​This summer I got addicted to Revisionist History, a new podcast about forgotten or misinterpreted people and events, created and presented by Malcolm Gladwell. If you’ve been reading Life Tonic for a while, you know that I am a big fan of Gladwell (see, for example, Why I wasn’t destined to become a swimmer or 10,000 hours), and his new podcast is as superb as his books: curious, erudite and thought-provoking. 

In one of the episodes, Food Fight, Gladwell invites us to sample canteen food at the Bowdoin College, a liberal arts and science college in Maine. Here is what I’ve copied from the College website: 

"Bowdoin meals are made from scratch by a staff of talented culinary professionals dedicated to providing a wide array of healthy and delicious options, many drawn from a variety of international cuisines and recipes submitted by students and their families. Our dining halls offer vegan options and selections made with no gluten ingredients at every meal, including plentiful salad bars and entrée salads at lunch and dinner. Because we prepare our dishes using mostly fresh ingredients, we have eliminated most trans fats and high fructose corn syrup from the dining hall menus.

We are constantly improving our methods of food preparation and experimenting with new recipes. The Student Dining Advisory Committee meets several times each semester to provide Dining with menu ideas and feedback to ensure we are providing the best service possible."

Indeed, the website displays photos of kale and asparagus, fresh berries and even lobster. Thinking back to my student days when I was waitressing in my College Hall, the best evening meals were lasagne and toad-in-the-hole, while the lunch buffet offered baked potatoes, coleslaw drenched in mayonnaise and soup, which gave me indigestion. Bowdoin food seems unreal in comparison, and listening to the podcast, I was silently congratulating the college for taking such good care of student welfare.

Once Gladwell ensured his audience was salivating, he introduced us to another College, Vassar, which is a similar private liberal arts and science college, based in the Hudson Valley of the New York state, and competing essentially for the same would-be students as Bowdoin. The food at Vassar is atrocious: you won’t find lobster there. However, what you will find is a generous financial aid programme. In fact, it’s the College goal "to make a Vassar education affordable and accessible to all admitted students”. In an interview with the College president, it becomes clear that the College budget (fees and endowment) is heavily skewed towards financial aid at the expense of other areas, such as fancy food.

I’ve written about the concept of opportunity cost before, but it never ceases to amaze me how often people seem to forget that every choice requires them to give something else up. Fancy college food is a great idea, but it must be weighed against other, arguably more important, subsidies. The British Parliament last month voted to replace Trident, UK’s nuclear submarines, ballistic missiles and nuclear warhead, which will cost the the UK taxpayers over £18 billion. In the age of ubiquitous international terrorism, military drones and cyber wars, I find it surprising that nuclear arsenal gets priority treatment. Looking at the required investment from the opportunity cost point of view, we must realise that Westminster voted to renew Trident at the expense of investment in healthcare, education, conservation, science, etc. Even the main opposition party, which supposedly stands against the austerity, has backed the renewal of the nuclear programme.

Last night I watched a video about Josh Coombes, a London-based hairdresser, who gives free haircuts to the homeless people, who receive a much-needed boost in self-esteem through his generosity. Josh is 29, and I could not help but think about his sense of priority. He could spend the time he gives to the homeless to earn money at a salon or to put his feet up, yet he chooses to do good at the expense of riches or leisure. 

Gladwell implores his listeners to send their kids to Vassar, where equal opportunities for the brightest kids, irrespective of their means, are prioritised above gourmand food. I would only add that any decision, be it over your next meal or the state’s budget, must be weighed up against its opportunity cost rather than just on its own merit.

Here is a link to Revisionist History on itunes. (It’s free.) 

When microeconomists mention an “opportunity cost”, they mean the value of the next best alternative to the chosen one. Every decision involves giving something up. 

The opportunity cost of a late networking event at work is kissing your child good night. The opportunity cost of watching live rugby match is going for a long training run. The opportunity cost of being a hands-on mum for a woman is advancing her career. 

This concept is so important because it can be applied to every aspect of your life and encourage you to examine your choices comprehensively. If you want a bit more of A (e.g. status at work), you must give up some of B (e.g. leisure time). 

The opportunity cost of a night in is the money you are saving on dinner and drinks out. Suddenly binging on Suits on a sofa looks a bit more sexy, especially if after a while you can treat yourself to cocktails at Dabbous. 

