Is economics a social science or business subject?

    Is economics a subject in social science? Without doubts, it is. But what's its role in social sciences? Meanwhile, is economics a business subject? It appears that economics must contain something more than business. There are economics not in the business area, such as the economics that studies poverty problems, labour relations, etc. 

   However, in universities, economics department may also belong to a business school while books in "business and economics" are often classified as one type, and are not associated with books in other social sciences, like psychology, sociology, geography, etc. These are signs showing that economics is a business subject.

   This question has troubled me for a long time as I am often asked by students about this. I originally thought that students were ignorant about the true nature of economics. So, what I need is to educate them. One day, or when they have studied economics for a longer period, they will understand. However, day after day, the same question repeats. It won't be eliminated. I now think that the issue is not so simple. 

   Let's start with some facts first. Basically most top universities in the world have economics in the faculty of social sciences (some in faculty/college of arts and sciences/social sciences), not in their business school (or faculty). If economics is in their business school, it is normally a smaller unit than the department in the faculty of social sciences. Thus, economics may be in both social science faculty and business school but, if it is in only one school or faculty, it will be in the social science faculty. 

   Thus, it appears clearly that economics is obviously a social science subject. Economics contains some business elements but it is only about certain overlapping areas (so they are handled as a unit in business school). 

   Of course, what I said is only about the situation in most top universities. What happens to most need not happen to some other universities. 

   I exactly teach in an environment where the above situation is not true. In Hong Kong, most universities have their economics department only in business schools (or faculties). The faculty of social sciences will not normally have economics in it. 

   Yet, my own university has economics in social science faculty. But my university's arrangement is an exceptional case instead of the norm in Hong Kong, exactly reversing what happens elsewhere. It is hard to say if it is good or bad for my university to embrace the "world" practice instead of the local practice. Many local students actually wonder why economics is not in business school and keep asking me why.  

   But so what? If the case in Hong Kong is an exception instead of the norm, the problem is simply that students don't understand or other people in Hong Kong don't understand. It is not deserving further discussions.       

   Well, things are not that simple. If there is misunderstanding, it is not limited to Hong Kong, and to students, but everywhere and someone else. As mentioned above, books in "business and economics" are often classified as one type. You can easily find that this is the common practice in bookstores. 

   Yes, perhaps bookstores are too casual in classification matters. Then, let's see how De Gruyter Brill, a famous academic book publisher, classifies their books. Again, business and economics is one type. In fact, I have also written a blog post in the past, grumbling how "economics books" are often used to refer simply to business books.  

   Hence, it appears that what happens in universities can only demonstrate how academic scholars treat economics. They treat economics as a social science subject. The common people may not have this impression. 

   Perhaps we should consider the academics are right and common people are wrong. Economics is a social science subject, not simply a business subject. That's of course what I believe to be true for long. But let me start with another story first. 

   For long, I have been told that economics is the "queen of social sciences". I was told this when I was enrolled by an economics undergraduate programme as a freshman. The slogan was printed in T-shirts and was used by tutors to introduce the subject. We were all very proud of having the opportunity to study economics as the "queen". 

   After many years, I have become an economist and have an opportunity to attend a talk given by a sociologist. To my surprise, and it is the first time I hear this, the sociologist said sociology is the "queen of social sciences"! Of course, I wouldn't question this sociologist in the talk. But I learn that what we (economists) consider to be obviously true may not be so, from other perspectives. 

   If you search the information source of the slogan, you will find that Paul A. Samuelson (1915-2009), a prominent economist, is considered to be the first to coin economics with "queen of social sciences". Well, Auguste Comte (1798-1857), the father of sociology, has crowned sociology with "queen of social sciences" much long time ago. 

   So, you can see: it is economists who say economics is the queen, and it is sociologists who say sociology is the queen. If we (economists) don't recognize sociologists' claim, why should they recognize our claim? 

   From this story, let's think deeper. While economists consider economics as a subject in social sciences (and the queen), will other social scientists also think so? Yes, most universities have economics in the faculty of social sciences. But this may not be a good evidence to demonstrate the claim: it may be that administratively it is the most convenient choice to place economics in social science faculty. Yet, what we are looking for is not the administrative classification, but the essence. 

   If we look at the essence, let's ask a question: is economics closer to other social sciences, or is sociology closer to other social sciences? I think it is easy for you to answer this question if you have ever taken some non-economics social science courses, offered by geography, political science, psychology, journalism, etc. The answer: sociology is closer to them. 

   It is obvious that economics uses markedly different methods in studying the same object - society. It uses mathematical methods, rational choice model, methodological individualism, etc. Most other social sciences don't use these methods. In contrast, sociology's concepts like identity, socialization, etc. are widely used in other social sciences, except in economics. 

   If we assess people's behaviours in bookstores, the situation is crystally clear: people reading "social sciences" books are normally not those who would read economics books; people reading economics books may often also read business books; people reading psychology books may often also read sociology, politics books, etc. 

   As mentioned above, economics also studies some non-business areas, such as poverty problem, labour relations, etc. Business studies are not concerned with these areas but economics will be. Hence, economics is not business, we claim above. 

   But let's suppose there is a sociologist or a non-economic social scientist. For some reason, this person studies economics related to the above areas. As a sociologist (etc.), this person should have studied these problems (from sociology perspective) already. Now, he or she also studies how economics studies these areas. What he or she will find? Will he or she find that economics does the same as sociology (etc.) does? Of course not. But what would be the difference? 

   In fact, I guess he or she will think that the economics of these areas may simply be a businessmen's perspective on these areas. For example, a businessmen will emphasize cost-effectiveness in tackling poverty problem, etc. This is also what economics' approach to such a problem. 

   As an economist, will I agree with such a sociologist for this assessment? My answer is mix. 

   On one hand, I of course won't be so naive in equalizing economists' and businessmen's perspectives. On the other hand, the two perspectives are also closer to each other: economists' and businessmen's perspectives are closer while economists' (or businessmen's) perspective is not so close to sociologists' perspective. 

   Yes, economists are not like businessmen, who emphasizes a simpler criterion like cost-effectiveness. Economics has its own criterion, like efficiency. Yet, from sociologists' viewpoint, the criteria may not be so different. Efficiency, perhaps to them, is just another type of cost-effectiveness. 

   As an economist, I can defend further for economics' position. But one thing is clear: there is no other social science like economics that emphasizes so much on efficiency. When economists study equity, one major focus is that how equity may impact efficiency and so a trade-off between them must be considered. The result is, of course, in economics, equity can't be achieved to a very high degree (as if efficiency is not impacted). Yet, that's exactly what other social sciences may not agree as they don't place a high weight on efficiency (if they have ever had any concerns on efficiency). 

