 cocktail party etiquette, 13-14
adverse selection, 143-145 Biddle, Jeff E., 13n cognitive bias, 158
advertising, 81-82, 82/i, 85, 85n Bierce, Ambrose, 150 Colette, Sidonie-Gabrielle, 89
Agee, James Rufus, 21 Big Four accounting firms, 146n collateralized debt obligations, 152,152n
AIG (American International Group, Black, Conrad, 161, 161 n collusion, 124-125
Inc,), 152, 164 Black, Fischer, 153 Colvin, Geoff, 64n
Aiken, Howard, 47, 47n Black, Sandra, 49n Commercial Paper, 149
Akerlof, George Arthur, 76, 143 BlackBerry, 42 commercial surrogacy, 22n
Aleynikov, Sergey, 157-158 Bogues, Tyrone “Mugsy,” 55n commissions, 46
allocation bonds, 149, 155, 160 commodities, 40, 117-118, 148
in market setting, 17 bonuses, 46 common property, 4In, 139-140
and markets, 29, 114 borrowing, 42 n The Communist Manifesto (Marx and
methods, 15-16 bottom line, 90n Engels), 24
optimal allocation, 102, 106, bounded rationality, 88n comparative advantage
107-108 Browning, Robert, 120 basic concept, 63
solutions, 16-18, 107 budget constraint, lOOn basis of, 57-61
altruistic surrogacy, 22n Buffett, Warren, 156, 157 described, 54
Amagashie, Atsu, 113 n Burke, Edmund, 31 differences in, 55-56
angel investors, 42-43, 42n Bush, George W., 26 dynamic comparative advantage,
anti-combine laws, 131 Butler, Samuel, 33 59-60
anti-competition laws, 131 buying on margin, 15In influence of, 61
antitrust laws, 12In, 131 and opportunity cost, 104
Apps, Patricia, 55-56, 55n c protectionism, 58-6!
Arcelormittal, 60, 60n cadastral survey, 147, 147n similar countries, 57-58
Ariely, Dan, 158 California Milk Processor Board, 85n competition, 36
Arrow, Kenneth, 80n, 93,109 Calvin, John, 103n competitive markets, 117, 118-119, 120
Arthur Anderson, 146n, 160 Canada, 40n, 44n, 84, 85,90n. 125, complements in consumption, 83, 98n
asset-backed commercial paper, 152n 13 In, 132, 132n. 148n concentrated markets, 162
asset-backed securities, 152, 164 Canadian National Railway, 132n conspicuous consumption, 11 In, 146n
Astor, John Jacob, 121 Canadian Radio-television and Telecom¬ The Constitution of Liberty
asymmetric information, 160, 162, 163 munications Commission, 13 In (von Hayek), 110
athletes, and business, 25-26 capital, 41-44, 74 consumer behaviour, 80-85
Atkinson, A.B., 103n capital markets, 42 consumer income, 82
Austen, Jane, 82, 155 capitalist, 43-44, 43n consumer preferences, 81-82
autarky, 34 Capone, Al, 63 consumption. 111, 112
carbon trading, 137 Copyright Term Extension Act, 122n
B career choices, 55 Com Laws, 56-57
baby boomers, 84 Carlyle, Thomas, 29, 107 cosmetic procedures, 49,49n
Bacanovic, Peter, 157 Carnegie, Andrew, 121 cost-benefit analysis, 105-106
bad, 63n Carroll, Lewis, 27 cost of capital, 43
Baldwin-Felts Detective Agency, 124n cartels, 124—125 costs, 29
bank accounts, 149 central bank, 155 firm vs. market, 68n
bank mergers, 13In CEOs, 26, 158 marginal costs, 109
Bank of England, 36 Certificates of Deposit, 149, 149n opportunity costs. See opportunity
Banker’s Acceptances, 149, 149n Chapter 11,129 n, 150 cost
bankruptcy, 151, 15 In Chesterfield, Lord, 106 production costs, 66
