TCS Daily

The Undercover Economist

By Nick Schulz - December 19, 2005 12:00 AM

Nick Schulz: Tim Harford is a columnist for the Financial Times magazine and the author of a new book, The Undercover Economist: Exposing why the rich are rich, the poor are poor, and why you can never buy a decent used car. Tim thanks for joining us today.

Tim Harford: Thanks very much for having me Nick.

Nick Schulz: There has been a lot of talk lately about the price gouging. Mostly in relation to energy prices. But in your book I noticed you discussed price gouging, what you call the "natural way." And you discuss organic food. Can you explain what you mean by price gouging in organic food? That is not something that we normally think about when we think about price gouging.

Tim Harford: What businesses do is they try to charge as much money as they possibly can for all of their products. And the question for the economist is, well how can they do this? And under what circumstances can they do this?

So each business is facing a dilemma. If they raise their prices, they get higher margins but they lose customers. And if they lower their prices they get lower margins but they gain customers. So you know you have the old joke, we're losing money on every sale, but we make up for it on volume.

Now it's a tradeoff. It's a painful tradeoff for a business. But if they could split their customers up somehow and identify the customers who are not willing to pay and the customers who are willing to pay, charge a high price to the customers who will pay it and a low price for the customers who won't, you get the best of both worlds.

You get all the high margins on those sales you are going to make. Plus you get the volume. So in my book I discuss lots of different examples of how companies can do this.

Nick Schulz: And it's called price targeting, right?

Tim Harford: Yes. I call it price targeting. Most economists would call it third degree price discrimination. I just find this pretty tedious. And the cleverest way of price targeting is to get the customers to identify themselves as price sensitive or not. So if you offer them some choices you may be able persuade some of your customers to reveal themselves as not looking at the price.

So sometimes you just offer the same product packaged two different ways at different prices. And if a customer is looking at the price they will buy the cheap one. And if they are not looking at the price, well 50/50 chance they will buy the expensive one. So that is very simple.

Or you can get more sophisticated. So I talk about fair trade coffee. There are some coffee chains in the U.K. who are charging markups of about 20 cents on a fair trade cappuccino. And the natural assumption of the customer is that that 20 cents is going to go to some poor farmer in Guatemala.

But actually hardly any of it does. It's not because the company is stealing the money. It's because there is just not that much coffee in a cappuccino. And while the farmer is getting much more money for his coffee, most of that 20 cents is markup. Just pure extra profit that goes to the cappuccino seller.

So I'm not saying don't buy fair trade coffee. I'm just saying the reason they offer fair trade coffee is not because they support fair trade. It is because it maximizes their profits.

And it is a similar thing with organic food. A lot of people like to buy organic food for various reasons. Some people say it is better for the environment. And some people say it is better for their health. Some people say it tastes better. I don't have a strong opinion on any of this. I have not studied the evidence. What I do know is that the markup is higher on organic food. Substantially higher.

Organic food is more expensive to produce. But most of the costs of getting something on the supermarket shelves -- staff time, electricity, rent, distribution costs -- they are not actually the raw cost of the produce. And I argue that in many supermarkets you will see organic food priced with much more substantial markup. And it is deliberately separated away from the conventional food because that would make the price comparison too obvious, too sobering.

And so I went to my local health foods store with a clipboard taking all kinds of notes. And one of the things I noticed was you can get your conventional bananas and you can get your organic bananas. You get your conventional apples and you get your organic apples. You'll never see them next to each other.

You might see the organic garlic next to the conventional onions and the organic bananas next to the conventional apples. You won't see the organic apples next to the conventional apples.

Nick Schulz: I was interested to read in your book that you suggested that agricultural subsidies are harmful to the environment. And that might be news to some people. How is that the case and why is that so?

Tim Harford: And actually let me broaden that. I mean we are talking about all kinds of agricultural protectionism. Agricultural subsidies get the most airtime. But actually more direct trade barriers like taxes and tariffs I think are more serious. They all push the same kind of way. They will push towards having crops grown on land which is not as suitable as it could be if their crops were grown in another country.

So you have got acres of fertile land in Guatemala that you could grow sugar there. But because of protectionism, the sugar is grown in Florida and the Everglades are destroyed. And meanwhile the Guatemalans are either growing coffee for basically nothing, or like the Columbians, they think, well, maybe we should grow cocaine instead.

Now this is not a good idea. And I have a little graph -- I don't have a lot of graphs in my book. I prefer the written word. But sometimes the picture is worth 1,000 words -- and it's just a graph of trade barriers for different countries and how much fertilizer they use on their agricultural land. The countries that have the highest trade barriers, Japan and Korea use so much fertilizer. Then it is the EU. They use a lot. American less, but you know they still have quite a lot of protectionism and they still use quite a lot of fertilizer.

And then countries like Brazil that don't have a lot of agricultural protectionism don't use much fertilizer either. And when you think about it, it makes perfect sense. The protectionism is necessary because the land is not good. And the fertilizer is necessary because the land is not good. So free trade in agricultural products is -- well it's good for a lot of reasons. But one of the reasons is it is good for the environment.

