Book Notes: Naked Economics

Book Notes: Naked Economics

Book Notes: Naked Economics

Naked Economics does a great job of giving an overview of the key frameworks in economics in an easy to read manner. Although this book focuses on  economics, it gives a lot of insights into why people do the things we do – because of our incentives. The main theme of the book is incentives and how they are structured globally, nation-wide, and ultimately on a person by person basis. If there’s one takeaway from the book, it’s how personal incentives can either create a positive outcome, such as productivity / wealth / etc., or a negative outcome, such as loss of wealth and even higher mortality rates.

Chapter 1 – The Power of Markets

  • Invisible Hand – The free market aligns self-interest with improving the overall standard of living for most members of society.
  • Firms attempt to maximize profit by taking ‘raw’ materials (steel, knowledge) and combine them in ways that add value.
  • Slight talent advantages can render large profits in large markets. Lebron James’s talents are uniquely suited to outperform others in professional basketball, if only marginally better, he gains an oversized share of the market.
  • Behavioral economics studies the intersection of psychology and economics, focusing on how humans make decisions.

Chapter 2 – Incentives Matter

  • If some firms invest heavily in areas that benefit an entire industry while others in that industry abstain, a free rider problem emerges. The firms who contribute put themselves at a cost disadvantage against their competitors. The tourism industry which includes some agencies who contribute to conservation and others who do not suffer from a free rider problem.
  • The standardized pay of teachers creates a set of incentives referred to as adverse selection. The most talented teachers are likely to be good at other professions where pay is more closely linked to productivity. Studies show that the most talented teachers are the most likely to leave the profession early because incentive structures leads them elsewhere, the least talented teachers incentives are just the opposite.
  • Perverse incentives are inadvertent incentives created when we set out to do something completely different. Also known as the law of unintended consequences. A law in Mexico City once required cars to stay off the road once a week on a rotating basis, using license plate numbers to decide. Policymakers did not anticipate that people would buy new cars and hold on to older cars with poor emissions to continue driving.
  • Good policy directs desired behavior by using incentives while bad policy ignores incentives or fail to predict how individuals might change their behavior to avoid being penalized.
  • A principal agent problem emerges when a principal (such as a firm) employs an agent (such as an employee) who has an incentives to do things that are not necessarily in the best interest of the principal. Executives may be incentivized to boost short term gains while she/he can exercise her stock options. The challenge is to reward good outcomes without creating incentives for employees to game the system in ways that damage the company in the long run.
  • Creative Destruction
    • A market economy rewards winners and crushes losers. The steam engine, spinning wheel, and telephone put an end to the blacksmith, seamstress and telegraph operator, respectively. In a market economy, creative destruction must happen.
    • Government intervention to minimize the pain inflicted by competition slows the process of creative destruction. American automakers could have been made stronger in the long run if they faced foreign competition head-on instead of seeking political protection from Japanese imports in the 70s and 80s.
  • Taxes provide incentive to avoid or reduce activity that is taxed.
    • Raising taxes to provide generous benefits to disadvantaged Americans can simultaneously discourage the kinds of productive investments that might make them better off. Scandinavia has seen high marginal tax rates contribute to growing black market economies.
    • Economists tend to favor taxes which are broad, simple and fair.
    • Deadweight loss refers to taxes which make individuals worse off without making anyone else better off.
    • Regressive taxes are those which fall more heavily on the poor than the rich.

Chapter 3 and 4 – Government

  • Externalities
    • Although all parties involved in a transaction perform exchanges to make themselves better off, all parties affected by the transaction may not be involved which generates an externality.
    • Externalities can be positive or negative
    • Every activity generates an externality at some level.
    • Markets left alone fail to close the gap between the private and social costs of activities.
  • Government makes a market economy possible through measures such as defining and protecting property rights, yielding confidence in behavior such as investing in your property and expecting to make a return.
  • Government provides public goods. Public goods are considered things that would make us better off but would not otherwise be provided by the private sector.
  • The private sector allocates resources where they will earn the highest return while governments allocate resources wherever the political process sends them.

Chapter 5 – Economics of Information

  • Statisitcal Discrimination
    • Statistical discrimination aka “rational discrimination,” takes place when an individual makes an inference that is defensible based on broad statistical patterns but (1) is likely to be wrong in the specific case at hand; and (2) has a discriminatory effect on some group.
    • Statistical discrimination includes assuming that a female candidate wants a family, will take maternity leave, and may leave shortly after taking leave. Statistical discrimination also includes assuming that a black applicant has served time in prison because blacks are more likely to have been sent to prison than whites (28% vs. 4%).
  • Branding
    • Branding offers trust to consumers
    • Firms can gain a competitive advantage by branding and look for ways to do this via differentiation

Chapter 6 – Productivity and Human Capital

  • Human Capital
    • Human capital is the sum total of skills embodied within an individual including education, intelligence, charisma, creativity, work experience, entrepreneurial vigor, even the ability to throw a baseball fast. It is what you would be left with if someone stripped away all of your assets and left you on a street corner with only the clothes on your back.
    • The price of a certain skill bears no inherent relation to its social value, only its scarcity.
    • Poverty is caused by a lack of human capital
    • High levels of human capital leads to well-educated parents who invest heavily in the human capital of their children. Low levels of human capital have just the opposite effect.
  • Productivitiy
    • Technology displaces workers in the short run but does not lead to mass unemployment in the long run.
    • Human capital is inextricably linked to one of the most important ideas in economics: productivity. Productivity is the efficiency with which we convert inputs into outputs.
    • Productivity growth depends on investment in physical capital, human capital, research and development, and things like more effective government institutions. Investments require that we give up consumption in the present in order to be able to consume more in the future.
    • High taxes, bad government, poorly defined property rights, or excessive regulation can diminish or eliminate the incentive to make productive investments.
  • Population
    • The large productivity gains of the Industrial Revolution made parents’ time more expensive. As the advantages of having more children declined, people began investing their rising incomes in the quality of their children, not merely the quantity.
    • One of the most potent weapons for fighting population growth is creating better economic opportunities for women, which starts by educating girls.

