The Science of Demand (21) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Chapter IV.  The Utility Concept

The word “utility” is commonly used in Western economics. Its usual translation in China, more like “effectiveness” which seems so realistic as if it does exist in the real world, is somewhat misleading. Never has Chinese culture this utility concept, it is therefore understandable why a proper translation may not exist. Nevertheless, without a proper translation is not that important, since for more than a century Western economists are not too sure what utility is, either. Passed on from older generations, they assume that they understand, yet they do not in fact. It was only until the mid-twentieth century that Western economics could provide a clear definition of utility. Even so, many economists until today are still unsure of its correct definition. There is no lack of bright people among these scholars, so it is unlikely due to stupidity. They are reluctant to know: if they understand and concur with the utility concept in this chapter, they will lose the ability to improve the society and, like myself, become small potatoes.

Section 1.  A Miserable Development

In 1789 and 1802, British economic philosopher, Jeremy Bentham (1748 – 1832), put forward the concept of utility which has broadly influenced later generations. Bentham’s original conception was threefold. First, utility is an index representing happiness or enjoyment. Second, every individual strives to attain the highest index. This index helps to express the selfish postulate in a mathematical manner, and when calculus was subsequently introduced to economics, the utility function became vastly popular. The utility function is still prevalent in economics today. This is not because of any indispensable explanatory usage of the utility function, but that it can be conveniently applied to mathematics. People who are adept at mathematics can easily write a good number of articles.

Bentham’s third conception was that when a person’s income increases, the marginal utility of his income will decrease. He then assumed the degree of enjoyment of every individual is the same regardless of the level of income, hence the marginal utility of income of the rich is low, while the marginal utility of income of the poor is high. The society as a whole enjoys the highest welfare when everyone’s income is identical. This is the theoretical basis of egalitarianism, as well as the predecessor of welfare economics that still exists today.

It is highly questionable whether a person’s increased income will lead to a decline in his marginal utility of income. What contemporary economists unanimously agree to, however, is that utility indices cannot be compared among different individuals. The importance of one dollar to a wealthy person might be much higher than that to a beggar on the street. On this point alone, welfare economics is highly problematic. In 1950, Paul Samuelson (1915 – 2009) pointed out in an abstruse article that irrespective of any increase in national income of an economy, as long as the incomes of some people (or even one person) are reduced, economics cannot confirm that social welfare has improved.

As he himself also professed, Samuelson is the primary persona of welfare economics. Why even today are there so many practitioners of welfare economics? I believe there are two reasons. First, as mentioned earlier, economists believe they have the ability to improve the society. Second, economists have to improve their own welfare: being economic advisers of the government can increase their own incomes. In fact, governments are generally liberal in passing taxpayers’ money to economists: in implementing policies for the self-interest of government officials, it is always preferable having the assent of economists.

From a scientific viewpoint, the most fatal problem of utility is Bentham’s first conception that utility is a happiness index. If one is not a fish, how can one know what makes a fish happy? How can one know whether I am happy, or whether I am happier today than yesterday? Overthrowing an empire is easier than changing a person’s character. Some economists always believe they have God’s extraordinary abilities. Even today, some people still to a certain extent consider utility as a happiness index.

In 1915, a self-taught Russian economist, Eugen Slutsky (1880 – 1948), published in Italian a weighty article. After his death, this article was translated in 1952 into English. A key contribution of this vital article was indicating that if we were to use utility to explain human behavior, the utility concept had to be detached from subjective happiness or enjoyment. Had it not? To explain behavior, we need to predict human choices, or how human choices will change under different circumstances. It is irrelevant and entirely insignificant whether human choices hinge upon augmenting happiness.

After Bentham, almost all notable and gifted economists got involved in the research of the utility theory. Sadly though, the work of all these talents only resulted in a history of blood and tears. In 1950, Stigler published a long article entitled “The Development of Utility Theory”, tracing the history of thought of the utility theory over more than a century with incredible insight and striking literary grace. In his conclusion, Stigler could not help abusing: he felt that economists were not keen on testing theories, hence despite the mammoth efforts of so many masters on the utility theory, the resultant contribution toward explaining human behavior was only negligible!

I like very much a passage in the concluding section of Stigler’s article. In 1968, I asked Stigler to write it down on paper for me to put beside my desk as an epigram for my research. The ink has since faded, but the manuscript is still with me. For readers to appreciate the penmanship and literary grace of this twentieth century’s talent, that passage is reprinted below:

“The criterion of congruence with reality should have been sharpened – sharpened into the insistence that theories be examined for their implications for observable behavior. Not only were such implications not sought and tested, but there was a tendency, when there appeared to be a threat of an empirical test, to reformulate the theory to make the test ineffective. Economists did not anxiously seek the challenge of the facts.”