Nick Schulz: You have a sub-headline in your book which says that globalization is green. Now this strikes a lot of people as false. What do you base your argument on?

Tim Harford: People have in their mind an idea that what's happening because of globalization is that companies are shutting down a factory in American that has rigorous environmental standards, and they are opening that factory up in say Vietnam where it doesn't have rigorous environmental standards. And the reason that those factories are moving is to avoid the environmental standards and this is terrible. And what's going to happen is the world is going to be destroyed because all the companies are going to move to avoid environmental standards.

Now in principle this could happen. Yes. In principle it could happen. But it isn't happening. And when you think about it, it is pretty obvious why it is not happening. Environmental standards even in somewhere like the U.S. or Europe where they are fairly tight make up a very small proportion of the cost. Even of heavily polluting industries, less than two percent of the cost.

Where do the rest of the costs come from? Well they come from labor costs; they come from infrastructure costs, electricity, et cetera. Now a company is not going to move to Vietnam -- move a highly advanced plant, very high technology reliant on a very sound business environment, relying on expert engineering, reliant on absolutely first-class infrastructure, electricity et cetera - it's not going to move to Vietnam to save one or two percent of their environmental costs.

Nick Schulz: Another big topic in the book is economic change and the tensions that can be created by that. You made an assertion that jumped out at me. You say "if you would like to be rich and have nothing change, then you will be disappointed." Now it seems to me many rich nations today - and you find some in Europe for example, but even here in the United States, these are very, very rich countries -- seem very change-averse in some areas. Are you saying that these countries are at risk of becoming poor, or no longer being rich over time?

Tim Harford: I start by looking at the medieval city of Bruges which was the richest city in Northwestern Europe, in the 13th, 14th, 15th centuries. And it was rich because of trade. People shipped goods from all over Europe. They were traded in Bruges. Bruges was the sight of the first stock exchange.

Tall ships sailed up and down the river's (wind). And then one day the river Zwin started to silt up. And Bruges was cut off from the world economy and just didn't change for 500 years. So this to the metaphor of what happens if the anti-globalizers get their wish. What happens if the protectionists get their wish? The river silts up. And basically all the trade moves to Antwerp.

Bruges is now bustling only because of tourists who come to see what a presently preserved 15th century city looks like. And they admire this beautiful architecture that these guys who were once incredibly wealthy, what did they put up? And now in Bruges basically you can get very nice chocolates and beer there. And it is a beautiful place. But it is just tourists sites.

So I say you can be rich like Bruges in the 13th to 15th centuries, or you can have nothing changed like Bruges from the 16th through the 20th centuries. But you know you can't be rich and have nothing change. Because economic change is dynamic.

So then what about Europe, Japan, the United States. Are they change-averse?

And the answer is, yes, to some extent of course. And these are countries where people got rich. And they have grown to like the lives they have. And they want those lifestyles protected. But I think all of these economies are to some extent dynamic. Because they all have substantial private sectors. And the private sector is by its nature dynamic.

Some of them are struggling. Germany is struggling, as we know. Japan is struggling. And some are booming. The UK has been booming in the last few years. The US has been booming in the last few years. But I think these are just wrinkles. All of these are dynamic economies moving forward.

And you know we are going to see people put out of work both by trade and by technology. And we're going to see people finding new jobs.

The way I like to think about the impact of trade -- you can point to a town where people are people are put out of work because what they did has now been shipped off to China. And the suffering is very real. But so was the suffering of secretaries who typed when they were all put out of business by Microsoft Word. We don't look back and say, if only Word Perfect had never been invented. All those girls would still be down in the typing pool typing away. They would still have those jobs.

Those jobs have been lost. Well yes those jobs have been lost. But we don't mourn the passing of those jobs even though the day when they got their unemployment slips was a painful day for them. And some people maybe never recovered. But a lot of people would have retrained, got better jobs. And certainly as a whole America was better off from not having erected high barriers against Microsoft.

A new technology is actually just the same as a new trade. China might just as well be some futuristic factory just off the coast of California for all its economic effects. We just ship all our stuff off the coast of California. It goes into the factory that is just floating outside Los Angeles. And all this great stuff comes back. For the economic effects on the United States, it makes no difference.

So we shouldn't be afraid of trade any more than we are afraid of technology. It has real effect. It does hurt people. But overall the effects are very positive.

Nick Schulz: I just want to shift lastly to another area that you tackle in the book, which is development. In your view, where has development policy worked well, and what lessons can we learn from those?

Tim Harford: My feeling is that the development policy has worked best when it has encouraged the private sector in developing countries. And this is not a simple proposition. A lot of people who have a lot of faith in free markets basically say we should end foreign aid and we should just let the private sector sort it out. But the reason these countries are poor countries is because the private sector has not been able to sort it out for various reasons.

So one of the projects that I have been very proud to work with at my short time at the World Bank -- I've been at the World Bank two years and I am just about to leave -- has been a project called Doing Business. Doing business is a project that measures the cost of business regulations in 155 countries now across the world. Basically almost every country in the world.