banks, 148, 148n, 149n, 160, Chesterton, G.K., 138 transaction costs, 134, 136
162-163, 164 Chicago Mercantile Exchange Cournot, Antoine Augustin, 12 In,
Barings LLC, 163n (CME), 3In 122-123
Barrymore, John, 41 child labour, 44—45 Coumot-Nash equilibrium, 123
barter, 31, 3In China, 33,33n, 34, 34n, 52n, 104n creative destruction, 127-128, 127n
choice, politics of, 15-16 Criminal Code, 163n
174
 Index 175

Crouch, Dennis J., 13m Elements of Pure Economics Gates, Bill, 13, 13m, 121, 125
Crown corporations, 132, 132m (Walras), 93 Gay, John, 107
cultural norms and values, 20-21 Elkind, David, 52n Geffen, David, 23, 24
Emergency Economic Stabilization Geisel, Theodor Seuss (Dr. Seuss), 160
D Act, 26 general equilibrium framework,
Das Kapital (Marx), 24,43m endowment effect, 158 47-48,93
de Blasi, Marlena, 43 Engels, Frederick, 24 General Motors, 66, 66n, 69, 150, 150m
de Gaulle, Charles, 141 n Enron, 146m, 160 Germany, 57
deadweight loss, 106m entrepreneurial ability, 46-47 Gibbs, Lois, 136 n
death taxes, 113-114 the environment, 40-41 Gilbert, William Schwenck, 87
Debreu, Gerard, 86,93 equilibrium, 88-94, 88/ 116 Gladwell, Malcolm, 48
debt, 149-150 equilibrium intersection, 88, 88/ Glasgow, Ellen, 154
Deloitte Touche Tohmatsu, 146m equity, 103m, 110-114,1 12m, 150 Glass-Steagall Act (U.S.), 163n
demand Emst & Young, 146m Goldman Sachs, 157-158
see also supply and demand European Commission, 132 Goldsmith, Oliver, 160
consumer behaviour, 80-85 exchange. See trade good, 63,63«
demand curve, 77,78/ executive compensation, 26 Goodby, Silverstein & Partners, 85m
described, 76-79 externalities, 102 n, 132-139, 159, 162 Gordon, Scott, 11 n
quantity demanded, 70, 77-78, 78/ governments
shifts in, 78, 79/ 80-85,94-99,94/ F and externalities, 136-138
Demuthin, Helene, 24 Facciponti, Joseph, 158 intellectual property rights, 35
Denham-Steuart, James, 6In fairness. See equity interest rates, 163
Depp, Johnny, 37m Fan, Sheggen, 50, 50m involvement, and supply, 73
derivatives, 150-151 Fannie Mae, 164, 164m and market failures, 141-142
derivatives exchanges, 151 n featherbedding, 123, 123 m ownership, 132
developed countries, 112, 132 Federal Reserve, 162 public programs. 50
developing countries, 44—45, 50, Field, Marshall, 121, 128, 128m spending decisions, 15-16
59-60,126, 147 m Fields, W.C., 136 and trade, 32-33, 33m
Dewey, John, 38 financial assets, 147-152 Gray, John, 87m
Dickens, Charles, 113 financial capital, 42-43, 147,153, 159 Great Britain, 52m, 56-57
Disney, Walt, 122 financial crisis, 43, 62m, 143, 146, 147, The Great Depression (Robbins), 10m
Disraeli, Benjamin, 15 151, 162, 165 Greenspan, Alan, 162
Doctorow, Cory, 30 financial investor, 147n Gresham, Joy, 12
Dodgson, Charles Lutwidge, 27 financial markets, 154-159, 164-165 Grossman, Sandy, 153
domino effect, 49 financial regulations, 162-163 Groves, Andrew, 48
Donne, John, 39 n Financial Times, 10
Drew, Daniel, 157 Fisher, Irving, 43 H
Drews, Frank A., 13m Fitzgerald, F. Scott, 95 Halloween, 30-31, 32, 33-34
Drucker, Peter, 104 Flynn, Errol Leslie, 26 Hamermesh, Daniel S., 13m
