Trillion Dollar Economists - Robert Litan - E-Book

Trillion Dollar Economists E-Book

Robert Litan

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A detailed look at how economists shaped the world, and how thelegacy continues Trillion Dollar Economists explores the prize-winningideas that have shaped business decisions, business models, andgovernment policies, expanding the popular idea of the economist'srole from one of forecaster to one of innovator. Written by theformer Director of Economic Research at Bloomberg Government, theKauffman Foundation and the Brookings Institution, this bookdescribes the ways in which economists have helped shape the world- in some cases, dramatically enough to be recognized with aNobel Prize or Clark Medal. Detailed discussion of how economiststhink about the world and the pace of future innovation leads to anexamination of the role, importance, and limits of the market, andeconomists' contributions to business and policy in the past,present, and future. Few economists actually forecast the economy's performance.Instead, the bulk of the profession is concerned with how marketswork, and how they can be made more efficient and productive togenerate the things people want to buy for a better life. Full ofinterviews with leading economists and industry leaders,Trillion Dollar Economists showcases the innovations thathave built modern business and policy. Readers will: * Review the basics of economics and the innovation ofeconomists, including market failures and the macro-microdistinction * Discover the true power of economic ideas when used directly inbusiness, as exemplified by Priceline and Google * Learn how economists contributed to policy platforms intransportation, energy, telecommunication, and more * Explore the future of economics in business applications, andthe policy ideas, challenges, and implications Economists have helped firms launch new businesses, establishednew ways of making money, and shaped government policy to createnew opportunities and a new landscape on which businesses compete.Trillion Dollar Economists provides a comprehensiveexploration of these contributions, and a detailed look atinnovation to come.

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Contents

Preface

Chapter 1: Introduction: Economists as Innovators

Organization of the Book

My Personal Interest (and Bias)

Notes

Chapter 2: An Easy Introduction to Economics

Rationality

Markets

Market Failures

The Macro–Micro Distinction

Economic Growth in the Short and Long Run

The Equity–Efficiency Tradeoff

Innovation and Growth: The Role of Economists

The Bottom Line

Notes

Part I: The Power of Economic Ideas: Direct Use in Business

Chapter 3: The Price Is Right

The Bloomberg Way of Pricing

Auctions

Different Prices for Different Folks

The Bottom Line

Notes

Chapter 4: Minimizing Costs

Optimization

Learning by Doing

The Bottom Line

Notes

Chapter 5: Beyond Moneyball

A Brief Guide to Regression Analysis

The Business of Forecasting

The Business of Economic Consulting

Data Analytics and Big Data

Econometrics and Sports: Moneyball

Regulatory Moneyball

The Bottom Line

Notes

Chapter 6: Experiments in Economics and Business

Economics in the Lab: Vernon Smith and Experimental Economics

Lab Experiments in Business: Focus Groups

Economic Experiments in the Field: Randomized Controlled Trials

Business Experimentation in the Field

Innovation and Entrepreneurship: Experimentation as the Foundation of Growth

The Bottom Line

Notes

Chapter 7: Matchmaker, Matchmaker

A Gentle Introduction to Market Design and Matching Theory

Matchmaking in the Labor Market

Matchmaking and Online Dating

The Bottom Line

Notes

Chapter 8: Economists and Mostly Good Financial Engineering

Not Putting Your Eggs in One Basket: The Rise of Index Investing

Efficient Markets and Their Implications

Behavioral Finance

Valuing Options: Upsides and Downsides

The Bottom Line

Notes

Part II: Economist-Inspired Policy Platforms for Private Business

Chapter 9: Planes, Trains, and . . . Trucks

Origins of Transportation Regulation

Airline Deregulation

Trucking Deregulation

Railroad Deregulation

Deregulation’s Impact: The Transportation Industry

Deregulation as a Business Platform

The Bottom Line

Notes

Chapter 10: Economists and the Oil and Gas Revolution

The Origins and Decline of Price Regulation of Fossil Fuels

The Oil and Gas Supply Revolution

The Energy Revolution as a Platform Technology

The Bottom Line

Notes

Chapter 11: Economists and the Telecommunications Revolution

Economists in a Quick History of Communications

When Natural Monopolies End: The Run-Up to the AT&T Antitrust Case

Competition in Telecommunications: The Benefits of AT&T’s Breakup

Economists and Price Cap Regulation

Economists and Spectrum Allocation

The Bottom Line

Notes

Chapter 12: Economists, Financial Policy, and Mostly Good Finance

Economists and Competition in Brokerage Commissions

Economists as Detectives: Accelerating Automated Trading

Economists and the Financial Crisis

How Did the Crisis Happen? A Quick and Easy Guide

Subprime Lending

Excessive Leverage: An Introduction

The Pre-crisis Demise of SEIR

The Glass–Steagall Debate

The Bottom Line

Notes

Part III: Looking Ahead

Chapter 13: Economic Ideas in Waiting: Business Applications

Prediction Markets

Potentially Good Financial Innovations

Congestion Pricing

The Bottom Line

Notes

Chapter 14: Economic Ideas and Challenges on the Policy Shelf: Business Implications

Federal Budget Deficits as Drivers of Policy Change

Premium Support for Medicare and Medicaid

Taxing Consumption

Taxing Carbon

The Bottom Line

Notes

Chapter 15: The Future of Economics: What It Means for Business and Economists

The Revolution in Economics

How Economics Will Continue to Affect Business

Implications for Economists

Concluding Thoughts

Notes

Appendix: Prizes in Economics

About the Author

Index

End User License Agreement

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Guide

Cover

Table of Contents

Begin Reading

Since 1996, Bloomberg Press has published books for financial professionals, as well as books of general interest in investing, economics, current affairs, and policy affecting investors and business people. Titles are written by well-known practitioners, Bloomberg News® reporters and columnists, and other leading authorities and journalists. Bloomberg Press books have been translated into more than 20 languages.

