One brilliant thing about Ray Fisman and Tim Sullivan’s The Inner Lives of Markets is that it shows you how economists used to just make things up and only recently have they been driven to provide proof that their theories work.
The authors trace the rise of mathematical proof to a paper on the economies of prisoners of war camps during the Second World War. In German camps, prisoners developed market economies where cigarettes became the currency, but in Japanese camps, the regimes were so brutal, no market economies developed. These harrowing circumstances allowed economists to consider how economies develop and function, and to test their theories.
The second brilliant thing about the book is that you do not have to know anything about mathematics or economics to learn about the world around you by reading it. Each chapter takes a theme and lets you understand how economic theory has developed. For example, the fifth chapter is on the subject of auctions, and shows how theory and practice come adrift. William Vickrey, a Nobel Prize-winning economist, demonstrated that the most effective auction process is one where the highest bidder pays what the second highest bidder offered to pay.
In a second-bid auction, you just have to bid what you think an item is worth to you – you do not have to worry about what other bidders think an item is worth. So if you think something is worth £25 and someone else thinks it is worth £20, then you get to buy it for £20.
Vickrey designed the process for situations such as when milk marketing boards sell their members’ output: “Suppose, for example, you are buying wholesale milk for a grocery chain. Maybe you would pay $10,000 for the first ton of milk. That may be enough to supply your stores with the bare minimum they need, so you are only willing to pay a little less – say $9,000 – for the second ton. If you are unlikely to sell much more than two tons in a week at the going price, you might not be willing to pay more than $2,000 for the third ton. Demand schedules of this sort would be fed into the […] algorithm, and moments later, you would find out how many tons of milk you had bought along with a bill.”
In the age of bricks and mortar, practical limitations when selling goods such as the Xbox One restricted the development of auction theory. But the internet seemed made for it – in 2000, The Economist wrote that it introduced the “possibility of a permanent worldwide bazaar in which no prices are ever fixed for long, all information is instantly available, and buyers and sellers spend their time haggling to try to get the best deals.” The Economist was wrong.
Amazon’s auction site never worked and Yahoo! shuttered its auction site in 2007. By the end of 2012, only 15% of listings on eBay used the auction format, down from nearly 100% 10 years earlier. The reason? No matter how much you simplify an auction, it still carries an inherent anxiety and the nuisance of entering bids.
In 2003, the auction discount on fixed price goods on eBay was 3%; today, it is closer to 15%. In 2003, taking part in auctions was fun. Today, using the internet is “about as exciting as walking the detergent aisles at Walmart.”
This is because there isn’t much uncertainty about what most things are worth. As the book notes, on the US eBay site, iPods are listed at between $180 and $200. On Amazon, there is an endless supply at around $190 to $200, with shipping included.
Most customers like the convenience of dealing with a fixed price rather than auction sales in the same way that most people cannot be bothered to collect coupons to get deals on bread and milk.
“Coupons allow retailers to give cheapskate-specific discounts, while leaving prices high for other customers. Low-price auctions similarly serve to give time-rich, cash-poor customers a chance at getting 15% off their iPod, while keeping prices high for others.”
The theoretical world of Vickrey auctions does not work for other reasons. In 1993 in New Zealand, a company that bid $100,000 for some wireless spectrum only had to pay the $6 that the second highest bidder bid.
What The Inner Lives of Markets does is open your eyes to how the world works. Faced with an endless supply of alternative market opportunities, you will be able to focus on the fundamentals that really work. If you are curious about the world, this book is highly recommended.