George J. Stigler

<INSERT HANDWRITTEN PASSAGE>

In any event, given that the utility theory is still popular today, I have to elaborate more on its main point.

In 1972, I published an article about the phenomena of “blind marriage” and “daughter-in-law raised from childhood” in traditional Chinese marriage. In the last section I vigorously criticized the utility theory, saying that it could be banned due to its limited application. The British Economic Journal was eager to publish that article, but asked for a reduction of five pages. I therefore simply deleted the last section. After the article had gone public, two masters in the profession wrote to me to condemn that I should not have deleted what they considered were the most important section. The draft of that section has never been located since.

The principal reason of my opposition to the utility theory is that “utility”, merely a concept envisaged by economists, is non-factual but a castle in the air. It is neither visible nor touchable, and does not exist in the real world. Consequently, it is not only difficult to derive implications that are refutable by facts, but pitfalls are aplenty. Since tautological statements tend to be unwittingly formulated, people are likely to be swindled.

At that time Coase sided with me, while on the other side were three people I admire: Friedman, Becker, and my teacher Alchian. They would rather hold on to the utility theory since certain economic goods – such as friendship, reputation, family fun, etc. – could not be pecuniarily measured. Their consideration was that since those goods were not measurable by money, they had to be measured by “utility”. I will explain why I cannot concur with the viewpoints of these three mentors, but let me first elucidate the “utility” concept as it is commonly agreed.

The Science of Demand (20) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 7.  The Economics Paradigm

Since economics cannot determine the good from the bad, what does its paradigm include? The answer is, the economics paradigm includes three fractions.

First, when the relevant constraints or game rules (i.e., the system of property rights or the delineation of rights among people) are known, we can infer which competition criteria will be adopted. This is a complex issue often difficult to manage, but if researchers are willing to pay the price, there is always a means. This is an area in empirical economics that can easily tell the masters from the mediocrities.

Real-world phenomena are like chess games that every game is different. Constraints are ever-changing, so no analysis can be all inclusive. Key constraints that are relevant have to be singled out for simplification. But what count as “relevant” and “key”? The analyst cannot make any rash judgments nor pick randomly, since in so doing desired conclusion can be reached as he pleases. In other words, the choice of constraints needs to be restrained, and such restraint requires theoretical underpinning. This is a more in-depth methodology-related issue which will be discussed in Volume III when analyzing price control.

Second – this is the easiest fraction of economics – when competition criteria are ascertained, economics can surmise how human will behave, how resources will be allocated, and how wealth or income will be distributed. As mentioned earlier, different criteria will lead to different behavior along with different winners and losers (income distribution). Quarter-allocation and queuing up to buy belong to this fraction.

In fact, leaving aside the development in the last forty odd years, this fraction is the only laudable area (non-value judgment yet with explanatory power) in Western economics in its history spanning over two hundred years. Economics is traditionally divided into two main categories: the so-called income distribution and resource allocation (or resource use). Today’s economics textbooks still employ such an approach, very often erring messily.

Most of the analyses of income distribution and resource allocation in traditional economics are based on the criterion of market price. This criterion can only exist under a private property system. In other words, though the brilliant analyses in traditional economics are able to explain income distribution and human behavior, their scope is nevertheless limited. The game rules restrained by private property rights are barely a subset of myriad rules. Even if we learn by heart the common economics textbooks of the highest level, the scope within which they can be applied to explain the real world is only tiny. Rigidly learning by memorizing textbooks may not even know roughly the right path of economics, let alone getting well acquainted. Science has to be learnt and applied in a flexible way, so has economics in particular.

Though the majority of traditional economic analyses using market price as criterion are narrow in scope, it does not mean that different competition criteria cannot be applied in economic analysis. Over the past forty odd years, the so-called new institutional economics has indeed been attempting to extend fundamental economic principles to multifarious criteria. Unfortunately, since the gentlemen undertaking the endeavors invented too many “castle-in-the-air” concepts, contravening the principle of “invisible means non-testable”, the result has been chaotic. Different competition criteria no doubt produce different effects, yet the same theoretical basis can be applied. So long as the competition criterion has been determined, it is not hard to predict the behavior of income distribution and resource allocation. That is, once the relevant game rules (constraints) are clarified and competition criteria ascertained, it will not take a master more than a few days to infer the resultant behavior, with accuracy similar to that in natural science.