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Trillion Dollar Economists

How Economists and Their Ideas Have Transformed Business

 

Robert E. Litan

 

 

Cover image: © iStock.com/solvod

Cover design: Mochael J. Freeland

Copyright © 2014 by Robert E. Litan. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

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Library of Congress Cataloging-in-Publication Data:

Litan, Robert E., 1950–

Trillion dollar economists : how economists and their ideas have transformed business / Robert E. Litan.

pages cm

Includes index.

ISBN 978-1-118-78180-7 (hardback) — 1. Decision making. 2. Economists. 3. Economics. 4. Commerce. I. Title.

HD30.23.L578 2014

338.5—dc23

2014013664

Dedicated to

Dr. Michael Boyle

Johns Hopkins Medical School

and

Dr. Steven Stites

Kansas University Medical Center

Preface

Many, and possibly most, authors have a love–hate relationship with what they do. Writing every day, or trying to, can be a painful experience. Some days you have it and the words flow, and other days, your head is in a fog and you struggle to write a single sentence or paragraph.

I have had numerous jobs throughout my career where writing was not my main function, but in each one of them, writing memos, briefs, and articles was one element of what I was hired to do. I also had the good fortune through most of my working life to be employed by organizations that either paid me to write books or encouraged me to do so. And, to be honest, I have that love–hate attitude toward writing that I just described.

But not for this book; I wrote it while I was 63, at or near the culmination of my career, and every day I spent working on it was a joy. Like the swimming I look forward to each day, I couldn’t wait to sit down for however long I was able to do it, and at least write a few paragraphs or, ideally, several pages.

It’s not my age that explains this, but the subject matter (or matters), to be more precise. I hope that as you read the book, you can tell that I love economics and I am grateful to have a career in which I have been able to meet and occasionally work with so many outstanding, brilliant individuals. This book is kind of an ode to all of them and to the subject in general.

I got the inspiration to write it from three basic sources. First, I felt after the financial crisis that the economics profession, while somewhat justifiably criticized, was also misunderstood by many in the media and many non-economist friends. Second, for a long time I have felt that many hardheaded people in business give too little credit to economists and their ideas. Many of them, as I argue in what you are about to read, probably are not even aware of where certain ideas originated that have powered businesses quite successfully, maybe even their business. This book is an effort to correct these misimpressions, while ideally helping many undergraduate students and perhaps some graduate business students taking their first or intermediate-level economics course to understand why the subject matters and how it has been, and will continue to be, highly useful in the real world. This is true even as the field of economics changes and conceivably morphs into other social sciences, as I will comment on in the last chapter.

Third, although I don’t know him, I want to credit Steven Leavitt, the award-winning economist at the University of Chicago, and his coauthor, Stephen Dubner, of the highly successful Freakonomics series, with demonstrating that there is a real market, maybe even a hunger, for books about economics in plain English. I was inspired by Leavitt’s and Dubner’s success and hope that this book will achieve at least some significant fraction of the attention and admiration that their books have.

No book can be completed without a lot of help from a lot of people. This work is no exception. I want to thank Rob Barnett, Barry Bosworth, Will Baumol, Patrick Driessen, George Kaufman, Richard Levine, Bruce Owen, Roger Noll, Chris Payne, Brian Rye, and Hal Varian for reviewing parts of the draft manuscript. I am indebted to my good friend Phil Auerswald for coming up with the title. I pride myself on coming up with titles for my own books and for others, but on this one Phil outdid me and for that I am grateful.

I am also grateful for the excellent initial drafting assistance in Chapters 5, 7, and 15 provided by Miguel Garrido, my close former colleague at Bloomberg Government. I also want to thank several others at Bloomberg: Dan Doctoroff, president and chief executive officer of Bloomberg, L.P., and Don Baptiste, head of Bloomberg Government, for their encouragement and support for this project, and Marialuisa Mendiola for providing research assistance. I also want to specially thank Norman Pearlstine, formerly chief content officer at Bloomberg and currently the chief content officer at Time, Inc., for reading the initial chapters of this book, and giving me his enthusiastic reaction that sustained me through the long months of drafting the rest of the book.

I also owe a deep debt of thanks to all my colleagues, some of whom are no longer with us, at the Brookings Institution, where I spent roughly two decades of my professional life, and where I am now a nonresident senior fellow. Certain of these economics superstars inspired me to go on to graduate school to get my PhD, along with my law degree (you’ll see why I did both at the beginning of the first chapter). Arthur Okun, the great economist who left us far too early, was the first to take a chance on me (on the recommendation of Lawrence Klein at the University of Pennsylvania), by hiring me as his research assistant for two years. While there I was also asked to work with two other great economists who are no longer with us, Ned Gramlich and Joe Pechman, the longtime director of economic research at Brookings. I also was greatly influenced by and privileged even-to-eat-regularly-with the likes of Alice Rivlin (who has been one of my mentors throughout my professional life), George Perry, Tony Downs, Barry Bosworth, and Charles Schultze, and also with (then) young Brookings stars, including Robert Crandall, Bill Gale, Cliff Winston, and Josh Epstein. You will read short biographies of or references to many of these individuals in the course of this book, and if my long experience at Brookings makes me biased toward emphasizing their influence on the profession, public policy, and indirectly on business (of which many of them may be unaware), then I plead guilty. I couldn’t have been more fortunate to work with a more committed, brilliant, and compassionate group of scholars, who became (and still are) like my own family.