The opportunity cost is also a handy concept to apply to your savings and investment decisions. 

Say you have received a bonus for all your hard work last year. Let’s say you are only considering two options: pay down some of your mortgage as a lump sum or put money into a savings account. Your mum tells you to pay down your mortgage, but with an economist’s hat on, you should compare the interest rate you are currently paying on your mortgage with the savings rate offered by your bank. Right now interest rates in the UK are low (the base rate is 0.5%), so chances are you are on a good deal paying just 2% interest. Many banks are currently offering saving rates of 3%, so leaving all other factors aside for the moment (e.g. tax implications), you can see that the opportunity cost of paying down some of your mortgage is forfeiting extra 1% interest you could earn on saving cash. 

The concept of opportunity cost helps us estimate true economic costs of every decision or venture. If you have a spare room, your opportunity cost of keeping it as an occasional gesture of hospitality to your mum and dad is earning extra income. Conversely, getting a lodger has an opportunity cost of having to share your kitchen and your fridge plus any other inconveniences you may come up with. 

Consider a former fund manager starting her own business making chutneys. Let’s assume she made £140,000 in a year selling chutneys and made a profit of £40,000 after taking into account all the costs. However, to estimate her true economic profit, we would also need to take into account the salary she would have made as a fund manager. The salary she decided to forgo is he opportunity cost of running her own business. (Of course, you may argue - correctly so - that running her own business has additional benefits too: greater freedom, doing something meaningful, working on something with a greater economic potential in future. Alternatively, sticking to the concept at hand, the opportunity cost of making chutneys is doing a meaningless job stuck in an office with a bunch of colleagues who bore her to death.)

It’s also important not to mix up opportunity costs with sunk costs I have written about a while back. An opportunity cost of a fancy dress outfit taking up a lot of space in your wardrobe is not £40 you bought it for, but a potential resaleable value on eBay (£4, taking into account all the spilt beer soaked up by the costume, posting costs and the eBay commission). 

The economist Tim Harford is fond of using opportunity costs to help him make daily decisions too. His recent article in FT Weekend has been re-published on his blog. He argues: 

"However dizzying the idea of opportunity cost may be, it’s something we must wrap our heads around. Will I write a book review? Will I chair a panel discussion on a topic of interest? Will I give a talk to some students? In isolation, these are perfectly reasonable requests. But viewing them in isolation is a mistake: it is only when viewed through the lens of opportunity cost that the stakes become clearer.

Will I write a book review and thus not write a chapter of my own book? Will I give a talk to some students, and therefore not read a bedtime story to my son? Will I participate in the panel discussion instead of having a conversation over dinner with my wife?

The insight here is that every time we say “yes” to a request, we are also saying “no” to anything else we might accomplish with the time. It pays to take a moment to think about what those things might be."

What decisions are at stake for you today? What are the opportunity costs involved?

My former economics tutor has gone soft. Once upon a time you’d spot David in a pub with a pint in hand; these days he makes his own hummus, eats salad for lunch and raves about quinoa. I believe it is referred to as 'middle age'.

Just as David became a fan of home cooking and baking, he also realised that food and taste buds can help illustrate economic theory. One day instead of showing his usual slides, he came to class with a box of homemade cupcakes. 

First he took out some vanilla cupcakes and asked his students to price them. 

How much would you be willing to pay for a vanilla cupcake? Does £2 sound about right? Let’s see. I found a cupcake menu of The Hummingbird Bakery online. Their vanilla cupcake costs £2. David students agreed and offered to pay just that. 

It makes sense: vanilla is kind of plain, isn’t it? It has an inoffensive flavour, if you see what I mean. 

David then plotted a demand curve for his vanilla cupcakes. A demand curve is just a graphical illustration of a relationship between quantity and price. In this example, the demand curve is flat because everyone offered to pay £2 for a vanilla cupcake (except for one student who was on a diet). 

What does that tell us?

If your product or a service is a bit like vanilla, it is hard to imagine charging a premium for it. For example, I'd expect to pay about £1.90 for a black americano in London. This means that if a coffee shop I used to go to in Soho changed its coffee price from £1.90 to £2.50 overnight, they won’t see me again. They might think their coffee is special but there are plenty of good coffee places within walking distance from them. 

