The Science of Demand (45) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 2.  The Scissor Analysis Refuted by Market Demand

Market demand and individual demand are not the same, the former being the aggregate of individual demand. The market demand for a good may be formed by aggregating the demands of innumerable individual demanders, while market supply is often formed by aggregating that of innumerable individual suppliers.

Goods can be divided into private goods and public goods. Private goods are common, while public goods are relatively few. We will first explore the former here, while the latter will be discussed in Chapter VIII.

The nature of private good is exclusive use, meaning one person’s enjoyment will exclude others from enjoying it. Apple is a case in point: while you are eating it, I will not be able to consume the whole of the apple. Private good does not necessarily mean privately owned; public good does not necessarily mean publicly owned or commonly owned. The difference between the two lies only in the nature of enjoyment, having nothing to do with property rights or institution arrangements.

The market demand curve of a private good is formed by adding together different individual demand curves horizontally: at each price, quantities demanded by individual demanders are added together. It therefore represents the relationship between the marginal use values of all the demanders and total quantities demanded. This curve of course also slopes downward toward the right.

Let us assume there is ample supply of a certain non-manufactured good, e.g., precious shells on the seashore, for which numerous people demand. In the market, a demander will buy more if the price of shells is lower than his marginal use value, and sell some if the price is relatively higher. The quantity transacted by an individual demander may be too insignificant to have any noticeable effect on the market price, yet his transaction will still have influence, albeit slight, on the price.

At times, a person may believe he possesses certain exclusive information to silently profit in the market. However, no matter how discreet this person is, as long as the transaction is contemplated in the market, his intention will be spread and expressed in the market price. Market price therefore becomes the reception center of information, and its ups and downs inevitably reflect the intentions or preferences of the demanders.

At times, misled by information that causes large fluctuations in market price, some market demanders will get rich while some will go broke. At times, some people will buy or sell in large quantities in the belief that their exclusive information could bring hefty return. Unfortunately, the chance of their going broke is generally higher than getting rich. The reason lies in the difficulty in accurately estimating the confines of the market. In the 1970s, two filthy rich brothers in America believed they could get even richer by speculating in silver. Little did they know that after silver prices had skyrocketed, numerous housewives reacted by selling their ancestral silverware. Such reactions sent these two brothers to bankruptcy.

Opinionated speculators aside, every demander will compare market price with his marginal use value before deciding whether to buy or sell. The result of everybody doing this is that the marginal use value of every individual will be the same as market price, and the marginal use values of different people will consequently be identical. In other words, if the marginal use values of different demanders toward a certain good are not identical, the market is not at its equilibrium state. Competing buying or selling behavior will ensue to influence market price, ultimately rendering every demander to have the same marginal use value. This of course assumes transaction costs do not exist.

When I was a kid studying in Hong Kong’s Wanchai College, my fellow students liked to play with “paper dolls”. They were included in cigarette packets that adults bought. The “dolls” on the “paper dolls” were often different, with some in greater demand than others. Students would, after school, happily exchange paper dolls according to their individual demand. That was a perfect market. Sometimes two were exchanged for one; sometimes three for two; sometimes the students used pocket money to buy; sometimes they used part money and part paper dolls to settle. These phenomena indicated that the school kids, acting according to market regularity, used the exchange ratios (exchange values) to measure their individual marginal use values of different paper dolls. The exchange ratio was thus price.

If we ignore the existence of information or other transaction costs, market equilibrium is attained when market price equals the marginal use value of every demander, hence fulfilling the Pareto condition. If there is difference between market price and the marginal use value of any demander, then in order to maximize self-interest, market transactions will either increase or decrease. The resultant changes in market price will eventually render market price identical to every individual’s marginal use value. Innumerable demanders will so act to maximize their self-interest, and the individual demand curves of these people added together will form a market demand curve of that particular good.

The price intersection of this market demand curve and its market supply curve is the market price, also called the equilibrium market price, which equals the marginal use value of every demander. That is, the price intersection of market demand and market supply is not decided by Marshall’s scissor blades. The determination of market price is due to innumerable demanders and suppliers, in maximizing their own transaction interests, making decisions to buy or sell by comparing their own marginal use values with the prices they face, thus causing prices to move up or down. When the marginal use value of every demander is equivalent to the price they face, everyone’s marginal use value is identical, implying the equivalent price is the market price. When this point is reached, the market demand curve happens to intersect with the market supply curve (ignoring production, the market supply curve is upright).