   Here, I won't try to defend economics' position. I simply point out the difference. In fact, economics and other social sciences do have a big difference. 

The danger of reading economics books (2)

   I have written a post on reading economics books. The main point of that post is that many books said to be about economics is not actually about economics. It is simply about business. These books may be about the economy, but not about economics. Economics is a scientific study with its own methods but studying the economy or economic behaviours may use various types of other methods. Sociologists or psychologists can also study them, without using economics. Thus, if students want to read some books to understand more about economics, many books may not suit them. In conclusion, I suggest students, if they truly want to understand economics, should read books written by economics teachers at the economics department in universities. 

   In the present post, I want to discuss another problem of reading economics books. Again I assume the readers, especially students, want to read some books to understand economics. Again I find certain books are not suitable for reading with this purpose in mind. 

   What are these books? In fact, in the past few years, certain very motivated students told me that they were reading some classics in economics, like Adam Smith's The Wealth of Nations and J.M. Keynes' The General Theory of Employment, Interests and Income. Some even read Fredrick Hayek's The Road to Selfdom, etc. 

   Without doubts, these are books written by economists. My original principle used to discourage students to read them can't work in the present case. I can't say they aren't books written by economists such that economics students needn't read them. 

   The point is, however, that reading these books will not help them to learn economics as they would learn in economics department in university, or even in high school. Reading them may even be counter-productive. 

   The point is that modern economics as taught in schools today is no longer the same as classical economics, like Adam Smith's economics, while Hayek's economic thinking is important but the book cited above is closer to a social and political philosophy book than an economics book (Hayek has other books that are certainly economics books). 

   Meanwhile, Keynes' economics is the origin of modern macroeconomics, and his economics is still taught, at least mentioned, in economics class in universities and high schools. Why should students not read them? The point is: unless you want to become a specialist in studying Keynes' thoughts, it is better to learn his economics by reading the assigned readings, normally just a textbook chapter. Reading Keynes on your own is counter-productive in learning Keynes' economics. 

   Why counter-productive? The point is: Keynes as an original writer uses his own jargons. Some (or even most) of them have now not been used anymore. Reading Keynes' own works require you to learn many new jargons created by him. This is labourious. Why don't you simply read the textbooks that use your familiar jargons to learn the same things? More importantly, when we learn a theory in economics, from Keynes or from others, we have to understand its position in modern economics as used by economists today. If a theory is considered to important, it will be integrated into the whole framework of modern economics. If you read Keynes' book, you can only learn the theory on a standalone basis. You don't know how it is used or integrated into a broader theory. 

   So, yes, you can read Keynes. But you will find it is a labourious job and it is extremely not cost-effective to get useful messages from the book. You will be confused and frustrated. You may even lose interests in economics by reading books not suitable for your purpose. Of course, you may not have all these problems above. But, to avoid this risk, I won't recommend economics learners to read these classics. 

   Perhaps you still have suspicions. You don't think that's the right way to study a subject seriously. Reading textbooks is okay if you are not serious enough in a subject. But if you are serious enough, you think you must read some classics. That's your experience in studying other subjects, such as philosophy, sociology, etc. 

   Then, why can't we study economics in the same way? I would say: it all depends on the nature of the subject. 

   If a subject emphasizes formal models or theories, reading the original works (papers or books) may not be necessary. The situation is same as that in physics. You don't need to read Newton's, not even Einstein's original writing. I doubt how many physics students can understand Newton's original writing today. The language and jargons used by him are so different from today's scientific terminologies. It will be extremely counter-productive to read Newton. It is good enough to read textbook to understand Newton's theory. 

   Of course, if you want to study Newton's thoughts, not his physics theory, you should still read his original writing. But that's not what normal physics students are supposed to do. 

   The situation is similar for Einstein's original writing except that it is perhaps easier for undergraduates of modern physics to read Einstein's than Newton's original writing (at least Einstein uses more modern terminologies). 

   The point is: economics as a modern social science emphasizes formal models or theories. It can't do as good as physics but it does take the same route. How important a theory is depends crucially on how far it can be expressed as formal models. If it can't be expressed as a formal model, it is only an idea, which may be good or bad. But a mere idea can't be taken as a part of the whole scientific body of the subject, at least not now, at least not before it is formalized. 

   Hence, if what we want is to learn modern economics as a science subject, our foremost task is to understand its formal models, not how it was introduced in the original classics. 

   I want to emphasize that I haven't undermined the value of studying economics thoughts. It is a valuable subject and I personally also like it. My point is: studying economics thoughts and studying modern economics as a science subject are two different things and require different types of readings. 

   At this point, you may wonder: if reading classics is not an effective way to learn economics, what is the appropriate reading? 

   In fact, the answer is extremely straightforward, though not highbrow: read economics textbooks, good textbooks. Journal papers are sometimes also useful but often not suitable as they may be too difficult or mathematical. A good textbook often presents the models from papers in a much more concise and user-friendly way. That's often sufficient unless you want to deepen your understanding and go beyond the points as presented in textbooks already. 

   Hence, my answer is textbooks, or textbook chapters. If you can appreciate the joy of reading textbooks, compare different textbooks, think seriously about points raised from them, you have already done very well. You don't need to try the classics. 

   Of course, what I said is for motivated students or learners only. As far as I know, nowadays, many economics students don't even read textbooks.      

Shops shut down but rents still stand firm?

   Since last year, we have more and more bad news in the business sector. Various famous or long-standing shops shut down, triggering more and more worries about the local economy. One notable voice associated with these closures is that landlords refused to revise down the rents for shop spaces in spite of the worsening market situation. As such, these retail operators, given declining revenue, were forced to shut down their businesses. 

   Do all these make sense in economics? At its surface, there is nothing wrong. The original retailers facing a declining business of course want lower rents, which is the only way for them to rescue their businesses. But the landlords do not need to share these retailers' concerns. The shop spaces they owned can be rented to any other retailers. If the original retailers can't secure sufficient businesses to pay a high rent, perhaps others can. There is no reason to revise the rents down unless all other retailers also can't pay a high rent. But then let's wait and see. If these landlords can't rent out their shop spaces for a long period of time, they will eventually revise the rents down. 

   Hence, everything appear to make sense. But things are not that simple. The process of adjusting rents down is said to be too slow. What we can observe in the market is that rents do adjust down. But some people believe that existing adjustments can't reflect the fundamentals. Vacancy rate in the retail shops is high enough for a sufficiently long period of time. If landlords simply want to wait and see, they do really wait too long. Their belated response can't be justified by information lag. These are some viewpoints aired in the market. 

   Should we take this viewpoint seriously? Should we say adjustments are too slow? In a way, this is a subjective judgment. There is no reliable criterion for us to judge if the market adjusts too slowly or appropriately.