By contrast, if you are offering something quite different, then you should be able to charge premium. I’d expect to pay about £7 for a paperback, but I’ve happily paid £15 for a hardback of Walking Home, signed by Clare Balding. If you are not a fan of hers, you won’t buy her book, even if it was half the price. I pay £5.99 for 500ml of Booja Booja chocolate ice cream because it is dairy and refined sugar free and tickles my taste buds, but you may rather go for cheaper brand like Carte D'or. The ‘kinkiness’ of the demand curve for ‘chocolate chili' is an important point to remember: some will rave about it, some will hate it. 

The classic example of absolute polarity is Marmite. A demand curve for Marmite would look like this.  

David plotted another diagram for his students. Suppose you are making a chocolate chili cupcake or chili hummus. How much chili should you put in?

When you buy chilli hummus in a supermarket, the trouble is that often a supermarket is trying to please everyone and is not making chili flavour distinct enough. The resulting product is bland. The trick is to remember that people who love chili will pay premium for it and they want to taste chili. People who don’t like chili would opt for a plain variety anyway. If you put moderate amount of chili, you’ll please no one as the diagram below illustrates.  

As a graduate in Economics, I should hate What Money Can’t Buy. Michael Sandel, Harvard’s political philosopher, attacks market principles and how they’ve invaded all areas of our lives. But it’s not the case. Another economist, Timothy Besley, Professor at LSE, was quoted in the Journal of Economic Literature, saying this:

“Michael Sandel’s What Money Can’t Buy is a great book and I recommend every economist to read it… brimming with interesting examples which make you think… I read this book cover-to-cover in less that 48 hours, and I have written more marginal notes than for any book I have read in a long time.”

I must agree: it’s the most thought-provoking book I’ve ever read. 

Michael Sandel lists dozens of examples of commercialisation of areas of life, where financial transactions crept into arenas where they don’t belong: matters of life and death, education, art, civil duty. He then argues that markets went too far: they corrupt us, they demean our values, they erode our society. 

Some examples - to an economist - are celebrating the way market failures are improved upon.

When Ryanair introduces services like speedy boarding, it improves upon a situation, where in the absence of the service, some passengers were willing to pay to board first, but instead, had to wait. 

Sandel considers it “odd if someone at the back of the line offered us $10 to trade places”. I disagree. I once tried to buy a place at the head of the queue to a Marina Abramović exhibition at the Serpentine Gallery, which was about to close. I did not succeed (but I still got in later), either because people in the queue had read What Money Can’t Buy or because I did not offer enough.

Other examples are truly shocking. 

Apparently, there are several websites offering to gamble on which celebrities will die by the year end. For $15 entry fee, stiffs.com offers contestants a chance to win a $3,000 jackpot for a correct list of names.

Getting inspiration from product placement on TV, a British novelist Fay Weldon wrote a book The Bulgari Connection, mentioning Bulgari thirty-four times, in exchange for an undisclosed fee. Needless to say, it’s not a novel I’d be dying to read, but it is not hard to imagine writers desperate to make a living and willing to compromise integrity in exchange for a payment. 

In the US it became popular to sponsor every aspect of a sports game. "By 2011, 22 of the 32 teams in the National Football League played in stadiums named for corporate sponsors.” The New England Patriots play in Gillette Stadium, the Washington Redskins play in FedEx Field. Of course, Arsenal football team in London also plays in a shiny new Emirates Stadium, but things progressed a little further over the pond. Corporate names started to appear during broadcast: an Arizona home run in baseball is announced as a “Bank One blast”, being sponsored by Bank One. In a different stadium when a baseball umpire calls a runner safe at home plate, an announcer must say: “Safe at home. Safe and secure. New York Life.” Guess which mutual life insurance company sponsors that. 

In 2011, a Colorado school district sold advertising space on report cards. Meanwhile, a retail giant General Mills sent teachers a science curriculum supplement on volcanoes called "Gushers: Wonders of the Earth.” The kit included free samples of its Fruit Gushers candy with soft centres that “gushed” when bitten. The teacher’s guide suggested that students bite into the Gushers and compare the effect to a geothermal eruption.

It’s not that Sandel blames the economists for corporate deals invading schools, literature and sport. He recognises that economists and political philosophers think about matters differently. 

