Part 1 of Reading Naked Economics
This is Part 1 of my detailed summary of “Naked Economics: Undressing the Dismal Science”. It covers foundational topics in economics, focusing on markets, incentives, government intervention, information, and human capital.
I started reading this book a second time because I really enjoyed it the first time around. So, I decided to create this detailed summary as a quick refresher for whenever I want to revisit the key points.
Table of Contents
- Chapter 1. The Power of Markets
- Chapter 2. Incentives Matter
- Chapter 3: Government and the Economy
- Chapter 4: Government and the Economy 2
- Chapter 5: The Economics of Information
- Chapter 6: Productivity and Human Capital
Chapter 1. The Power of Markets
Decentralized Order
It’s incredible how markets function: the sum of a bunch of self-interested (i.e. selfish) parties forms a fully functioning society. There is nothing wrong with being selfish (Note 1), as it is selfishness that has led us to civilization. People act to make themselves better off (in theory), and while doing so, they end up making other people better off as well.
This chapter is based on this rhetorical question: Who feeds Paris? Somehow, the stores and restaurants in Paris get the exact amount of food and ingredients that they need in order to feed its citizens (ignoring all the food waste for a moment). The fish you were served at the local restaurant was caught in the Pacific Ocean by a company called Tokyo Seafood Inc. It was then sold to Global Fish Distributors, who transported it by air to Paris. Upon arrival, the fish was delivered to a local wholesaler, from whom the restaurant purchased it and prepared it for your meal. This seamless supply chain ensures Paris is always well-fed.
This process works because of the (decentralized) market system, where each person, from fishermen to wholesalers, acts in their own best interest but ends up helping everyone. Fishermen sell their catch for the best price (not too high, not too low), distributors and transporters handle logistics to make a profit, and wholesalers manage stock to meet demand. Prices act as signals, indicating scarcity or abundance, and guiding decisions on where resources are needed most. No central planner trying to micromanage and orchestrate the entire dance. Just decentralized and individualized decision-making, driven by incentives and coordinated by prices.
But as we all know, humans aren’t perfect. Some of us lack the self-discipline to do things that we know will make us better off in the long run. So it is not unreasonable for society to help individuals do things which they otherwise would not or could not do. This is where the government and public policy come in.
Quotes from Ch.1
“I will argue that a market economy is to economics what democracy is to government: a decent, if flawed, choice among many bad alternatives. Markets are consistent with our views of individual liberty. We may disagree over whether or not the government should compel us to wear motorcycle helmets, but most of us agree that the state should not tell us where to live, what to do for a living, or how to spend our money. True, there is no way to rationalize spending money on a birthday cake for my dog when the same money could have vaccinated several African children. But any system that forces me to spend money on vaccines instead of doggy birthday cakes can only be held together by oppression. The communist governments of the twentieth century controlled their economies by controlling their citizens’ lives. They often wrecked both in the process. During the twentieth century, communist governments killed some 100 million of their own people in peacetime, either by repression or by famine.” (Note 2)
“[We] can and should use the government to modify market in all kinds of ways. The economics battle of the twentieth century was between capitalism and communism. Capitalism won. […] The economic battles of the twenty-first century will be over how unfettered our markets should be.”
Chapter 2. Incentives Matter
Science of Unintended Consequences
One of my favorite chapters for sure. So eye-opening on the unintended consequences of setting up a policy.
Consider the well-meaning idea to require car seats for infants and small children on planes, even though you can currently fly with a “lap child” without buying an extra seat. During the Clinton administration, the FAA pushed for this, arguing that children should have the same protection as adults in case of an accident. It seems logical (I guess?): car seats could save lives in a “rough landing” situation.
But here’s the problem: buying an extra plane seat for the car seat makes flying much more expensive (you are essentially forced to buy an extra plane seat for your little one), so some families might choose to drive to their destination instead. The catch? Driving, even with a car seat, is far more dangerous than flying. So, ironically, this rule could lead to more injuries and deaths, not fewer.
Another example: Mexico City, one of the most polluted cities in the world, tried to cut down on pollution in 1989 by requiring cars to stay off the streets one day a week, based on their license plate numbers. The logic was simple: fewer cars, less pollution.
But here’s the problem: people who didn’t want the inconvenience just bought extra cars or kept their old ones when buying new ones. The result? More old, dirty cars on the road, making the air quality even worse.
These examples highlight a key lesson: policies that seem beneficial on the surface can sometimes have hidden costs that outweigh their intended benefits.
This isn’t to say good policy doesn’t exist. London addressed traffic congestion by charging an $8 USD fee for driving in central city areas during rush hour, starting in 2003. Over time, they raised the fee and expanded the coverage area.
This policy leverages a basic market principle: raising prices reduces demand. The result? Fewer cars on the road, reduced traffic, increased use of public transit, and faster-moving buses due to less congestion.
Misaligned Incentives in the Corporate World
The private sector has its troubles as well, both at the lowest and highest levels.
On the low end, take a cashier working at Burger King. The cashier might have incentives that don’t align with the company’s best interests. It’s in the cashier’s interest to steal money, perhaps by selling you a meal without recording the transaction and pocketing the cash. Burger King could spend significant resources monitoring its employees for theft, or it could offer an incentive for customers to do the job by putting up a sign that reads “Your meal is free if you don’t get a receipt. Please see a manager”.
