The Science of Demand (49) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 3.  Like a Range Like a Peak, from the Front from the Side

In defining public good by the principle of concurrent use and non-interference, the market demand curve is formed by vertically adding different individual demand curves together, i.e., at every quantity, the marginal use values of each demander are added together. However, the concurrent use of a public good might at times lead to congestion, causing inevitable interference. The key point here is: irrespective of how congested it is, as long as the quantity of the public good remains unchanged, it will not because of congestion turn into private good. Congestion will lead to the demand curves of some consumers shifting vertically but not horizontally. That is, individual marginal use value will sometimes shift downward due to interference caused by congestion; individual marginal use value will sometimes shift upward due to liveliness caused by more people participating. Regardless, what a producer of public good considers is market demand instead of individual demand. Since non-payers have to be excluded, exacting payment in the sale of public good is generally harder than that of private good – admission by ticket only is one solution.

Remember, irrespective of how congested it is, whenever consumers of a good increase yet the quantity of the good does not increase, this is a public good. Its market demand curve is formed by adding up vertically the marginal use values of individual consumer. In the belief of visualizing the emperor’s new clothes, some scholars added together horizontally the demand curves of individual consumer to handle congestion of public good. This is absolutely ridiculous – given no change in quantity, adding them together horizontally can never be right. Whenever an increase in consumers of a good leads to an increase in its quantity, this is a private good. Its market demand curve is formed by adding together horizontally individual demand curves, i.e., at every price, the individual quantities demanded of every demander are added together. The distinction is clear – vertical addition for public good; horizontal addition for private good.

Let’s revert to the pianist example and make it more complicated. The performance of a pianist can be viewed as a good. An audience large or small is consuming the same quantity of good, performance is therefore a public good, and admission arrangements are for excluding non-payers. From the viewpoint of selling this public good, its market (a concert hall) demand curve is formed by vertically summing individual demand curves. Assuming the quality of all the seats are identical, fares will be standardized at such a level that, as envisaged by the concert organizer, will generate the highest gate receipts. Under this arrangement with every audience paying the same price, given the marginal use values of different audiences are not necessarily the same, the concert hall may not be filled. If transaction costs are low enough, the concert organizer will adopt price discrimination, making different audiences pay different prices to increase total income. As long as there are enough patrons, the concert hall will be filled. Marginal use values of different consumers will not be the same. This is one difference between public good and private good. And as said earlier, the Pareto condition has to be interpreted differently. In order for the marginal use values of different consumers to reach the same level, the fares for seats of the same quality have to be the same, and there have to be a number of identical concerts so that different consumers can choose to attend different number of concerts. On a separate front, if the qualities of seats are different, different pricing arrangements of the concert organizer are not counted as price discrimination.

Let’s raise the complexity level further. The demand for a piano concert can be considered market demand, yet seats in a concert hall are not public goods: unless you are a beauty, you cannot sit on my lap when I am occupying a seat. From the perspective of seats, for a single concert, the demand for seats is also market demand, yet its demand curve is formed by summing horizontally individual demand, i.e., at every price, the number of seats are added together. For seats of identical quality with the same fare, in order to attain the state that the marginal use values of individual consumer are the same, unless by coincidence, different consumers have to purchase different quantity of tickets: some buying three tickets with only one person sitting in the middle. A bit weird? Certainly. And for seats of different qualities with different fares, one person buying one ticket for one seat will pull the marginal use values of different consumers closer.

The main point here is: attending a piano concert is from one perspective a public good, but a private good from another. The market demand curve for the former is constructed by summing individual demands vertically, while summing individual demands horizontally for the latter. It is the kind of behavior or phenomenon to be explained that determines which addition is applicable.