Chapter 7 – Financial Markets

  • All financial instruments are based on four simple needs which include:
    • Raising Capital
    • Storing, protecting, making profitable use of excess capital
    • Insuring against risk
    • Speculation
  • Basic economics provides us with a basic set of rules to which decent investment advice must conform:
  • Save. Invest. Repeat
    • Capital is scarce. This is the only reason that any kind of investing yields returns.
    • The more you save and the sooner, the more rent you can command from the financial markets.
    • Albert Einstein is said to have called compound interest the greatest invention of all time.
    • Take Risk, earn reward
      • Riskier investments must offer a higher expected return in order to attract capital.
    • Diversify
      • A well-diversified portfolio will significantly lower the risk of serious losses without lowering your expected return.
    • Invest for the long run
      • The odds are stacked in your favor if you are patient and willing to endure the occasional setback.

Chapter 8 – The Power of Organized Interests

  • When it comes to interest group politics, it pays to be small.
  • All else equal, small, well-organized groups are most successful in the political process because the costs of favors they get from the system are spread over a large, unorganized segment of the population.
  • Two percent who care deeply about something are a more potent political force than the 98 percent who feel the opposite but aren’t motivated enough to do anything about it.

Chapter 9 – Keeping Score

  • GDP represents the total value of all goods and services produced in an economy.
  • Vital signs of any economy:
    • Unemployment
    • Poverty
      • Roughly one in five American children is poor as are nearly 35 percent of black children.
    • Income inequality
      • Economists have a tool that collapses income inequality into a single number, the Gini index.
    • Size of the government
    • Budget deficit and surplus
    • Current Account surplus/deficit
    • National Savings
    • Demographics
      • American workers pay into Social Security, that money is used to pay current retirees. The program a pyramid scheme, it works as long as there are enough workers on the bottom to continue paying the retirees at the top.
    • Total national happiness

Chapter 10 – The Federal Reserve

  • The Fed must facilitate a rate of economic growth that is neither too fast nor too slow.
  • The way to think about inflation is not that prices are going up, but that the purchasing power of the dollar is going down. A dollar buys less than it used to.
  • Unexpected bouts of inflation are good for debtors and bad for lenders.
  • Difference between real and nominal interest rates:
    • A nominal rate is used to calculate what you have to pay back, the number you see posted on the bank window.
    • A real interest rate takes inflation into account and reflects the true cost of renting capital.
  • Inflation is bad. Deflation, steadily falling prices, is much worse. Falling prices cause consumers to postpone purchases. Prices are falling because the economy is depressed, now the economy is depressed because prices are falling.

Chapter 11 – International Economics

  • A government that deliberately keeps its currency undervalued is taxing consumers of imports and subsidizing producers of exports. An overvalued currency does the opposite, making imports artificially cheap and exports less competitive with the rest of the world.
  • A single currency across Europe (and in the fifty states) reduces transaction costs and promotes price transparency.
  • The goal of global economic policy should be to make it easier for nations to cooperate with one another. The better we do it, the richer and more secure we will all be.

Chapter 12 – Trade and Globalization

  • Specialization
    • A modern economy is built on trade. We pay others to do or make things that we can’t or choose not to, usually because we have something better to do with our time.
    • Our standard of living is high because we are able to focus on the tasks that we do best and trade for everything else.
    • When different countries are better at producing different things, they can both consume more by specializing at what they do best and then trading.
  • Trade > Specialize > Productivity > Rich
    • Productivity is what makes us rich. Specialization is what makes us productive. Trade allows us to specialize.
  • Cutting off trade leaves a country poorer and less productive, which is why we tend to do it to our enemies.
  • Workers willing to accept a dollar or two a day because it is better than any other option they have.
  • If sweatshops paid decent wages by Western standards, they would not exist.

Chapter 13 – Development Economics

  • With less hardship, you have less incentive to help yourself.
  • All countries that have had persistent growth in income have also had large increases in the education and training of their labor forces.
  • Higher rates of education for women in developing countries are associated with lower rates of infant mortality.
  • Skills are what matter for individuals and for the economy as a whole. Skilled workers usually need other skilled workers in order to succeed.
  • Those who do become skilled find that their talents are more valuable in a region or country with a higher proportion of skilled workers, creating “brain drain.”
  • Not being open to trade is done at great cost. Open economies grow faster than closed economies.
  • Poor countries, like poor people, often have very bad habits.

Epilogue – Life in 2050

  • Productivity growth gives us choices. We can continue to work the same amount while producing more, produce the same amount by working less, or strike some balance.
  • The easiest and most effective way to get something done is to give the people involved a reason to want it done. Although we recognize this as obvious, many of our policies are designed in ways that do the opposite.
  • Markets don’t solve social problems on their own. Need to design solutions with the proper incentives
  • Overborrowing always ends badly, whether for an individual, a company, or a country.

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