At the higher end of corporate America, consider CEOs. If I own stock in a company, how can I be sure the CEO is acting in my best interest? For instance, two-thirds of corporate mergers don’t add value to the firms involved, and some even harm shareholders. So why do CEOs pursue these often questionable deals? Because it benefits them; bigger companies mean more prestige, higher salaries, and larger perks like private jets. To align their incentives with shareholder interests, companies often pay CEOs in stock options: if the company’s stock does well, they do well too. But this isn’t a perfect solution, as it can drive CEOs to seek short-term gains at the expense of long-term stability. Studies show that firms with large options grants are more prone to accounting fraud and debt defaults.
Finally, let’s come back to earth and look at an example of misaligned incentives in our lives: real estate agents. Both from the buy and the sell side.
On the buy side, you’re looking for a house and want to negotiate the price down. But your agent, who earns a percentage of the purchase price, benefits from a higher price and a quicker sale. Your interests are completely opposite. (Note 3)
On the sell side, it seems like your incentives are aligned with your agent’s: both of you want to sell for as much as possible. But consider this: if you’re selling a $300’000 house, your agent could list it at $280’000 and sell it quickly, or list it at $320’000 and wait for a higher offer. The extra $40’000 means a lot to you, but to your agent, it’s only an additional $1’200 after weeks of extra work, extra showings, extra open houses. If I were the agent, I’d sell it quick and move on to the next deal.
Not All Taxes Are Created Equal
The topic of incentives also touches the world of taxes. You can’t just say “tax the rich” and expect them to sit still. The rich aren’t static; they adapt. They change their behavior to avoid as much taxation as possible. Take Bjorn Borg, for example. He became wealthy playing tennis, and the Swedish government taxed him heavily. Borg simply moved to Monaco, and Sweden ended up collecting nothing from him.
If the government imposes a heavy tax on red sports cars, most people will just stop buying red cars. The result? The government collects no revenue, and car enthusiasts miss out on driving their favorite red sports cars. This phenomenon, where taxes make individuals worse off without benefiting anyone else, is known as “deadweight loss”.
In general, it’s better to have a broad tax. It’s harder to evade since fewer activities are exempt, and the tax rate can be lower because it’s spread across more people. This way, there’s less incentive to dodge it. But even with broad taxes, you have to be careful: if everyone pays the same tax, it hits the poor harder because it takes up a larger portion of their income. This kind of tax is called a regressive tax.
Quotes from Ch.2
Definition to understand the quotes: Creative destruction is a term that describes the process in which new innovations and technologies replace outdated ones, leading to economic progress but also causing disruption as older industries and jobs become obsolete. It’s a core feature of market economies, driving growth and improving efficiency, even though it can be disruptive in the short term.
“Capitalism can be a brutal, cruel process. We look back and speak admiringly of technological breakthroughs like the steam engine, the spinning wheel, and the telephone. But those advances made it a bad time to be, respectively, a blacksmith, a seamstress, or a telegraph operator. Creative destruction is not just something that might happen in a market economy. It is something that must happen. At the beginning of the twentieth century, half of all Americans worked in farming or ranching. Now that figure is about one in a hundred and still falling. […] Note that two important things have not happened: (1) We have not starved to death; and (2) we do not have a 49 percent unemployment rate. Instead, American farmers have become so productive that we need far fewer of them to feed ourselves. The individuals who would have been farming ninety years ago are now fixing our cars, designing computer games, playing professional football, etc. Just imagine our collective loss of utility if Steve Jobs, Steven Spielberg, and Oprah Winfrey were corn farmers.
Creative destruction is a tremendous positive force in the long run. THe bad news is that people don’t pay their bills in the long run.”
“During the Industrial Revolution, weavers in rural England demonstrated, petitioned Parliament, and even burned down textile mills in an effort to fend off mechanization. Would we be better off now if they had succeeded and we still made all of our clothes by hand?”
Chapter 3: Government and the Economy
Negative Externalities
The problem with the free market is that if you let it roam free, it will destroy the planet. Why? Negative externalities: those cases in which individuals or companies engage in private actions that have harmful consequences for society at large. The market, if left alone, actually encourages individuals and firms to cut corners in ways that make themselves better off, but make society as a whole worse off.
Consider this scenario: A large agricultural company produces a pesticide that seeps into local water supplies, poisoning families. There’s no market solution here; the market itself is the problem. The company maximizes profits by selling a product that causes cancer in innocent victims. Meanwhile, farmers who are unaware of (or indifferent to) the pollution will actually reward the company by buying more of its cheaper, more effective product, further incentivizing the harmful behavior. Competitors who invest in making safer, non-toxic alternatives might lose out because their products are more expensive. This is where the government must step in, regulating or banning such harmful practices to protect public health. (Note 4)
But not all externalities require government intervention. Take, for example, small children on airplanes. They scream, kick the seat in front of them, and generally make the flight less enjoyable for everyone around them. Imagine being stuck on a 12-hour flight with a 5-year-old directly behind you and a 1-year-old beside you. Even if the ticket was free, you’d probably hesitate to take that seat. Here, parents don’t bear the full cost of traveling with their young ones; other passengers do.
So why doesn’t the government need to step in here? Because this is a problem the airline itself can address. It’s a manageable issue involving a relatively small group of people. For instance, airlines could designate seating for families with children under 5 in the back of the plane, grouping them together. They could also offer noise-cancelling headphones to other passengers during the flight. The key point is that government intervention isn’t necessary when companies can implement practical solutions on their own, and whenever possible, it’s better to let them handle it.