The third fraction of the economics paradigm – to explain how game rules are established – is the most difficult. Why on earth do we have communist system? Why was there rent control in Hong Kong? And since game rules are directly related to competition criteria, this part also includes explaining how competition criteria are determined. Why are staff quarters of the University of Hong Kong allocated by a point system? Why did China in the past assume a hierarchical system?

How are different systems of property rights established? Why are laws different at different times in different places? What is a state? Why do we have states? Why do some states have constitutions and some do not? Why were there people’s communes in China? These are all profound questions.

It is astonishing that sometimes economic issues considered by economists to be enigmatic are regarded as extremely trivial by people who know nothing about economics. The latter enjoy talking endlessly on these issues, though their “explanations” are not at all scientific. If you ask Hong Kong’s legislators: why did the so-and-so bill get passed? As is usual with politicians, they would eloquently express their views. But if we analyze their “theories” in detail, we will generally arrive at four conclusions: (1) what they say are ad hoc theories that have no generalized explanatory power; (2) what they say are tautologies devoid of content; (3) what they say are their own value judgments that are no science; (4) they only talk nonsense.

Friedrich Hayek did spend substantial time explaining this third area of economics paradigm, albeit achieving little. Over the past forty years, theory of the state has become a hot topic in economics, with participants including James Buchanan, George Stigler, Gary Becker, Douglass North, Harold Demsetz, Yoram Barzel, etc., yet not much was achieved, either. Certainly, their other researches do bear fruit. I myself established in my little book “Will China Go Capitalist?” a theory on political system. Self-satisfied, yet only Coase and Barzel value this theory. Published in 1982, this theory accurately surmised China’s systemic transformation. Even more self-satisfying is my 2008 publication of “The Economic System of China”.

“Economic Explanation” integrates my knowledge in this field over the past fifty years. This third fraction of economics paradigm, being the most difficult in economics, has been my main focus for three decades since I was forty-five. I specifically targeted this fraction while writing Volume III “The Choice of Institutional Arrangements” eight years ago. When reviewed today, certain areas are not satisfactory. Inspired by China’s reform, my knowledge in this fraction has expanded. With a little luck, maybe my substantial editing this time could successfully master this third fraction.

The Science of Demand (19) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 6.  Economic Analysis and Value Judgment

As aforementioned, competition criteria determine the economic operations of a society. But on this theme of “criteria”, there are both economic analyses and subjective, moral issues which bear no relationship to objective theoretical analysis. These two have to be clearly differentiated.

We know that under different criteria, winners and losers belong to different people. Therefore, some people prefer a certain criterion while others prefer another one. Such behavior falls into the sphere of economics. For instance, in school examination, some students prefer essay questions to let them answer liberally, while others prefer multiple choice questions believing their chances of winning would then be higher. All behavior about choices falls into the realm of economic analysis.

Which criterion is good, or beneficial to social welfare, is a question of moral or value judgment unrelated to objective analysis. For instance, as aforementioned, since market price induces increased production, using it as a competition criterion will not cause any wastage, while all other criteria must to a certain degree lead to wastage. I did not, however, say increased production is good or wastage is bad. Whether the criterion is good or bad can only be determined by individual value judgment, or only God knows.

People’s communes in former mainland China led to hard times of the people. The reason why is a question of economic analysis. But whether having hard times is good or bad is subjective judgment. Economics can explain human behavior, can explain under what constraints people would suffer hunger and cold, yet it cannot determine whether it is good or bad. “Cannot determine” here refers only to economics but not economists. Let’s not forget economists are only human, thus have their own value judgments. If I say suffering from hunger and cold is a bad thing, is no good, I am expressing my subjective view from a human’s standpoint which is not based on objective economic analysis. Certainly, I have every right to hold such a subjective view since I have the right of a human, though no training in economics is needed for the possession of this right.

I can express my value judgment. Other people can likewise do so. Nevertheless, only God knows whose value judgment is more correct or more commendable. The expression of value judgment does not require analytical training. You may like blue color while I prefer red. Who can make a convincing judgment on which is more preferable? You may say government providing assistance on education is a good thing while I believe it to be bad. No conclusion on good or bad can be drawn even if we debate for years, since no scientific analysis can reach an objective consensus on good or bad, like or dislike.

If I say suffering from hunger and cold is no good, is a bad thing, most people would agree. This is only due to most (may even be all) people not preferring themselves suffering from hunger and cold. Everyone agrees because the same value judgment is shared rather than because of objective analysis. Economics can explain why people suffer from hunger and cold, explain what effects governmental assistance have on education, but cannot make judgment on the issue of good or bad.