   Someone says the retail sale data has declined much faster than rents. This is an indication that rents decline too slowly. Nonetheless, retail sale and rent can't be compared so directly. In fact, when retail sale increases, normally rent also won't increase as fast. Of course, rent may decline much much slower than retail sale. When the degrees of change differ very much for the two variables, up to a point we tend to think there is something wrong. But how much slower is too slow? There is still a subjective judgment involved. For economists, normally they won't make such kind of subjective judgments. Furthermore, they normally will (perhaps blindly) believe in market efficiency. They won't blame the market as adjusting too slowly. 

   But anyway, market players are sufficiently serious about this judgment. Some of them actually raised a hypothesis to explain why the adjustment is slow. 

   Here is how this hypothesis says. 

   Many landlords did not self-finance their purchases of their retail properties. Instead, they borrowed money from banks to finance their purchases. Banks made loans based on their valuations of the properties. For example, for a property valued at $10 million, a bank may lend 50% of the value, or $5 million, to the landlord. However, if the property value fell (as what happened these years), say, to be close to or lower than $5 million, the bank will require the borrower to return the money immediately. The landlord may need to sell the property immediately to cope with the bank's demand. The landlord may think the property value can recover to $6 to $7 million in a year but the bank's call disables the landlord to wait and avoid the value loss.

   The story, as told, is this. Since these landlords want to gamble on market recovery, they don't want banks to immediately call back the loans made to them. To facilitate this, they would rather leave their properties vacant instead of leasing them at a lower rent. This is because banks' valuations on properties are based on rental income generated from properties. 

   For example, if a property's rental income is $5 million, and a bank believes that a reasonable rental return is 5%, then it will value the property at $100 million ($5 million/5%). If the property is now rented at a much lower level, say, $3.5 million, the bank will value it at $70 million ($3.5 million/5%). 

   Fearing that bank's valuation is sharply revised down, the landlord may leave the property vacant. Doing so, the bank will not have sufficient data to assess the rental income and may wait for a while until more data can be collected. As such, the landlord may be able to buy time for market recovery. Nonetheless, when many landlords do this, the market adjustment in rents will be slow. 

   This hypothesis has been aired in the market for some time. I have encountered it at least twice in some talk shows. In one time, it has been mentioned by a property agent (called Agent A) specializing in retail properties. In another time, even an economist mentioned it while in the same occasion another property agent (called Agent B) not specializing in retail properties didn't believe in this hypothesis, saying that bankers wouldn't be so stupid. 

   Interestingly, in this second occasion, the economist's viewpoint looks more like a property agent while the property agent's looks more like an economist's. 

   Now, turn to my original question: Does all these make sense in economics? In particular, does the hypothesis of bank valuation make sense? 

   As mentioned before, economists have a tendency to believe in market efficiency. If so, they should tend to reject the above hypothesis (like Agent B above). Why? The point is exactly that we don't have an objective method to judge if the market adjusts too slowly or not. Without such a method, economists tend to simply take what happens in the market as what is most appropriate. Thus, if the market adjusts slowly, that should also be the best adjustment speed. The market is efficient. 

   As an economist, do I take this view? Honestly, I don't. I think taking what happens in the market as best is simply a lazy way of thinking. Also, it is not meaningful to take this line. It tells us basically nothing about the market, except that it places a colourful word "best" on it. 

   As an economist, we should be more interested in understanding how the market works and how could we change its direction (so that it comes closer to our wanted situation). From this perspective, the naive market efficiency doctrine as described above is not a useful and good doctrine to be followed. Though some economists embrace it, not all will. 

   In this sense, Agent B above thinks more in line with this naive efficiency doctrine. He can't believe market players, notably bankers, are so stupid. So, the slow adjustment can only be interpreted as these market players truly can't discover the real market situation and therefore adjust slowly. In a sense, Agent B thinks like an amateur economist. But I don't think his belief (say, bankers can't be so stupid) is truly substantiated. He simply believes in the market.

   In this sense, the economist mentioned above, believing in the hypothesis, is at least not so naive. He is not like an amateur economist who says what happens in the market must be the best. At least he has tried to uncover a mechanism that can explain why adjustments would be slow. Though the hypothesis may be wrong, it is at least a description about how things work. 

   So, do all these make sense? My point is twofold. For one thing, I don't think blindly believing in the market is a sensible attitude. Under this attitude, everything makes sense. But it is not sensible to believe that everything makes sense. What we need is a hypothesis that has potentials to explain what happens. 

   Then, eventually we have to assess if the hypothesis about banks make sense. 

   As mentioned above, I heard the hypothesis twice and the first occasion involves also a property agent, Agent A. Unlike Agent B, Agent A specializes in retail properties. Agent B doesn't specialize in retail properties while Agent A does. Thus, it is more reasonable to expect Agent A knows more about retail property owners' concerns than Agent B. Then, if Agent A raised the hypothesis above, it is less likely that the hypothesis is completely artificial. Perhaps he misunderstood some details. But he has no reason to fabricate the entire story. 

   So, what appears to be true is that landlords do have a concern that lowering rents fast will fasten bankers' downward adjustments in valuation, which eventually triggers loan recalls. The tricky point is: Why bankers also wait together with the landlords when rents stand firm but vacancies increase? Why bankers didn't take the initiative to re-value these retail properties, and took quicker actions to recall loans? 

   In fact, I think a banker will take fast actions if they observe other bankers also do so. If a banker calls back a loan from a borrower, the borrower will have a smaller capital and this makes it less able to return the money to other bankers who have also lent money to the same client. To avoid this, a banker would want to be the first one to call loans instead of the second. In such a situation, bankers have pressure to take fast actions. 

   However, bankers do not have such a pressure at the moment. There is no such a wave of calling loans at the moment. If you move, then I will move. But you don't move, and so I don't need to move. This is what happens at the moment. Hence, what we need to explain is why no one moves at the moment. Why do bankers not take the initiative to re-value properties and call back the loans? 

   One simple explanation is bureaucracy. A bank is not a person. It involves a hierarchy. Decisions may be made in steps. Thus, slow motion is the norm, not exception. 

   I do not know how far this can explain the phenomenon. But I think there is a limitation of this line of explanation. It must be that the decline in property value is not too obvious. Otherwise, despite bureaucratic, bankers must still take actions to protect their own interests. Therefore, to me, the key is why the value depreciation is not obvious, though some outsiders think that it is obvious. 

   At this point, I think the answer is almost found. The answer is that the degree of value deprecation is truly not very obvious. We may think it is obvious that the property value should have depreciated a lot. But to each specific property, how much its value has declined is not so obvious. The key is that retail properties are extremely heterogenous. Each shop differs from another a lot and so each shop's value can't be easily assessed. 