duopoly, 121,123 Foot, David, 84n happiness, 100m, 102-103,104-106,112
dynamic comparative advantage, 59-60 forced trade, 34 Hardin, Garrett, 41m
Ford, Henry, 65, 74, 144-145 Harford, Tim, 26 n
E Ford Motor Company, 66, 66n, 69,90n Hart, Michael H., 36
Earhart, Amelia Mary, 17, 17m foreign exchange, 148 Harvard Mark II, 47, 47m
economic concepts, 63-64 foreign exchange market, 148, 148m health spending, 140
economic crimes, 106 Franklin, Benjamin, 91, 110, 149 hedge funds, 151, 164
economic growth, 48 fraud, 163 Hegel, Georg Wilhelm Friedrich, 132
economic loss, 106 Freddie Mac, 164, 164m Heilbroner, Robert L., 56
economic profits, 47, 68,90n free markets, 33, 102, 107-109, 108/ Heinlein, Robert, 156
economic surplus, 105-106, 105/ 114, 115-116, 130 helicopter parents, 51, 5 1m, 56
108/ 114 free riders, 140 herding behaviour, 158
economics, classic definition of, 10, free trade, 33, 34, 52 Hershey, 30m
11-16 freedom. 111, 112 Hicks, John R„ 79-80,93
economies of scale, 58, 126, 162, 162m Freud, Sigmund, 163 high-paying jobs, 13
economies of scope, 162, 162m Friedan, Betty, 55m Holmes, Oliver Wendell, 94
The Economist, 10 Friedman, Milton, 110, 148m. 153 Honda, 66m, 69
Edison, Thomas, 44 front running, 163/i Horton, Teri, 19m
Edmunds.com, 62n Frost, Robert, 12, 12n housing market, 98-99, 99/ 164
educated mates, 13-14 Froude, James Anthony, 68 Hoy, Michael, 15m
education, 48, 114, 140 Fujita, Masahisa, 64m Huesmann, L. Rowell, 102m
Edward VIII, King of England, 12 Fuller, Thomas, 14 Hugo, Victor, 75, 164
effective freedom, 112 funds, 152 human capital, 45-46, 45m
efficiency, 103m, 111,112 n, 113, 114 futures, 151n Human Development Index, 112
Efficient Market Hypothesis, 153, Hume, David, 35, 116, 116m
156-159 G hydroelectricity, 132m
efficient markets, 114, 130, 155-156 gains from trade, 31
eigenvalues, 87n Galbraith, John Kenneth, 81, 81m, 159 I
Einstein, Albert, 63, 118, 140, 158 Gandhi, Mohandas Karamchand, 19 IDG News Service, 60
Electronic Broking Service, 148 Gasset, Jose Ortega y, 86 ImClone, 157, 157m
176 Index

immigration, 85 Lewis, C.S., 12 money markets, 149

income, 82 Lewis, Sinclair, 125 numbers prices, 18
income statements, 90n Lewis, Susan, 14/i over-the-counter markets, 149
incremental value, 27 Lichtenberg, George, 71 pressures, 89f, 90-91,91/
individual decisions, 52 life peers, 11, 1 In setting, 17
Industrial Revolution, 48-50 lighthouses, 140/1 thick vs. thin, 45/t
infant industry argument, 60 Lim, Vivien K.G., 73/i Marquis, Donald Robert Perry, 115
inferior goods, 82 Lincoln, Abraham, 73 marriage market, 13-14
infertility, 22-23 Lindbeck, Assar, 142 Marshall, Alfred, 10, 41, 64
information, 162 Lindt, 30/i Martin, Judith, 13, 14/r
initial public offering, 150, 150/7 Lipsey, Richard, 142 Martin, Paul, 131/z
innovation, 48-50, 128/7 living wills, 20, 20/i Marx, Karl Heinrich, 16,24-25,25/i,
input-output tables, 47 loans, 159 43/i, 115, 132
inputs, 38-47,49, 50, 63, 73-74 Lomborg, Bjorn, 40/i Marxian economics, 24
insiders, 157 London School of Economics and Politi¬ Matter, Herbert, 23/7
insurance industry, 144 cal Science (LSE), 10, 80, 109 Maugham, William Somerset, 37,60