In 2002, an electricity company in a small Ohio town started getting complaints from nearby residents about heavy pollution from its power plant. The 221 residents had every right to sue the company, but instead, the company decided to make it simple. They paid each resident about three times what their homes were worth in exchange for a promise not to sue for pollution-related damages. It cost the company $20 million, but it solved the problem quickly: no heavy government bureaucracy, no drawn-out lawsuits, just a clean and simple deal.
This kind of solution was only possible because of the relatively small number of people involved in the externality. Private companies are not going to solve something like CO2 emissions on a national or global scale because those problems are far too big.
Now, let’s look at how the government can help with dealing with externalities. Sure, the government can ban harmful practices or chemicals outright, but sometimes there are better ways to change behavior. Take the Hummer, for example. The Hummer is incredibly inefficient when it comes to fuel consumption, yet some people still use it to go to the grocery store instead of driving something their Honda Civic. If the government wants to discourage people from buying/driving fuel-inefficient cars, what can they do?
One way is through taxes. This could mean a gas or emissions tax, a weight tax, or a combination of both. First, taxing limits the behavior since you probably will not want to drive a Hummer if it costs twice as much to fill up. Second, it raises revenue, which can be used to help cover the costs related to global warming, like investing more in R&D for alternative energy sources. Third, if people know they will pay for the extra weight and poor fuel efficiency, they will make different choices at the dealership. Thanks to competition in the free market, car manufacturers will respond by making vehicles that are lighter and more efficient.
However, taxing externalities is not always a perfect solution. First of all, how do you determine the right amount of tax? Secondly, raising the cost of driving large SUVs and pickup trucks will mean that only those who value it most will continue to drive them. But we measure how much we value something by how much we are willing to pay for it, and the rich can always afford to pay more. So such a tax would unfairly disadvantage a poor contractor who is struggling to make ends meet but actually needs his pickup truck.
One way to address this would be to use the revenue from those gas-guzzler taxes to offset taxes that hit the middle class the hardest, like payroll taxes. This way, the contractor might pay a bit more for his truck, but less to the IRS, which helps balance it out.
Positive Externality
There are also positive externalities: situations where an individual’s actions benefit others without any extra compensation. For example, if my office has an absolutely amazing view that inspires me every day when I go to work, and it’s one of the main things that puts a smile on my face throughout the workday, I don’t need to send a check to the builders or the architect for providing that view.
Now imagine I’m a small brick-and-mortar business owner in a small town. Someone decides to build an amusement park nearby. A few months later, new restaurants open up, residential homes are built, more people move in, and so on. Naturally, my shop will see more customers as a result, yet I won’t owe anyone a penny for the increased business I’m getting.
This is exactly why governments offer subsidies for such investments. Building something like an amusement park can bring value to an entire community—it creates jobs, attracts more businesses, and boosts the local economy. Since the builder isn’t directly compensated for all the additional benefits they create, the government might step in to provide incentives or subsidies to encourage these kinds of investments. This way, projects that benefit everyone are more likely to happen, even if the private gains aren’t enough on their own to make them worthwhile.
Property Rights
Another way the government smooths the rough edges of a free market is by enforcing property rights, including intellectual property (IP) and copyright laws, which are a form of property rights.
Take Napster as an example. Napster was one of the first peer-to-peer file-sharing platforms, which revolutionized how people accessed music in the early 2000s. However, it encountered serious legal difficulties due to copyright infringement. Bands like Metallica and artists like Dr. Dre filed lawsuits because Napster was facilitating the distribution of their copyrighted music without permission or compensation. Copyright laws exist to protect creators and ensure they are paid for their work, encouraging more creative output. Without such laws, artists and companies would be less likely to invest time and resources into creating new content if anyone could freely copy and distribute it.
Similarly, consider the example of Pfizer and its patent on Viagra. This book was written in 2013, and back then, Pfizer held the patent on Viagra, allowing it to set the price at $7 per pill, despite the production cost being only a fraction of that. The patent, guaranteed by the government, meant no other company could legally copy Pfizer’s formula. Many may argue that this leads to inflated prices, but patents are crucial for encouraging innovation. Without the protection of a patent, other companies could immediately copy and sell Pfizer’s product, making it impossible for Pfizer to recover the hundreds of millions of dollars spent on R&D.
If companies couldn’t protect the products they spent years developing, why would anyone invest in costly and time-consuming processes like searching rainforests for plants with potential medical benefits? Intellectual property rights provide an incentive to innovate by ensuring that inventors and companies can profit from their discoveries, which ultimately benefits society with new and improved products.
Regulations
Building on the previous section, governments create rules and regulations that help lower the cost of doing business in the private sector. They enforce contracts, crack down on fraud, and keep a sound currency circulating. Without these things, markets can’t function smoothly. Imagine trying to run a business without a stable dollar, or a way to enforce contracts when someone doesn’t hold up their end of the deal. This is where agencies like the SEC (protects investors from corporate fraud), FAA (safety while flying), FDA (safety of food and drugs), FBI (protection from crime), IRS (tax collection and enforcement), INS (immigration services and enforcement), and the U.S. Patent Office (protection for inventions) come in. They protect consumers, keep companies accountable, and make sure the playing field is fair enough that business can actually thrive.