   In a way, we may say all properties are heterogenous. A residential flat on 10/F of a building must differ from the flat next to it on the floor above (or even on the same floor). Nonetheless, the difference is not so great and so there can be an easier way to assess how much different the values of two flats should be. Flat A may differ from Flat B as the former has 100% sea-view while the latter has only 96%. Such a difference is calculable and can be properly valued. 

   The value of a retail property is not determined in a similar way, however, as its value depends crucially on the business revenue that can be generated from the shop. Of course, location is an important factor. But rarely do we observe that next to a coffee shop is also a coffee shop though it may be a restaurant. The reason should be clear: a new coffee shop owner doesn't want to open a shop so close to an existing coffee shop such that potential clients are spread. So, you can see: location may sometimes be just a secondary factor in determining the value of a retail property. 

   In fact, the situation is even more complicated and the logic is not strict. Unlike coffee shops, sometimes we find bubble tea shops are clustered together on the same street or even next to each other. Why don't they fear that each shop steals business from each other? 

   On the one hand, clients come and go quickly for bubble teas. Seats are not offered while the consumers also don't need seats. As such, each bubble tea shop will not occupy their clients for long. The clients actually flow in from everywhere nearby. A coffee shop will fear that their clients will be occupied by another shop next to them. But bubble tea shops won't fear because the former type of shops occupies the limited number of clients for quite a while but the second type won't. 

   On the other hand, clustering may generate a promotion effect that attracts clients wanting bubble teas to come to a specific area, which bring more clients than without clustering. 

   Now, you can see: the values of retail properties depend on many factors and can't be easily assessed. It is much more complicated to evaluate a retail property than residential property. Yes, bankers may have some standard valuation models but they should also know that such models are not very reliable for retail properties. Shop A and shop B may be both located on the same street but their rents could differ greatly due to some factors that can't be easily captured in a standard valuation model. 

   In short, the heterogeneity in retail properties is not comparable with that in, say, residential properties. In this situation, rushing to revise down the value of a shop may not be a wise decision. Of course, when a property is rented at a much lower level, the bank will have sufficient data to revise down the value of a property. Their next action may be to call back the loan from the landlords, who don't want this to happen. Hence, this may create an incentive for landlords to stand firm on rent and wait for a longer while. Of course, while landlords may delay renting out a property, they can't wait for too long. Sooner or later landlords have to face the reality. It is simply that adjustment may be slowly made, and not as quickly as some people may expect.        

Producer's vs consumer's perspective in economics

   These days, tariffs are a hot issue for an obvious reason. Economists have of course made various analysis and commented already. Their opinions are usually negative. In particular, tariffs are said to generate higher prices and consumers will suffer although domestic firms may be protected by and benefit from tariffs. Hence, the basis for the negative result is consumers' interests, not the producers'.

   In fact, in various other analyses, economists take consumers' interests seriously while producers' interests may not be similarly concerned. For example, economists also have negative comments on monopoly power. Why? This is because price will be increased by monopoly power (than that in the competitive market). Consumers will be hurt in this way and that's disliked in economics. 

   Perhaps you would say: an analysis as such is not biased towards consumers against producers. Monopoly power generates changes in both consumer surplus and producer surplus (when compared with a competitive market counterpart). The gain in producer surplus (due to a higher price) can't offset the loss in consumer surplus. As such, a net loss is resulted. Hence, what is concerned is the balance between producers' and consumers' interests, not purely consumers'. 

   You may argue further: a typical analysis in economics is to draw demand and supply curves. When economists comment on a policy, say, a price floor or tax, both the consumer surplus and producer surplus in such a diagram will be taken into account. The so-called deadweight loss analysis often shows that both consumer and producer loss are involved. It is not biased towards either side. 

   Nevertheless, this seemingly balanced emphasis on both sides cannot reflect the true practice in economics. The practice of concerning both sides is more a high-school economics practice. Ultimately, economics is not paying equal attention to both sides. 

   To understand this, we had better introduce a distinction not mentioned in high school: partial equilibrium analysis versus general equilibrium analysis. 

   Partial equilibrium analysis is not normally mentioned in high-school economics but it is exactly almost the only focus in high-school economics. It is about analyzing one single market's situation, without taking care of its impacts on other markets in an economy. If apple market is the concern, orange market is normally ignored, not to mention markets for coffee, pork, smartphone, car, residential properties, oil, .... When we analyze apple, we just focus on apple, and the demand and supply curves of it, as well as the consumer and producer surpluses of it. We ignore other markets. This is partial equilibrium analysis. 

   General equilibrium analysis is, however, about all markets in an economy at the same time. Even if a factor is mainly targeted at one market, say, a tax on apples, general equilibrium analysis focuses not only on that concerned market, say, only on the demand and supply curves of apples. It will also explore how other markets will be affected by the changes in the targeted market and how this will generate feedbacks into the original market. When apples are taxed, not only apple price will go up and quantity will go down, orange and other fruits, as substitutes for apples, will also be affected. Demands for apple substitutes will increase and their prices will go up too. This will generate a feedback to apple: if apple substitutes also become more expensive, some buyers will be back to apple market and so eventually apple quantity will still decrease, but shouldn't decrease as much as what may be seen in a partial equilibrium analysis. 

    At this point, you may get that a general equilibrium analysis is not only more complicated, but also more right. Taxing apples of course will affect orange and other markets, not just apples. Hence, a partial equilibrium analysis cannot be more right than a general equilibrium analysis. We sometimes focus on partial equilibrium simply because it is simpler and it may not be far from the truth under some conditions (say, for a product without good substitutes). But if we aim at a getting a more accurate analysis, we should opt for general equilibrium.

   Then, why all these matter to our claim that economics is concerned more with consumers' interests than producers' interests? The point is this. An equal concern for consumers' and producers' interests happen only in a partial equilibrium analysis. In a general equilibrium analysis, consumers' interests are the ultimate concern. 

   When we draw the demand and supply (or cost) curves of a good and analyze how the consumer surplus and producer surplus will change due to an incidence, a policy or the presence/absence of monopoly power, it is an analysis focusing on one good and ignoring other sectors. So, this is a partial equilibrium analysis. 

   But we know this can only be a short-cut analysis. Ultimately, the full impact of the event or policy etc has to be analyzed in a general equilibrium setting. Of course, even if all sectors in an economy are taken into account, there are also demand sides and supply sides in each sector. But don't forget that the producers in one sector (say, apple farmers) must be the consumers in other sectors (say, pork, electricity, smartphone, etc). There is no producer who is not at the same time a consumer. 

   Meanwhile, are there consumers not producers? Yes, of course, some people are not producers, in particular, not those whose contributions can be recognized in producer surplus. But when they consume, their benefits got will be recorded in consumer surplus. 

