The Science of Demand (41) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 4.  Mono-Quality Demand Test

“Mono-quality” refers to a good having only a single quality, therefore higher quality means more quantity, lower quality means less quantity, quality being equivalent to quantity. Gold is gold, silver is silver; one tael of gold is one tael of gold, one tael of silver is one tael of silver (working on pure gold and pure silver of course). This is different from the diamond example in Chapter V. Diamond has multi-quality, but since the different “qualities” have all been measured with each having its own price, it becomes multi-quantity. The transacted price of a diamond is a combined price of several quantities and several prices. If we say multi-quality but not multi-quantity, the reason is that the different qualities of certain goods have not been separately measured and each quality has not been separately priced. The so-called quality merely refers to the other quantities that have not been directly priced.

I will first use a “mono-quality” good to demonstrate a more thorough application of the law of demand: how to assert test conditions to couple quantity demanded and quantity transacted. The example I pick is photocopied papers which are priced by its number. Certainly, photocopying can have several different “qualities”, though we assume these other qualities either do not exist or are insignificant.

My example is professors of some universities can apply for certain research fund. Such research fund is not endowed to the professor for his own use, but is controlled by the university. Not only is the fund limited to be used only by that professor, but also to be used only for research – the professor cannot utilize the fund to enjoy life with his mistress. Research uses are clearly spelled out, one of them being photocopying.

Let’s assume it costs the professor $0.2 to photocopy in the university whether he pays for it himself or from the research fund controlled by the university. In the latter case, deduction is made from the fund by the university. Let’s also assume two options are available to the professor, out of which only one is allowed. The first one is the university awards him a one-off pay rise of $100,000 that he can use for photocopying or enjoying life. The second one is for him to receive a $100,000 research fund for research purposes which he can use for photocopying but not enjoying life. Under these two asserted constraints, which option will the professor photocopy more? Photocopying cost being the same $0.2 per page, will getting a pay rise of $100,000 or a research fund of $100,000 lead to a greater increase in photocopying quantity? The answer is of course the option of research fund. The certainty of this answer is identical to the sure fall of a coin.

To explain why photocopying will increase more when a professor receives a research fund than a pay rise, we can have innumerable hypotheses. The hypothesis that I derive from the law of demand is: for a pay rise which can be used to enjoy life, $0.1 is worth $0.1; but for a research fund which is restricted for research purposes, the worth of its $0.1 is definitely less than the pay rise of $0.1. Supposing $0.1 of the latter is only worth $0.06 of the former, for the same photocopying cost of $0.2 a page, the cost after a pay rise is $0.2, while the cost after a research fund is $0.12. The fall in price then triggers more quantity demanded.

There are four important points in this example. First, changing from pay rise to research fund is a change in constraints, as well as a change in test conditions. As long as we are able to choose the appropriate test conditions, real-world phenomena can be much more readily explained. Second, with a good choice of test conditions, logically, the trends of quantity demanded and quantity transacted would be identical, hence these two can be said to have been coupled. In the aforementioned example, the increasing or decreasing trends of intended quantity demanded and factual quantity transacted are the same. Third, irrespective of what hypothesis you have invented, under my asserted test conditions, my hypothesis will be confirmed while yours may be falsified. If yours is refuted, under the same test conditions with one right and the other one wrong, this test then becomes a critical test. Obviously, this can only be achieved when test conditions are smartly chosen. Fourth, the so-called change or non-change of other things can be ignored in the above hypothesis. As long as test conditions are smartly chosen, turning their changes into significant marginal changes, other things become irrelevant.

The Science of Demand (40) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 3.  The Implication in Ignoring Quantity Transacted

Quantity demanded does not exist in the real world, only quantity produced and quantity transacted do. The invisibility of quantity demanded has therefore affixed a difficulty barrier in using the law of demand to explain real-world phenomena. Authors of innumerable economic researches, having no idea that quantity demanded is merely a concept, invented grandiose equations that were awfully embarrassing. So did experts. And so did quasi-experts to a greater extent.

