The Science of Demand (34) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 7.  What is Quantity?

Quantity transacted and quantity demanded are two distinct matters.

Quantity transacted is an observable fact. The quantity bought and quantity sold of a good are always the same: the two are one and the same, merely different perspectives of quantity transacted.

Quantity demanded is not a fact but a non-observable concept. Without economists, “quantity demanded” will not exist. Quantity demanded refers to the quantity of a good that a demander intends to obtain at a certain price, while quantity supplied refers to the intent of a supplier, both quantities being non-factual. Since they are merely “intentions”, quantity demanded does not necessarily equal quantity supplied. The concept of equilibrium was conceived by economists of a situation when quantity demanded equals quantity supplied. “Equilibrium” is not a fact, either. It exists only in the cogitation of economists. Quantity bought should never be confused with quantity demanded; neither should quantity sold with quantity supplied.

Conceptually, quantity demanded refers to the highest quantity that a consumer intends to exchange at different prices (exchange values). The demand curve is therefore a line showing at different prices the highest quantities demanded.

Quantity – irrespective of quantity demanded or quantity transacted – is rather complicated yet very interesting.

I submit that “quantity” can be classified into “in substance” and “by proxy”, as well as a combination of the two. Let’s first discuss quantity in substance.

When you buy gold in the market, gram is the unit of measurement. Gold stands for gold, and one gram of gold stands for one gram of gold which is double that of half a gram, or half that of two grams. This is called quantity in substance.

When you buy for your girlfriend one carat of diamond, the size of the diamond is represented by carat, a unit of measure. However, other than carat, there are other “quantities” being measured and included in the price. Color (color97, color96, etc.), clarity (VVS1, VVS2, etc.), cutting, are all qualities separately measured and priced. As such, what you get after spending $100,000 to buy one carat of diamond is not simply one carat, but a combination of four kinds of qualities: carat, color, clarity, and cutting. If you go to a diamond wholesaler, he may put in front of you hundreds of diamonds. There are plenty of choices with different combinations of the four qualities. When you pick a one-carat diamond for $100,000, all four qualities have in fact been measured and priced, and you are paying for a combination of the four prices.

What does the quantity in the demand curve of diamond refer to? The answer being there are four curves with four prices and four quantities. Since carat can be conveniently ranked numerically, it is most often used as a representative of quantity. But if quantity is singly represented by carat, the other three qualities have to be assumed unchanged. Whenever quality is directly measured and priced, it is a quantity in substance. Essentially, if the other three qualities are to vary freely, the demand curve of diamond using singly carat as quantity may not necessarily slope downward from left to right.

I can cite another similar example. In the United States, when you buy eggs in the market, the unit of measure is “number” of eggs. The criteria for eggs as set by the Department of Agriculture can be divided into extra large, large, medium and small, as well as grading of AAA, AA and A. The latter is determined according to the firmness of yolk. The firmer the yolk, the more expensive is the egg. In this egg example, “number” has substance, since both size and firmness of yolk have substance, and are measured and priced, albeit not as delicately as diamond.

Let’s turn to the concept of “by proxy”. This was first envisaged in 1969 when I was investigating piece-rate contracts in Hong Kong’s factories. This concept, given prominent coverage in my 1983 article of “The Contractual Nature of Firms”, was considered significant by Coase. Subsequently, when writing the first edition of Volume III of this book in 2002, I applied this “proxy” concept again when analyzing the law of contractual performance and generalized contractual theories.

As an example, if a factory uses piece-rate, i.e., according to every product or portion of product, to calculate wages, this pricing has “substance” since it is directly based on product. If wages are calculated using hourly-rate, time itself is merely a proxy of quantity since it does not represent the worker’s contribution, therefore may not be worth anything. Time worked is merely an approximation of the production of a worker within a time-span. The reason for sometimes using piece-rate and sometimes hourly-rate involves extensively the issue of different transaction costs in monitoring and operation. This will be discussed in Volume III.

Noteworthy here is that even in our familiar product market, the adoption of proxy is still very common. The law of demand is always applied to depict the relationship between price and its directly-linked quantity. It can be made very complicated: if on top of pricing using a proxy quantity, a product is simultaneously priced using several substantive quantities, the way to approach it will be similar to the aforementioned diamond example. There may be several demand curves for the same good, but remember well, the law of demand restrains always the relationship between price and its directly-linked quantity.