   Now, when a producer must also be a consumer, the interests of the same person should be counted only once. Furthermore, if a producer's surplus is high but, say due to higher prices of consumer goods, the producer may not benefit a lot from such a situation. Eventually, a producer's interests lie in how many consumer goods that can be traded by the producer's outputs. So, what we need to count, ultimately, is the benefits of consumers, some of whom are also producers while some are not. 

   Perhaps not all economists are aware of this practice because some of them do only partial equilibrium analysis. In particular, economists in a subfield known as "industrial organization" often (but not always) do only partial equilibrium analysis. In such an analysis, there is no way to count the interest of a producer of a good as a consumer of other goods because other goods do not appear there. As such, counting both consumer and producer surplus is the only way to count the benefits from a deal or policy. 

   Meanwhile, economists in some other subfields are particularly aware of the abovementioned practice as they need to do general equilibrium analysis. Public economics and international economics are two such subfields. 

   One important task of a public economist is to design a tax system for an economy. Consider commodity tax such as GST, etc. This is a tax that will directly affect both consumers and producers. But public economics doesn't handle the analysis like what high-school economics may handle, which is to draw demand-supply diagrams for all the commodities that will be taxed and count all the consumer and producer surpluses from all the demand-supply diagrams. 

   In public economics, both the producers and consumers will be concerned. However, the producers are concerned in a specific way. What public economists truly concern is the efficiency of the production sector. The sector is efficient if an economy can't produce more of one good without reducing the outputs of any other goods. In so far as the production sector is efficient, public economics turns to concentrate on consumers' benefits. 

   Why is this practice justified? 

   First, if production is inefficient, we can increase the output of a good while the outputs of all other goods remain unchanged. The extra output, if given to any one of the consumers in the economy, can make some consumers better off. So, from consumers' perspective, the first job of a taxation policy is to ensure that production is efficient, or the consumers' interests are not best promoted.  

   Second, if production is efficient, we don't need to care about producers' interests anymore as they are also consumers. Caring about the consumers' benefits is sufficient. 

   Public economics effectively care only about consumers' interests while the producers' problem is limited only to its efficiency aspect. This is justified as it is doing a general equilibrium analysis. 

   Similarly, international economics is concerned with the whole economy. It is concerned with whether trades will benefit a trading country on the whole or not. The comparative advantage principle shows us that trade generates mutual benefits to both trading countries. But what benefits? Consumers' or producers' benefits? 

   On the surface, it seems that comparative advantage simply enables a greater production when producers in each country can specialize in what one can do best. Thus, it is about producers' interests. But producing more in both countries doesn't mean that the producers can earn more. A higher output supply actually likely pushes down prices and so (domestic) producers may earn less (though not necessarily so). Then, do we need to calculate if a lower price due to trade makes the producer earn more or less? In fact, we don't. International economists don't do this. The reason is: if the same resources can produce more in both countries, the consumers have more goods to enjoy. That's a sure gain from trade. 

   Well, perhaps some producers facing lower prices of their products will be hurt. But producers are also consumers, who will benefit from trades. Some producers may earn less and so can buy fewer goods at the same prices (of other goods). But prices are lower with international trades. Hence, as consumers, they may still be able to buy more goods even if they earn less. Even if they can't buy more goods (as they may earn much less), some others must be able to buy more goods. Taken as a whole, people in a country must be able to buy more goods after trade (don't forget that trades make total outputs available in both countries increases). So, on the whole, consumers must be better off. As everyone is a consumer but not everyone is a producer, it is sufficient to know what happens to consumers so as to know if a country is made better by international trade. 

   Now, we can revisit the point of tariffs. Most economists do not want higher tariffs. Trades will be impeded by tariffs. Prices will become higher. And consumers will be hurt. Perhaps some (domestic) producers will benefit from tariffs. They may earn more as their foreign rivals are weakened by tariffs. But as a whole, the country is made worst off in terms of consumer interests, based on the logic outlined above. 

   At this point, I think my point made in this post is clear: economists do not pay equal attention to consumers' and producers' interests; actually, they pay more attentions to consumers' interests, or ultimately they are concerned with consumers' interests. 

   At this point, you may then understand why sometimes economists' viewpoints are not welcomed, in particular, by businessmen. The former cares more about consumers' interests while the latter cares about their own interests, which are producers' interests. Yes, businessmen are also consumers. But why should they think like an economist? Would they convince themselves that even if they earn less, they as consumers will benefit? Of course not. A businessman's loss may be partly offset by their gains as a consumer but normally the latter gain is too little to be compared with the loss in business. Even if all consumers' gains are big enough such that, from a social viewpoint, the gain can more than offset the loss of some businessmen, the hurt businessmen will not want to sacrifice themselves for the society (while economists will think this is worthwhile).  

   As an economist, I of course will by and large concur with such an economics viewpoints: ultimately, it is the consumers' interests that matter. But these years I start to rethink. The trigger point is exactly the tariff issue. Yes, tariff wars happened in the past in human history. But that's a long time ago. That's not what are experienced by the current generations of economists. And after the tariff wars happened in history, economists reflected and concluded that tariffs were not good and so proposed free trade. Nevertheless, history can return and we now face a new wave of tariff bombs launched. Economists will certainly reflect on this. 

   I also start to reflect on it. My first reflection result is that economics is concerned more with consumers' interests, not equally with consumers' and producers' interests. Somehow we may not be fully aware of it but that's what economists effective do, upon reflection. This result also means that economists may often disagree with businessmen, who are concerned more with producers' interests. There is a conflict between us and them.

   My second reflection points to something more fundamental: is the economics approach reliable, justifiable, or acceptable from a broader perspective? I have no doubt that consumer interests are the ultimate concerns. But the economics approach to take consumer interests into account is specific approach, in the following sense. 

   Consider a change that makes each gains $1 in a society with population of 100 million while each producer, a total of 10,000, suffers $6,000. The economics approach, as implied in the international trade theory, will consider this change makes the society better off as a net gain of $40 million will be resulted. The 100 million includes all consumers (some are also producers), and so the 10,000 producers lose on net $5,999. Nonetheless, as there are much more consumers gain, on the whole, the society still gains. 

   Well, there may be nothing wrong about this judgment. But this analysis obviously cannot take something into account: when the 10,000 producers lose, each may lose their whole career - lose their job forever or lose their businesses forever. It is an extremely deep loss. Meanwhile, each consumer gain very little. They can buy goods a little cheaper. Even if they must buy it a little bit more expensive, they won't suffer a lot. The economics analysis as normally practiced will not try to evaluate how painful is a loss from $6,000 and how little is a gain from $1. We just add the money values up. But is there something missed in such an analysis?      

Would you eat less in a buffet when it is free?