Free-Rider Problem
Governments also provide public goods. These are things that make us all better off but would not exist if we left them to the private sector.
Suppose I decide I want to buy an anti-missile system to protect myself from a belligerent neighboring country. I ask my neighbors if they want to pitch in. Most say no because they have a strong incentive to be “free riders”. If the system is built, they’ll benefit from it without having to pay a cent. In the end, the system doesn’t get built, even though it would have made us all safer if everyone had chipped in.
A private company can’t force people to pay for these kinds of goods, no matter how much they use them or benefit from them. Think of a lighthouse, a public park, a radio signal, research in the Higgs Boson, or law enforcement.
Let’s expand on law enforcement. Sure, you could hire a personal bodyguard, but they’ll only protect you from immediate threats. Who’s going to trace the gangs or potential criminals who may someday target you? Who’s handling counter-terrorism? Public goods like these require collective funding, which is why they’re provided by the government, not by private businesses.
Stop Blaming the Government for Everything
Government also redistributes wealth. It collects taxes from some citizens and provides benefits to others. Contrary to popular belief, most government benefits do not go to the poor; they go to the middle class in the form of Medicare and Social Security. But who decides how much the government should tax, and who should receive those benefits?
Consider this: which scenario is better for the overall state of the country? A society where everyone earns $25’000 (enough to cover basic necessities) or the status quo, where some Americans are incredibly wealthy, some are desperately poor, and the average income is around $48’000? The second scenario describes a larger economic pie, but with unequal slices. The first is a smaller pie, but more evenly divided.
Economics does not provide clear answers to philosophical questions like these. It cannot tell us whether taking a dollar from a billionaire to give to a struggling family is “right” or “wrong”. This is not a science, and sometimes there is not a single clear answer.
Most importantly, every presidential administration, whether conservative or liberal, will find qualified economists who will support their ideological opinion.
Quotes from Ch.3
“Liberals (in the American sense of the word) often ignore the fact that a growing pie, even if unequally divided, will almost always make even the small pieces larger. […] One historical reality is that government policies that ostensibly serve the poor can be ineffective or even counterproductive if they hobble the broader economy.
Meanwhile, conservatives often lithely assume that we should all rush out into the streets and cheer for any policy that makes the economy grow faster, neglecting the fact that there are perfectly legitimate intellectual grounds for supporting other policies, such as protecting the environment or redistributing income, that may diminish the overall size of the pie.”
Chapter 4: Government and the Economy 2
If governments were inherently efficient, then government-heavy countries like North Korea and Cuba would be economic powerhouses, but they are clearly not, and they lag behind developed Western nations (Note 5). While a government can effectively address externalities, it can also regulate an economy into stagnation. It can provide essential public goods, but it can also mismanage and waste tax revenue. It can redistribute wealth to help the disadvantaged, but it can also divert resources to the politically well-connected.
Public vs. Private Sector Roles
Anything that private companies can do should be allowed to be done by them. For instance, the USPS held a monopoly on mail for years until UPS and FedEx built better delivery systems, creating more competition and improving service for everyone. But not everything belongs in private hands. The DMV (Department of Motor Vehicles), which issues driver’s licenses, is better left with the government. Private companies would have incentives to attract customers by issuing licenses to drivers who do not deserve them.
Imagine the government running steel mills, coal mines, banks, hotels, or airlines. All the benefits of competition, like efficiency and innovation, would be lost, and citizens would be worse off. In the private sector, markets direct resources to where they are most valued, and money flows wherever the return is highest. In contrast, governments allocate resources based on political priorities. It is therefore no surprise that the USSR was the first to send a rocket into orbit. Even if the people would rather have had fresh vegetables or contraceptives, the government still chose to invest in their space program. In the worst case scenario, car plants don’t get built, students don’t get loans, and entrepreneurs don’t get funding.
Regulatory Deception
Market interventions can have significant consequences, and regulation is often one of the tools used. At worst, regulations can become a political weapon for well-connected firms to stifle their competition.
In the 1990s, nail salons in Illinois were thriving, with a remarkable 23% growth. But just as these new businesses were establishing themselves, a campaign suddenly emerged, calling for stricter licensing requirements for manicurists. Was this a response to consumer complaints or a wave of botched pedicures? Not quite.
Behind this push was the Illinois Cosmetology Association, representing established spas and salons that wanted to cut off their competition. The target? New immigrant “entrants” who were opening salons and offering affordable services, threatening the profits of long-established businesses. By tightening licensing rules, these established salons could force new competition to face countless obstacles, while conveniently exempting themselves from the hassle. What appeared to be a campaign for higher standards was, in truth, a cleverly disguised strategy to dominate the market and stifle competition.
Furthermore, countries that make starting a business difficult end up undermining both economic growth and quality standards. In places like Canada and New Zealand, streamlined processes support new ventures, but countries like Mozambique and Bolivia impose months-long, costly procedures. And what do they get for all that regulation? Lower compliance with quality standards, not better. Instead of making things safer, these hurdles push businesses underground, away from oversight, and right into the hands of corruption. In the end, both consumers and the economy pay the price.
The Laffer Curve
The Laffer Curve is a concept in economics that illustrates the relationship between tax rates and government revenue. Proposed by economist Arthur Laffer, it suggests that there is an optimal tax rate somewhere between 0% and 100% that maximizes revenue. If taxes are too low, the government does not collect enough revenue, while excessively high taxes may pushe people to leave the country altogether or discourage them from working, reducing taxable income and thus revenue.