I often cite the sale of vitamin capsules as an example of proxy quantity in the product market. When you go to buy multivitamin capsules, they are apparently priced by the bottle. However, the bottle itself, bearing no relationship to vitamin, has “no substance”. The bottle is just a proxy unit of vitamin capsules for pricing. The proxy here is clearly shown, with a label on the bottle specifying the number of capsules inside and the different ingredients of each multivitamin capsule. These different ingredients have been separately measured and priced, yet we are buying multivitamin capsules by the proxy bottle.

In terms of proxy bottle with no substance, this example of multivitamin capsules is the most detailed and clear-cut example commonly seen in the market. However, since price is set for each bottle, a consumer could only pursue, at the margin, his highest use value per bottle to equal each bottle’s price. Unless by a none in a million coincidence, the marginal use value of the capsules, particularly the marginal use value of each type of vitamin, will not be identical to their prices. This is different from the diamond example.

In the aforementioned instance of vitamin capsules, the law of demand is only applicable between the price of each bottle and the number of proxy bottles. Though the number of capsules and the ingredients of each type of vitamin have all been measured and priced, the demand curves of these qualities may not necessarily slope downward from left to right. Consumers may consider certain ingredients of some vitamins too many, hence they would be willing to pay more for less. Yet this has not refuted the law of demand, since the demand curve of this law only restrains the relationship between the price of each bottle and the number of bottles. In other words, since the “quantities” of the different vitamins are not directly linked to the price, the law of demand is not applicable.

Let me switch to the example of watermelon. Watermelon is usually sold by weight, in pound or kilogram. The weight of watermelon is different from the bottle in the earlier example: weight itself represents certain quality of watermelon. The question is: in buying watermelon, a consumer values its composition of sugar, water and vitamin C, as well as the tastiness of its fibers. These qualities have never been measured. Buyers can at best estimate when picking. Hence these important qualities have to be entrusted to weight.

When there is a bumper harvest of watermelons in California, roadside watermelon stalls often do not sell by weight but by each watermelon. Though the watermelons differ in size, their prices are the same. There is therefore another proxy of quality in addition to weight.

This reminds me of the cedar round market in the United States. The trunk of cedar is not prone to be eaten by worms, therefore is often crosscut into circular pieces of about one foot in diameter and six inches in thickness as foot mats in gardens. These round cedar pieces differ in size, yet their prices are usually identical. Sellers first allow customers to select the better ones themselves, then mark down the price of the remaining stock for sale. After further time has been allowed for customers to further choose, the remaining will be marked down for sale again. Such practice is obviously due to sellers trying to avoid the costs of identifying different grades of cedar pieces and determining their respective prices. Instead, sellers let customers decide themselves. As such, after different rounds of markdowns, a decrease in price does not necessarily lead to an increase in quantity demanded. This, however, has not refuted the law of demand, since when price declines, so does the quality of cedar pieces.

With the above examples, I would like readers to realize that, in the hands of different people, the same demand curve can have completely different power. On one hand, theory has to be simplified; on the other, focus has to be precisely clenched, and phenomena in the real world have to be subtly observed. Generally speaking, explaining behavior cannot be accomplished simply by coupling government statistics with a few equations.

The law of demand confines the regularity between “price” and its related “quantity”. Quantity may be “in substance” or “by proxy”, or a combination of the two. Of essence is that there must be a direct linkage between price and quantity: “quantity” must be the quantity directly expressed by “price”. However, as seen from the diamond example, there are several demand curves in buying a diamond. In the example of multivitamin capsules, one demand curve represents a combination of multivitamins, and quantity is entrusted to “non-substantive” bottle. Here, the demand curve is only limited to the price of each bottle and the number of bottles. The composition of different vitamins is pre-determined in multivitamin, yet the different ingredients are not separately expressed by different prices, and each of them cannot be separately transacted, hence there is no individual demand curve for each vitamin. Certainly, we can find in the market bottles of single vitamin, but that belongs to the scope of another demand curve.

In the watermelon example, the demand curve refers to price and weight, or price and number of watermelons. Not measured are qualities like sugar, water and fibers, though consumers have in mind a rough combination. In the example of round cedar pieces, the demand curve refers to price and piece of cedar, albeit each piece is different. After customers have finished one round of buying, the price of the remaining lower-quality pieces is reduced for another round of sale. This then falls into the scope of another demand curve.