The following is a well-known example. A train was nearly fully-occupied with only one empty seat left. The marginal cost for carrying one extra passenger was close to zero. Train tickets had to be bought beforehand, making it difficult for price discrimination; close-to-zero ticket price will cause the train operator to suffer huge losses. Yet non-loss-making ticket price would far exceed the close-to-zero marginal cost, contravening the traditional Pareto condition. Certain gurus therefore proclaimed: if the government did not control ticket prices, this industry had to be operated by the government. It has been said that this was the reason why today the so-called public utilities (water, electricity, gas, etc.) are typically intervened by governments. Was that a reason, or an excuse?

Readers have to note that, turning from the demand for a concert to the demand for individual seats in a concert hall, or from the demand for a train to the demand for its individual seats, we are turning from public good to private good, with market demand curve turning from vertical addition to horizontal addition. Of interest is, turning from concurrent use to private use, the marginal supply cost for individual demander drops very sharply – in the train example marginal cost was close to zero. Continuous decline of marginal cost is a popular topic in natural monopoly, which I will put aside for the time being. While still on the concept of public good, I will hereby clarify a few tricks.

As for public good, I have to remind readers once again what I said earlier in Chapter V about the law of demand: “What is price? What is quantity? Which price does the demand curve refer to? Which quantity? Is quantity in substance or by proxy? These questions are inevitable.” From the discussions on public good and private good, we know that for the consumption of the same product or service, it can be a public good from one perspective, a private good from another: different are quantities and prices for these two kinds of goods, as well as the approaches adopted. Why does the market use that price and that quantity? To which price and which quantity does the law of demand refer? Clarifying these issues is essential in explaining behavior.

Allow me to add some variation. Strictly speaking, almost all goods bear the nature of both public good and private good. For instance, appreciating the beauty of a diamond is concurrent use while wearing a diamond is private use. As such, transaction of a diamond is a kind of tie-in sale. Generally, the market is more inclined to determine price and quantity based on the nature of private use due to its relative ease in excluding non-payers, unlike the case of a piano concert that requires a gate attendant to check tickets. That is, using carat as quantity to price a diamond, the value of concurrent appreciation has already been included in the price. There are also other instances where, due of the existence of the nature of public good, valuable product or service becomes difficult to measure, or non-payers cannot be excluded, no market transaction results. Similarly, an apple can be eaten (private use) or viewed (public use). The key point here is: other than the two aforementioned “exclusion” or “tie-in” approaches to assist in exacting payments, the law of demand in respect of private good implicitly embodies the goods and bads of public good, and the concurrent-use quality and quantity are assumed constant.

Let’s do a quick test. Strolling along the street is a pretty woman dressing up like a fairy. Turning everyone’s head, this is enjoyment of a public good. Without exacting any payment, why does this beauty spend so much money and time dressing up? The key point is: the purpose of a lady dressing up dazzlingly is for tying public good onto herself so as to promote her own identity, similar to a diamond having a sparkling luster becomes more valuable.

Let’s add another key point: traditionally, market demand curve is generally formed by summing individual demand curves horizontally. This treatment of private good, adopted not due to the scarcity of the nature of public good but rather due to the existence of “exclusion” costs, explains why the market prefers pricing according to the quantity of private good. In other words, economists happen to be right without knowing why!

Volume I, “The Science of Demand”, is coming to an end. If readers are still following the footsteps of this old timer, then the better you have become in this game of economic explanation. In Volume II, “The Behavior of Supply”, though the law of demand will be often applied, it will not be often mentioned. It is time to turn to imperative concepts like “cost”, “rent”, etc. I will lead readers through a novel universe.

The Science of Demand (48) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 2.  Guru’s Views Questionable

The dispute over public goods was started off by the lighthouse example propounded by John Stuart Mill in 1848. Subsequently, the masters who had participated included Henry Sidgwick (1883), Erik Robert Lindahl (1919), Arthur Cecil Pigou (1938), Paul Samuelson (1953), etc. Mill’s example stated that lighthouse that guided ships passing by had problem in exacting payment, since ships, after following the direction of a lighthouse to avoid reefs at night, could easily escape in the dark. He therefore considered that private lighthouses could not be profitable but required governmental assistance to levy charges. The opinions of Sidgwick and Pigou that followed were that lighthouses should be built by the government and provided free to ships.