During Ronald Reagan’s presidency, the administration adopted the principles behind the Laffer Curve, leading to significant tax cuts in the 1980s. The theory was that lower taxes would encourage people to work more, save, and invest, ultimately broadening the tax base and stimulating economic growth. For instance, if the tax rate is initially 50% with a tax base of $100 million, the government would collect $50 million in revenue. Now imagine the tax rate is reduced to 40%. With lower taxes, people are more motivated to work since they get to keep more of their earnings. Some may decide to work extra hours, and others might take on second jobs. As a result, the tax base grows to $110 million. The government now collects $44 million, which is less than before but still benefits from the additional economic activity that emerged due to increased incentives for work. This approach aimed to demonstrate how reducing the tax burden could partially offset revenue losses by promoting more economic output. Similar tax policies were later adopted during George W. Bush’s presidency.
Tax experts must consider these behavioral responses, such as how people adjust their work, saving, and investment habits, when estimating the effects of tax cuts or increases.
The Goldilocks Zone
The government should ideally find a balance in its role in the economy; it should neither control everything nor be completely absent. Somewhere between the extremes is the right level of involvement that ensures efficiency and welfare. If everything is left to the free market, we end up with businesses catering to luxury wants, like custom-made birthday cakes for dogs, simply because there is demand. But the free market does not always address essential needs, such as feeding the homeless. Finding the right balance is essential to support both economic growth and the well-being of society.
Quotes from Ch.4
“There is an old joke, one of Ronald Reagan’s favorites, that goes something like this:
A Soviet woman is trying to buy a Lada, one of the cheap automobiles made in the former Soviet Union. The dealer tells her that there is a shortage of these cars, despite their reputation for shoddy quality. Still, the woman insists on placing an order. The dealer get out a large, dusty ledger and adds the woman’s name of the long waiting list. “Come back two years from now on March 17th,” he says.
The woman consults here calendar. “Morning or afternoon?” she asks.
“What difference does it make?” the surly dealer replies. “That’s two years from now!”
“The plumber is coming that day,” she says.
If the USSR taught us anything, it is that monopoly stifles any need to be innovative or responsive to customers. And government is one very large monopoly.”
“Markets work because resources flow to where they are valued most. Government regulation inherently interferes with that process. In the world painted by economics textbooks, entrepreneurs cross the road to earn higher profits. In the real world, government officials stand by the road and demand a toll, if they don’t block the crossing entirely. The entrepreneurial firm may have to obtain a license to cross the road, or have its vehicle emissions tested […], or prove […] that the workers crossing the road are U.S. citizens . Some of these regulations may make us better off. It’s good to have government officials blocking the road when the ‘entrepreneur’ is carrying seven kilos of cocaine. But every single regulation carries a cost, too.”
Chapter 5: The Economics of Information
When Scholarship Programs Backfire
When Bill Clinton was running for president in 1992, he floated the idea of adding a new type of scholarship: the Hope Scholarship. The idea was simple: students could borrow money for college and then repay the loans after graduation with a percentage of their annual income rather than the usual fixed payments of principal plus interest. Graduates who went on to become investment bankers would owe more in student loans than graduates who counseled disadvantaged teens in poor neighborhoods. The plan was designed to address the concern that students graduating with large debts are forced to do well rather than do good. After all, it’s hard to become a teacher or a social worker after graduating with $75,000 in student loans.
In theory, high and low earners would balance each other out, and the program would recoup its costs. Students who became brain surgeons would pay back more than average, while students who fought tropical diseases in Togo would pay less.
Here’s the problem though: students know more about their future career plans than the university, so they can determine if a Hope Scholarship would be more or less expensive than a conventional loan. An aspiring doctor would avoid this scholarship, while the future kindergarten teacher would opt in. In the end, the program attracted predominantly low earners, and the repayment calculations had to be redone because there was now a new sample consisting mostly of low-income earners. The program was unable to recover its costs and quietly died down within five years.
Information and Rational Discrimination in Hiring
Consider a small law firm interviewing two job candidates, one male and one female, both recent Harvard Law graduates and equally qualified (Note 6). If the “best” candidate is the one who will make the most money for the firm, then the rational choice would be to hire the man. The interviewer cannot ask about family plans but can infer that women are more likely to take paid maternity leave and may not return to work, leaving the firm with additional costs.
Is this certain? No. The male candidate may want to stay home, and the female candidate may not want children. But the firm makes decisions based on broad social trends, not individual cases. Is this fair? No. Is it legal? No. But the firm’s logic is economically rational, even if it may offend our sensibilities and violate federal law.
The good news is there is a simple solution: a generous but refundable maternity package. Women keep the benefit if they return to work and return it if they do not. This reduces the firm’s concern about paying benefits unnecessarily and makes them more willing to hire women.
Employers sometimes make decisions based on statistical trends that may be rational for them but lead to unfair outcomes. For example, suppose an employer dislikes hiring people with criminal records but doesn’t have access to that information. He may discriminate against black male applicants (28% of whom have been incarcerated) over white males (4%). All the employer wants to know is whether the person in front of him has a record, which means specific information trumps broader statistics.