Price and quantity of the law of demand can be as delicate as an imperfection in a diamond, as approximate as one whole watermelon; as mammoth as all agricultural or industrial products of the whole economy, or even worldwide demand for real estate. However, irrespective of how delicate, approximate, or mammoth, the approach remains the same. What is price? What is quantity? Which price does the demand curve refer to? Which quantity? Is quantity in substance or by proxy? These questions are inevitable.

The Science of Demand (33) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 6.  What is Price?

What is price? Price is the highest-valued option forgone at the margin by a willing consumer for a good. What exactly is his highest-valued option forgone at the margin? The answer is: the highest use value of the good at the margin. In the case of a market, exchange value is market price. If the marginal use value of a good is higher than its market price (exchange value), the consumer will buy more; if lower than market price, the consumer will refrain from buying. This is in accordance with the postulate of maximization. Consequently, at the equilibrium point, market price equals marginal use value. As such, market price is marginal use value. (When we later discuss consumer’s surplus, market price may equal average use value. This will be explored in Section 7 of this chapter.)

With the above concept of “price”, several key points have to be clarified:

1. As aforementioned, certain goods have no market; or they are non-pecuniary goods; or market does not exist under certain systems, hence the goods have no market price. In the absence of market price, we need to work on option forgone. Market price equals option forgone, yet option forgone does not necessarily equal market price. In terms of option forgone (exchange with other goods), the equilibrium point is reached when option forgone equals marginal use value. Using option forgone in place of non-existent market price, we have to incorporate the postulate of substitution into the law of demand and make judgment with reference to observable changes in constraints. These have been earlier discussed.

2. Price is always relative. Since there are no non-relative prices, the word “relative” is often omitted. So is option forgone. The so-called relative price means that the price of Good A is always the “quantity” of Good B or other goods that has to be forgone in exchange. If we express the price of Good A in money terms, such monetary amount represents the quantity of Good B or other goods that has to be forgone. Monetary amount is merely a number used to substitute for the marginal use value of goods forgone.

In a system with no market, there is no monetary price. We can therefore only use option forgone to analyze, and this option forgone also equals the marginal use value of the good given up. It is more difficult to analyze without market price, yet guided by the highest-valued option forgone, we can say what is given up is what the demander currently owns.

3. Price is generally measured by present value – the price payable in the future has to be discounted. This is because choice decision is normally made today: if we decide today that decision be made tomorrow, this is a decision today. With no market, hence no market interest rate, analyzing becomes harder. On one hand, we have to utilize the aforementioned highest-valued option forgone at the margin; on the other, we have to refer to other phenomena in order to make objective judgment on the value of time. Time and interest will be expounded in Volume II.

4. Price or option forgone is dynamic which can be further categorized into flow and stock. Periodic payment (like rent) is flow; lump-sum payment to buy a property is stock. Sometimes we use one instant of time instead of flow or stock. The former, often adopted these days, refers to not taking into account the issue of time. There are two key points here: first, in order to avoid contradictory analysis, the dynamics of price must be identical to the dynamics of quantity; second, as long as the dynamics of price and quantity are identical, there are no exceptions to the law of demand.

The Science of Demand (32) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 5.  Use Value and Exchange Value

Since the utility concept is not a necessity, and the simpler the theory the better, let’s do without it then. As aforementioned, the law of demand does not allow the existence of the Giffen paradox, and this law is more powerful than the convexity postulate in restraining behavior, we can therefore conclude that a downward sloping curve from left to right alone already possesses more extensive explanatory power than the whole utility analysis.

The law of demand, as said before, does not require any content of utility. We only have to assume that Jeremy Bentham had never existed before. Without Bentham, let’s retrace the view on price back to economics towering originator, Adam Smith. In his 1776 classic work, “The Wealth of Nations”, Smith advocated two simple yet correct concepts of price. Regrettably, these imperative concepts were wrongly analyzed from the outset, resulting in little attention from later generations.

Correct concept may be accompanied by incorrect analysis. And if we believe since analysis is incorrect, then the concept is inherently incorrect, we are heaping error on error. This is Logic 101 of the Vienna Circle.

Smith pointed out that there are two types of values. The first one is use value, exchange value being the second one. As the names imply, use value is the highest value a good provides to its owner or consumer, or the highest-valued option this person is willing to forgo. Exchange value is the option forgone in getting the good. And in the market, exchange value is the good’s market price.

Smith made an unfortunate mistake in quoting at the outset the paradox between diamond and water. He said that a good with a high use value may have a very low exchange value; and one with a high exchange value may have a very low use value. His example was: water has a high use value, but its exchange value (market price) is very low; diamond has a high exchange value, yet its use value is very low. This is the famous “paradox of water and diamond”. However, three mistakes were committed.