   In a buffet, we can eat any food provided that we want (and we can) within a time period. The question is: if the buffet is offered for free, would we eat less than if the buffet has to be paid by our own money? In fact, buffet is expensive and so often people take it only when it is funded by the company they work for. They personally do not need to pay in such a situation. So, the question asked by this post is not artificial. It is quite relevant in the real world. 

   I exactly encountered such a free buffet. During the buffet, I raised the question and said that I would eat more if I had to pay for it. That's my answer, which, I think, purely reflects my personal choice. There is nothing wrong or right about it. 

   But a colleague, an economist, did not think so and said that my choice was irrational. His point was that the cost of the buffet was a sunk cost, and sunk cost shouldn't affect one's decision (to eat more or less); otherwise, one is irrational. 

   As an economist too, I of course know what sunk cost is about (actually I have to teach this concept in class). The concept is that cost mentioned in economics is about opportunity cost, not accounting cost. Opportunity cost is the foregone value from the next best option. What does it mean? It means that when people choose, there must be some options that they can choose. When one chooses an option instead of all others, one forgoes all these other options. Among these forgone options, one of them is of highest value to the chooser. Its value is just next to the chosen option. The cost of choosing an option is the value foregone of the next best option as this is what one sacrifices in order to get the chosen option. 

   Economics considers that opportunity cost is what a decision-maker should be mindful. If what is next best is still less valuable than the chosen option, taking the chosen option lets the chooser get the highest value among all available options. If what is next best is more valuable than the chosen option, taking the chosen option is a mistake: taking it won't let the chooser get highest value. 

   The logic is in fact quite tautological once we figure out the meaning and the definition. But this self-explanatory principle will be violated by actual choosers (and so they need economists' reminder of the principle) especially because the term "cost" in the real world is often used to refer to something else (not opportunity cost). The daily usage of the term "cost" will confuse our decision-making and so we need economics to remind us. In particular, the term "cost" used in daily life is normally an accounting concept: whatever is spent is a cost item. Sunk cost is exactly a "cost" in accounting sense but not in economics sense (not opportunity cost). 

   Then, what is sunk cost? It is about certain expenditure that has been spent but the item purchased can only be used for one purpose (say, for running a business unit) and the money spent can't be recovered (say, by re-selling the item). 

   It seems that high-school economics often uses concert ticket as an example. If you have paid $200 for a ticket, the $200 is a sunk cost. You can't get it back (assuming that re-selling it is illegal). The ticket has no alternative use (can only be used as a permit to attend the concert). So, high-school economics tells you that you should ignore this $200 when making further decisions. 

   For example, after you has paid $200, you realize that there is another concert to be held in the same time. You have to decide to go to another concert or the original one. For this decision, the $200 should not matter. If you think that the new concert is valued at $300 while the original one is valued at $250, you should go to the new concert. If you think that going to the new concert, your cost is $200 (original concert ticket) and $260 (new concert ticket), which is higher than $300, and so you shouldn't go, you are wrong. You should ignore the sunk cost $200. 

   This example explains why sunk cost should be ignored. In fact, I don't like this example very much but it is frequently mentioned by my past students. I heard it from them. So, I think students are familiar with it, and therefore use it here. Why I don't like it? Let me mention this later. 

   Turning back to the buffet problem, is eating more irrational when I have to pay on my own? My colleague's point is that the buffet cost is sunk. Hence, it shouldn't affect one's decision to eat how much, or one is irrational. Is the buffet cost a sunk cost? Yes, it is. The money can't be recovered, once paid. It won't be that you can get back part of the money if you eat less. Thus, if one's decision is affected by whether a sunk cost has been made or not, one is irrational. 

   In fact, people often haven't made decision rationally. In particular, they make decisions differently depending on whether the sunk cost has been incurred or not. This is a well-documented phenomenon known as sunk cost fallacy. My colleague obviously thought that I had committed this fallacy. 

   But do I think I had made a mistake? Do I think I acted irrationally? I don't think so. Nonetheless, with a sudden attack from my colleague as such, I failed to respond immediately. In my view, my choice is very natural. A choice like this won't be right or wrong. I had expressed this view at that time. But obviously such a common-sense based argument couldn't convince an economist. You need an economics argument to refute an economics argument. But I couldn't thought of any at that time. 

   Somewhat knowing that I was embarrassed by the attack, my colleague thought of some escape routes for me. He said that it could be a taste change when one had to pay a bill. If bill-paying in itself could change my taste for food, eating more when I have to pay is of course rational. I am simply doing something (eating more) to satisfy my new taste (stronger desire for food). 

   But I don't think my taste has changed with or without paying the bill. Furthermore, I don't like the explanation via taste change. Taste change is too much an "everything works" explanation: whenever you can't explain something, you can always explain it by taste change. It always works as no one can demonstrate if there is a taste change or not. Nevertheless, I couldn't think of other ways to avoid the accusation of being irrational at that moment. 

   The buffet was over and I still couldn't think of a satisfactory defense. We left but I still kept this in my mind. I still think the choice is natural and nothing wrong. It is not about rationality or irrationality. But how can I explain away the sunk cost factor?

   Afterward I had thought about several explanations but none very convincing (to me). Eventually I have an idea and wonder why I couldn't think of it earlier. The issue is extremely simple. 

   It is simply about income effect. 

   What is income effect? If we have more money, will we buy more of a good? If so, there is a positive income effect from this good. If we buy less, there is a negative income effect from the good. If we simply won't buy more or less, there is no income effect from the good. 

   The fallacy of accusing me to have committed sunk cost fallacy is that it assumes the income effect must be zero for any goods for any one. 

   As mentioned, buffet is expensive (perhaps some richer people may not think so but I do) and so there should be a significant income effect from it. Having paid the buffet cost, it is equivalent to a reduction in one's income. The payment won't be affected by eating more or less. So, it is basically about an income change. Yes, the money can't be recovered, once paid. But you can't say, therefore, no income effect exists. If one has to pay, one's income is lower. By eating more, this means income effect is negative (a lower income is associated with a higher consumption of a good). By eating less, this means income effect is positive. By eating the same with or without paying, this means income effect is zero.

   The income effect of buffet food to me is negative. Having paid, I am poorer, and I will eat more. The case is just as simple as this. This is not about rationality or irrationality. 

   Of course, you may wonder why the income effect of buffet food is negative. Wouldn't we have more buffets if we are richer? However, food in one buffet and the number of time having buffets are different things. Richer people may more frequently go for buffets. But they may eat less in each buffet.

   In fact, the negative income effect from buffet food is also an understandable pattern for a normal person (like me). Buffet is expensive. If I have to pay, I may choose to eat less before (and after) having it. I save the money for eating before (and after) having it. If I don't have to pay, I can also choose to save but there is no reason why a richer me and a poorer me choose to save the same. It is not about taste change. It is simply about the fact that income may have an effect on a person's choice, given the same taste. 