As an economist, I would argue that economics simply provides tools of how resources could be allocated more efficiently (i.e. making someone better off without making anyone else worse off) and explains social phenomena with laws of supply and demand. Ethics too can be analysed this way. 

If management of Arizona’s team signed a deal with Bank One, it must have weighed financial benefits of corporate sponsorship against the potential costs of eroding the public enjoyment of baseball and decided the benefits were greater. A school in Colorado must have been severely strapped on funding to offer school report cards as advertising space. 

Another argument made by Sandel, which made me ponder a lot, is a suggestion that markets creep into our lives so that eventually we stop noticing them, and our ethical standards fall.  

In 2000s a North Carolina company offered to provide brand new, fully equipped police cars to US municipalities for $1 a year in exchange for the right to advertise on cars. When deliberating the deal, city and state governments cited an example of sport stadiums having ads on fences and corridors, arguing that some corporate branding is acceptable, when compared with benefitting from brand new fleet.

AIDS epidemic of the 1980s and 1990s gave rise to the so-called viatical industry: a market in life insurance policies of terminally ill. People diagnosed with AIDS and told they had a year to live sold their $100,000 life insurance policies at discount (e.g. for $50,000) in order to be able to afford medical care or to live well in the short time remaining. Investors paid $50,000 to cash in $100,000 when original policyholders died. Obviously, investors were interested in people dying as quickly as possible and were disappointed when new AIDS drugs extended life expectancy well beyond what they were hoping for.

Unfortunately, the viatical industry developed only because there was supply and demand for it. Terminally ill patients needed cash, investors were keen to provide it. No doubt, it is a morally objectionable market, but I do not see how economics as a science is at fault. The problem lies with morally bankrupt investors. 

After the breakthrough in the treatment of AIDS, the same investors went ahead to buy policies from cancer patients and healthy senior citizens, willing to cash in, formed death securities, packaging individual policies into bonds, then reselling them to pension funds. According to a New York Times article, published on September 6, 2009, “Goldman Sachs has developed a tradable index of life settlements, enabling investors to bet on whether people will live longer than expected or die sooner than planned.” 

Before you exclaim: “Outrageous!”, answer this: do you have a pension plan? If so, are you 100% sure that Fidelity or Legal & General hasn’t invested your money in life settlement funds? 

What I liked best about What Money Can’t Buy is that it did not spoon-feed me conclusions. It made me think and question things more. Sandel encourages us to reflect and debate. You can bet that I’ll be bringing up all sorts of questions at the next dinner party: “Should we sterilise heroin addicts and pay them for it?” and “How would you feel if you found out that your best man paid for the speech he delivered at your wedding?”. But the larger question remains: will our governments listen to political philosophers as well as economists when formulating their policies?

When people think of economics, they are usually led by media headlines discussing economic growth, interest rates, inflation, unemployment and government deficit. All of these are 'macroeconomic buzzwords' - easily confusing, even if we use them all the time. This article dips into the fundamentals of macroeconomics: let's look at what we mean by  an "economy" and understand its components.

Whilst microeconomics studies the behaviour of firms and individuals, macroeconomics studies the behaviour and performance of an economy as a whole. When we say "economy", we refer to gross domestic product or GDP, as it is commonly abbreviated. It is the total value of all goods and services produced in a country or any other selected region (say, Europe or the whole world). When we talk about economic growth or economic decline, we imply changes in the GDP. 

GDP is measured as the sum of consumption, investment, government spending and net exports:

Consumption refers to private spending on products and services, and it is the largest component of the GDP for most countries. According to the World Bank, household consumption accounted for two thirds of the UK's GDP in 2013. Investment is simply the total spending on goods and services by businesses. It includes spending on raw materials, machinery, equipment, offices and factories, but not salaries paid to employees because salaries are accounted for in Consumption (as household income spent on goods and services). Government spending includes government consumption, investment and such activities as national security and defence. Its relative share of the GDP indicates the size of the government and its historical and political decisions. Net exports is the balance between all goods and services exported by an economy and the value of imports into that economy. Net exports, also known as trade balance, can be positive or negative. The US and the UK have negative trade balances because they import more than they export. Germany, Russia, China and oil-rich Gulf countries are 'net exporters'. 

"Wait a minute! What about savings and tax? How do they fit into the GDP?"
"An excellent question, my imaginary reader!"

