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.