Finally, every good book (and I hope readers will agree with me about the adjective) benefits from excellent editing, and here too, this book is no exception. I am grateful to my editors at John Wiley & Sons, Judy Howarth and Tula Batanchiev, and everyone else at Wiley for deciding to publish and market this book.

Robert E. Litan

September 2014

Chapter 1Introduction: Economists as Innovators

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

—John Maynard Keynes

Kids ask the best questions, like the one I am sure most economists who have children get at some point in their lives: Mom or Dad, what do you actually do? Not only have my own children asked that question, but even my mother couldn’t understand why I wanted to go on after finishing college to earn a doctorate in economics (she told me to go law school instead because it would enable me to get a real job, so I went to a school that let me earn both degrees, on the theory that at a relatively young age it would be best to diversify). One reason I have written this book is to tell you why my instincts about economics were right, not just for me but many others in the very practical world of business and policy making.

I suspect most everyone who is not an economist thinks economists are trained to be soothsayers, predictors of how the economy will perform over coming months, and perhaps a year or two, or longer: to tell us how much inflation or unemployment will rise or fall, and how fast total output (GDP or gross domestic product) will or will not grow. Perhaps even more important, many non-economists may believe that economists can tell them what’s going to happen to the stock market, and maybe their particular stocks, and to the prices of their houses. Some highly respected economists have essentially agreed. As the late Nobel laureates Milton Friedman and Lawrence Klein have argued, the ultimate test of the worth of economics is the accuracy of its predictions.1

If that is the case, then the financial crisis of 2007 to 2008 and the subsequent Great Recession and slow recovery since have probably changed a lot of minds about economists, but not for the better. Few economists warned of these events in advance or in time for most people to sell their stocks or not to borrow so much against their houses, or buy them at all before housing prices in many areas began to fall in 2006. If instead many economists had issued their warnings in time, maybe policy makers in the United States and elsewhere would have clamped down on extending easy credit to many U.S. homeowners who couldn’t afford them, especially for mortgages requiring little or no money down, thus minimizing the growth of the housing bubble. Maybe elected officials wouldn’t have pressed the two housing giants, Fannie Mae and Freddie Mac, to buy or guarantee so many securities backed by subprime mortgages that later went sour. And maybe financial regulators would have pressed the nation’s banks, especially the largest banks, to fund more of their assets with shareholders’ money so they would have had a greater cushion against mortgage losses that later would bring some of them down and put others in the desperate position of having to take government investments to keep them afloat.

But none of that happened. Indeed, even the two economists thought to be in the best position to predict future hard times and to recommend measures to avoid or at least minimize them—Federal Reserve Chairmen Alan Greenspan and Ben Bernanke—publicly indicated that the economy was doing pretty well up until the crisis. They didn’t even warn that when the housing market turned downward and borrowers began defaulting, the rot would slow the rest of the economy. Perhaps they each believed these things would happen but as public officials whose every word is sliced and diced by the media and the public, they couldn’t voice their misgivings out loud without triggering mass panic and thus the very crisis they wanted to avoid.

Nonetheless, to be fair to both of these distinguished economists, they were in good company: Many other highly credentialed economists didn’t issue such warnings either. Moreover, Alan Greenspan later apologized for not reining in the subprime mortgage lending boom earlier, while at least in my view (one that I know is not universally shared), Ben Bernanke’s extraordinarily innovative easy-money policy helped save the U.S. economy from a far worse recession than actually happened, one that was the worst since the Great Depression of the 1930s.

The failure of the economics profession—with a few notable exceptions like New York University’s Nouriel Roubini and Yale’s Robert Shiller—to see the crash coming has pretty much tarnished the reputations of all economists since. It has also promoted deep soul-searching among economic forecasters about how to improve their models so that they will be better able to warn the rest of us of future trouble with enough time to head it off, or at the very least to keep its impacts to a minimum.

I wish them luck because they have an uphill battle. Economic forecasters as a whole have never had a very good track record of predicting the turning points in the economy, either the beginning of recessions or recoveries. In his latest book, Greenspan argues, in my opinion persuasively, that forecasters have an especially difficult time calling financial crises and sudden downturns when economies, and especially banks, are highly leveraged—that is, when they operate with thin cushions of reserves or capital to absorb losses when economies hit bumps in the road or asset bubbles deflate.2 When that happens, financial panics can lead to sharp downturns that cannot easily be seen in advance.

Nonetheless, a major thesis of this book is that prediction is not what all economists do and the worth of economic ideas should not be measured by the success or failure of the few who attempt to make predictions. This proposition is important, I submit, not only for those who make policy—elected and appointed officials—and for the wider voting public, but also for those who run and create the businesses that produce the goods and services we want to buy and in the process generate the incomes with which to pay for them.