Intel Corporation, 48 long-run supply curves, 68/i McCracken, Jeffrey, 66n
intellectual property, 35,48,48/7 Loo, Geok Leng, 73/i McLuhan, Herbert Marshall, 93
interest rate, 43, 155, 163, 163/7 Love Canal, 136n Menger, Carl, 93
International Encyclopedia of Social Lowndes, William, 106/1 mergers, 131/7, 162
Sciences, 24 Ludlow Massacre, 124/i Merrill Lynch & Co., 151-152
intrinsic value, 22 Lynch, Lisa, 49/i Michelangelo, 129
invention, 48-50 Lynch, Peter, 156 microcap stock, 150/t
investment banking, 149/i Microsoft Corp., 125
invisible hand, 36, 89, 134 M middlemen, 49
IQ, 52n MacDonald, George, 11 Mill, John Stuart, 100/7, 102/r
The Isolated State (von Thunen), 64 MacDonald, Glenn, 49/i Miller, Merton, 153
mad cow disease, 34 Miller, William, 156
J Mann, Charles Riborg, 129/1 mining companies, 126, 126/7
Jaffe, William, 93 Mann, Horace, 45 Mlodinow, Leonard, 156/7
James, LeBron, 25,25n Mao Zedong, 104, 104/1 M&M, 153
Japan, 38,46 Marcs Inc., 30n models, 64, 64n
Jevons, William “Stanley,” 93,101,123 marginal analysis, 106 Modigliani, Franco, 153
Jordan, Michael, 55, S5n marginal costs and benefits, 109 Moliere, 20
Joyce, James, 76 marginal value, 27, 103 money, 31-33,43, 53/t, 147-149, 148/7
JPMorgan Chase, 162 market economies, 33 money markets, 149
Jung, Carl, 85 market equilibrium, 88-94, 88/ 116 Monk, Adam (monkey), 156/7
justice system, 141 market failures, 114 monopoly, 116, 117-122, 127, 127/7,
externalities, 132-139, 159, 162 131-132, 142
K government interference, 141-142 monopsony, 116, 125-128, 142
Kahneman, Daniel, 158/7 illustration of, 129 moral hazard, 143-145, 161, 163
Kelly, Kevin, 94 market power, 130-132 morality, 20-21
Kerviel, Jerome, 163/7 problems leading to, 130 morals, 103/t
Keynes, John Maynard, 10, 10/7, 29, property rights, 139-141 mortgages, 152, 159, 164
110, 148, 148/i and regulation, 162-163 multi-tasking, 13-14
Kierkegaard, Soren, 38 spillovers, 132-139, 159 mutual fund, 152, 152/t
King, Stephen, 102/7 “The Market for ‘Lemons’” Myrdal, Gunnar, 110, 142, 142/7
Kinky Boots, 72/7 (Akerlof), 143
Kipling, Rudyard, 129 market forces, 92, 94 N
Kissinger, Henry, 147 market game, 100, 100/ nano caps, 150/7
Knipschildt, Fritz, 76/7 market makers, 149 Nash, John Forbes, 86/7, 123
KPMG, 146n market power, 130-132 Nash equilibrium, 86n
Krugman, Paul, 53-54, 53/i, 54n, market prices, 107-109 National Hockey League, 127
57-58, 64/i marketing boards, 118, 125, 125/t national security, 60-61
markets natural disasters, 28/7
L and allocation, 29, 114 near banks, 160, 164
labour, 44-46, 74 athletes. 26 near money, 149
labour markets, 126 blaming the markets, 36 Nelson, Horatio, 109
Lancaster, Kevin, 142 buyers in market, 84-85 Nestle, 30n
land, 39-40 capital markets, 42 Netherlands, 39/t
Lau, S.C., 161/i concentrated markets, 162 New Trade Theory, 58
LCBO (Liquor Control Board of efficient markets, 114, 130, 155-156 Newton, Isaac, 61, 70
Ontario), 33/i, 127/1 equilibrium, 88-94, 88/ 116 Nietzsche, Friedrich, 130, 145
Leacock, Stephen Butler, 25, 126 financial markets, 154-159,164-165 Nintendo Wii, 92,92n
