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.
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