Indeed, through the years I have found many in business to be skeptical about economists who spend their time in the Ivory Tower and not in the trenches where business is actually done. How is it possible, people in business often ask, that economists can really understand what is going on in the real world if they are not actually working in business? Others in the business world are simply innocent about the economics profession. I can’t resist repeating this story that Hal Varian, Google’s chief economist whom you will meet in Chapter 3, told me about someone from the human relations department at Amazon, which now has a chief economist but was then looking for one, asking of Hal the same question my own mother asked me: “Now, could you tell me what it is that economists actually do?”3 Presumably, Amazon has figured that out by now.

The truth is that relatively few economists actually engage in economic soothsaying or prediction. Yes, let me repeat that, or phrase it in a slightly different way: The popular perception of what most economists do is wrong, and I intend to show that in the chapters that follow.

A third and even more important reason I have written this book is to tell readers, even economists, that some economic ideas have proven to be extremely important in launching or improving the performance of many businesses. In doing so, I will focus on U.S. businesses, because the United States is the country where I was born and live, and thus has the economy I know best. But readers from or interested in other countries should find the following material useful as well. Many businesses elsewhere around the world are modeled on successful businesses launched in the United States, so if economics is useful here, it can be useful anywhere. In Part II of the book, I show how policy ideas urged by economists, once they were adopted, actually led to the creation and growth of many businesses, a fact of which their founders, current executives, and employees may not even be aware.

Although I have not quantified the business impact of economic ideas with precision, I plan to show you that collectively the notions discussed in this book have created trillions of dollars of income and wealth for the United States and the rest of the world, hence the title of the book. Along the way, I hope to teach some economics through examples, ideally reawakening your interest in the subject if you took it long ago, but without the graphs, charts, and maybe lots of equations you were required to solve but whose relevance you did not immediately (or ever) grasp. Likewise, if you are running or thinking about creating a business, perhaps one or more of the stories in the chapters that follow may quiet your skepticism about the importance of economics in business, or maybe even inspire you to change the way you or your company operates. Finally, and I know this is a long shot, there may be a chapter or two in here that inspires some economists to change the way they teach the subject, by relating at least some economic ideas to their practical uses or consequences in business settings.

I focus primarily on the positive contributions of economists to business because they have been largely overlooked, in my opinion. The financial crisis and the Great Recession have provided many examples where economic ideas have been misused and taken too far—some derivative financial instruments that went bust and took a good portion of the U.S. economy with them last decade are perhaps the best known to this generation of readers—and I will briefly discuss those where it is relevant to do so. But I am deliberately going light on these instances for two reasons: They already have been discussed extensively by others, and where economic ideas have been misused, it was those who engaged in the misuse rather than economists or their ideas that were at fault.

This book is written in the spirit of Better Living Through Economics, edited by Vanderbilt economist John Siegfried, who also was a long-time secretary of the profession’s main professional organization, the American Economic Association.4 This useful book contains essays by some leading economists on how various economic ideas have changed society through the adoption of public policies urged by economists. There is a bit of overlap between Siegfried’s book and this one—especially in my later discussion of some policy-related topics—but most of what readers will find here is new, even my gloss on public policies in the second section of this book. It is the business perspective in this book that I believe is unique and one that I know that business readers will appreciate, and hopefully others will too.

Organization of the Book

This book takes key insights from various economists—some, but not all, rewarded for ideas with one of the two leading prizes for economists—the Nobel Prize or the Clark Medal, both described in detail in Appendix A—and show how these concepts, knowingly or unknowingly, have been applied in real businesses to make real money, and also in the process to benefit consumers in the United States and elsewhere around the world.

Let me clarify, by the way, whom I mean by economists—mostly, but not exclusively, individuals with PhDs in the subject. I take a broader view because the main purpose here is to focus on economic ideas, so along the way you will not only meet some famous economists but also some statisticians, specialists in finance, psychologists (one, Daniel Kahneman, has even won the Nobel Prize in Economics), or business executives or entrepreneurs who have commercialized an economic idea. For me, since it’s the ideas that count, I will give the originators credit for being economists if the content of their ideas is related in some fashion to how the economy or some portion of it really works.

I have been privileged to know, and occasionally work with, many of the economists (so broadly defined) whose work is featured in this book. I feel a bit like Forrest Gump since I have had the good fortune to meet and know so many outstanding members of the profession during some very exciting times. My personal connections to the entrepreneurs and business executives are fewer. Where relevant, I will tell you a few personal stories about the individuals I know, in sidebars throughout. I do this not out of vanity—I have just been lucky enough to know these people—but instead because I believe this will help humanize both the individuals and the subject of economics, which I have learned over the years, can be intimidating (or boring) to many.

Each chapter of the book is devoted to one or several related economic ideas and to one or more economists who developed them. You will learn something about why some of the economists went into the field and, in particular, what led them to their ideas. The chapters contain similar information about a number of entrepreneurs and business leaders, and their companies that commercialized these ideas. Along the way, I’ll mention or introduce you to some very interesting and (believe it or not) readable books by certain economists, so if nothing else, consider this book a reader’s guide to some of the best popular economics writing by those who really know their stuff. At the same time, I apologize to the many worthy economists whose great ideas have not made it into this book because of space limits and my judgment that their research does not bear directly on the business-related themes of this particular book.