   [Being a little bit technical (hi,economics' readers can ignore this part), I mean the indifference map is the same (same taste) but at higher levels of the indifference curves (richer) and at lower levels of the curves (poorer), the same person may consume different quantities of the good.] 

   Hence, when one says sunk cost shouldn't induce people (like me) to choose differently, they are assuming no income effect. How can they make such an assumption in general? It may be true in some cases but not in all cases!

   Well, there is an occasion where income effect can be validly assumed to be zero though normally high-school or even university microeconomics may not mentioned it. 

   In consumer theory, economics assumes that a person will choose to attain the highest feasible satisfaction (the technical term is "utility"). This satisfaction is not the same as money. It is not that economics assumes people's goal is to earn as much money as possible at all cost (caring only about money but not other things). This is a reasonable assumption (for example, people may choose to earn less so that they can enjoy more leisure time or they want to become an artist or musician instead of a banker). But perhaps few economists are now aware that this amounts to the assumption that income effect may not be zero. In fact, the opposite side is: if one assumes that money is a decision-maker's only goal, then there is no income effect. 

   This looks so surprising. Why does money-only implies no income effect?

   First, we must bear in mind that normally a human being will not care only about money. He or she cares about what money can buy but not simply wants more money only. If we say a person cares only about money, it must involve stepwise decisions: one may set a target as getting the highest amount of money as a first step; achieving this first step, one will then wisely use the (highest) money amount in achieving the real life goal (eating, living, enjoying, etc). 

   Second, now if we can validly assume a person take money as the only goal (in the first step of the whole plan), this person is like running a business (either as one's personal money-making plan or working for a profit-maximizing company). 

   Third, if one is running a business, every buying and selling decision intends simply to maximize the money earned. Now, suppose that you have $1 million, and you think the best way to earn most is to buy materials worth $1000, which enables you to produce something worth $1500 for sale. In this situation, you will do it for earning the $500 as this is the profit-maximizing action. 

   Will your decision be affected if you don't have $1 million but $2 million, provided that the buy-$1000 and sell-$1500 is still the best way to earn? If you are rational, you won't change your decision. If you change your decision and you are rational, there must be something other than money you have to consider (say, you need to keep the $1000 to buy a present for your mother). If so, you are not purely concerned with money amount. If you are purely concerned with money amount, your decision won't change. 

   Now, you should understand why money-only implies no income effect. For a money-only decision maker, maximizing money is the only goal. Then, one should simply take the money-maximizing action. The decision-maker's income alone is not a factor that can change what is the money-maximizing action when all the actions are feasible under different income levels. 

   Well, sunk cost fallacy is exactly a valid accusation for a money-only decision maker. A restaurant owner finds that there will be too few clients if lunches are served. The revenue of $40,000 a month cannot cover the rent of $100,000 a month. In addition, salary and food cost amounts to $30,000 a month if lunches are served. Deciding to stop serving lunch, the restaurant owner commits a sunk cost fallacy as the rent should be ignored. Serving lunches can cover other costs at only $30,000 and is thus a profit-maximizing move (though the $100,000 is still not covered by serving lunches). 

   In such a case, the obvious advise that an economist can give is that lunches should be served if one aims at earning money. But don't forget that money is usually not the only goal for a decision maker. Income effect is present. Extending sunk cost fallacy to all other cases, such as non-business decisions, is like treating all decision makers as a firm or a business unit. When a consumer makes decision, we shouldn't advise as if the consumer must act like a business unit. Otherwise, we commit another fallacy. Nevertheless, I know not a few number of economists will do so. (One example is Ronald Coase, who is well known for ignoring income effect when formulating his famous theorem in his name; but I don't want discuss this in this blog post.) I almost also let myself do so (when thinking about the buffet decision). 

   Finally, let me say: I also observe that there is a habit or even a trend that economists forget about all these foundational issues like income effect. Sometimes economists simply ignore individual decision-makers have their own goals and money is not necessarily the only goal, and there are decisions other than business decisions. Not a few economists prefer using examples like concert tickets to illustrate sunk cost but that's exactly a case involving not a business decision but a consumer's decision and so income effect may be at work. 

   My observation is that this situation is particularly severe in elementary economics courses. Perhaps I am old-fashioned. I do not like this style of teaching: treating an individual as a firm, or an individual should learn the way a firm makes decisions. In fact, the textbook used in my microeconomics course, Pindyck and Rubinfeld, introduces sunk cost only when discussing a firm's decision, not in the theory of consumer (like some elementary economics textbooks do). When I handled this part in the past, I don't have any feeling. But now I think there is wisdom in such a treatment. 

Think at the margin, but why? (4)

   I have already written three posts for "think at the margin, but why?". I have raised doubts about the usefulness of marginal thinking. I think the marginal thinking is useful but it may not be as useful as advertised by some textbooks. Also, the examples used to illustrate the usefulness of the marginal thinking are often not consistent with the mathematical part of this thinking. 

   The shortcoming of the examples used in textbooks is that they often involve sequential decision but usually decision is not made sequentially. We won't wait and see if one more can of coke should be purchased, having drunk one already. We won't stop the machine and assess if producing one more product is worthwhile. Sometimes the examples are too artificial and so cannot convince me very much. Yet, marginal thinking has its value and can't be ignored. I am simply not very satisfied with the examples given. 

   Recently I've encountered a news report about enrolling more non-local students for local universities. The news report spent much time on discussing the cost issue. The information it gave is roughly this. Local students pay $40,000 to $50,000 a year for their university education. Non locals pay $120,000 to $140,000. But universities are subsidized by the government for the operation. The government subsidy to universities amounts to $240,000 to $250,000 per student. The news report therefore said that enrolling more non-local students is loss-making as the student fee is lower than the average subsidy (or the cost of enrolling a student). 

   Of course, enrolling local students is also loss-making. But local students' parents perhaps pay taxes that are used to finance their children. Non-local students' parents do not pay taxes as local parents do and so there is no reason to enroll them at a fee below cost. That's the major contention of this news report.

   In fact, I heard such a similar argument many years ago. In fact, every time there is a plan to enroll more non-local students, a similar argument will appear. 

   Why do I mention this in this blog? Answer: I think exactly this is a mistake due to common people's failure to think at the margin. Why "think at the margin" is important? Not because there are artificial examples to show its importance. It is because common people will really ignore it, and not once, but many times. The non-local student cost problem exactly illustrate this. 