So they measure how many days does it take if you want to start up a small domestic business? How many procedures do you need to go through? How much is it going to cost you? Somebody doesn't pay an invoice. You want to take them to court. At every stage through the court process the judge rules in your favor. How long does it take? How much does it cost relative to the expense on the invoice?

Say you want to trade. You're a farmer or an entrepreneur. You've made some goods. There is nothing positive or dangerous about these goods. There is nothing exceptional about the goods. You'll want to ship them from your factory and you want to get them onto a ship sailing out to Europe or America. How long is that going to take? How many signatures do you need? How many documents do you need?

We've got that data for 155 countries. This is an incredible project. And the data really seemed to be motivating change in a number of ways. Partly governments see the data and they get embarrassed. They get cross. And they want to change things.

Recently the Mexican government asked the Doing Business team to rate one of their reformed proposals versus a rival proposal that had been put forth by business groups. The Doing Business team did the math. Took very little time. They were able to show that the government's proposal was going to do much more to improve Mexico's ranking on the ease of doing business than the counter proposal. And with that information in hand, the proposal passed easily in parliament. So this can really help advance reform. It's also prompting reforms from donors because some aid is now conditional on showing improvements in these statistics.

Nick Schulz: Actually while I am talking to you here, I just did an internet search. I would just like to alert out readers that if you go to, this is the World Bank site Tim is talking about with some of the information here. And it does look like an extremely exciting project.

Tim Harford: Yes. The aim of the project is to make this all transparent and the methodology, all the data, everything. So anyone can use it.

Nick Schulz: How big are the gaps in our knowledge about development policy? Or is it that we have some of the answers or continue to get some of the answers but the real challenge is in execution?

Tim Harford: Well I think one of the things that we really don't know that we must know is: we don't know which aid agencies are doing a good job. I'm not one of those people who believes that because a bureaucracy is a bureaucracy it can't work. I don't believe that. Some bureaucracies work extremely well. And some jobs can only be done by a bureaucracy. They can't be done by a business. However, a lot of aid agencies are clearly not operating as well as they might. And it's not surprising because these agencies are being given money. And nobody really knows whether the money is being well spent or not.

So one of the things that I have been arguing for along with some colleagues here at the World Bank is for much better valuation of different aid agency performance. So at the most basic level, how much money have they spent, and what have they spent it on? We know that about some aid agencies. But more importantly, did it get any results?

What about randomized trials? You could -- say you want to improve school performance in Kenya. Well, you could give out textbooks to half the schools. And measure the results. This is the half that got the textbooks and the half that didn't.

One charity actually did this as a randomized control trial the same way that you would evaluate a new pharmaceutical product. And they found textbooks didn't really help. So they tried again. They said OK, we're going to supply teachers with flip charts, whiteboards, and marker pens. That didn't work either. They tried something else. They said OK, we're going to give the kids de-worming tablets so that the tapeworm that infects a lot of these kids is going to be killed. The kids are going to be better nourished. They will be able to better concentrate in schools. Now that worked. That worked big time.

And to me those two failures of the textbooks and the flipcharts, they were tremendously successful failures. Because we learned something. Unfortunately a lot of development agencies are not using these methods. And I think until they do, we are not going to get the most out of aid.

Nick Schulz: In your view how important is fighting corruption in addressing development?

Tim Harford: Developmental professionals love to say there are no panaceas. Of course there are no panaceas. To be sure this is a very important aspect of development. But it is not the only thing. It is linked in with other problems.

So for example, the red tape that I described. In some places if you are trading goods out of the country you need to get something like 35 signatures. Every single signature is an opportunity for a bribe. It's an opportunity for corruption. But even if there is no corruption, those 35 signatures are about 30 signatures too many. So we can measure the regulations. We can measure the requirements for the signatures. We can point to the laws that require the number of administered procedures. And we can eliminate those. We can argue for eliminating them. We can exhort. We could, if we wanted, make aid conditional. I'm not sure how effective this really is. And you eliminate the signatures. You also eliminate opportunities for corruption. It's very difficult to eliminate corruption directly. But it is not so hard to eliminate indirect opportunities for corruption.

Nick Schulz: Just one last question for you. You're still at the World Bank. So if you can't answer this question that is fine. But you will be leaving there soon you said. Paul Wolfowitz has recently come into the World Bank. If you could give one or two bits of advice to a new head of the World Bank that he may want to focus on, what would that be?

Tim Harford: This performance measurement agenda -- measuring the performance of aid agencies is very important. And I think that this investment climate agenda, measuring the red tape, measuring the barriers to doing business is also important.

But from what I have seen of his public pronouncements, he already believes that. So I am hopeful that we are going to see a good few years from the World Bank.

Nick Schulz: Terrific. Well Tim thank you so much for taking some time to talk to us. And good luck with the book.

Tim Harford: Thank you very much. It is a pleasure to talk to you Nick.

Click here to listen to an excerpt from this interview.

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