The chapters in the book are structured in three broad groups. The first part includes chapters that center on ideas that have directly found their way into certain businesses. In some cases, there is a straight line from the ideas to the businesses. In other cases, the line is not so clear, or the lines are parallel: that is, economists came up with a given idea that businesses thought of independently and found a way to make money off it. In a few cases, the economists learned from the businesses. Whichever way the causation runs, I simply want to demonstrate the importance of the ideas themselves as a way of illustrating the usefulness of economic insights, regardless of who thought of them first.

The second part focuses on economic ideas that have influenced public policies that created opportunities for a surprisingly wide range of companies to emerge and grow and, in the process, have changed much of the way business is done in this country. Many economists (including me) make it their career because they believe it will help them influence policy in some way for the better, not so much out of a desire to run for office (although many politicians have studied the subject in college and a few even have had graduate degrees), but through their writing and, for some, as advisers to elected officials or government agencies. Each of the chapters in the second part of the book discusses economic ideas that have powerfully changed governmental policy, specifically facilitating the deregulation of industries where conditions never or no longer warranted it, and in turn unleashed major, positive forces for existing and new businesses in the U.S. economy.

The concluding part of the book peers into the future by identifying a few economic ideas already in circulation that are waiting for potentially large business applications or policy changes that will create platforms for many businesses in the future, many that almost certainly cannot now be imagined. The last chapter in this part of the book concludes with some thoughts about the future of economics as a separate academic discipline, and the implications this might have for business in the future.

At the end of each chapter I summarize some of the main takeaways or “bottom lines.” I haven’t said enough in this introduction to warrant a bottom line for this chapter, but to whet your appetite for what’s in the rest of the book and to justify the “trillion dollar” claim in the title of the book, here are a few things you will find as you read further:

Economists have been instrumental in implementing and designing auctions in a variety of companies that collectively have market values in the hundreds of billions of dollars, or more.

Economists have built the mathematical backbone for minimizing costs in much of the transportation industry.

Statistical techniques developed and refined by economists are increasingly being used in the sports industry (and not just in baseball!).

Economists have contributed to a growing “matchmaking” industry, of human organs and whole people (in the “marriage market”).

Economists and their insights helped spawn the growth of index investing and financial options contracts (collectively involving several trillion dollars).

Without the deregulation of the transportation industry and the breakup of AT&T, events in which economists played prominent roles, Internet retailing would not exist on nearly the scale that it does today, if at all.

Economists also played prominent roles in encouraging the deregulation of the prices of oil and natural gas without which energy firms would not have had the financial incentives to make the technological breakthroughs that have dramatically increased U.S. oil and gas production, reversing the “energy pessimism” that has overshadowed the country and world since the early 1970s.

Not bad for a relatively small profession, if you ask my opinion.

My Personal Interest (and Bias)

I find economics to be a fascinating and exciting subject. While I had some interest in it before attending college, I really got turned on to it by the best teacher I have ever had, a then young, dashing, and brilliant economist from India, Jamshed Ghandi, at the Wharton School of Finance at the University of Pennsylvania (the nation’s first undergraduate school of business, which later added a famed master’s program and a limited PhD program). As my choice of schools implies, I went to Wharton to learn about business, and specifically corporate finance, a subject I then only vaguely understood. Although my enthusiasm for choosing economics as a major waned a bit after taking the standard introductory level course in my freshman year—an experience I’ll bet many readers and countless other former college students have had—that attitude changed completely the following year when I had the great fortune and privilege to take Ghandi’s seminar in finance, which was really about macroeconomics. Ghandi had a reputation for being a very tough but fair grader, and an outstanding teacher, a reputation he maintained long after I took his course and graduated.

You will find as you read through the book that other economists were attracted to the subject in the same way that I was, through the gifts of one special teacher, admittedly a not unusual way in which many people choose their professions. In my case, what appealed to me most about economics is that it was a practical way to apply mathematics, which I was good at, but not good enough to be a mathematician, or even to be a physicist (a trait shared by other famous economists, too, although the field has become more mathematical over time, and the very best economists tend to be those who are both mathematically gifted and can express themselves well in writing). That is because, as MIT Professor Robert Solow reportedly once quipped, “Little boys don’t grow up wanting to be economists, they have to learn about it later in life.” (He made this remark at a time when it was rare to find women economists, a situation that has changed significantly, as it has for other professions).

For students who are thinking about taking an economics course, I hope this book will help you get through the graphs and equations and understand, at least at some level, that they actually have been or can be useful. For those who have suffered through an economics course and want an easy way to go back and remember some of what you learned, or perhaps learn a few new things with business relevance, then hopefully this book is for you.

I realize that those running a business or working in one are perhaps my toughest audience. Many of these readers are probably skeptical that economists have very little understanding of the real world, or their particular business. One of the noted economists featured in a later chapter, Franklin Fisher of MIT, told me a great story that encapsulates this attitude.

The building at MIT that houses both the business school and the economics department is called the Sloan building, named after one of America’s leading industrialists, Alfred P. Sloan, who built General Motors (in the good old days, long ago). When the MIT president at the time told Sloan about the plans to name the building after him, he reportedly replied something to the effect, “That’s all very nice and I’m grateful, but only if you move all the economists out of the building.” They weren’t moved, but Sloan’s attitude is not at all unusual in business, in my experience, and I fully understand it.

