Fact 6: Our Unknown Economy
Dr. Nova Cain, DDS, has her office in the mini-mall just north of city hall. You know the sort of mini-mall. It has a branch of Interstate OmniBank, Smilin' Ted's All-Comers Insurance Agency, an auto parts store, a branch of the public library, and four chiropractors.
Dr. Cain's location near the Shady Valley City Hall is most fortunate. One of my back molars is beginning to shoot sharp pains through my eyeball, into my brain, and out the back of my head. I've been meaning to stop by for a cleaning and check up, but, well, the thought of sharp needles and high-speed drills grinding away large portions of my teeth convinced me that other activities were more important.
Now, however, just as we're trying to trek through the complexities of the economy, that back molar has decided to throb incessantly. It's best if I stop in and let the kind and (hopefully) gentle Dr. Cain check it out.
Guess what? ROOT CANAL!
If only I had known the seriousness of my inaction. If only I had known the consequences of eating so many donuts (or perhaps it was the whipped cream on the economic pie). If only I had known the value of a cleaning and checkup. If only I had known...
FACT 6 MORE THAN MEETS THE EYE -- Every action has more than one consequence, some that are direct and easily observed and others that are indirect and difficult to detect.
I didn't know that over-looking an annual checkup or two, and eating too many extremely mouthwatering donuts would lead to a ROOT CANAL. But, let's not dwell on my eminent pain and suffering. Let's think about the importance of information to the economy.
It's What You Know That Counts
I wouldn't be guilty of exaggeration to say that information is the key to a healthy, efficient, and productive economy. Efficiency in the use of our resources to satisfy our needs would be close to impossible without information. Two points illustrate this:
- First, to get the most satisfaction, consumers need to know what products are in the market place, their location, and their prices. It's hard to satisfy any need if you can't find the good to do the satisfying. THE good that will satisfy a really, really, REALLY pressing need might be in the room right next to you. But, if you don't know about it, then your need goes unquenched.
- Second, to do their producing, producers need to know the prices of the inputs and where they can be found. Producers also need to know where the potential markets are, and whether or not it would be worth their effort -- profit-wise -- to produce the goods.
The more information we have and the more accurate that information is, then the better we're able to direct our limited resources to the most pressing needs. This is what makes our economy efficient. It's also what makes consumers happier, gives businesses more profit, creates more income, and does a lot of other really good things for the economy.
Unfortunately, information is not only very valuable, it also tends to be limited. If it wasn't, then you would already know everything that I'm about to say in this chapter. In fact, you would already know everything in this book and every other book ever written.
In spite of the vast amounts of information that's floating around via newspapers, magazines, books, and cable channels, we never seem to have enough of the right information at the right time. Sure you may know what Liz Taylor had for breakfast every day last week, but do you know how often that used car that you're thinking about buying had its oil changed (if at all) in the past decade?
I've Got a Secret
Like other stuff, limited information isn't just limited, it's also unequally distributed. You probably recall that nothing in the economy -- resources, income, production, or wealth -- is equally distributed. This applies to information as well. Some people have a lot of it and others don't -- which means you know stuff that I don't and I know stuff that you don't. This creates some interesting problems in our economy. One example is illustrated by the used car market -- which, as most used car buyers know, contains nothing but lemons (cars in serious need of mechanical therapy). Unequal information is one reason that so many previously-owned cars are better used as lawn decorations than transportation.
Let's say that you're thinking about buying a used car -- a 1990 OmniMotors XL GT 9000 to be precise. Now OmniMotors XL GT 9000s are fine automobiles, but used cars are used cars. You can't know for certain how well this particular 1990 XL GT was maintained. Did it have regular tune-ups? Was its oil changed on scheduled? Was it involved in any accidents? So many questions, but so few answers. As a buyer, you're not likely to have all of the information that you would like about the history of this XL GT 9000.
So, what price will you pay for this car? Let's say that a 1990 XL GT 9000 that's in really great shape -- a gem -- sells for $5,000, while one that's are in dire need of remedial work by an auto mechanic -- a lemon -- sells for $3,000. If you have a 50-50 chance of getting a gem or a lemon, you're best price is $4,000. You're chance of paying too much for the lemon is offset by you're likelihood of paying too little for a gem. Because other buyers feel the same, $4,000 would be the going demand price for an XL GT 9000.
A $4,000 price might be okay for you as a buyer, but what about the sellers -- they who know a great deal more about their cars than you. How do you think the owner of a well-maintained gem of a car is going to react when you offer a mere $4,000? "No deal," is my guess. This owner knows for certain that the gem is worth $5,000 and would be not willing to sell it for $4,000. The not-so-proud owner of the lemon, in contrast, would jump at the offer.