Leeson, Nick, 163/1 foreign exchange market, 148, 148/1 Nissan, 66/7, 69
Lehman Brothers Holdings Inc,, 151,164 free markets, 33, 102, 107-109, non-excludable, 139, 140
“lemons problem," 160 108/111, 114, 115-116, 130 non-rivalrous, 139-140
L’Engle, Madeleine, 104 housing market, 98-99,99/ 164 normal goods, 82
Leontief, Wassily, 47-48, 93 meaning of, 30-35, 115n normal profits, 47, 68
 Index 177

NPD Group, 92n predatory pricing, 132 Reynolds, Joshua, 62

number of buyers in market, 84-85 price Ricardo, David, 56-57, 61, 61n
numbers prices, 18 and abundance, 27-28 risk, 143-145
described, 29 "The Road Not Taken” (Frost), 12, 12n
o government-legislated prices, 163 Robbins, Lionel Charles, 10-11,80, 109
oil, 74,74/t, 124-125 inputs, 73-74 Robbins report, 11
oil embargo, 6In international comparisons, 46 Robinson, Joan, 21,46,46«
oil sand, 40n magic of, 107 Rochefoucauld, Francois de La, 103
Okun, Arthur, 113 market prices, 107-109 Rockefeller, John D., 121, 128n
oligopoly, 127 monopoly, 117-122 Rogers, Will, 152
Oppenheimer, Valerie, 14n movement along supply curve, 70 Roosevelt, Franklin Delano, 49
opportunity cost numbers prices, 18 Rose, Billy, 135-136
basic concept, 63 pricing policy, 17-18 Rothbard, Murray Newton, 6
changes, and supply curve shifts, related products, 83-84,98n rotten boroughs, 56, 56n
72-75 supply curves, 67 Ruskin, John, 144
and comparative advantage, 104 and value, 27-28
described, 11-12 price setter, 117 S
high-paying jobs, 13 priceless, 19-21,23/1 Saint-Cyr, Marshal Gouvoin, 122
of land, 40 PricewaterhouseCoopers, 146n salaries, 46
marriage market, 14 Principles of Political Economy and Salonia, A., Tin
and money, 43 Taxation (Ricardo), 56, 61 n Samuelson, Paul, 64
of production, 67,68 problems, and scarcity, 9-10 Sanlu, 85n
and revealed preferences, 22-23 production, 65 satisfaction, 100/7. 102-103
and scarcity, 17-18 production costs, 66 Saudi Arabia, 40
supply curves, 67 production process, 38,74 Say, Leon, 92
and talented people, 54 productivity, 38,73 scarcity
and women’s choices, 55 professional associations, 124 and allocation, 15-16
optimal allocation, 102, 106, 107-108 property rights, 134, 139-141, 147n basic concept, 63
options, 15 In, 161 protectionism, 58-61 the environment, 41
Organization of Petroleum Exporting protectionism for dynamic reasons, implication of, 9-10
Countries (OPEC), 124 59-60 labour, 74
Ortberg, John, 141 public goods, 139-140, 162 land, 39
Orwell, George, 77 Pulford, Bob, 127 natural disasters, 28n
Ostrom, Elinor, 41n pundit, 42 n and opportunity cost, 17-18
outputs, 38,48,49 purchasing power parity (PPP), 46n politics of choice, 15-16
over-the-counter markets, 149 pure competition, 117, 127 pricing policy, 17-18
ownership of company, 47 and problems, 9-10
Oxford Dictionary of National Biography, Q raw materials, 40
1 In, 25n, 35n, 56n, 79,134n quality assurance, 45-46 resources, 39, 104
quantity demanded, 70, 77-78, 78/ scarcity mentality, 6-11
P quantity supplied, 69-70, 71 “stones story,” 9
Palahniuk, Charles Michael “Chuck,” 74 quotas, 58 of time, 12-13