Sloan’s skepticism about the usefulness of economists uttered many decades ago persists elsewhere. Even a famous historian, Harvard’s Niall Ferguson, has climbed on the anti-economist bandwagon. Worrying about how America has lost its way (in his book by that name),5 Ferguson singles out the profession for failing to recognize how increasing bureaucracy and regulation are stifling American entrepreneurship, a position with which I am sympathetic. I personally applaud Ferguson for turning his attention to the importance of entrepreneurs in advancing innovation, a theme I have stressed in my own past writings and discuss later in this book, and even agree with his assertion that “[n]ot many economists talk about [institutional impediments to entrepreneurship],” a situation I spent nine years as research director at the Kauffman Foundation trying to rectify (even recommending the funding of historians like Ferguson himself to study the subject, which he clearly has). It’s his diagnosis of the reason why economists ignore these impediments, echoed by many in business—“because not many economists run businesses”—that I want to counter.6

By the end of this book (maybe even before), I hope all readers will come away with a different impression of at least some economists, and more importantly, with a more positive view about the importance of economic ideas or the way economists tend to think. I may not be able to tell you everything about economics you might benefit from knowing, but ideally it will be enough for you to realize that Keynes was right when he famously uttered that practical men (he wasn’t thinking of women) have little idea of the extent to which their beliefs and actions have been heavily influenced by the writings of some defunct economist. Most of the economists you will meet vicariously in this book are not yet defunct, but alive and well and still contributing to the ongoing process of understanding how economies work, and still coming up with ideas that real people in real businesses are using to improve their lives and those of their customers, suppliers, and employees.

Finally, to those with a business background you should know that this is not your standard business or economics book. It will not give you or your company five steps to success, or seven steps to happiness. It will not tell how certain companies were built to last, went from good to great, or fell from grace. I will attempt, however, to draw out some general lessons your business may be able to use from each chapter. As noted earlier, you’ll find those lessons in “The Bottom Line” section at the conclusion of each chapter.

So, sit back and actually enjoy reading about economics. It will make me happy if you get even half the pleasure reading the book as I have in researching and writing it (feel free to skip things you already may know or anticipate you will disagree with).

Notes

1

. The statement about Friedman is in Alex Rosenberg and Tyler Curtain, “What Is Economics Good For?,”

New York Times Opinionator

, August 24, 2013, and Klein’s statement is from Glenn Rifkin, “Lawrence R. Klein, Economic Theorist, Dies at 93,”

New York Times

, October 21, 2013.

2

. Alan Greenspan,

The Map and the Territory: Risk, Human Nature, and the Future of Forecasting

(New York: Penguin, 2013). For an excellent summary of the book and a reflection on Greenspan himself, see Gillian Tett, “Crash Course,”

Financial Times

, October 26–27, 2013, 19.

3

. Interview with Hal Varian, July 15, 2013.

4

. John Siegfried, ed.

Better Living through Economics

(Cambridge, MA: Harvard University Press, 2012).

5

. Niall Ferguson,

The Great Degeneration: How Institutions Decay and Economies Die

(New York: Penguin Group, 2012).

6

. Niall Ferguson, “How America Lost Its Way,”

Wall Street Journal

, June 8, 2013, C1,

http://online.wsj.com/article/SB10001424127887324798904578527552326836118.html

. It is getting ever-harder to do business in the United States, argues Niall Ferguson, “and more stimulus won’t help: Our institutions need fixing.”

Chapter 2An Easy Introduction to Economics

If you’ve made it through the first chapter, you’re now probably asking an important threshold question: How much economics do I have to know to understand what follows? The answer is, not much, and what you do need to know before you plunge in, I will now tell you. For readers who have taken economics but forgotten a few things, this refresher may also be helpful. In whatever camp you fall, you will learn the rest of what might be useful to know before you read coming chapters. You will also discover how the economic ideas featured in these chapters use or build upon one or more of the following concepts.

Rationality

First, most economists assume that all actors in the economy behave rationally—that is, they act in their self-interest, even if that interest includes altruistic behavior, from which many people derive pleasure. Actually, the notion of pleasure, or utility, is a philosophical idea that predates modern economics and is associated with the British philosopher Jeremy Bentham, who argued that people act in such a way as to maximize their total utility. More sophisticated versions of this concept have appeared since in the writings of many economists, but the notion is that people are made happier more by the pleasure they derive out of doing various activities and, yes, buying things, than from accumulating money per se. Now, it is true that a large majority of people would rather have more money than less, but all of us know that money is not the only thing that drives people’s behavior or makes them entirely happy (often it doesn’t). The key notion for economists, whom one would assume care only about money, is that whatever people value—and money and the things it can buy are certainly important—they act in the workplace and as consumers to maximize what they value. In that sense, they are said to be rational.

As for businesses, the calculus is simpler, and is generally assumed to be all or almost entirely about money—profits, to be precise. Standard economics textbooks don’t tell firms how to reduce costs or enhance revenues in order to maximize profits, but rather assume that whatever technologies are available for producing goods and services, firms will pick the cheapest ones available to them (some may be proprietary to other firms, giving them a leg up in the competitive race), while selling as much as consumers want at prices set by the market (see next subject). Business schools specialize in teaching future and current business leaders techniques for minimizing costs while maximizing sales. What many business leaders may not realize is that some of the material they learn from their business school professors originated from economists, some of whom you will meet, as well as their ideas, in later chapters.

