Part 1 (1/2)

THE UNDERCOVER ECONOMIST

by Tiot me into economics; Tony Courakis, Simon Cowan, Stan Fischer, Bob Garhart, Paul Klemperer, Brendan McElroy, Elinor Ostrom, Hyun shi+n, Bill Sjostrorateful to them all

At Shell, Ged Davis let me work part-time while I produced the first draft of the book I was flattered by his reluctance and grateful for his support Other colleagues at Shell were inspira-tional, especially Betty-Sue Flowers, Anupa McKay, and John Robinson

At the Financial Times, Pilita Clark, Andy Davis, Chris Giles, Andreers, John Kay, John Willave me opportunities and then made sure I didn't waste them

At the World Bank, Michael Klein and Suzanne Sues and every day with them is an education

David Bodanis, Felicity Bryan, Penny Dablin, Moore Flannery, Juri Gabriel, Mark Henstridge, Diana Jackson, Oliver Johnson, John Kay, Cho Khong, Paul Kle McKay, Fran Monks, Dave Morris, Rafael Ramirez, Jillian Reilly, John Robinson, Tiht improved the book with their coent, has been superb Tim Bartlett and Kate Hamill at Oxford University Press infuriated ht-I have been very lucky to ith them

Most importantly, emotional support came from Diana Jackson, my wife Fran Monks, ”Uncle” Dave Morris, and Jillian Reilly Above all I have to thank Andrew Wright, a genius, without whom the book could never have been finished, and David Bodanis, an inspiration, without whom it would never have been started

Introduction

I would like to thank you for buying this book, but if you're anything like ht it at all Instead, you've carried it into the bookstore cafe and even now are sipping a cappuccino in comfort while you decide whether it's worth your money

This is a book about how econoht be an econoht not spot hi at an econo remarkable But normal people look remarkable in the eyes of econo? What could he tell you, if you cared to ask? And why should you care?

Youa frothy cappuccino, but the econoath and battles of wits The gaet that coffee in front of you made a lot of money, some of them made very little, and soht now The econoet what, how, and why My hope is that by the tis But please buy it first, before the storeto the economist for another reason: he doesn't kno to make a cappuccino, and he knows that nobody else does either Who, after all, could boast of being able to grow, pick, roast, and blend coffee, raise and milk cows, roll steel and mold plastics and assemble them into an espresso ? Your cappuccino reflects the outcole person in the world who could pro-duce what it takes to make a cappuccino

The economist knows that the cappuccino is the product of an incredible teae of the teaht re to coe of the supply of bread to the population of London?” The question is co

When the econos his attention away froanizational challenges are even greater The complexity of the system that made the store possible defies easy description: think of the accun and development, frohts that illuminate the shelves to the software that keeps track of the stock, not to h which the books are printed, bound, stored, delivered, stacked, and sold

The systeht this book-you have bought this book by now, haven't you?-you probably did so without having to give instructions to the book-store to order it for you Perhaps you did not even knohen you left your hoic, dozens of people took the actions necessary to fulfill your unpredictable desires: me, my editors, marketers, proofreaders, printers, paper manufacturers, ink suppliers, and many others The economist can explain how such a system works, how companies will try to exploit it, and what you as a custoht back

Now the Undercover Econo out of theat the traffic ja fact of life To the economist, there is a story to tell about the contrast between the chaos of the traffic and the s from the bookstore that will help us avoid traffic ja about the things going on around the local ht talk about the difference between bookshops in the developed world and libraries in Caht point out that the gap between the world's rich countries and the world's poor countries is huge and appall-ing The economist would share your sense of injustice-but he could also tell you why rich countries are rich and poor countries are poor, and what ht be done about it

Perhaps the Undercover Economist seems like a know-it-all, but he reflects the broad ambition of economics to understand people: as individuals, as partners, as coanizations we call ”economies”

This breadth of interest is reflected in the eclectic tastes of the nobel Prize committee Since 1990, the nobel Prize in Eco-nomics has only occasionally been awarded for advances in the obviously ”econoe rates or business cycles More often, it has been awarded for insights less obviously connected hat you y, history, voting, law, and even esoteric discoveries such as why you can't buy a decent secondhand car

My aim in this book is to help you see the world like an econoe rates or business cycles, but I will unlock theissues, such as how China is lifting a million people a month out of poverty, and the little ones, such as how to avoid paying too much money in the supermarket It's detective work all the way, but I'll teach you how to use the investigative tools of the economist I hope that by the end of the book, you'll be a more savvy consumer-and a more savvy voter too, able to see the truth behind the stories that politicians try to sell you Everyday life is full of puzzles that many people do not even realize are puzzles, so above all, I hope that you will be able to see the fun behind these everyday secrets So let's start on fa, who pays for your coffee?