paradox of value, 27-28 and value, 21-24
Paris Convention for the Protection of R and wants, 23
Industrial Property, 35 Ranelagh, John, 11 On Scholes, Myron, 153
patents, 48 Rao, Neetha, 50, 50n Schultz, Theodore W., 45/i, 153
penny stock, 150n rate of return, 43 Schumpeter, Joseph Alois, 116, 127/1
pension funds, 152, 154, 16! rational self-interest, 36 Scotiabank Group, 89/i
perfect competition, 117 raw materials, 40 Scott, Henry, 35
Pernod Ricard, 51n Rawls, John, 102n, 112 scrip, 126/1
Philosophy, Politics, and Economics Reagan, Ronald, 110 securitization, 152
(PPE) school, 79 real wages, 46 self-interest, 36, 101, 101/1
physical capital, 41-44 Recherches (Cournot), 123 sellers
Pitkin, Walter B., 146n Rees, Ray, 55-56, 55n competitive markets, 117,
Planck, Max, 140, 140n Reform Act, 1832, 56n 118-119, 120
Plant, Arnold, 134 Regan, Chris, 84n monopoly, 117-122, 127, 127//,
Plato, 22n, 52 Regulation Q, 163, 163n 131-132, 142
Pohang Iron & Steel Co. Ltd., 60 regulations, 58, 73, 131-132, 137-138, monopsony, 125-128, 142
Poisson, Simeon-Denis, 123 141-142, 162-163 oligopoly, 127
political left, 33n related products, 83-84, 98n Sen, Amartya, 112
politics of choice, 15-16 religious convictions, 20-21 Settlers of Catan, lOO/i
Pollock, Jackson, 19,19n, 23-24,23n, 27 rent, 40 Shakespeare, William, 9, 51/i, 52/i
pollution, 135, 136-138 rent controls, 142 Shaw, George Bernard, 73
pollution permits, 137 Repurchase Agreements, 149, 149n Shiller, Robert James, 76, 146
Polor, Hernando de Soto, 147n Research In Motion (RIM), 42,42n short-run supply curves, 68/i
Ponzi scheme, 163, 163n resources, 39-47, 104 short-term debt, 149
pooling assets, 151-152 return on investment, 43 Simon, Herbert, 88/i, 153
Popper, Karl, 110 Reuters, 148 Simpson, Wallis, 12
poverty, 44-45 revealed preferences, 22-23 Skott, Peter, 146
 178 Index

slavery, 21, 44 tar sands, 40n intrinsic value, 22

small caps, 150n tariffs, 58 marginal value, 27, 103
Smith, Adam, 35-36, 35n, 46, 61,61n, taxes, 58, 73, 113-114, 142 paradox of value, 27-28
89, 103n, 116/i. 130, 134 Taylor, Laramie D., 102n potential vs. actual, 32
Societe Generate, 163n TD Canada Trust, 13In and price, 27-28
Solow, Robert, 153 technology, 48-50, 74-75 priceless, meaning of, 19-21
Sophie's Choice, 12 Templeton, John, 42 and scarcity, 21-24
Sorkin, Andrew Ross, 26n, 159 temporary protectionism, 59-60 sports as a business, 25-26
Soros, George, 117 Teo, Thompson S.H., 73n subjective nature of, 20
South Korea, 60 Terence, 72 van Dyke, Henry, 69
Sowell, Thomas, 8 Teuber, Klaus, lOOn van Gogh, Vincent, 23
specialization, 52-56 Thackeray, William, 43n Van Sligtenhorst, Gilbert, 31
spending decisions, 15-16 Thaler, Richard, 158n, 159 Van Sligtenhorst, Margo, 84
spillovers, 132-139, 159 Thatcher, Margaret, 109-110 Van Uden, Jacco, 122/i
sports, 25-26, 126-127 A Theory of Justice (Rawls), 112 Vanderbilt, Cornelius, 121
Sraffa, Piero, 93 The Theory of Moral Sentiments Veblen, Thorstein, 48, 11 In, 146n
standard of living, 39,46n, 49, 111, 113/i (Smith), 35 Veblen goods, 146/i
Standard Oil, 12In Thoreau, Henry David, 32 Venezuela, 40n