Another way of looking at the economy's income is to split it into three baskets: consumption, saving and taxation:

If we did not save, we would not have the money to invest, and if the government did not earn tax revenues, we would not have state education, healthcare, infrastructure and space programmes. Combining both ways to express GDP, we get a picture of what a balanced economy would look like:

In reality, economies aren't perfectly balanced so it's common to see domestic spending surplus (when investment is greater than savings), trade deficit (when imports outweigh exports) and budget deficit (when government spending is greater than taxation). 

It is important to point out that GDP is a flow value as opposed to a stock value. It measures national output over a period of time not at a point of time, like an annual income vs. funds on a bank account on a certain date. As such, budget or government deficit (often expressed as a percentage of GDP) should not be mixed up with national debt or government borrowing - watch out for confusing newspaper headlines!
 
Comparing GDPs of different economies, we need to take into account a few other factors, most notably, population. Real GDP (which means it has been adjusted for inflation) of China may very well catch up with the US by 2016, but looking at GDP per capita (GDP divided by population) suggests that the US population

is vastly better off than the Chinese: $53,143 vs. $6,807 (World Bank, 2013). According to the World Bank, the poorest countries in the world in terms of GDP per capita are Malawi, Burundi and Central African Republic, while the richest economies are Luxembourg, Norway and Qatar. 

GDP is how we measure economic well-being and of course it is not perfect. British economists Mell and Walker point out that "most economists feel about GDP the same way Winston Churchill felt about democracy when he quipped that: "Democracy is the worst form of government ... apart from all the others that have been tried from time to time." 

The most eloquent criticism of the GDP was delivered by Bobby Kennedy in 1968. He said: 

"Our gross national product ... if we should judge America by that - counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for those who breaks them. It counts the destruction of our redwoods and the loss of our natural wonder in chaotic sprawl. It counts napalm and the cost of a nuclear warhead, and armoured cars for police who fight riots in our streets. It counts Whitman's rifle and Speck's knife, and the television programs which glorify violence in order to sell toys to our children.

Yet the gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages; the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage; neither our wisdom nor our learning; neither our compassion nor our devotion to our country; it measures everything, in short, except that which makes life worthwhile."

That was a lesson in macroeconomics with a bonus section on inspired speech-making. 

Have you ever wondered why is it that nouveau riche from China and other rapidly growing economies are so obsessed by designer brands? 
According to a report by Bain, quoted in The Economist blog, the number of luxury consumers has more than tripled in under 20 years, to around 330 million people in 2013. Spending has risen at a similar rate, to an estimated €217 billion ($300 billion). Around 130 million of these consumers are in emerging markets, with 50 million of those in China. 

Microeconomics, which simplifies and models social behaviour, has the answer at hand. In economics when demand for a product rises by a greater proportion than income, such good is referred to as a luxury good. A Louis Vuitton bag, a pair of Jimmy Choo shoes, dinner in a Michelin-star restaurant are luxury goods. (By contrast, if demand for a product changes less than proportionately to income, such a product is a necessity. That’s public transport, a mobile phone contract, a pint of lager.)

When Chinese entrepreneurs stroke gold, their income went up. Let’s imagine businessman Li, whose income has doubled over a year. Just because he now has twice the money, it does not mean he’ll be buying twice more rice than he did last year. However, his demand for luxury goods, such as imported whisky, he likes very much, has increased tenfold. 

Percentage change in demand divided by the percentage change in income is called income elasticity of demand and measures the relationship between demand for a particular type of good and income. 

Luxury goods have income elasticity of demand greater than one: in our expensive whisky example, it is nine (900% divided by 100%). Necessities have income elasticity of demand between zero and one: if Li’s income rose by 100% and his consumption of rice increased only by 30%, rice has income elasticity of demand of 0.3. For the so-called inferior goods income elasticity of demand is negative: Li is so rich now, he can afford a car and a driver, his demand for public buses in Shanghai has plummeted. 

Technicalities aside, it is easy to see that an increase in income causes a greater increase in demand for luxury goods than any other goods. 

What happens when income drops? Demand for designer brands, taxi rides, expensive cocktails and opera drops by an even greater factor, due to high income elasticity of demand for such products and services. 

How can you apply this lesson to the product or service you are selling? What does it teach you about your own behaviour when you got your first graduate job? 