As aforementioned, economists are only human who have their own value judgments. However, when examining an issue, they might intentionally or unintentionally state whether certain outcome is good or bad. Though there is nothing wrong when subjective preferences are associated with objective analysis, it may sometimes confuse the audience. Of essence is that people undertaking economic analysis have to clearly distinguish subjective matter from objective one, and never let subjective judgment affect objective analysis. If an economist considers governmental assistance on education is good (subjective judgment), and then distort his analysis intentionally or unintentionally to fall outside logical bounds, this is what science forbids.

At times, some economist has not stated whether something is good or bad, yet others interpret that he has done so. For instance, when I say using market price as a criterion can increase production, many readers might interpret that I mean using market price as a criterion is good. Yet not that have I said. Readers believe I have said so because they themselves think increasing production is good. Certainly, to avoid monotony when writing newspaper articles, I would occasionally express my personal view on good or bad. The focus of this book, however, is objective economic explanation.

Many readers consider that I embrace the market and have a particular penchant for it. True is my belief in the capabilities of the market, though I also know very well the market’s incapabilities. My personal value judgment is against the market as well as communism, since under both of these it is hard for me to stand out above the rest. My personal preference is using examination results to determine the allocation of wealth in the society, as I could excel under whatever examination criteria. Unfortunately, nowhere in the world today uses examination results to allocate wealth or pretty women. (The national “zhuangyuan” examination in ancient China indeed has the effect of wealth allocation, yet who knows if I could be at the very top!)

The Science of Demand (18) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 5.  The Implication of Competition Criteria

In track events, speed determines winners from losers. Speed is the criterion in determining winners in track events. If such events have no rules specifying what behavior constitutes foul play, then the criterion of speed cannot be easily established. By the same token, without rules, the criterion of strength in weightlifting cannot be easily set. In chess games, the more intelligent wins; in snooker, the winner belongs to the player with sharp eyes, better skills, and better hand control – these criteria are brought about by the relevant game rules.

The contest (competition) in economics is no different. In a free market, the highest bidder gets the good. Market price therefore becomes the criterion in determining winners from losers. The rule that leads to this market price is the private property system. This is Coase’s and Alchian’s central thinking.

The economic analysis of market price has long been focused on how price is determined. Only in the hands of Alchian this price concept finally got blossomed. He said: “What price determines is far more important than what determines price!” This statement alone advanced our knowledge of the world by a great stride. Price is a criterion in determining winners, and private property rights is the rule in determining this criterion. Since both of them had made a few inspiring statements, Coase and Alchian are known as the founders of property rights economics.

There is a direct relationship between the rules of the game and the criterion that determines winners: the former determines the latter, and the latter determines the economic operation of a society. An interesting question arises. Is it because of the need for a certain criterion that leads to the emergence of a rule, or people requiring certain rule that brings about the emergence of a criterion to determine the winner? The sequence seems hard to resolve at a glance.

I consider criteria come before rules, since what criteria determine is the issue that mankind tries to resolve by competition, but rules merely facilitate the establishment of criteria. Speed is the center of attention in a track event, but the rules of this game are merely to facilitate the determination of “the faster wins, the slower loses”. The examination result criterion at school is for assessing whether students have put in their efforts in studies, while examination rules are merely for facilitating the fair winning of those with higher knowledge (this intended objective is of course not necessarily achieved). Facilitated by a private property system, market price not only determines winners and losers, but also those with higher productivity win. Readers will have a more in-depth understanding when I analyze rent dissipation in Volume III.

As noted earlier, the criteria for determining winners will determine the economic operation of a society. On one hand, the distribution of wealth or income in a society is determined by the criteria of competition. Criteria are aplenty, and under different criteria, each individual has different chances of winning. For people who are good at running a business or production, the criterion of competing under a private property system is to their advantage. Some people are adept in politics. Under a non-private property system, they can put their political shrewdness to good use. There are also people who do not know how to adjust to ever-changing market operations but are good at routine work. Using years of service as a criterion would benefit them a lot.

On the other hand, since competition criteria have a decisive impact on income and enjoyment, under different criteria, human behavior will differ accordingly. Let’s use the example of the highest bidder gets the good. If a person aims to profit in the market, he will work hard to produce, invent new products, streamline operations, or find ways to reduce costs, etc. However, if goods have no market price but are only rationed, people would instead choose the “back door”, or employ political means to seek an official post, etc.