In more than a century, economists have often misunderstood how the market price of a good is determined. The determination of market price is definitely not due to the intersection of the market demand curve and the market supply curve. On the contrary, the intersection of these two curves is due to the individual actions of innumerable demanders and suppliers – numerous selfish people striving to equate their own marginal use values to the market price – thereby facilitating the price intersection of the market demand curve and the market supply curve.

This opposite perspective, proper as it is, also leads us to apprehend the problem of Marshall’s scissor blades in determining market price by the intersection of the market demand and supply curves. This problem hinders us from handling certain significant phenomena caused by the disparity between marginal use value and market price. For instance, before my 1974 article “A Theory of Price Control”, there were no economic theories explaining the different behavior caused by price control.

Let’s put price control aside first, but assume price inexplicably sits lower than market price. According to the traditional scissor blades viewpoint, quantity demanded in the market is more than quantity supplied. The difference between the two is termed shortage. Shortage is different from scarcity: the former refers to quantity demanded being more than quantity supplied; the latter refers to the demand for a certain good rendering its price (or the option required to be forgone) higher than zero. From the viewpoint of scissor blades, since quantity demanded in the market is higher than quantity supplied, disequilibrium exists. Such shortage would pressure price to go up until the equilibrium point of market price is reached. Yet, what is pressure? Without saying that goes quantity demanded is higher than quantity supplied.

Furthermore, both quantity demanded and quantity supplied are merely intended quantities. They are neither visible nor touchable. The so-called “shortage” is only a castle in the air that does not exist in the real world. Abstracts are often necessary as a starting point in theorizing. But since abstracts heighten the level of difficulty in testing hypothesis, they should never be adopted unless absolutely necessary. In inventing this abstract term “shortage”, economics is made more “profound” without any commensurate increase in testable content, so what value does it bring?

Conversely, if price inexplicably sits higher than market price, the traditional theory depicts the emergence of “surplus”. Quantity supplied being more than quantity demanded means disequilibrium, another castle in the air. Here pressure comes again, lowering price until it reaches the market price.

Traditionally, for the sake of making things difficult, economists invented stable and unstable equilibrium. The latter could lead to explosive circumstances – the sky would soon collapse, the bubble-economy concept spreading like fire, even to the extent that if the viewpoint of dynamic economics is not adopted, economics would have no future. These tricks are invented by economists living in ivory tower. Interesting stuff, yet unrelated to the real world. “Ivory tower” means not identifying with real-world phenomena.

I still prefer using simple analysis to tackle complicated real-world phenomena. If price is higher or lower than market price, the marginal use values of market demanders would be lower or higher than price. In order to maximize self-interest, these selfish people would sell, sending prices down, or buy, sending prices up. Market price therefore rises or falls because of mankind’s selfishness, and settles down also because of mankind’s selfishness. Readers should by now understand why I remarked earlier that the law of demand comprises the postulate of “maximization of self-interest”. The law of demand, if appropriately applied, could replace the analysis of constrained maximization, thus saving a lot of trouble. Not only do we have to master the law of demand, the even more difficult part lies in how to turn changes in constraints into changes in price or option forgone. This is the heart of economic explanation.

Back to price control. Simply discussing the common phenomenon of price controlled under market price is sufficient to demonstrate that the traditional scissor blades analysis holds no theory at all. With price controlled under market price, the inexplicable “shortage” appears, disequilibrium comes into existence, and the world turns staggeringly chaotic. The problem is that the competition among people for any kind of good must be resolved. “Disequilibrium” signifies no solution, and implies the non-existence of testable hypotheses. The so-called “pressure” cannot pressure out any hypothesis.