Policies aimed at helping ex-offenders by suppressing criminal record information can also have unintended consequences. In theory, access to criminal background checks should reduce discrimination against black men without criminal records. Economists found that firms conducting background checks are more likely to hire African-American men, especially among employers with aversions to hiring people with records. Without access to that information, employers may rely on racial stereotypes, worsening disparities.
Branding as a Solution to Information Gaps
Firms often create their own mechanisms to solve information-related problems. For example, every McDonald’s burger is the same, whether in Mexico or in Ohio. Before we had Google reviews to tell us about the opening hours and quality of a small mom-and-pop fast food restaurant, there was a lot of missing information. McDonald’s solved that issue for themselves by being consistent across all locations. If someone is driving on the highway, they are hungry, and they see a McDonald’s sign, they know it will be open, the bathroom will be clean, and they might even know exactly how many pickles will be in their Big Mac. This predictability makes people more likely to choose McDonald’s over a random restaurant they’ve never heard of, even if that restaurant might be better.
It makes sense for companies to spend a lot of money building an identity for their products. This is what branding is. In a world where consumers must make assumptions, branding helps provide an element of trust that is necessary for a complex economy to function. Modern business requires that we conduct major transactions with people we have never met. Therefore, it comes as no surprise that businesses routinely advertise their longevity with phrases like “Since 1927”, essentially saying, “We wouldn’t still be here if we ripped off our customers”.
Imagine you won the lottery and are now looking for an investment adviser. The first firm you visit has a nice marble lobby, high-quality wood paneling on the walls, original Impressionist paintings, and executives wearing custom handmade Italian suits, fitted to perfection. Do you think: (1) “My fees will pay for all this very nice stuff, what a ripoff!” or (2) “Wow, this firm must be extremely successful, and I hope they will take me on as a client”. If you’re not convinced that the answer is the latter, imagine you go to another adviser, and he works in a shabby office with flickering lights, mismatched furniture, and computers from the 1990s.
The marble and the handmade suits say absolutely nothing about their work. However, they are signals that reassure us that the firm is top-notch. As the author put it, “They are to markets what a peacock’s bright feathers are to a prospective mate: a good sign in a world of imperfect information”.
What constitutes a “good sign” can also be cultural. For example, in some parts of Asia, firms show their wealth and prestige by having air-conditioned offices, kept so cold that some workers use space heaters.
Quotes from Ch.5
“In the world of Econ 101, all parties have “perfect information.” The graphs are neat and tidy; consumers and producers know everything they could possibly want to know. The world outside of Econ 101 is more interesting, albeit messier. A state patrolman who has pulled over a 1990 Grand Am with a broken taillight on a deserted stretch of Florida highway does not have perfect information. Nor does a young family looking for a safe and dependable nanny, or an insurance company seeking to protect itself from the extraordinary costs of HIV/AIDS. Information matters. Economists study what we do with it, and, sometimes more important, what we do without it”.
Chapter 6: Productivity and Human Capital
Human Capital
What are the root causes of poverty, and why do so many people struggle to escape it?
Let’s take Bill Gates as a case study. Any discussion about why he has significantly more wealth than someone sleeping under a bridge must include “human capital”.
As the author defines it, “Human capital is the sum total of skills embodied within an individual: education, intelligence, charisma, creativity, work experience, entrepreneurial vigor, even the ability to throw a baseball fast”. Human capital also includes qualities like perseverance and honesty. If all of your assets, such as your job, money, and home, were taken away, human capital is what remains. Bill Gates, for instance, would still fare well because companies would immediately seek him out for roles as a consultant or CEO. Similarly, Tiger Woods could win a golf tournament if someone handed him a set of clubs.
In market economies, the price of a skill is determined not by its social value but by its scarcity. Robert Solow, the 1987 Nobel Prize-winning economist, was once asked if it bothered him that Roger Clemens, who was pitching for the Red Sox at the time, earned far more than he did. Solow’s response was simple: “No. There are a lot of good economists, but there is only one Roger Clemens”. Clemens’ skills as a star pitcher were rarer, which is why he earned so much more.
The skills required to ask, “Would you like fries with that?” are not scarce. Millions of people in America could fill that role, so it remains a minimum-wage job. Meanwhile, a top trial lawyer’s skills are rare, allowing them to charge $500 an hour.
Some might say that people are poor in America because they can’t find good jobs. But that is the symptom, not the cause. The deeper issue is often a lack of skills or human capital. The poverty rate for high school dropouts in America is 12 times higher than for college graduates.
However, a healthy economy also plays a role. It was easier to find a job in 2018 than in 1975 or 1932. A rising tide does indeed lift all boats, but that high tide will not turn a valet parking attendant into a college professor. Investment in human capital is what makes that transformation possible.
The Lump of Labor Fallacy
“The lump of labor fallacy is the mistaken belief that there is a fixed amount of work available in the economy, and that increasing the number of workers decreases the amount of work available for everyone else, or vice-versa.” (Taken from Investopedia)
While the lump of labor fallacy may seem intuitive, it is a common misconception worth clarifying.
First of all, let’s think about over the last 40 years. The entire Internet sector was created out of thin air.
In the mid-20th century, millions of women have entered the workforce. Did they take away work from men? Obviously not. Similarly, immigration has introduced new workers across multiple sectors without reducing the overall availability of jobs.
Were there short-term displacements? Of course. We all see an increase in competition as the supply of labor grows, as we have to compete with new entrants to the labor force. But as mentioned in chapter 2, this is all part of the “creative destruction” process. In the long-term, we are all better off.
