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.