If you’ve ever heard of game theory, you must have come across Prisoner’s Dilemma. What is it actually about and how can we apply it to real life situations outside economics classrooms?

Game theory is an area of microeconomics which studies interactive behaviour, i.e. situations where players’  actions  are interdependent. Players could be firms, competing on the same market, politicians, hoping to attract the same voters or a husband and wife, playing on each other’s nerves. As such, game theory can be applied to any situation, involving strategic interaction, and it can help analyse and predict behaviour.

Prisoner’s Dilemma is a simple game with only two players, but it’s a brilliant tool to understand economic, political or social phenomena, where two parties fail to cooperate despite the fact that it would be in their best interest to do so. The original game considered a situation where two prisoners, partners in crime, were being questioned in separate rooms. Each prisoner (A and B in the figure below) had a choice of either confessing to a crime, and thereby implicating the other, or denying his participation. 

If only one prisoner confessed, then he would go free, and the police would charge the other prisoner and put him into prison for 5 years. If both prisoners denied being involved, then both would be given 6 months for a minor offence. If both prisoners confessed, they would be locked in for 1 year. 

The figure below is a payoff matrix for each prisoner. For simplicity, the payoffs are indicated with numbers: the best outcome is 0 years in prison and the worst is 5 years, represented as a negative number.  

This situation is a classic game because a decision of player A affects the outcome for player B. Imagine, you are player A. If player B denies the crime, then you are better off confessing, because then you’ll walk free. If player B confesses, it is once again better to confess and get a reduced sentence. Exactly the same strategy works for player B, which means that both players would be better off confessing, regardless of what the other player does.

Since both players choose to confess, they get a year each (-1, -1). You don’t need to be an economist to see that both players could do better, if they hang tight. They would both get 6 months (-1/2, -1/2), which is a better outcome in aggregate. It’s also a Pareto efficient outcome, meaning that you cannot make anyone better off, without making someone worse off. It would be better for the society (comprising two prisoners in the game) if they both chose "Deny, Deny" (speaking in economic, not ethical terms!). 

The problem is that the prisoners cannot coordinate their actions, and they probably don’t trust each other enough to sit tight. They both confess and get a year each.

How can we apply this game to real life? Ukrainian government and separatists fight in a civil war. Interpret “Confess” as “keep fighting” and “Deny” as “stop fighting”. Obviously, the society would be better off if both players stop fighting, but because it is tempting to crash the opposition when one player stops fighting, the war goes on when two sides cannot agree on the future of their country. 

In business, consider Virgin Media and BT setting the price for fibre broadband in the UK. They both would be better off keeping the retail price at £15 month - “Deny” in our example. But if one competitor keeps the price at £15, another would be better off undercutting its rival slightly by offering a deal, e.g. 6 months at £7.50, thereafter at £15, thereby attracting more customers and making more profit through the higher volume of sales. This is a “Confess” scenario, both Virgin Media and BT offer deals and end up shaving off their own profit margins. 

Finally, brothers Mads and Kristian agree to call their mother regularly. If they both do that, she’ll be best off. But if Kristian sticks to this agreement, Mads can skip calling his mother because she is already being cheered up by one son. Unfortunately, Kristian applies the same logic, and the poor woman does not hear from her sons for weeks, thinking them ungrateful brats. 

Can you think of other commonplace applications of Prisoner’s Dilemma, where two players end up making decisions which could be bettered, had they cooperated? Jot them down in comments below. 

There is a Safestore in Holloway, North London. The company offers storage facilities for business and personal use. I used them once to store personal possessions when I went travelling and rented out my flat.

If you go to their website or give them a call, they’ll tell you that Safestore would beat any local comparable quote by 10% for the first 8 weeks and thereafter would price match the competitor for the anticipated length of storage. This offer applies to self storage rooms of the same size within a 3 mile radius of the store.

I am sure you’ve come across similar ‘meet-the-competition’ or MCC offers at your local supermarket or another services provider, such as the Flight Centre. (Scroll down to the bottom of their homepage to read the MCC clause.)

As a consumer, you may be delighted with such fair and friendly policies. "For once we aren’t getting ripped off!”

Unfortunately, all that glitters isn’t gold.

Economists refer to such practice as an example of tacit collusion when a few companies in the same market (and therefore interdependent) act in concert to the keep the prices high.