Let’s use an example with which Asians are familiar – the stock market. Chart school (I term feng-shui school) commonly uses the rise and fall of turnover volume to predict the trend of the stock market, with precision not much different from that of feng-shui masters’ crystal ball. Nonetheless, this school, having been popular for so many years, like feng shui, has no shortage of followers. In principle, when the stock market has no turnover at all – volume transacted being zero – stock prices could still fluctuate dramatically.

Anyhow, the law of demand is the spirit of economics, and the center of this spirit is on understanding how to manage the abstractive concept of quantity demanded. This is a prerequisite of science. In applying the law of demand to explain behavior, we either have to logically couple quantity demanded with quantity transacted, or by ignoring quantity transacted, simply use the implication of the change in quantity demanded to interpret phenomenon. Since the latter approach is relatively straightforward, let’s illustrate with a few examples.

When analyzing consumer’s surplus in the previous chapter, we said that one way of extracting this surplus is to charge membership fee. With the imposition of this fee, food prices within the club are cheaper than their outside comparables. This is implied by the demand curve that slopes downward toward the right. If considerable membership fee had been charged yet food prices within the club were to escalate, the law of demand would have been refuted.

And in the disappearance of a $100 note example cited early in this chapter, I pointed out that the less the police around, the higher was the chance of the note disappearing. If passers-by were still rushing to snatch the note despite two policemen standing by, the law of demand would then be overruled.

Never have we seen shops on the street prominently display: “Dumping at mark-up prices!” Neither have we seen people fight while bargaining because of customers insisting on paying more. Neither have we seen people queue up to buy because of prices too high. Neither have we seen the warranty card of a watch say: “Stop working within three months!” Neither have we seen a lady at a courtship coat her face in black… These are all implied in the law of demand.

Maybe we can say: all human behavior is restrained by the law of demand. Let’s now get more thorough in the examination of phenomenon: asserting test conditions to couple quantity demanded and quantity transacted.

The Science of Demand (39) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 2.  Test Conditions

There are similarities among “other things”, “test conditions” and “constraints”, though there are significant differences in perspective. We might as well use the law of demand to further explain.

A downward-sloping demand curve from left to right (sloping downward from left to right is a law) restrains the relationship between price and quantity of a good, both of which are variables. “Other things” refers to all the variables other than these two, of which we allow some to change and disallow others. We have analyzed the choice between variables and invariables in the previous chapter. To be supplemented here is that certain variables bear no relationship to the good under analysis. We should ignore these irrelevant ones.

The term “test conditions”, seldom used in economics, is what I borrowed from scientific methodology in the study of logic. From the perspective of the law of demand, test conditions, only a minor subset of other things, refers to the conditions required to yield an implication that can be empirically tested. As discussed in Chapter I, an implication or a hypothesis, if not refuted by facts, can be said to have explained the facts, and can also be said to have predicted the occurrence of facts. However, such prediction requires certain conditions: according to the law of demand, for a logically-yielded hypothesis, under certain circumstances, the occurrence of A will lead to the occurrence of B. The circumstances described here are the test conditions.

Though the term “test conditions” is seldom used in economics – economists like to use “other things” or “constraints” – this is what I prefer. The perspectives of these three in evaluating the implication of a theory are different, yet I consider the perspective of test conditions the clearest among the three.

There is a critical test in empirical science. To explain facts or behavior, we can have many different hypotheses. Supposing there are two different hypotheses in front of you, you can test one of them first and then the other. Or you can ponder long and deep to formulate one or several test conditions, which when asserted, only one of the two hypotheses can be logically supported by facts or phenomena. That is, if test conditions are smartly chosen, testing can yield the following result: one hypothesis being right means the other hypothesis must be wrong. This, termed critical test, is the most fascinating and admirable in empirical science. To explain human behavior, instead of investigating into constraints, if a critical test is formulated from the perspective of test conditions, more may be achieved from less effort. An illustration will be provided In Section 4.

“Constraints”, referring to all the conditions that restrain behavior, are the most commonly used in economics. With regard to the law of demand, constraints include not only other relevant things, test conditions, but also price. In terms of testing a hypothesis or an implication, the perspective of constraints is not as acute as that of test conditions. But if the issue is magnified, the perspective of constraints is relatively superior. Alchian’s preference in starting from the constraint of property rights has had far-reaching impact on me; his credence that the constraint of property rights is identical to that of competition enlightened me all of a sudden. The prowess of Coase, on the other hand, is to generalize all constraints into costs.