Stanhope, Philip Dormer, 51 Thurber, James Grover, 146 Vend, 61, 61n
statistical life, 20n ticket scalping, 96-97, 96/ 97/ 98/ venture capitalists, 42/i
Stem, William, 52n time, 12-13, 14 Vessey, John Jr., 15
Stewart, Martha, 157, 157n time management, 13-14 von Hayek, Friedrich, 80, 80n, 102,
sticky wicket, 139n Tolle, Eckhart, 14 109-110
Stigler, George, 135, 153 Too Big to Fail phenomenon, von Mises, Ludwig Heinrich Edler, 114
Stiglitz, Joseph, 153 159-161, 162 von Thiinen, Johann Heinrich, 64
stimulus spending, 10 Townshend, Charles, 35
stock exchanges, 3 In, 150, 150n Toyota, 66n, 69,74n W
stock markets, 3 In trade Wager, W.H., 161 n
stock options, 161 autarky, 34 wages, 46
stocks, 42n, 154-159, 161 comparative advantage. See com¬ Waksal, Samuel D., 157
Stoll, John D., 66n parative advantage Wales, Jimmy, 110
“stones story,” 9, 103 described, 32-33 Walmart, 33, 33/t, 127/t
Strayer, David L., 13n forced trade, 34 Walras, Leon, 92-93, 123
strikes, 14 In free trade, 33, 34, 52 Walras’ Law, 93n
subprime mortgage crisis, 152, 164 gains from trade, 31 Walton, Sam, 121
subsidies, 58 and governments, 32-33, 33n Wanadoo, 132
substitutes, 83-84,98n protectionism, 58-61 water, 40,40/t
Sullivan, Arthur Seymour, 87 specialization, 52-56 Waugh, Evelyn, 59
supply supply and demand. See supply wealth of nations, 38
see also supply and demand and demand The Wealth of Nations (Smith), 35,
meaning of, 69-70,75 trade-offs, 113 35/i, 61,61/t
movement along supply curve, tragedy of the commons, 41,41 n, 141 weather, 74
70-71,70/ transaction costs, 134, 136 Webb, Ursula, 80
quantity supplied, 69-70, 71 trusts, 121 n Weisbach, Michael S., 49n
shifts in, 71-75, 71/ 94-99,94/ Tversky, Amos, 158/i welfare economics, 103/t
supply curves, 67-68,67/ 68n Twain, Mark, 51, 112, 157 Westhead, Paul, 54
supply and demand Twiss, George Ransom, 129n Weyerhaeuser, Fredrick, 121
see also demand; supply White, Joseph B., 66n
approaches to, 30 U Whitehead, Alfred, 66
basics, 30 underwriting, 149/t Wilde, Oscar, 19, 142
bottom-up approach, 30 unions, 123-124, 124«, 126, 128, Wilkinson, Priscilla Anne, 56
cost-benefit analysis, 105-106 131n, 142 willingness to pay, 111
market, 30-35 United Nations, 38 Wilson, Woodrow T., 101
market equilibrium, 88-94, 88/ United States, 34,39n, 40,52n, 62n, 84, women, and choice, 55-56
shifts, effects of, 94-99,95/ 85,90/t, 122n, 148/t, 163,164 Woods, Tiger, 25, 25n
top-down approach, 30 University of Chicago, 128n World Bank, 60
use of framework, 87-89 U.S. Environmental Protection World Trade Organization (WTO),
use of phrase, 61n Agency, 20n 34, 122
supply and demand curves, 67, 77 U.S. Securities and Exchange Wright, Frank Lloyd, 97, 135
surrogacy, 22, 22n Commission, 157n
swaps, 15 In utility, lOO/i, 102-103, 102/j Y
sweatshops, 45 see also happiness Yang, Ling, 15/t
Sweden, 57
Szasz, Thomas Stephen, 126 V z
Szent-Gyorgyi, Albert, 150 value Zimbabwe, 38,46
CEOs, 26
T cultural norms and values, 20-21
T-bills, 149n economists’ viewpoint, 21
Taleb, Nassim, 147-148, 147n. 154 incremental value, 27
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