The assumption of rationality is important to most economists for two reasons. If actors are rational, then it is easier to predict how they will behave. Consumers will thus buy less of something the more expensive it is, while firms will do the opposite, eagerly producing more of it the higher the price. I’ll have more to say about this famous supply and demand analysis in a moment.

A related advantage of the rationality assumption is that it makes economic analysis more mathematically tractable—important to economists—since mathematics has become the lingua franca of academic economics. You can have a good idea, but unless it can be expressed mathematically, you are unlikely to be taken seriously among your academic peers—and you’ll have a very small chance of ever winning a Nobel Prize (you’ll meet one famous exception in a later chapter). A number of critics, including many economists themselves, believe the field has become too mathematically abstruse and less relevant to the real world than it used to be. Although I personally find some merit in this critique, I also recognize that economists have used or improved upon a number of mathematical methods to develop important insights and techniques that are used in many businesses today, as I demonstrate in later chapters without writing a single equation!

Other critics, including some economists, have attacked the rationality assumption, especially by individuals. People oftentimes are emotional and they do not have the time or inclination to search out all of the relevant alternatives before buying or selling, and thus do not always pick the perfect or the optimal outcome. One economist, Herbert Simon, a longtime professor at Carnegie Mellon University, even won a Nobel Prize for showing how and why many individuals and firms may be content to settle on an acceptable outcome or one that satisfies rather than optimizes. Simon, and other economists who have elaborated on his work, has also used the term bounded rationality to describe how people often behave: They are rational, but within limits, not wanting or having the time to explore and examine each and every possible option or choice they might pick.1 Research in psychology and a branch of economics called behavioral economics (more about this subject in a moment) shows that offering consumers too many choices can be suboptimal for society—a phenomenon known as choice anxiety.2

Perhaps the most articulate and vociferous defender of the (unbounded) rationality assumption is another Nobel Prize winning economist, and probably one of the most recognized names in economics, the late Milton Friedman (see the following box). Among his many writings, Friedman penned an essay on just this subject in the 1950s, arguing that it didn’t matter whether everyone in the economy behaved rationally. The key was that the marginal actor—that last purchaser of a particular item—behaved “as if” he or she were rational.3

Milton Friedman: Capitalism’s Defender

To economists of my generation, there were three figures who towered above them all. You will meet two of them in this chapter. The first is Milton Friedman.4

Freidman found economics, like many others, at college through the influence of two professors, Arthur Burns and Homer Jones, who then were teaching at Rutgers University, which Friedman attended on scholarship. But even after finishing college, Freidman was torn between pursuing a career as an applied mathematician or economist, and received graduate scholarships in both subjects. Freidman claims a toss of the coin determined the outcome, though he acknowledges that the challenge of figuring out how countries can escape severe depressions—it was 1932—also played a role. The world would not have been the same had the coin toss turned out differently.

At the University of Chicago, where he attended graduate school, Friedman was heavily influenced by Jacob Viner, then a leading theorist of international trade, but also by other members of an outstanding faculty. At Chicago, he met and later married another student, Rose Director, the daughter of Aaron Director, a Chicago faculty member who had a profound impact on many economists.

After graduate school, Friedman joined the faculty at the University of Wisconsin briefly but then went to work at the Treasury Department during World War II, helping to devise the withholding tax system for income taxes (an assignment that Friedman has written his wife never forgave him for, perhaps not entirely tongue in cheek). After the war, Friedman eventually found his way back to Chicago, which was his academic home throughout his teaching career, before he moved in his later years to the Hoover Institution at Stanford.

Friedman’s academic work was far ranging. He established the monetarist branch of macroeconomics, which emphasized the exclusive role of the money supply in determining inflation; developed a theory of economy-wide consumption; revised an understanding of the tradeoff between unemployment and inflation, which Friedman argued was true only in the short run; and became an ardent advocate for flexible exchange rates, a policy that has governed international markets since the demise of the Bretton Woods system of fixed rates established after World War II.

Friedman also wrote for a popular audience and was the author or promoter of a wide range of policy ideas, including an all-volunteer military force and vouchers for elementary and secondary schools. He wrote articles for newspapers and magazines throughout his career, most notably Newsweek, alternating with Paul Samuelson of MIT (whom you will meet later in this chapter).

Friedman also dispensed policy advice to leading Republican politicians in the United States and to leaders of many foreign countries. Although his writings and research did not directly influence business, his tireless advocacy of free market policies found a warm reception among many (but not all) in business.

His Capitalism and Freedom is one of the most influential economics books of all time (up there with John Maynard Keynes’ classic General Theory of Employment, Money and Interest, and a lot more readable). His widely popular book, Free to Choose, coauthored with his wife, Rose, was made into a television documentary. He was awarded the Nobel Prize in 1976, and died in 2006 at the age of 94.

The emphasis on that marginal buyer or seller has a long history in economics, and is perhaps most associated with a famous nineteenth century economist, Alfred Marshall. The central insight of the marginalist revolution can be illustrated with a paradox that perplexed the great Adam Smith: Why are diamonds—frivolous and nonessential consumer goods—so much more expensive than water, an essential necessity of life? The answer, the marginalists taught us, is that although water has greater total utility, diamonds have greater marginal utility, and therefore command higher prices.5 That is to say, the value of one extra diamond, because diamonds are so scarce, is much higher than an extra drop of water, which generally is much more plentiful (though in many parts of the country or the world, water is becoming increasingly scarce, and is generally not priced to reflect that scarcity).