Lindahl did not analyze lighthouses, but used the example of public security to first introduce the concept of public goods, saying that market demand equaled summing individual demand curves vertically. Public security is in fact not a good example of public goods, yet “summing vertically” was widely celebrated as soon as it had been proposed. The reason why public security is not a good example of public goods is apparent in Hong Kong soon after World War II. In those days, the public security services provided by the government were insufficient to maintain public order, hence my father’s shop and several shops nearby jointly hired some escort services, also a kind of public security. However, for those shops that did not pay, the hired security guards offered them no protection when robberies broke out. Similarly, in Guangzhou back in 1947, the rich generally subsidized security personnel provided by the government, resulting in the poor having no protection. Public security services therefore became the private good of the rich.

The primary persona in the dispute of public goods was again Samuelson. This twentieth century’s talented theorist agreed with Mill’s view that it was difficult for privately-run lighthouses to exact payment. Yet he added a crucial point: even if it were easy for lighthouses to levy charges, they should not do so. This surprising twist made the whole economics profession turn like a carousel. Samuelson’s argument was that after a lighthouse had been built, the cost of servicing one extra ship was zero – marginal cost equaled zero. Under such circumstances, levying charges would cause some ships to detour. Since marginal cost was zero, such “detour” would harm the society, not charging would therefore be preferred. When Samuelson subsequently received his Nobel Prize, his article containing this argument was referenced.

Public good refers to a good that can be concurrently used, therefore when it is supplied to one extra person, its marginal cost must be zero. If no fee should be charged when marginal cost is zero, then when marginal cost approaches zero, maybe no fee should be charged, either. The analysis then follows is, if fee charged is less than average cost, operations run privately must incur a loss (this is correct), and if fee charged equals or is higher than average cost, then fee charged will be higher than marginal cost (average cost will fall because of increased production, which is correct, too). Since it would harm the society if fee charged is higher than marginal cost, the preferred option is therefore no levy at all or subsidization by the government coupled with price control. This is already a commonplace.

The main point here is: as far as charging is concerned, there are two contradictory views on public good. One is adopting price discrimination to charge to the utmost in order to attain the Pareto condition. The other one is since the marginal cost in servicing one extra customer is zero, no fee should be charged whatsoever. This interesting value judgment, though incapable of explaining market phenomenon, can nevertheless explain the behavior of certain politicians and economists.

According to Samuelson’s argument, if there are no traffic jams, Hong Kong’s cross-harbor tunnel should not levy any toll – the marginal cost of servicing one extra vehicle is close to zero. But if no toll is to be levied, who would build it? The answer is of course the government. Agree or not? Industries having a characteristic of the higher the quantity demanded, the lower the average cost, e.g., electricity, gas, telephone, etc., should all be run by the government, or at least have their fee-charging basis controlled by the government. All this is also a commonplace. The nonsense of economists encountering a government with a propensity for power is similar to a fish finding water, resulting in today’s so-called public utilities typically controlled by the government. The key point here is: for an industry having a characteristic of the higher the production, the lower the average cost, it must have in certain aspect the nature of public good.

A could-not-be-more-superficial error about public good has to be clarified: Samuelson said that no fee should be charged when the marginal cost to service one extra customer is zero, and the service should be provided by the government. Just using an example of a pianist is sufficient.

A pianist charges via his manager for performing in a concert hall. Such a charge is the income of the performer for practicing hard every day. The music that he plays is a public good. Should the government pass new legislation saying that pianists should be nurtured by the government?

Undoubtedly, public goods can be privately produced. Also without a doubt is that for every product or service that has or partly has the nature of public good, the marginal use value of every customer may not be the same. However, it is not exclusive to public good that marginal use values are different for different people. When eating apple, you prefer eating to the core while I would throw it away after a few bites – the marginal use values toward apple between yours and mine are different. Should the government intervene?