ONE

Who Pays for Your Coffee?

The long commute on public transportation is a commonplace experience of life in major cities around the world, whether you live in New York, Tokyo, Antwerp, or Prague Coly combines the universal and the particular The par-ticular, because each co the run fro the timetables and the correct end of the platfor off the disadvan-tages of standing rooainst a seat on the last one Yet commutes also produce common patterns- bottlenecks and rush hours-that are exploited by entrepreneurs the world over My coton DC is not the sa, but it will look surprisingly faut West is the Metro station ideally positioned to serve the World Bank, International Monetary Fund, and even the White House Every , sleep-deprived, irritable travelers surface frout West into the International Square plaza, and they are not easily turned aside froet out of the noise and bustle, around the shuffling tourists, and to their desks just slightly before their bosses They do not welcome detours But there is a place of peace and bounty that can tempt thehts are served with s barista whose na, of course, of Starbucks The cafe is placed, inescapably, at the exit to International Square This is no quirk of Farragut West: the first storefront you will pass on your way out of the nearby Farragut North Metro is-another Starbucks You find such conveniently located coffee shops all over the planet and catering to the same desperate commuters The coffee shop within ten yards of the exit froton's Dupont Circle Metro station is called Cosi New York's Penn Station boasts Seattle Coffee Roasters just by the exit to Eighth Avenue Coh shi+njuku Station, Tokyo, can enjoy a Starbucks without leaving the station concourse In London's Waterloo station, it is the AMT kiosk that guards the exit onto the south bank of the Thames

At 255 a tall cappuccino from Starbucks is hardly cheap But of course, I can afford it Likeat that cafe, I earn the price of that coffee every fewto save a few pennies by searching out a cheaper coffee at 8:30 in the e demand for the most convenient coffee possible-in Waterloo Station, for exah each year That makes the location of the coffee bar crucial

The position of the Starbucks cafe at Farragut West is advantageous, not just because it's located on an efficient route from the platforms to the station exit, but because there are no other coffee bars on that route It's hardly a surprise that they do a roaring trade

If you buy as much coffee as I do youfilthy rich out of all this If the occasional gripes in the newspapers are correct, the coffee in that cappuccino costs pennies Of course, the newspapers don't tell us the whole story: there's milk, electricity, cost of the paper cups-and the cost of paying Maria to s But after you add all that up you still get so a lot less than the price of a cup of coffee According to economics professor Brian McManus, markups on coffee are around 150 percent-it costs forty cents to make a one-dollar cup of drip coffee and costs less than a dollar for a s a lot of ht think that the obvious candidate is Howard Schultz, the owner of Starbucks But the answer isn't as simple as that The main reason that Starbucks can ask 255 for a cappuccino is that there isn't a shop next door charging 200 So why is no-body next door undercutting Starbucks? Without wishi+ng to dis-miss the achievements of Mr Schultz, cappuccinos are not in fact coe of drinkable cappuccinos (sadly, there is no shortage of undrinkable cappuccinos either) It doesn't take much to buy some coffee machines and a counter, build up a brand with a bit of advertising and some free samples, and hire decent staff Even Maria is replaceable

The truth is that Starbucks' e is its location on the desire line of thousands of commuters There are a feeet spots for coffee bars-by station exits or busy street corners Starbucks and its rivals have snapped them up If Star-bucks really did have the hypnotic hold over its customers that critics coetting people to trip over its cafes The nice in that Starbucks makes on their cappuccinos is due neither to the quality of the coffee nor to the staff: it's location, location, location