MCC clause serves primarily as an information exchange. The Flight Centre does not need to monitor every single air fare from the UK to see what other High Street or online travel agencies are up to. A helpful customer will call up and do the job instead. If competitors know that the Flight Centre will match their reduction in prices (the threat is credible - it’s on their website, after all), they’ll be less likely to cut their fares and therefore their margins. 

MCC is also very effective at deterring new companies entering the industry. Would you launch a business to compete with Safestore, knowing that you’ll be competing with an incumbent, who does not only have the advantage of being trusted by its existing customers, but it will also match your discount, should you decide to allure consumers with lower prices?

Next time you see Waitrose advertising milk at Tesco’s price, be aware of tacit collusion among the supermarket chains. 

A week ago I went to visit my friends in Switzerland. I love Switzerland: chocolate, cheese, the Alps, Roger Federer and … exemplary waste management. That’s right, today’s story is about rubbish.

You see, as an economist, I could not help but applaud the Swiss home recycling programme, now introduced in almost every area of the country.

In Lausanne the new tax on waste disposal has been introduced in January 2013. Under the new rules, food scraps for compost and items for recycling are collected for free. Any other waste will only be collected by the council if it is left outside in specifically designated bags. A small bag costs 1 Swiss franc (a large bag costs 4 francs). 

"What a rip-off!” - I hear you say, but think about how clever this scheme is. If the government’s objective is to incentivise people to recycle, then surely you can see how this tax on waste disposal is doing just that. Suddenly, Swiss citizens pay more attention to packaging and religiously collect banana peel.

If you don’t believe me, consider this report on how effective the waste tax scheme has been. In the first  6 months since its introduction, glass recycling increased by 12%, paper and cardboard recycling improved by 27% and fruit and vegetable waste recycling increased by 61%. Non-recyclable waste left outside went down by 41% and overall waste decreased by 9%, which represents a whopping 3,140 tons.  

The reason the Swiss waste tax works so well is because it affects marginal decision-making. Conversely, in London recycling is voluntary and it’s up to your own good consciousness to do your bit for the environment. The council tax charged in London includes rubbish collection services, but it does not affect a marginal decision of whether one should separate waste or dump everything into the same bin. Once the lump-sum council tax is paid, there is no economic incentive to recycle. 

I should add that a well-constructed tax scheme would also be expected to do better at earning tax revenue and paying for (hopefully better) government services.

We don’t often praise policy-makers, but this is an example of a government job very well done indeed.  

Do you remember Claire who wasn’t having much luck with online dating? Well, I’m pleased to say she’s met an eligible bachelor, they’ve been seeing each other for a while and she asked him to move in with her...

…Unfortunately, as the eligible bachelor (let’s call him Fred) settled in, he started to let things slip. Dirty socks weren’t making their way into the laundry basket, tea bags were left on the coffee table and date nights turned into pizza nights in. Needless to say, Claire isn’t pleased.

Any economist would spot the problem instantly. It’s moral hazard, another issue, arising from imperfect information between the parties, which comes up after a contract is signed or a deal is made. Moral hazard is essentially an incentive problem - the agent isn’t compelled to do the right thing after the deal. 

Think of buying a policy to insure your bike against theft: once your bike is insured, you become more careless and would not think twice about leaving it outside the pub in Soho. If someone cuts the lock and takes your bike, an insurance company will pay you to get a new one. 

Another example is a new hire who has a great CV, makes all the right noises during the interview, gets hired and then spends most of her time at work planning her wedding. 

Fortunately, her employer Alex studied economics and included a probation clause in her contract. He also offered her a relatively modest base salary and a highly attractive sales commission, which means that she is incentivised to delegate wedding planning to her fiancé and focus on making sales calls. 

Insurance companies weren’t born yesterday either and they always include an excess penalty in their contracts so that policy holders don’t get into the habit of making claims and take greater care instead.

These examples seem obvious but how many times did you hire a contractor: a builder to do some work in your house or a photographer to take memorable snapshots at your wedding only to get frustrated with the time it was taking to fit the new kitchen in or to get your photos… A penalty clause for late delivery might be a good idea next time.  

Claire isn’t an economist so it’s only fair to give her some advice. You can override the moral hazard problem by putting incentives in place. I’ll let you get creative here but do make sure it’ll be costly for Fred not to pick up his socks.