The proper analysis is, with price controlled under market price, demanders, realizing their marginal use values are higher than price and rushing in vain to buy, will be forced to offer non-monetary options as supplements. These supplementary criteria could be by queuing up to buy, by order of seniority, by force, by political means, by connections, etc. Once the adopted criterion, or combination of criteria, is known, we will be able to work out the value of options forgone. Such value, together with the monetary price, will equal the marginal use value. “Shortage” will then disappear and competition resolved, resulting in another form of equilibrium. “Shortage” is only derived from the shortage of thoughts of economists.

The difficulty in analyzing price control lies not in disequilibrium, but in not knowing which non-monetary criteria will be adopted. Once the criteria become clear, “equilibrium” analysis is a piece of cake. My 1974 article “A Theory of Price Control” paves the way to systematically derive which criteria will be adopted. This will be subsequently elaborated.

The Science of Demand (44) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Chapter VII.  The Transaction Theory and Market Demand

Only because of the existence of more than one person in the world, the difficulty level of economic explanation has gone up not even hundreds of times!

To resolve competition among people, our society invented institution. There are different kinds of institutions, and market, being one of them, is the most covered and talked about. From the perspective of today’s new institutional economics, market has traditionally been overemphasized. It is noteworthy that certain non-market institutions have become popular, yet before the rise of the new institutional economics, not much attention was paid to “non-market”. The rise in the 1960s of the new institutional economics was due to the efforts of me and a few teachers and friends. Regrettably, soon afterward, it went astray before degenerating into a big mess. In Volume III I will ruthlessly perform a major house cleaning.

Section 1.  Transaction Being All Participants Maximizing Self-Interest

Transaction reminds me of the two axiomatic paragraphs in “The Wealth of Nation”, published in 1776 by our towering economics originator, Adam Smith. These two paragraphs have been reproduced in Section 4 of Chapter II. Readers ought to study thoroughly.

Compared with no transaction, vastly greater personal gains, often amounting to tens of thousands of times, can be derived from transaction with each participant striving for self-interest. Such gains are mainly due to transactions following individual specialization in production. There may still be gains in transaction without specialization in production, though these would only be negligible by comparison. Since we have neither analyzed production nor introduced the cost concept, the analysis of transaction here is focused on transaction theory without production. We will add specialization in production into transaction for further analysis in Volume II.

It is mainly due to differences in our marginal use values of goods that we all gain in transaction without production. Using apple as an example, the marginal use value of A is $0.8 while that of B is $1.3. If the apple belongs to A and can be sold for more than $0.8, A would be willing to sell. B, however, would be willing to buy for less than $1.3. Assuming transaction is concluded at $1 (exchange value), A gains $0.2 while B gains $0.3 – the latter being B’s consumer surplus. Since transaction is concluded at $1, the marginal use values of A and B are both $1. Otherwise, difference in marginal use values would lead them to keep on bargaining. Given both marginal use values are identical to the $1 market price, there is no further room for bargaining. That is, since market price (exchange value) is $1 and the marginal use values of A and B are both $1, the marginal use value of each consumer equals the market price. The renowned market equilibrium is attained, simultaneously fulfilling the vital Pareto condition. The Pareto condition will be progressively expounded in this book.

In the aforementioned apple example, the “marginal” issue has not been clearly handled. Before moving on to other important elements, let me repeat the above analysis by increasing the quantity of apples to aid readers in fully understanding.

Suppose there are only two individuals, A and B, in the whole market, and the total supply of apples is six. The demand curves of A and B are as follows:

Number of apples	1	2	3	4	5	6
A’s marginal use value	$1.00	$0.90	$0.80	$0.70	$0.60	$0.50
B’s marginal use value	$2.00	$1.60	$1.20	$0.80	$0.40	$0.00

Since in order to maximize self-interest, each individual has to make his marginal use value the same as price, the law of demand can be viewed as reflecting an inverse relationship between marginal use value and quantity demanded – one goes up while the other comes down. The above numbers are randomly assigned. Besides the regularity that the higher the quantity, the lower the marginal use value, there is no other deliberate arrangement.

Assume A owns all six apples. A’s marginal (the sixth one) use value is $0.50; B has no apples, the marginal use value of his first one is $2.00. As such, at higher than $0.50, A would be willing to sell; at lower than $2.00, B would be willing to buy. A’s marginal use value would rise if A sells; B’s marginal use value would fall if B buys. The point at which their marginal use values are identical is $0.80.