But who controls the location? Look ahead to the negotiations for the new rental agreement The landlord at International Square will not only be talking to Starbucks but to other chains like Cosi and Caribou Coffee, and DC's local co's, Capitol Grounds, and Teaisreereement with only one She'll quickly find that no-body is very eager to pay much for a space next to ten other coffee bars, and so she will get theto work out who is going to make all the money, si co table and on the other side is a landlord ns a single priainst each other, the landlord should be able to dictate the terms and force one of them to pay rent, which consumes almost all their expected profits The successful com-pany will expect soh to leave a substantial profit, another coffee bar will be happy to pay a little extra for the site There is an unlimited num-ber of potential coffee bars and a limited number of attractive sites-and that means the landlords have the upper hand

This is pure ar It's reasonable to ask if all of this is actually true After I explained to a long-suffering friend (over coffee) all of the principles involved, she asked me whether I could prove it I adht say, a piece of ”observation and deduction,” based on clues available to all of us A couple of weeks later she sent me an article from the Financial Times, which relied on industry ex-perts who had access to the accounts of coffee co any money” and con-cluded that one of theretail outlets in pri accounts is dull; econoet to the sah the old econo out the first analysis of twenty-first-century coffee bars Published in 1817, it explains not just the modern coffee bar but much of the modern world itself Its author, David Ricardo, had already made himself a multimillionaire (in today's money) as a stockbroker, and was later to become a Member of Parlia-ed to understand what had happened to Britain's econo the then-recent Napoleonic wars: the price of wheat had rocketed, and so had rents on agricultural land Ricardo wanted to knohy

The easiest way to understand Ricardo's analysis is to use one of his own exaine a wild frontier with few settlers but plenty of fertilefarht to grow crops on an acre of good rain an acre of meadoill pro-duce, but they cannot decide how e of land lying fallow, coh rentor any significant rent at all Each landlord would rather collect a small rent than no rent at all, and so each will undercut his rivals until Axel is able to start farh to compen-sate for the landlord's trouble

The first lesson here is that the person in possession of the desired resource-the landlord in this case-does not always have as much power as one would assume And the story doesn't specify whether Axel is very poor or has a roll of cash in the false heel of his walking boot, because it doesn't th coh scarcity: settlers are scarce andpower

That means that if relative scarcity shi+fts fro shi+fts as well If over the years rants follow in Axel's footsteps, the amount of spareas there is any, competition between landlords who have not attracted any ten-ants will keep rents very low One day, however, an aspiring farmer alk into town-let's call him Bob-and will find that there is no spare fertile land The alternative, far on inferior but abundant scrubland, is not attractive So Bob will offer to pay good money to any landlord ill evict Axel, or any of the other far virtually rent-free, and let hi to pay to rent meadowland rather than scrubland, all of theto pay not to ed, and quickly: suddenly the landlords have acquired real bargaining power, because suddenly farmers are relatively common and meadows are relatively scarce

That means the landowners will be able to raise their rents By how h that far rent, or far on inferior scru-bland rent free If the difference in productiveness of the two types of land is five bushels of grain a year, then the rent will also be five bushels a year If a landlord tries to charge more, his ten-ant will leave to farm scrubland If the rent is any less, the scrub far to offer ed so rapidly simply be-cause one more man arrived to farm the area This story doesn't seem to explain how the world really works But there is ht think, even if it is oversimplified Of course, in the real world, there are other ele-term contracts, and even cul-tural nor one person out and installing a new tenant the next day is just ”not done” In the real world there are more than two types of far a far a cab All these facts complicate what happens in reality; they slon the shi+ft in bargaining power, alter the absolute numbers involved, and put a brake on sudden movements in rents

Yet the coer trends behind the scenes, as scarcity power shi+fts froroup to another The econo process We should not be surprised if, suddenly, the land o up dra-matically; or if the world is covered by coffee bars over a period of just a few months The si reality-but the e ith really do change quickly, and with profound effects on people's lives We often co a cup of coffee, or even a house The sy the patterns of scarcity which underlie theinal” land is of central i power don't have to stop there While the far story can be elaborated indefinitely, the basic prin-ciples re, they will eventually cultivate not only the meadowland but also all of the scrubland When a new settler, Cornelius, walks into town, the only land available will be the grassland, which is even less productive than scrubland We can expect the saotiations: Cornelius will offer et onto scrubland, rents will quickly rise on scrubland, and the differential between scrubland and meadoill have to stay the same (or farmers would want to move), so the rent will rise on meadow too