I can use two allocation-of-property examples in Hong Kong to demonstrate the motto of “criteria determine a society’s economic behavior”. We know Hong Kong’s free property market applies the method of “the highest bidder gets the good” to determine winners. Those who are able to afford and willing to pay high enough prices or rents can buy or rent their favorite properties for their own use. Regardless of the payer’s age, appearance, political skills, education, there is no preferential treatment as long as the required price is not paid.

But in the University of Hong Kong, lecturers’ quarters are allocated using a point system. Department heads have six points; those who are married have six points; those having one child get six points, having two children get twelve points; one year of service gets two points, so having worked for eight years gets sixteen points. The total score is the criterion used to determine the sequence of allocation and the size of the quarter. Regardless of how learned a lecturer is, or how outstanding his research results are, if his score is not high enough, he will sure lose out in the competition for staff quarters.

The above point-scoring criterion in the allocation of quarters is very similar to the way quarters were allocated to cadres in the early days of China’s reform. The reason being the constraints in the University of Hong Kong are very similar to a state-run system. The assets of the University of Hong Kong are not private property, but belong to the public or the government. From the perspective of property rights, the system in the University of Hong Kong is a kind of “common property”, and its quarter-allocation criterion bears no relationship to the market price of the quarters. The main difference between the University of Hong Kong and mainland China in former times is that the “common property” system in the University of Hong Kong is limited to the matters of the university only, whereas the common property in former mainland China was generally stretched to the whole nation.

From the above examples of property-allocation by the market and by the University of Hong Kong, we can obviously find that since the criteria to determine winners are different, winners and losers under the two systems are people of different categories. A person with unique business acumen gains no particular advantage in the University of Hong Kong, while a person with more kids carries none priority rights in the market. On second thoughts, we realize that when criteria are different, human behavior differs accordingly, hence production efficiency is also different. The quarter-allocation system of the University of Hong Kong encourages lecturers to get married early, have more children, and serve longer terms in the university. Allocating under the criterion of “the highest bidder gets the good”, on the other hand, encourages behavior to produce for making profit, to reduce costs and to save up, etc.

In economics, “wastage” is no simple concept. This concept will only be explored in detail in Volume II. Here I will only introduce a “wastage” concept, as per ordinary textbooks, which is relatively easy to understand though not entirely correct. In general, wastage refers to the existence of other means, or other ways of asset allocation, that can increase the society’s wealth or income, but these “other” means are somehow not adopted.

From the above definition of wastage, among the numerous competition criteria, only one criterion leads to no wastage. This non-wasting competition criterion is market price. A few examples can illustrate this point. In queuing up to buy, using the criterion of “first queue first buy”, one has to forgo time. Time spent idly queuing up instead of in production brings no gain to anyone in the society, hence the value of such time is wasted.

Let’s go back to the point-scoring system to allocate quarters in the University of Hong Kong as another example: a lecturer in the University of Hong Kong can gain higher points provided he has more children, or continues in office for a longer time. Therefore, when hesitating (the so-called “marginal” situation) whether to have more children, or to switch job, gaining more points to have a nicer apartment will become a deciding factor. It is wastage when those originally not planning to have more children give birth to more children, since the points themselves do not represent the value of any product, and the choice of having more children is only “coerced” by the objective of gaining higher points.

Using age as a criterion in allocation will encourage people to employ all means to falsify their age, or increase their intention of getting old in the shortest time. In a survival-of-the-fittest society that uses force to determine winners, people will be induced to invest in weapons. Many years ago, gold mines were discovered in the freezing state of Alaska. With the gold rush, local rules were then set that whoever got to a mine first on a day would have excavation right of that mine for that particular day. Consequently, people rushed to invest in breeding sled dogs as strong and as fast as possible. All this behavior constituted wastage.

The only competition criterion that leads to no wastage is market price. “Highest bidder gets the good” is the only criterion that induces people to increase production in exchange for their needs. More effort spent on production to profit means a higher chance of winning, and such production contributes to the well-being of the society. Therefore, this market price criterion does not lead to wastage.

Ever since the early 1970s, I have been calling the aforementioned “wastage” viewpoint rent dissipation, as its nature is similar to the rent dissipation in high seas fishing. In fact, when I was writing “The Theory of Share Tenancy” in 1967, I had conceived such an idea in its Section 4 of Chapter VI, though the perspective was a bit different. This is a complex, crucial and fascinating analysis which I have been working on for more than forty years. Details will be discussed in Volume III.