This is when A sells four apples – 6, 5, 4, 3; B buys four apples – 1, 2, 3, 4. Under competition (for simplicity, other buyers and sellers are observers who will join only when personal gain is foreseen), the transacted price is $0.80, the same as A’s and B’s marginal use values.

With each striving for self-interest, A gains $0.60: ($0.80 – $0.50) + ($0.80 – $0.60) + ($0.80 – $0.70); B gains $2.40, his consumer’s surplus being: ($2.00 – $0.80) + ($1.60 – $0.80) + ($1.20 – $0.80). When transaction reaches “equilibrium” at a transacted price (market price, i.e., exchange value) of $0.80, B buys four apples, A leaves two for personal consumption, total quantity demanded is six.

From the above straightforward example, we can identify several rather imperative implications:

1. Quantity bought always equals quantity sold, as well as quantity transacted. In the above example, all the three quantities are four. At the price of $0.80, total quantity demanded is two for A and four for B, or six in total. Total quantity supplied is also six (before transaction, all six were owned by A). At equilibrium, quantity demanded (six) is the same as quantity supplied (six), but quantity transacted (four) is not the same as quantity demanded or quantity supplied. Even without any transaction, quantity demanded or quantity supplied could be huge.

2. Ignoring production, in the market, every individual is both a demander and a supplier. Regardless of what I own, if the price is low, I demand; if the price is high, I supply. For instance, being a maniac in collecting Shoushan stones, if their price is low enough, I buy; if their price is high enough, I can sell all of mine to you.

3. At equilibrium, market price equals the marginal use value of every market participant ($0.80 in the above example). Otherwise, assuming no transaction costs (including information cost), market participants will renegotiate a new price, transactions will be increased to benefit both buyers and sellers. If an individual does not act to maximize self-interest, the Pareto condition will be contravened.

Vilfredo Pareto (1848 – 1923) was a top-notch Italian economist. He propounded that in the use of scarce resources and the exchange of goods, a certain condition could be attained where the well-being of one individual could not be improved without hurting another. In other words, if this condition is not met, we can always alter the use of resources or market exchanges so that at least one individual would benefit without hurting another – this is also equivalent to improving the well-being of the society as a whole. This is the most fundamental version of the Pareto condition. With the emergence of transaction costs analysis, the more magnificent and profound this condition has become. The Pareto condition is generally termed the Pareto optimality. Since “optimality” carries subjective connotation, to be in line with scientism, I prefer using “condition”.

4. A and B compete for apples in the above example. Such competition can be resolved by the market: whoever pays a higher price gets the good. When the marginal use value of a good of an individual is higher than its market price, he will buy more of the good; when lower than its market price, he will sell. Whoever buys goods is the winner, while the person who sells is the loser, and both sides benefit. Price, therefore, becomes a criterion in the determination of winners and losers. Alchian said: “What price determines is more important than what determines price.” This is the vision of a guru.

5. The above example also shows that the demand curves of the two competitors both slope downward toward the right. If the demand curve of one of them slopes upward toward the right, treating apples as Giffen goods and contravening the law of demand, no transaction will ever result. This is because the person whose demand curve slopes upward will only keep the apples to himself and never sell. In principle, a person’s demand curve can have a portion sloping upward with another portion sloping downward. However, transaction will only result along the portion of the demand curve that slopes downward. This is the reason why I have twice emphasized earlier that whenever there is competition, Giffen good does not exist.

6. With the existence of transaction costs, the equilibrium where market price equals the marginal use value of every demander may not necessarily be reached. And if a transacting party holds a patent or monopoly over a good, the determination of market price will not be as straightforward as in the example. All this will be subsequently discussed.