There are not many principles or postulates in economics as a whole. If you follow the guidance of a master, you will realize how simple these principles are, and where their main points lie. The problem is, when these principles are applied to explain behavior, their level of difficulty will increase substantially. In general, their difficulty lies in three areas. Though earlier discussed, I will systematically repeat them here.

1. Constraints in the world – restraining every individual to maximize self-interest – are very complicated. Constraints cannot be randomly assumed but must exist in the real world. We need to simplify, yet constraints after simplification must be essentially congruent with reality. On the other hand, since constraints are innumerable, whether they are relevant or irrelevant to a phenomenon has to be clearly differentiated – such “differentiation” cannot be arbitrarily done but has to be restrained by theory.

One example can illustrate the difficulty in investigating relevant constraints. By economic reasoning, when a government subsidizes education, adopting a voucher system is a commendable solution. Many people in fact believe that Hong Kong ought to implement such a system. However, the chance of implementing it is often considered slim. Why is that? To say that is due to opposition by pressure groups is certainly correct, but under what constraints can their opposition be so powerful? Naturally, in explaining why a voucher system is not adopted in Hong Kong, one demand curve plus constraints are sufficient. Demand curve is simple yet constraints are difficult – that’s where the difficulty lies.

2. Testable implication – the occurrence of A will lead to the occurrence of B – the A and B here, or other relevant variables C, D, etc., must be observable in the real world. Quantity demanded in the law of demand is an intended variable that is non-factual. In other words, the law of demand itself is not testable. While applying the law of demand, we have to vary constraints to logically derive an implication that can be empirically tested. That is, we must derive certain implication so as to logically circumvent the perplexity of the abstractive quantity demanded. To achieve this, the assertion of test conditions poses a mounting challenge.

3. We have already discussed the choice of change or non-change of other things (variables). If you assume certain other variables unchanged, how can you be sure they indeed do not change? You could do extensive research and then use statistics to control variables that are to change or not to change. Alternatively, you could ponder long and deep to formulate some test conditions. As soon as these conditions are confirmed to exist, other things or variables need not be our concern any more. Doing so is another challenging task.

The Science of Demand (38) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Chapter VI.  A Casual Demonstration

Some people do not consider economics an exact science. They believe that economics, unlike natural sciences such as physics or chemistry, is ambiguous in explaining phenomena, and is often off target at least three times out of ten, hence cannot be on a par with natural science. When lecturing students in class, how would you respond to such question?

The banknote example that I quoted to freshmen during lecture is reportedly often used in colleges in the United States. I held a coin in hand, released my hand, the coin fell, then I said to the students: “With no powerful magnet above, when I release my hand, the coin will fall. Who dare to make a bet against it?” There was no response from the students. “The odds are ten to one, who would like to bet?” No response. “How about a thousand to one?” No response. “Ten thousand to one?” Again no response.

I put back the coin, took a $100 note from my wallet, and said to the students: “If I place this banknote in a prominent place on a sidewalk, with no wind or police, this banknote will disappear. Who would like to make a bet against it?” No response. “How about ten thousand to one?” Again no response.

I therefore told the students that under my specified conditions, the banknote will vanish on the street. Only can it be explained by economics, but not by physics, chemistry, biology, psychology, nor sociology. In fact, the accuracy is exactly the same between the disappearance of a banknote as explained by economics, and the fall of a coin as explained by physics. Physics applies the law of gravity to explain the fall of a coin, while economics applies the law of demand to explain the disappearance of a banknote. That’s right, with neither police nor many pedestrians around, the option forgone for picking the banknote for own use decreases. This is the same as specifying under what conditions a coin will fall.

If we cannot stipulate the relevant constraints, problems will often arise when we try to explain human behavior. Yet is natural science not like this? The accuracy of science never refers to how many decimal places there are, but rather the concurrence of observers. The fact that you dare not make a bet with me signifies concurrence. In the chapter on “The Utility Concept”, I had already pointed out that measurement is merely the assignment and ranking of numbers, as well as discussing the two kinds of numerical measures.