You, therefore, will be able to buy the lemon, but not the gem. In fact, the gem owners probably won't even place their cars on the market when the realize the going price is $4,000. The only cars you're likely to see for sale in this case are a bunch of lemons. The good cars just aren't sold.
The Challenge of Information Search
The right information at the right time is not easy to get. In fact, it can be downright costly. Fortunately, Dr. Cain's office is located in the same mini-mall as a well-stocked branch of the public library. Before my anesthetic wears off, we can saunter past the auto parts store, the insurance agency (quickly, because Smilin' Ted has spotted us), and two of the chiropractors, to reach the public library where we can uncover any information about any conceivable subject. All it takes is a little time and effort on our part.
For example, after a mere six or seven hours of reading we might discover that the University of Ibadan is a Nigerian university that was founded in 1948 and has about 12,000 students. The usefulness of this information is unclear. But, we can find it, and much, much more, with a little effort on our part. Okay, maybe a great deal of effort on our part.
Unfortunately, this information about the University of Ibadan is pretty costly to obtain. And more than likely, the cost of obtaining the information is a great deal more than any benefit we're likely to get from it. Perhaps we should be a little more careful next time when searching out information. In fact, some sort of guideline -- such as making sure that the potential or expected benefit of the information is at least as much as the cost of getting it -- would seem to be useful. This is a good rule to follow for anything that we do. For example, if you're about to buy an electric sander, you'd better weigh the anticipated benefit against its price. Will you be sanding a lot of wood, or just knocking an occasional rough edge off of your big toenail?
Information Isn't Free
Getting information is much like producing any good that you care to name. We use limited, scarce resources to acquire information, much like we use limited, scarce resources to produce frozen waffles, table lamps, or aircraft. Because the resources have alternative uses, using them to acquire information has an opportunity cost.
More specifically, the cost of acquiring information includes many of the following: our time and effort, the cost of travelling from store to store, telephone expenses if we decide to let our fingers do the walking, or the purchase price of information sources such as magazines, newspapers, books, and cable television.
But It Can Be Useful
While information is costly to get, it also provides benefit -- otherwise we would never bother to know anything. We could probably run through a litany of really philosophical benefits of information, such as fulfilling our souls in search of inquiry, but the bottom line is well, our bottom lines. The benefit of information for consumers is what we can save on purchases. If we can save a few bucks here or there on stuff, then we have an important benefit -- a few bucks.
Here are a some things that affect the benefit of information search:
- Price differences. If you suspect that an item has a range of prices in different stores, then it's in your best interest to do a little bit of searching for the lowest price. For example, because of some interesting government policies milk prices vary little from store to store in any town. It's probably not worth the effort to drive 30 miles across town to save 2 cents on a gallon of milk. Car prices, on the other hand, are likely to differ greatly among dealers. A little search effort in this case will probably generate big savings.
- Total expense. There's another reason why searching for the lowest price on cars is likely to be more beneficial than searching for the lowest price on milk -- the amount spent. Because milk is a relatively small fraction of your household budget, price differences are also going to be a relatively small fraction of your budget. Cars, however, are big ticket items and a big part of your household budget. While you might be able to save a few pennies on the milk, you stand to save thousands on a car.
- Frequency of purchase. How often you buy stuff can also help determine the benefit of information search. If you buy the same good often, then a few pennies of saving on each purchase will add up to big savings over a longer period. In this case, identifying the store with the lowest milk price might be worth the effort.
- Price volatility. With seasonal sales, close outs, assorted discounts, etc., the prices of some products tend to fluctuate a lot.. The more prices fluctuate, the greater is the potential benefit of searching. For example, you might be able to save 10 percent on the price of sofa at one store, but the clearance sale at a competing store next week may let you save 40 percent on the same sofa.
With this in mind, here are a few tips on the information:
Information Searching Tips
- Because you can't know everything, you should be selective about the information that you seek. Try to determine the potential benefit of information and its cost.
- Look for ways of reducing the cost of information. Handy reference books like this one are a good place to start. A few moments spent organizing search efforts can save a great deal of search time and cost. It's easier to find a book at the library by going through the card catalog than by randomly searching the shelves. Likewise it's easier to find someone who already has the needed information. For example, if you're pondering the possibility of purchasing a powerboat, find a friend who did a similar deed.
- The telephone can be a tremendous information search cost-saving device. A few inexpensive minutes on the telephone can save the time and effort of trips to stores.