The Science of Demand (43) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 6.  Garment Quota Analysis

As earlier said, since we have not discussed production, market structure, etc., the demonstration here of the explanatory power of the law of demand is only precursory instead of flexing all muscles. Yet my November 26, 2003 article, “Quota: No Lessons Drawn from Previous Examples?”, is a very good demonstration of the might of the law of demand. Readers do not have to wait till Volume II to comprehend. The concept of monopoly rent, a wonderful plot that I introduced in that article’s latter part, was also comprehensible. For readers to realize the mightiness of the law of demand, a translation of that article is set out below:

With the signing of the agreement of the World Trade Organization (WTO) two years ago, the quota system for textile and garment imports into the United States has been progressively banned, with quotas for some of them already abolished. Due to the abolition of quotas, imports of three kinds of products into the U.S. rose sharply. This led to the U.S. deciding to re-introduce quotas early next year. China voiced its opposition, claiming the U.S. has violated the WTO agreement. The U.S. insisted there was no violation, erupting a dispute between the two countries. I have no idea which country is right, but whichever is right is not an issue to be explored here.

Often can we find analyses of economists on the effect of quota. They generally follow textbook approach, shifting a few curves to and fro, adding a few changes with reference to legislation, and then compile quantitative analyses using statistical tools like regression. Such analyses are not wrong, but since too much emphasis is put on mathematical equation and import/export figures, the most imperative implication of quota for manufactured goods is overlooked. In other words, the most imperative content is being disregarded. Let me elaborate.

In the 1970s, Hong Kong became the world’s largest exporting “country” of garments (textile products). Why? The reason was since the mid-1960s, the U.S. and other developed countries used quotas to restrain the import of textile products from Hong Kong!

I in those days was in the U.S. and saw that myself. In the 1960s, textile products from Hong Kong, of low quality and cheap prices, were only sold in basements of lower-class shopping outlets. So shady were they that they were displayed together with products of other developing countries. After the imposition of quota restriction, there was a dramatic rise in the quality of Hong Kong garments. Within just a few years, they rose through the ranks from basement to the floor selling top-quality products, with prices rising sharply as well. Many high-class U.S. brands lost grounds as a result or were eliminated. In fact, in the late 1970s, when well-off ladies from Hong Kong flew to the U.S. for shopping at posh shopping centers, the clothes they bought were all made in Hong Kong.

Is this at all surprising? Forty years ago, some states in the U.S. changed the levy of tobacco tax to a per-pack basis. Cigarettes were instantly made longer. And some years ago, the garbage collection agency appointed by a certain district council in Seattle went out of its mind to charge garbage fee on a per-bin basis. Garbage bins in that council were instantly made bigger and stuffed to their fullest possible. Parents asked their kids to jump on garbage to make additional room, resulting in garbage bins too heavy to be lifted!

Quota is valuable. One piece of garment requires one quota for export, so there is no reason why a manufacturer would not improve the quality of garment. This is similar to the U.S. apples and oranges which get imported into Hong Kong. Since the same freight applies irrespective of quality, exporters would definitely choose high-quality ones. Suppose I, without the knowledge of my wife, take a lady like a young Song Meiling out to the Amigo Restaurant for dinner, I would not be so stupid to ask the waiter for a burger.

Suffice it to explain is the same law of demand. The answer that Form 6 students in Hong Kong will be able to provide is, with the inclusion of freight charges, the prices of high-quality apples and lower-quality ones are both increased, but from the perspective of relative price, the price of high-quality apples has gone down. Prices in the law of demand are always relative. By the same token, improving the quality of garment raises its price, yet when the same value of a quota is added onto a piece of high-quality garment and a lower-quality one, the relative price of the high-quality one will go down, therefore the quality of exports shoots up.

Form 6 students who can provide this analysis would get full marks, while post-doctoral fellows would merely get 60, a bare pass, as it is only roughly correct. A more correct, or more thorough analysis, has to interpret “quantity” in a pretty complicated manner. My book, “The Science of Demand”, deals with this issue in Section 5 of Chapter VI.

With quantity restricted by quota, why, then, did Hong Kong become the world’s largest exporting “country” of textile garments? The answer is a combination of two reasons. First, higher quality escalates price, and export is calculated on price. Second, higher-quality garment, being more durable, indirectly reduces the export quantity of other countries.