“Thinking on the margin” means to consider the economic consequences of the next step forward.6 That is, individuals and firms should consider only the additional costs and benefits of the next unit—not prior sunk costs—when making decisions. Since we can’t do anything about the past, it’s best to focus on the present and the future if we want to maximize utility or profits. Admittedly, this is often hard to do. If we’ve sunk a lot of money into a project or an item, it is often difficult to walk away from putting even more money into it, even though if we stop and think rationally about it, we may never recover what we’ve put in already.

The emphasis on marginal thinking nonetheless has huge implications for how economies behave. In particular, as long as the last (or marginal) buyer and seller meet at a price both can agree upon, that is all that matters for markets to clear. It doesn’t matter that many uninformed or less-than-rational buyers (less so sellers) are in the market.

Economists have debated Friedman’s as-if metaphor for years, and this is a debate I have no desire or need to resolve, because I will provide examples of ideas that are essentially on both sides of the debate that have found their way into the business world. The efficient markets hypothesis associated with the setting of stock prices, the subject of Chapter 8, is a clear example of Friedman’s hypothesis at work, and real money has been made by enterprising entrepreneurs using that concept.

At the same time, there is a newer school of economists who have paired with psychologists, or drawn from their literature, who draw out the implications of behaviors that are not always rational in the way either Friedman or other economists would define. These behavioral economists, such as Herbert Simon, have noticed many situations in which people do not always act rationally, and the results in the marketplace do not look like they follow Friedman’s as-if assumption.

Behavioral economists look at the way people actually behave and find out that context matters. For example, setting the default option can lead to very different outcomes. Take, for example, the seemingly simple choice of whether to set aside a percentage of people’s salary each month in a tax-deferred savings account to build up money for retirement, commonly called 401k accounts (or variations of them). If you tell workers they have to affirmatively opt in to such automatic salary deductions, they are much less likely to save than if you switch the default setting to an opt out—that is, everyone is presumed to sign up unless they affirmatively decide not to. Or changing the food options in a school cafeteria toward healthier food can nudge kids to choose healthier and less fattening items.

One popular book featuring behavioral economics is Nudge, co-authored by a lawyer, Cass Sunstein of Harvard Law School, and economist Richard Thaler of the University of Chicago.7 Sunstein and Thaler focus on policies that firms and governments can take to nudge people toward decisions that are better for them and for society as a whole. When met with the objection that these policies take away people’s freedom, the two authors respond that almost every decision that people must make is framed in a certain way, and that accepting one particular framing over another always happens, either implicitly or explicitly. They would rather have those decisions made explicit and create contexts that enhance the broader social welfare.

Behavioral economics has had an important impact on the world of finance, as you will learn in Chapter 8. The development of the field has many intellectual fathers, but one of the most influential is not even an economist at all, but rather a psychologist, Daniel Kahneman. Readers who want a nontechnical guide to his work should read his popular book Thinking, Fast and Slow.8

Markets

A second economic proposition it would be useful to know is that in capitalist economies—those in which individuals and firms can own and trade property, including goods and services—the market is the central institution that sets prices, rather than any governmental body (there is a limited exception to this rule, discussed shortly).9 Prices, in turn, are really important in any economy—even in the former communist countries—as key signals to guide the behavior of producers and consumers. Hold that thought, however, until I quickly define the term market.

Actually, there are multiple kinds of markets, and each tends to be suitable for different kinds of goods and services. One kind of market is an organized exchange, like the stock markets (there are many of them, but that is a detail), where millions of people and institutions submit and buy and sell orders for stocks and more complicated financial products known as derivatives (such as options or futures contracts whose values are derived from the value of some other underlying financial instrument or commodity). Exchanges are ideal for completing trades and thus determining the prices of fungible or standardized items, such as a stock certificate, or many commodities, such as oil, corn, or wheat.

In the old days, human specialists and traders who worked on the floors of stock exchanges would match buy and sell orders, or complete the transactions themselves, hoping to profit from a later trade. Today, computers do the matching and complete much of the trading (all this is discussed in greater detail in Chapter 12).

More commonly, when economists refer to the market they are thinking about the aggregation of millions or billions of uncoordinated actions of buyers and sellers of often very different goods and services. In most cases, the items are offered on a take-it-or-leave-it basis by a vendor (a retail outlet, restaurant, or a service provider such as a doctor or a lawyer). Most items now for sale on the Internet are offered the same way. If buyers like the price, they purchase; if they don’t they go somewhere else, either on foot, by car, or by clicking their computers, or touching their phones, each hooked to the Internet. Providers who have difficulty selling their wares eventually may lower their prices, while those who can’t keep up with demand may raise them. Although there may be no single market clearing price for every good and service, the market in the aggregate tends to iterate so that prices for identical items or services converge. There are exceptions to this tendency, when prices are not readily apparent, as is generally the case in health care, but even in that sector, there should be movement over time toward greater transparency, which should lead to more price convergence.

Despite its flaws, this common notion of the market is pretty amazing. Several years ago, the economics writer for the New Yorker, James Surowiecki, wrote a wonderful book, The Wisdom of Crowds