The Hazards of Soothsaying
One area where information is really critical for consumers, workers, and taxpayers is the future. Very few people, with the exception of the psychics who write for newspaper tabloids, know what's going to happen in the future. The future is, shall we say, fraught with uncertainty and risk. (A brief note here. In spite of the well-documented fact that the future is unknown, many economists have made it their lifelong pursuit to forecast the future condition of the economy. Sometimes they get it almost right, and sometimes they really screw up.)
While a lot of different things could happen tomorrow, today -- right now, at this very moment -- you don't know which one it will be. For example:
- Ed McMahon could knock on your door and present you with a $10 gadzillion check.
- The sun could explode, killing all life on the planet.
- Elvis Presley could land in your backyard aboard an extraterrestrial spaceship, steal your peanut butter and banana sandwich, sing a few bars of "Jailhouse Rock," then leave for a planet in another solar system.
- You could wake up to the sound of your alarm clock, get dressed, eat breakfast, and go to work.
While each of these events could occur, their likelihood is not the same. Economists, scientists, statisticians, and others who spend a lot of their adult lives doing funny things to numbers, like to talk about the probability, or chance, of an event occurring. Of the different alternatives given here, the probability is greatest that you will wake up, get dressed, and go to work tomorrow. (If my speculation concerning your activities for tomorrow turns out to be wrong -- especially the one about Elvis -- please, please let me know.)
This probability is based on your historical experience, what is known about the laws of physics, the life expectancy of the sun, the existence of extraterrestrials, the life and death of Elvis Presley, and the functioning of contest give-aways. Yet, even though we're very certain that the waking up/work scenario will happen tomorrow, we don't know and can't know for sure. This uncertainty not only helps the sales of supermarket tabloids, it keeps our lives interesting. One interesting part is how different people react to this uncertainty.
Scaredy Cats and Gamblers
Some of us hate the idea of an uncertain future, while others revel in it, and some really don't care one way or the other. We can affectionately refer to those who don't like an uncertain future as scaredy cats and those who do as gamblers.
What makes a scaredy cat a scaredy cat? They prefer certainty more than uncertainty, and are willing to pay for it. Before you start to ridicule scaredy cats, you should know that most people are scaredy cats most of the time in most circumstances. That is, we are all generally happier if we know what's going to happen. And (this is an important "and") we are willing to pay for that certainty. This, in fact, is what the entire insurance industry is based on.
We willingly buy health insurance, car insurance, and homeowners insurance, knowing for certain that our future income and subsequent satisfaction will be less by the amount of the premiums. But, we avoid the uncertain losses in income and well-being created by illness, accidents, natural disasters, or whatever.
Let's throw together a few simple numbers to illustrate this idea. Suppose that you have ten dollars to bet on the flip of a coin. If it's heads, you get another ten dollars for a twenty dollar total, if it's tails, then you end up with nothing, zero, zippo, nada.
If you flip the coin and make the same wager hundreds of times, how much money do you think you'll have at the end? Most likely ten dollars. Because the coin has an equal chance -- probability -- of coming up heads or tails, the number of times you win ten dollars will cancel out the number of times you lose ten dollars, leaving you with ten dollars.
But, it's not the money itself that's important, it's how you feel about the money you win versus the money you lose. That is, how much satisfaction do you give up from losing ten dollars and how much satisfaction do you gain from winning ten dollars? Some people place an equal amount of satisfaction on the winnings as on the losings. Others actually get more satisfaction from the money won than from the money lost. Most of us, however, are more personally attached to the loses than we are to the winnings. Therefore, even though we might end up with the same ten dollars that we started with, after a hundred or so flips of the coin the pain from our satisfaction loses outweigh the satisfaction gains of our winnings -- each time we lose hurts more than each time we win.
The reason for these differences is how we view extra income. If an each extra dollar of income is worth less than the previous dollar, then you value the lost ten dollars more than you value the won ten dollars. If, in contrast, each extra dollar is worth more, then you value the lost ten dollars less than the won ten dollars.
The three types of people (pick your own from the list) that we can identify are:
- Scaredy cats (risk averse). Those who value extra income less and less are going to be reluctant to undertake any type of risky proposition. They would rather have a guaranteed amount of income than an equal amount of income that involves some uncertainty.
- Gamblers (risk loving). Those who value extra income more and more are going to enjoy the prospects of a risky situation. They would rather have an uncertain income than an equal of amount of known income.
- In-Betweeners (risk neutral). Those who value all extra income the same are indifferent between a guaranteed income and an uncertain income. They could go either way. It really doesn't matter to them. They don't care.
At one extreme, scaredy cats are those who buy insurance, take secure jobs at lower pay, stay in the same unexciting jobs for years on end, plan trips well in advance and down to the detail (if they take any), and generally try to remove uncertainty from their lives. Is this bad? No, because scaredy cats gain more satisfaction from certainty than from uncertainty.