Another issue arises. In those days, other Asian countries or regions all faced the same quota restrictions, why was it mainly Hong Kong that came out in front? The answer utilizes the same law of demand: only Hong Kong in the whole Asia allowed free-trading of quotas in the market. This freedom of transfer not only permitted quotas to fall into the most efficient or appropriate hands, but also allowed the value of quotas to heighten, which in turn enabled the relative price of Hong Kong’s high-quality garments to drop further. It is believed that there is also a quota-transfer market in the mainland for textile products, but since it is illegal, the market has invented certain transfer schemes to circumvent the rules. This results in increased transaction costs. However, it is generally observed that quota transfer is commonplace in the mainland, its impact on product quality, therefore, should be similar to that of Hong Kong in those days.

Any manufactured product can have different grades of quality. In free-trading international market, different regions will choose to produce goods of such quality level that suit their comparative cost advantage. Manufacturers which make the wrong choice will be eliminated by the market. It is not that Hong Kong manufacturers were unable to produce high-quality, high-grade garment before the introduction of quota, but that they believed, under free international competition, their cost would have been no match for developed countries had they invested in high-grade products.

The introduction of quota has altered the quality-grade rankings in free market. Why was it possible? Before the quota system, garment manufacturers in Hong Kong believed that the cost in producing high-grade garment was too high to succeed. Did such cost drop with the quota system? Certainly not. The answer was: the introduction of quota restricted competition among garment manufacturers, rendering each quota holder a certain degree of monopoly. The value of quota represented monopoly rent, and the existence of this rent allowed the quota holder to increase cost, thereby permitting a dramatic rise in garment quality. With competition among quota holders, equilibrium would be reached when, at each and every margin, the cost increase in improving quality equaled the quota rent. The dramatic increase in garment quality therefore can be viewed from two perspectives: first, the law of demand compels the choice of improving quality; second, quota rent makes room for increase in cost. This is economics.

So ill-advised is protectionism that it is hardly imaginable. In those days, the U.S. and other developed countries, in order to protect their own garment manufacturers, imposed quota restrictions on Hong Kong textile products that were lagging behind with poor quality. Given the protection of quota, Hong Kong manufacturers had on hand considerable quota rent that allowed them room to raise cost and improve product quality, resulting in the downfall of quota advocates. This is called lifting stone to stone one’s own feet.

In recent years, mainland China’s garment industry, joined by many Hong Kong manufacturers, has been producing goods of a wide range of qualities and grades, with no lack of top-grade products. Following China’s accession to the WTO and the abolition of quota, these garment manufacturers have been facing surging competition. Under such circumstances, with the return of quota system driving them to further excel, even the most glamorous suit may be produced. Innocent yet implicated, the famous brands in Europe will see disaster coming!

The Science of Demand (42) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 5.  Multi-Quality Demand Test

Nice demand hypotheses are not all invented by me (a smile). Teacher Alchian invented one which was not only brilliant but important. Unfortunately, a half-step blunder led some people to think that Alchian was comprehensively wrong. I will slightly amend Alchian’s hypothesis here, assert a little supplement, before making some generalizations.

More than forty years ago, teacher Alchian noted that the highest-quality brand of Californian oranges, Sunkist, was mostly exported overseas and rarely found in California. Why are high-quality products exported and less-desired products left behind? After Alchian’s hypothesis had seen the light of day, two professors from the University of Chicago disagreed and wrote to oppose. One of my students, John Umbeck, also joined the written polemics, orange somehow became apple. The often-talked about within the profession is now apple instead of orange.

The Washington State of the United States abounds with apples. There are tens of species, the most popular being Red Delicious, and its market price is the highest, too. However, as clearly observable, high-quality Red Delicious apples are mostly exported overseas, and the local people in the Washington State often have the lower-quality ones or other species. Indeed, in Hong Kong and mainland China these days, almost all the American apples that we find in the market are Red Delicious, whereas other species produced in Washington are seldom found.

In Alchian’s explanation, top-quality apples in the United States were assumed to be selling for $0.2 each, lower-quality $0.1, therefore their relative price was 2 to 1. If the apples were exported to Hong Kong, with freight charge $0.1 a piece, each top-quality apple would be selling for $0.3 in Hong Kong and lower-quality one $0.2, their relative price then became 3 to 2. 2 divided by 1 was 2, 3 divided by 2 was 1.5, 1.5 being less than 2. The conclusion was, when apples were transported to Hong Kong, though the market prices of top-quality and lower-quality ones were both higher than that in the States, in relative terms, top-quality ones were comparatively cheaper (1.5 being less than 2), hence Red Delicious but not others were exported to Hong Kong.