Let’s get back to Samuelson. His renowned “Economics” textbook, sold extremely well all over the world, made him a fortune. Each textbook was a private good, yet Samuelson’s thinking in the book was a public good. He tied his thinking (public good) with each textbook (private good) for sale – a kind of tie-in sales – and made himself a fortune, then won the Nobel Economics Prize by opposing to public goods being produced privately. A genius he truly was (a smile).

The crucial point here is: tying public good with private good for sale is a good way to exclude non-payers from enjoyment. Transaction costs can be reduced.

The Science of Demand (47) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Chapter VIII.  The Economic Analysis of Public Goods

The analysis of public goods, having a long-lasting history, has always been considered by economists a big conundrum. More than forty years ago, several teachers and friends said that I was the best candidate to crack this open, yet it is far easier said than done. At 4 a.m., April 15, 2010, for some reason I could not get to sleep. Sitting down at my desk, I wrote down the key attributes of public goods that had been hovering in my mind over the years, arbitrarily adding a little more. To my pleasant surprise, that amounted to a comprehensive analysis. On top of clarifying traditional analysis, eleven points of interest were added. As a Chinese proverb says: nowhere was the target found after searching far and wide, yet with no sweat it may come to you.

Section 1.  The Nature of Public Goods

We said in Section 2, Chapter VII that there are two categories of goods: private goods and public goods. The term public goods was invented by Samuelson; it was a misleading term that misled later generations, causing its Chinese translation to carry the meaning of “common goods” which heaped error on error.

Let’s use apple as an example. Apple is a private good. If the price of an apple is $1, and my quantity demanded is two while yours is three, then at the price of $1, the quantity demanded including yours and mine is five. The market demand curve is formed, at every price, by adding up horizontally toward the right individual quantities demanded. This is the market demand for private good.

Suppose the good is a television program that you watch at home, and I watch the same program at home, too. Since you watch yours and I watch mine without any cross-interference, that television program is therefore a public good. The nature of private good is exclusive use, while the nature of public good is concurrent use. There are neither too many nor too few public goods. In addition to television program, other examples include a thought, an invention, Mozart’s music (not referring to a music album but to the music itself), the content of my “Economic Explanation” (not referring to a book but to the content of the book), etc.

More than twenty years ago, an economist published an article in a Hong Kong newspaper, citing public toilet as an example of public good. That was wrong. Public toilet, built by the government and provided free to the public, is undeniably of public use. However, since public toilet cannot be used concurrently, it is thus a private good. The beach can be “publicly used” but not “concurrently used” – while I am lying down for a sunbath, I would not let you lie on top of me. Private goods can be publicly owned, and public goods can be privately owned – these cannot be confused.

The market demand curve of a public good is formed by adding up vertically the individual demand curves of each demander: at every quantity, the marginal use values of each demander are added together. This leads to an interesting question: for a television program, I am willing to pay $2 to watch while you are willing to pay $3. The total of our individual marginal use values is $5. If the television station (cable television) charges $2, its total income is $4; if the charge is $3, you will watch while I will not, total income is only $3. In order to increase total income to the level of total marginal use values for boosting production, the television station has to adopt price discrimination: charging me $2 and $3 for you. However, the cost in adopting price discrimination is exceptionally high: it is not easy for the television station to know the marginal use values of yours and mine. Without price discrimination, the production of television programs will have to be less than optimal. That is, in respect of public good, unless every demander is born equal, or else charging one single price will not attain the Pareto condition. This is an old view of the Pareto condition. A new view includes transaction costs which I will defer till later to discuss. (Free-to-air television charges indirectly: our time value in watching television advertisement is cost, or price in disguise.)

The above analysis has three main points. First, since public good allows concurrent use and exacting payment requires the exclusion of non-payers, public good is more difficult to exact payment. In the case of private good, only exclusive use is allowed. Therefore, with exclusion already in place, exacting payment for private good is certainly easier. Second, when transaction costs or costs in exacting payment are low enough, price discrimination will be adopted in the production and sales of public goods. Third, for the same public good, the marginal use values of different consumers are different.