Imagine a farming community where every family owns land and produces just enough food for themselves. They have no surplus harvest and no additional farmland, which makes it seem like there’s no room for another worker. Every family has to teach their own children, make their own clothes, repair their own tractors, etc. Now, imagine a guy gets dropped off a bus into this village, but he has no skills. Since there’s no more land, this guy has nothing to do. This village has “no jobs”.
Now imagine “guy number 2” gets off the bus into this village, but this guy has a PhD in agronomy. His research was in developing a new kind of plow that improves corn yields. He trades his plow to farmers in exchange for a small share of their harvests. In this scenario, the agronomist can live in the village on infertile land and still support himself, while the farmers have more food for themselves. This village has now created a new job: plow salesman.
A few weeks later, a teacher arrives in the village. Now, instead of the parents teaching their children, they can give that job to the teacher. Now the farmers have even more time to do what they do best: farming. They are growing more food than they can eat themselves, and so they now have a surplus of it, which they can “spend” on the agronomist and on the teacher.
So what started with a village that has no more room for an extra person suddenly has “space”. And this space was created. After some time, there will be novelists, firefighters, engineers, and politicians, and it won’t be a village anymore, but a city.
Unfortunately, over time, someone will come up with a better plow design that produces better yields than the one that “guy number 2” came up with, and so “guy number 2” will see his revenue decrease as farmers buy the better product. This is unfortunate for “guy number 2”, but this is part of the process. One person will lose their job, but overall, the city will be better off because of the new technology: farmers will get better yields, and so they will have even more to “spend”. One day, some other person with a PhD might develop new hybrid seeds, and the farmers will spend their surplus on that, which will, in turn, make them yet again even richer.
So the point of this exercise is to show that the farmers get richer, which creates demand for new jobs elsewhere in the economy, since the village “can afford it”.
Human Capital > Everything Else
Your country could be sitting on oil and diamonds, but there seems to be a lack of correlation between natural resources and standard of living. Meanwhile, there seems to be a positive correlation between a country’s level of human capital and its standard of living.
Countries like Japan and Switzerland have barely any natural resources, yet they are some of the wealthiest in the world. Meanwhile, countries like Nigeria have lots of oil, but still have a poor quality of living.
Why? Because of productivity. America is rich because Americans are productive. They work less and produce more than ever before. Work hours have come down from 3100 hours to 1730 hours per year, while real GDP (an inflation-adjusted measure of how much each person produces, on average) has gone from $4800 to $40000.
And productivity is another reason why not all jobs are leaving the US and heading to Mexico or Vietnam or Bangladesh, where labor is much cheaper. A worker who costs a tenth as much but produces a tenth as much is not a bargain. But in industries such as garment manufacturing, producing footwear, or assembling basic goods like basketballs and t-shirts, where workers may be half as productive but cost a tenth as much, that’s a good deal.
Revenge of the Nerds
Why is it that in 1979, the top 1% of Americans earned 9% of the nation’s total income, while by 2013, it was 16%? Human capital.
Human capital has become more important and therefore better rewarded. This is evident among college graduates, who in 1980 earned 40% more than high school graduates, while by 2013, they earned 80% more.
Society is evolving in ways that favor skilled workers. For example, the shift toward computers in nearly every industry benefits workers who either have computer skills or are smart enough to learn them on the job. Technology makes smart workers more productive while making low-skilled workers redundant. ATMs replaced bank tellers, self-serve pumps replaced gas station attendants, and automated assembly lines replaced workers doing mindless, repetitive jobs.
On top of that, globalization and international trade put low-skilled workers in greater competition with other low-skilled workers around the globe. It’s hard to ask for $15/hour when Nike can pay workers $1/day to make shoes in a Vietnamese sweatshop.
Quotes from Ch.6
“Technology displaces workers in the short run but does not lead to mass unemployment in the long run. Rather, we become richer, which creates demand for new jobs elsewhere in the economy. Of course, educated workers fare much better than uneducated workers in this process. THey are more versatile in a fast-changing economy, making them more likely to be left standing after a bout of creative destruction.”
“Families who live in public housing on the South Side of Chicago are not poor because Bill Gates lives in a big house. They are poor despite the fact that Bill Gates Lives in a big house. […] Bill Gates did not take their pie away; he did not stand in the way of their success or benefit from their misfortunes. Rather, his vision and talent created an enormous amount of wealth that not everybody got to share. There is a crucial distinction between a world in which Bill Gates gets rich by stealing other people’s crops and a world in which he gets rich by growing his own enormous food supply that he shares with some people and not others.”
Notes
1
By selfish, I mean we all seek our own happiness, and the path we take varies for each of us. Some people might be happy by purchasing a new car, while others are happier when they help someone cross the street, or volunteer somewhere. The latter have value as well, even if not monetary. This is the concept of utility in economics: the total satisfaction or benefit derived from consuming a good or service.
2
I think I’ve only heard two good arguments thus far in defense of communism.
First, external influence from capitalist countries. I mean, the CIA went nuts shortly after its creation in 1947. Iran 1953, Guatemala 1954, Congo 1960, Cuba 1961. Bribing politicians, funding protests, funding labor movements to undermine governments. Setting up a fake radio station pretending to be coming from that country, broadcasting false reports of uprisings and protests (this happened in Guatemala). Providing equipment and training to exiles and rebel groups. These are the lengths to which the U.S. and its allies went to ensure that communism didn’t gain a foothold in those countries.