Gamblers, at the other extreme, are those who speculate in the stock market, buy products from mail order catalogs, tell their boss in no uncertain terms where the latest efficiency memo can be filed and then quit without having any other employment prospects, begin a new business on nothing but a whimsical idea, and generally seek out risky situations. This lifestyle is not necessarily bad either, because gamblers gain satisfaction from uncertainty. They wouldn't have it any other way.
Please note, however, that scaredy cats and gamblers are two extreme positions. Most people have a mixture. You aren't necessarily a gambler or scaredy cat under all circumstances. Today you might hazard the unknown with great bravado, but tomorrow you could tend to be a little more cautious.
- Make sure you know your own preferences. If you're a scaredy cat, don't let a gambler talk you into a risky situation. You'll only regret it. Remember many of us are scaredy cats in most circumstances. Carefully select those situations in which you're a gambler.
- Likewise, if you're a gambler, don't let scaredy cats avert you from the risk you crave. However, a word to the wise, make sure that you recognize the degree of risk and uncertainty involved. Don't let your desire for uncertainty enter into wagers that can't be won. For example, make sure that you're not waging on the flip of a coin with two tails.
- Get as much information as you can about the risk of winning or losing in an uncertain situation. Even a scaredy cat would be willing to enter a wager, if the winning is great enough to compensate for the loss. A scaredy cat might be willing to wager on the flip of a coin if the potential loss is only five dollars and the potential gain is twenty dollars.
A Quick Jog though the Financial Markets
Uncertainty, risk, and the future have a big part to play in financial markets. These are markets that trade legal claims on resources or goods, such as corporate stock, government securities, and foreign currency -- to name a few. The key with financial markets, unlike product markets, is that you're buying and selling promises. For example, if you buy an Omni Conglomerate, Inc. OmniChef 7000 waffle iron, then you have an OmniChef 7000 waffle iron, with all of the satisfaction it provides. If you buy a share of Omni Conglomerate, Inc. stock, then you have a piece of paper that represents a legal claim on the assets of Omni Conglomerate, Inc.
Uncertainty and risk enters the picture because a gadzillion things could happen to keep you from exercising your legal claim on Omni Conglomerate, Inc. The company could fold, the President and CEO could head for the Cayman Islands with the company's profits, or a rival competitor (TechBake Industries) could come out with a new, improved waffle iron (one that uses lasers) that takes away OmniChef's market. Because you don't know what's going to happen, uncertainty runs rampant.
In fact, a great deal of the reward investors hope to get when entering the financial markets is a reward for uncertainty and risk. I might guess that the price of Omni Conglomerate, Inc. stock is going to rise while you guess that it's going to fall. If I'm right, then I stand to get gadzillions of dollars because I bought the Omni Conglomerate, Inc. stock before the price went up and you didn't. I win, you lose.
What Does It All Mean?
The efficiency of our economy is limited by the information we have. The more information we have about the present and the better our prognostications are of the future, then the more efficient our economy will be. While information is costly to get, all information is not equally costly. And therein lies some potential pitfalls.
Some information is readily available and immediately known. It is directly observable and pretty darn obvious. If you jump into a lake, you know that you're wet. You can feel the water-saturated clothing next to you skin and you can see the water droplets on your finger tips.
Other information, however, is not so obvious. The lake might contain infectious bacteria that enters you system and in a few days makes you sick. However, maybe your illness wasn't caused by the lake bacteria, but an improperly washed water glass at the restaurant where you had lunch before jumping in the lake. Such is the problem with information. Our economy is so complex that it's impossible to know what's happening right now, let alone what might happen in the future.
With this in mind, you need to be wary of the information purveyors -- especially those who stress the obvious and promote only one side. Information is a commodity that's produced by our limited resources. Moreover, those limited resources are not equally distributed throughout the economy. Those same people who have more ownership and control of the economic pie -- the first and second estates -- also have greater control over information.
Those who control the information can make the information that benefits them more readily accessible to the public. If I own a cardboard factory and a television station, I'm not likely to let the station broadcast a news story about defective cardboard from my factory. I might not prevent the broadcast, but I'm not going to encourage it either. What I will encourage, if I can, are glowing accounts of the wonderful uses of our friend -- cardboard.
As members of the third estate -- the estate with limited ownership and control over resources -- you need to heed the tired but true warning to consider the source of any information. Be especially suspicious of any information from the first two estates.
My tooth is feeling better now. In fact, if you're willing, we might spend an hour or two walking around the Shady Valley's amusement park. It's only a few blocks away. And, I'm sort of ashamed to admit it, but I'd really like to ride on the merry-go-round.