First, we cannot compare diamond with water, since one gram of diamond is totally different from one gram of water. Second, given Smith had never been married (there are several versions whether he had ever fallen in love), he did not seem to comprehend women’s tastes. To him, a professor who was well-known for being absent-minded, diamond might not have any use value. But to women, the use value of diamond can never be any higher. From the perspective of choice, for a woman to voluntarily pay $10,000 (exchange value) for a diamond, its use value to her must be no less than $10,000. Unless a person makes a wrong choice, use value can never be lower than exchange value.

And third – the most important one – is that Smith in those days did not have any concept of “marginal” analysis. The use value of water is indeed very high; its exchange value indeed very low. However, at the margin, the use value of water is very low. At home these days, one extra glass of water (marginal quantity) costs (exchange value) less than $0.01, while its use value is also less than $0.01 – unlike the situation in a desert, the way we drink water at home is until we want not another sip. What about diamond? Dearly loved by women for its nobility, coupled with scarcity, its marginal use value is exceedingly high.

Let wrong be wrong, and right be right. Aside from the above fallacies, I have a very high regard for Smith’s concepts of use value and exchange value. These simple and easy-to-apprehend concepts, being non-abstractive, are an exactly fitting to someone like me who insists on applying theory to explain behavior! A key point to note is that the use value and exchange value advocated by Smith are not castles in the air. They are not non-existent. Rather, in principle, any of their changes are measurable by changes in option forgone or market price. Unlike “utility” which is purely imaginary, these two values are observable. In applying Smith’s concept of use value to replace the content of utility, I consider it a giant leap forward in demand analysis.

The Science of Demand (31) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 4.  The Assumption of Unchanging Tastes

In the analysis of demand, it is commonplace that change in taste will affect demand. Whenever taste changes, the whole demand curve will shift to the right (demand rises) or to the left (demand falls). Maybe I am the only one with a different view. If the law of demand is applied to explain behavior, we should assume the taste of every individual stays unchanged.

Philosophically or in faith, I agree that taste does exist and am unsure if taste does not change. The problem is we are no God, therefore unable to determine how a person’s taste is like and whether that person’s taste has changed. Change in taste in economics is just a game: whenever a person’s behavior changes, it is claimed that person’s taste has changed. What kind of science is this? When all behavior is explainable by change in taste, what refutable implication would still remain? Maybe it can be so stated: all who draw on change in taste to explain behavior are mentally deficient.

Everyone is born with dissimilar taste. This being highly agreeable, I therefore cannot deny the existence of taste. However, from the perspective of empirical science, applying changing tastes to explain behavior is devoid of content.

Let’s cite a few examples. As mentioned earlier, recurrent plane crashes will spread a negative message around to lower demand for air tickets. Yet is it due to a change in the taste of consumers, or the negative message having an adverse impact on the demand for air tickets? Change in message will possibly lead to change in taste, yet unlike change in message, change in taste is not visible. We cannot derive any refutable implication by merely referring to change in taste. But since change in message is a fact, an implication that the demand for air tickets will fall can be derived. As such, we need not be concerned if taste has been changed.

Another example is: if time is spent appreciating classical music by people who originally dislike it, after a while, they may start to enjoy it, or may even be captivated. I will not object if you say the tastes of these people toward classical music have changed, though we need not draw on any change in tastes to explain the increase in demand. By pointing out that these people listen more to classical music, or the cultural environment has changed, or their new acquaintances are all fans of classical music, we can surmise their increased demand for classical music.

I am not saying taste is indeed unchanged, but that in using change in taste to explain behavior, it is impossible to derive any refutable implication. What we need to find out is the reason for the change in taste. And if we know the reason, there is no need to refer to any change in taste at all.

The question is that no one has ever been able to explain behavior purely by drawing on change in taste. Doing so is no more than a tautological statement – stated but devoid of content. To explain change in demand, we must base on changes in observable things or constraints. Having done this, there is no need to draw on taste.

I am neither saying there is no such thing as taste, nor that taste does not change. Maybe man is borne with unchanging taste, with his demand only influenced by different information, experiences or knowledge; or man may change his taste due to change in information. These issues are outside the realm of economics. What I insist is that economics cannot use taste as a pretense to explain behavior that we are incapable of explaining, or to salvage theoretical implications which have already been refuted. To abrogate these pretenses, the simplest way is to assume everyone’s taste remains unchanged.