Now, the U.S. simply did what was necessary to protect its strategic interests; they did what they believed was essential to maintain their position as the world’s superpower. If it’s the middle of the Cold War and you know that Congo has rich deposits of Uranium, you’re going to make sure it stays out of communist hands (video explaining the Congo situation). The stakes were global, and they played the game accordingly, pulling whatever strings necessary to tilt the balance of power in their favor. I love this video as well detailing the meddling of Chile and Nicaragua.
I’m not saying the USSR didn’t engage in the same interferences, but it’s hard to determine the effectiveness of a system if the world’s superpower keeps meddling in your business.
And second, let’s all remember the historical context in which the USSR emerged. The USSR, for example, started as a largely agrarian society already devastated by World War I (2 million soldiers killed), followed by a brutal civil war (~10 million deaths). Just as they were developing, World War II killed 27 million Soviet citizens (as well as displacing millions more and destroying industrial and agricultural zones). They were essentially trying to industrialize and build a new economic system while simultaneously recovering from multiple catastrophes and playing catch-up with more developed nations. How much did US benefit from having the two largest oceans surrounding it as natural protection?
I would also like to note that I’ve heard people claim that Communism has killed 100 million people. How stupid or intellectually dishonest must people be to make these analyses? I’ve heard claims that Stalin alone killed 40 million people. The truth is that Stalin killed ~1 million during The Great Terror of 1937 (a political purge against dissidents), ~1.5 million through his gulags, ~1 million during deportations of ethnic groups (mainly during WW2), and ~4 million Ukrainians during the 1932-1933 Holodomor. The only way to reach that 40 million figure is by including all the war deaths, which you cannot fairly blame on communism itself.
And even the deaths through Stalin, can you blame it on communism itself? I haven’t looked into the link between authoritarianism and communism, so I’m not sure. But I remember enjoying reading Animal Farm by George Orwell. Really good book!
Quick note: After Stalin’s death in 1953, the level of state violence in the USSR decreased significantly. Under Khrushchev (1953-1964), most gulags were shut down, political prisoners were released, purges ended, and no more mass deportations. Things remained authoritarian, but to a much lesser extend with less severe consequences.
And China I’ve heard killed 60 million people. The truth is that during the Great Leap Forward (1958-1962), Mao’s attempt to rapidly industrialize caused the largest famine in human history, killing somewhere between 15-25 million people. This happened because farmers were forced to make steel instead of growing food, and local officials lied about grain production to meet quotas which was devastating because these fake numbers meant the government kept taking and exporting grain while people were actually starving. They literally couldn’t fix the problem because no one knew how bad it really was. While this disaster wasn’t caused by communist ideology directly, it was made possible by the total control of a communist system where no one could oppose these policies or safely report the truth. Then during the Cultural Revolution (1966-1976), another 750,000 to 1.5 million died from direct violence through Red Guard persecution of “class enemies” and forced relocations.
Obviously, that’s a lot of deaths, and it shows something important about communist systems: when they fail, they fail big. Because when you have total state control and no one can speak up or change course, bad policies don’t just cause problems, they cause catastrophes with no brakes to stop them.”
I’m just saying that communism wouldn’t necessarily succeed without external pressures outside of its control (the first two points I mentioned about the USSR). Bureaucratic inefficiencies are a problem, concentration of power is another, and so it economic calculation (which basically means prices can’t naturally adjust to reflect true scarcity and demand).
3
This is the case when you’re a first-time buyer, not an investor. If you’re an investor and your real estate agent knows you’ll be buying and selling properties throughout your life, then their incentives align with yours. It’s in their best interest to look out for you because they know you’ll be a repeat customer. That’s when a partnership forms; one where your success becomes their success too. In the long run, this kind of relationship is what will make the agent the most money.
4
6
A classic example of negative externalities is the “Great American Streetcar Scandal” of the mid-20th century. Between 1938 and 1950, General Motors, along with Firestone Tire, Standard Oil, and others, systematically bought and dismantled electric streetcar systems in about 25 cities including St. Louis, Baltimore, Los Angeles, and Oakland, replacing them with GM buses. While this was profitable for the companies involved, it had massive negative externalities: increased urban pollution, higher transportation costs for citizens, and the destruction of efficient public transit infrastructure that had served communities for decades.
The conspiracy fundamentally changed how American cities looked and functioned. Instead of having dense, walkable neighborhoods connected by streetcars (like many European cities today), cities kept expanding outwards with endless rows of single-family homes far from city centers. Living in these new suburban areas made car ownership essential, leading to more traffic, pollution, and longer commute times.
This case perfectly illustrates how private market actions can create lasting negative impacts on society, especially when those decisions reshape infrastructure in ways that force certain consumption patterns (in this case, making car ownership practically mandatory for most Americans).
5
That said, these countries have typically faced significant external pressure and economic sanctions from powerhouses like the United States, which have severely affected their economies. For example, Cuba has faced a U.S. embargo for decades, which has drastically limited its ability to trade and access vital resources.
6
I want to note that (like most of the examples in this book) this example of how firms make decisions under uncertainty, while supported by economic logic, is a generalization. It’s important to note that real-life situations are complex, and the book uses hypothetical scenarios to illustrate economic principles rather than to provide specific case studies.