The Science of Demand (46) - Unofficial Translation of Steven Cheung's 经济解释 - 科学说需求

Section 3.  Constraints in Transactions

We have repeatedly touched upon constraints when we analyzed the issue of demand. But constraints in demand are different from constraints in transactions. We may wish to think in terms of Crusoe’s one-man economy first when analyzing transactions. Crusoe’s economy had demands, had constraints, but could not have transactions. Constraints in transactions only exist in a society.

From the viewpoint of rights delineation, property rights do not exist in a one-man economy. Property right is a constraint set up for society. From the viewpoint of costs, transaction costs do not exist in a one-man economy, therefore such costs only exist because society exists. The definition of society is the existence of more than one person. In Volume III, I will give transaction costs a broader definition termed institution costs, which refers to all the costs that exist only in a society. Even without market transactions, institution costs, which are non-existent in a one-man economy, still exist in a society. Also in Volume III, I will explain institutional costs (including the costs of market transactions) which can be viewed as costs in restraining competition among people. These concepts come from the thirty years of my following China’s development. I will go into the details later.

The paradigm of the new institutional economics includes the relationship between property rights and transaction costs, and the impact of their constraints on institutional arrangements and human behavior. I was fortunate enough to be around when the new institutional economics was incubated, and started participating in its cultivation as a graduate. Counting back, I have been pondering unrelentingly over this field for forty-eight years. Unfortunately, in the past thirty years, the road I have chosen diverges from my teachers’ and friends’. Some of them have turned to developing the game theory; some have chosen to approach from non-observable viewpoints resembling the game theory’s shirking, threatening or opportunism. In fact, “shirking” was first advocated by me in 1969. Soon afterward, realizing that such jargon implied non-observable behavior with which no testable hypotheses could be generated, I therefore abandoned such a viewpoint. Some colleagues say it was the “shirking” I advocated that led to the revival of the game theory. If so, undesirable influence that is, regrettably.

The significance of property rights and transaction costs is evident. Imagining in a one-man economy, we will not have banks, lawyers, nor police, civil servants, councilors, clerks, accountants, brokers, merchants … these professions emerged all because of the existence of transaction costs in a society. The reason for my focus on applying changes in these cost constraints to explain behavior is not only due to these costs are common, but also changes in these constraints are real and in principle observable. They are neither easy to measure nor easy to handle, but these can be accomplished both in principle and in practice.

Thus far, economic explanation is centered on two major topics: resource (factors of production) allocation and income distribution, while a blind eye is turned to far more amazing phenomena. The latter include the establishment of institutions, the organization of structures, the choice of contracts, pricing arrangements, etc. These phenomena are brought about by the existence of transaction or institutional costs. Continuing disregard of these phenomena amounts to a crucial missing link in economics, resulting in economists providing merely rudimentary explanation on resource allocation and income distribution.

Let’s revert to the aforementioned. The equilibrium point (i.e., when the marginal use value of every demander for a particular good equals its market price) may display myriad changes given the existence of transaction costs. A major difficulty is we cannot assume no transaction costs in this perfect market – even though most economists say so. The problem is, market itself is an institution, and institution arises due to the existence of transaction costs. If transaction costs equal zero, why would market exist?

One thing is certain – market exists to reduce certain transaction or institutional costs. But what exactly are these reduced costs? A big conundrum indeed. We will defer its exploration until Volume III.

The Coase theorem, having a profound influence on me, suffers the same problem. In a nutshell, this theorem says if there are no private property rights, there will be no market transactions. This viewpoint is correct. However, Coase in his monumental work added another condition: transaction costs equal zero. This is problematic. Private property rights is a system arising due to the existence of transaction costs. If there are no transaction costs, why would the system of property rights come into existence? The Coase theorem is inconsistent in its constraint assumption and contradictory in its logic. This will also be subsequently expounded.