It is time to employ some real-world examples to demonstrate the application of the law of demand. I must point out at the outset that we have not yet discussed production, the different structures of the market, the organization of the firm, the different types of property rights, etc., therefore only relatively straightforward examples are chosen here as casual demonstrations of the law of demand. But first, let me overrule certain textbook examples proclaiming that the law of demand had been refuted.

Section 1.  The Implication of Ignorance

You meet on the street a stranger. He says to you: “Dear friend, I have a genuine 2-carat diamond of very high quality that comes with a certificate. Its market price is at least $300,000, but since I am in urgent need of money, how about selling it to you for $5,000?” He then showed you the sparkling diamond. You would certainly not buy as you would never trust a stranger on the street. Even if the diamond is indeed genuine, since you do not know how to appraise, you would still not believe so. If you happen to be an expert appraising that the diamond is indeed genuine, due to its unknown history, you may still decline to buy. Or maybe like some other people, you would not even bother to have a look, since you believe that something worth $300,000 would not be selling for $5,000.

You may, however, be willing to pay $300,000 for the same diamond in an elegantly-decorated branded shop. Your behavior has not refuted the law of demand, though, since due to difference in information, you trust an established shop instead of a stranger on the street.

For almost any good, accurately assessing its quality is no easy matter. We often have to spend a lot of effort before becoming an appraiser of a certain good. To become an appraiser of several goods may demand your whole lifetime. And becoming an expert in everything is impossible. When I was young, I was very knowledgeable about cameras and color processing of different lenses. But with today’s technological changes, I now need to seek advice from friends before buying a camera.

In general, given ignorance and our past experience, for the same kind of goods, we often believe the higher the price, the better quality it has. Such assessment is not necessarily right, yet the chance of being right is not bad. Similar to me, you would likely assume, given market differentiation, the good with a higher market price ought to have better quality.

Under the aforementioned circumstances, we do often buy when the price is high, and not buy when the price is low, particularly in relation to cheap and insignificant goods that do not warrant our attention. For instance, I very seldom use ball-point pen, but if I do, I would choose the cheapest type made of transparent plastic, since I prefer seeing the remaining ink inside. One day, I asked my secretary to buy me the cheapest ball-point pen. She came back with a $3 one. I said: “Not this one. I want the transparent one.” She replied: “The transparent one only costs about $1!” She obviously believed that the higher-priced pen meant better quality, and for me, a professor who relies on writing for a living, my choice would unlikely be the cheapest one.

Owing to insufficient information, price is frequently used as a yardstick for quality. This certainly does not contravene the law of demand. Such behavior of assessing quality by price is not only real but important. It is unjustifiable that economists very often ignore this phenomenon. I myself have devoted many years working on bargaining behavior in the market, reaching an ultimate explanation by using quality assessed by price as the starting point. This phenomenon is most apparent in the antique market: lowly-priced is often perceived to be fake. I will analyze bargaining behavior which involves the constraint of transaction costs in Volume II.

Back in the 1960s – 70s, oil imported into the United States was controlled by quota. Unsure if related or not, a bizarre phenomenon in the prices of gasoline has hitherto been unexplained. That is, the retail prices of gasoline followed cyclical movements that were as orderly as the teeth of a saw. The hike in price was a one-off rise by about one-third; the fall in price was a gradual decline over a span of about two weeks. As such, many customers, realizing the regularity of gasoline price changes, deferred buying when price first started to fall until it had fallen further.

Price change can lead to expectation of continuing changes in the same direction, thereby affecting demand (shifting of the whole demand curve). Neither has this refuted the law of demand.

Let’s return to the sawteeth-pattern phenomenon of gasoline price changes. I debated at length with Reuben Kessel (deceased in 1975) who was renowned for his natural talent. He only agreed with part of my suggested explanation – if the government had allowed vehicle users to store gasoline in large container (that was illegal) when price was low, the sawteeth pattern would not have existed. However, that did not explain why such pattern existed.