This Alchian’s explanation was fantastic, but in an article published in the early 1970s, two scholars from the University of Chicago (John Gould and Joel Segall) applied the indifference curve in the utility analysis to prove that Alchian’s analysis was wrong. The observation that the Californian oranges and Washington State apples exported were of top quality could not be wrong; on the other hand, the indifference analysis of the two scholars was so logical that no mistake could be found. Their fault in fact lies in their counter-evidences: Boston lobster in its place of origin is the most delicious; vegetables in a farm are tastier than in the city. These two counter-evidences are untenable since lobsters and vegetables are best consumed when fresh. By the time Boston lobsters have arrived at Hong Kong, their flesh would have shrunk by one-third.

I submit that Teacher Alchian’s analysis is not incorrect, though an incorrect perspective was adopted; the analysis of the two scholars was wrong because they wrongly used “quantities” in the y-axis and x-axis of their analytical diagram. All three of them overlooked the point that analysis of top-quality goods and lower-quality ones must start from the perspective of multi-quality. Using number of apples as quantity implies that other important qualities – such as sugar content – are different, analysis can then easily go astray. The sugar content of apple, though not directly priced, has a determining effect on price. If we indirectly work out the price of sugar content, the issue will be clarified.

(In those days, over this issue I pondered long and deep. It was only after several years that I conceived the difference between quantity “in substance” and quantity “by proxy”, and realized the quantity of apples is a combination of “in substance” and “by proxy”. Once sugar content is entrusted to the number of apples, the issue becomes clear. This new concept of “by proxy”, never before published, can now be found in Section 7, Chapter V.)

Since irrespective of the sugar content of an apple, freight charge remains the same, therefore, the higher the sugar content in the apples shipped to Hong Kong, the cheaper the indirect price of each sugar content unit. In explaining why Hong Kong people get to consume top-quality Washington State apples, it was wonderful of Alchian to assert the test condition of freight charges. However, comparing the relative prices of top-quality apples and lower-quality ones in the United States with that in Hong Kong was an incorrect perspective. The correct perspective is, once freight charges have been fixed, the higher the sugar content and other qualities, the sharper is the fall in indirect prices of these qualities in Hong Kong. When consuming top-quality apples or oranges in Hong Kong, we are nonetheless restrained by the law of demand.

Let me make further clarification. Suppose a unit of sugar content has been measured and priced, and this unit price remains constant in the State of Washington (e.g., one unit for $0.05, two units $0.1, three units $0.15), then after the inclusion of a fixed freight charge, with any increase in sugar units, the fall in relative price between different qualities of apples will be sharper. In other words, the mono-quality approach in the indifference-curve analysis of the two scholars from the University of Chicago was wrong. Only is it right in adopting a multi-quality approach. The perspective of Teacher Alchian in those days was in fact not incorrect, yet without separating units of sugar content, the whole picture was blurred.

Suppose a mother wants to send a parcel of winter clothes to her son overseas. If air freight is calculated per parcel but weight, and the size of parcel is prescribed by the post office, then the mother will always pack the parcel as full as possible. Maternal love follows the law of demand, too.

Friends, let’s imagine that you, handsomely dressed, take your new girlfriend out to fine dining. You will not order burgers. As a matter of fact, the restaurateur, knowing that you will not order burgers, never has burger on his menu. This is an implication of the law of demand.

Having bought an upmarket residential block of land with breathtaking views, you will not build on it a plain house. Assuming that you treasure simple and crude, going crazy to eventually build such a house, your building costs will definitely go down the drain: when you come to sell your house, the proceeds you receive will at best be the price of the land. Upper-class residential sites will have upper-class buildings built. This is also implied by the law of demand.

A person whose time is precious who does everything possible to attend a concert will not buy cheap seats. Dining out while holidaying in Paris, the wine ordered by a holidaymaker will be more expensive than that ordered by a local resident. The attendance rate of a student who pays for his tuition fee himself will be higher than that of those students who do not. All this, similar to apples and oranges, exemplifies that behavior is restrained by the law of demand.