As can be seen from the several examples above, handling the so-called “ceteris paribus” is no easy matter. Conversely, from the way “ceteris paribus” is handled, the caliber of an economist is often revealed. The difficulty is that we cannot arbitrarily use “ceteris paribus” as an excuse to remedy an implication that has been refuted by facts.

With econometrics so popular these days, regression analysis can assist in handling “ceteris paribus” to a certain extent. The problem is this analysis has too many pitfalls making it unreliable! At times people employing this analysis are trapped without knowing.

The most reliable approach is to keep on pondering. We have to derive certain implications refutable by facts in order to safely avoid the perplexity of “ceteris paribus”. To achieve this, our focus has to be placed on test conditions or constraints: this condition should be inserted, or that condition should be withdrawn, shuffling conditions here and there in the hope of generating certain testable implication, and being refuted has to be acknowledged. These test conditions or constraints cannot be castles in the air. They can be simplified, yet must be essentially congruent with reality.

The Science of Demand (37) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 10.  The Second Law of Demand Untenable

Since there is price elasticity, and we cannot foresee a ballpark estimate of it, Alchian and Stigler separately invented the second law of demand. They envisioned appending a little tool in explaining behavior by better understanding the regularity of elasticity.

This second law says: elasticity coefficient is directly related to time. That is, if the price of a good has changed, irrespective of up or down, then the longer the time the price has changed, the higher the elasticity coefficient. Its logic being: the price elasticity of a good, other than depending on the nature of the good itself, is largely determined by the more or less of substitutes and their prices. The more the substitutes; the more identical they are; and the lower their prices, the higher is the price elasticity coefficient. Alchian and Stigler considered that it took time to locate substitutes. The longer the time, the higher is the chance of substituting, therefore the price elasticity coefficient of a good is directly related to time.

Let’s first consider the price of a good going up. With a higher price, quantity demanded will decrease. And after some time, when substitutes are found, quantity demanded will drop further. As such, the related portion of the demand curve will shift toward the left.

How about the price of a good going down? With a lower price, quantity demanded will increase immediately. And after some time, consumers will reduce their demand for substitutes, or from the viewpoint of demand of the whole market, other consumers will gradually buy more of this discounted good, partially or wholly substituting for what they bought before. As such, the related portion of the demand curve will shift toward the right.

The aforementioned logic looks fine originally. However, having been refuted by facts in this ruthless world, this second law of demand is untenable. After careful observation of two phenomena in Hong Kong, I cannot accept this second law.

The first instance relates to Hong Kong taxi fares, which have been raised a number of times. Every time after a fare hike, patronage drops initially. Yet after several months, patronage almost returns to the level before. The second one is Hong Kong’s cross-harbor tunnel toll. After toll hike, the change in patronage is similar to that of taxis – drops initially before recovering.

Following my cue, a colleague in the Hong Kong University located the patronage figures of Hong Kong’s tunnel for several years, clearly indicating patronage initially dropped after toll increases before gradually recovering. Unfortunately, this colleague caught a deer but failed to cut its antlers off, making a mess with computer inappropriately handling too many statistical equations, resulting in rejections by academic journals to publish his close to 60-page long essay (at least five-fold too long).

Why was the second law of demand refuted by facts? My explanation is, Alchian and Stiger were half-right but forgot about the other half. The half they got right was that finding substitutes requires time. The half they forgot was sometimes substitutes are widely known that do not require any searching. As such, when price goes up, consumers will immediately turn to substitutes. But after a while, when they realize that substitutes are not so satisfactory, they revert to the original good.

When taxi fare goes up, who in Hong Kong would not immediately know what other substitute transportation is available? Such substitute transportation takes no time to find. When the toll of cross-harbor tunnel was raised, even though there was only one tunnel in those days, who in Hong Kong did not know vehicles could cross the harbor by ferry? After trying out ferry, unsatisfied, people would revert to using tunnel. The second law of demand was thus refuted.

Science is that marvelous. There is no need for additional law to restrain behavior. A simple one could already have incessant power. The law of demand itself having unstoppable power, there is no need for a second law.