   What is the mistake? It is about the cost of enrolling a student. Yes, on average, the cost may be as high as $240,000. But this is the average cost. Why the average cost is high? Because there is a high fixed cost for providing university education, including maintaining a team of high-quality university teachers. But these costs are largely fixed. Once the team is employed, the cost will not increase by enrolling, say, 1, 100, 1000 or 10,000 more students. 

    Thus, when assessing if enrolling more non-local students is loss-making or not, please don't look at average cost. Please look at marginal cost. If universities enroll 10,000 more non-local students, of course there is a marginal cost for doing so. But it won't be $240,000 for one more student. It will be much lower as $240,000 is only the average cost, which contains a bulk of fixed cost. If we think at the margin, we will find that the marginal cost of enrolling one more student is almost zero as universities will not provide any new facility and employ new staff to serve just one new student. The cost is not $240,000! Of course, the marginal cost of enrolling 10,000 more students is not zero. But it won't be $240,000 x 10,000 either. It must be much lower!

   So, please, please think at the margin. This principle is indeed important. 

Analyzing the economies without using economics

   Since I am an economics teacher, I am particularly concerned with the use of economics by its learners. Honestly, in the early stage of my teaching career, I didn't care about this at all. At that time, I had a strong belief that economics had something good in itself (such as its logic rigor as an analysis for the society). Even if its learners didn't appreciate, it was only a loss to the learners. We didn't need to care about this. 

   But now I have taught economics for years, and perhaps may retire in a foreseeable (though unknown) future. I have changed my attitude. Now, I do care about what my students have learned from me. Of course, there are good students who can learn very well for everything I taught them. Some are very keen to learn. However, I am not sure how many of them are so keen because of exams. If they don't need the exam results, will they still be so keen, or will they still be interested in economics? The answers to these questions are positive to me, but I am not sure if they are positive to most economics learners. As an aging teacher, I start to care about this. Towards a stage for me to review my career life, I am no longer indifferent to what I may contribute to this career.

   I know obviously that people may be interested in economics as there is a great demand for analyzing the economies. No matter you work in banking and finance sector, or in a company whose performance will be affected by business cycles, or you may simply need to do personal investment, you must not ignore what happen to the economies and need to formulate a perspective about it.  So, economics is useful. What I taught is useful!

   But is it? These years, I start to take note of the "economic" analyses that are circulated in media or among those who spoke publicly. Are they really using economics to do their "economic" analyses? Unfortunately, I found many were not. Some people did actually offer analyses for the economies but the concepts or even "theories" used are not from economics. Most of them blend some economics with some common sense that lacks economics foundations. Some basically use an economics terminology but distort the original meaning of the terms to suit for their own analyses. Unfortunately, I may not find too much evidence that economics is useful, from a common person's viewpoint. 

   But are these common-sense-based "economic" analyses good enough? Before making any judgments, let me share with you such an analysis first. 

   Recently, I have encountered a feature story, broadcasted by a news channel, about Japan economy. It is well known that Japan's economy has not been performing well since 1990s. The news feature interviewed a Japanese economic analyst, who gave an explanation for this weak performance. The key point, he said, was persistent deflations, which happened since 1990s and lasted for more than 20 years. 

   Well, deflation, or declining general price level, is a rather standard explanation for the weak economy in Japan. This is not controversial. But why deflation makes an economy bad? The analyst above went on: If prices kept falling, people would wait and see before they decided to buy goods. They would worry that prices might fall again. If they bought too early, they might miss the chance of buying at an even lower price. But this damaged the demand for goods and the economy. 

   It must be admitted that this analysis is easy to understand and may even be persuasive. But is it an analysis using economics? Which part of the economics? 

   In fact, the analysis given by the person mentioned above is more a common sense than economics. It doesn't mean that it makes no economic sense. It makes sense indeed. But it is not economics. 

   If so, what economics can be applied in analyzing the case of Japan? Is the analysis using economics better? Why do we need to use economics, not just common sense?

   Well, the economics concept involved is real interest rate. What matters to an economy is the real interest rate, which is approximately the nominal interest rate minus inflation rate (more exactly, the expected inflation rate). 

   As mentioned in a past post, in economics, what matters to an economy is the real variables, not the money nor nominal variables. How many goods (real values) we can use really matters to our living standard. How much money (nominal values) does not. We may have a  lot of money. But if the money can buy only few goods (as prices are higher), we are still not well off. 

   Now, real interest rate matters because it is the real variable that affects investments. Investment is essentially a delay of current consumption for a return (more consumption) in future. If someone lends funds to someone else for investment, the funds can't be used for her present consumption. The lenders delay today's consumption, enabling someone else to invest. Meanwhile, when someone borrows funds for investment, the borrower doesn't need to delay present consumption. But he must pay back the principal plus interests. His future consumption will be reduced by the interest payments. He has to pay back for not delaying his own consumption today. The motivation to invest is reduced if more is required to pay back. 

   But what is more to pay back? Is it about more money to pay back? Suppose borrowing $100 today must pay back $108 after a year. So, the nominal interest rate is 8%. It looks high. But suppose that inflation rate is 10% for the year. The borrower of $100 doesn't need to sacrifice present consumption worth $100, or 100 units of goods (assuming price is $1), today. After a year, he has to pay back $108 and sacrifice the future consumption worth $108. But since price has already risen to $1.1 (inflation rate of 10%), he sacrifices only 98 units (=108/1.1) of goods. The deal involves trade 98 units of goods next year for 100 units of goods today. It is indeed a very good deal for him. He will be happy to invest by borrowing. 

   Then, consider another case. Borrowing $100 today must pay back $102 next year. The nominal interest rate is only 2%. It looks low. But the inflation rate is -4%, or deflation rate at 4%. So, the deal is to keep a consumption of 100 units of goods for today but reduce future consumption by 106.25 units (=102/0.96). Many people would not find reducing 6.25% of goods a good deal. So, he may not invest even though the nominal interest rate is 2%. 

   Now, you can see why the real interest rate is nominal interest rate minus (expected) inflation rate. Nominal interest rate measures only how much more money one needs to pay back in future by avoiding sacrifice today. But what matters is not money. It is the real that matters. If inflation rate is high, the money to be paid back in future can be used to buy much fewer goods. So, this effectively reduces the sacrifice in future, or the burden of paying back. In contrast, if inflation rate is low, or even negative, the burden is high. Thus, inflation is something to be substracted from the nominal rate for calculating the real rate. 

   Back to the Japan economy, yes, deflation constitutes to be a problem because it implies a high real interest rate. When inflation rate is low, or even negative, real interest rate is high, at given nominal rate. Investors will find it not worthwhile to invest when investing requires them to sacrifice more future consumption, given deflation. Of course, this motivation looks quite similar to the common sense explanation that people won't buy when buying later is cheaper. But the key point is not only about the delay of buying (capital) goods today, i.e. investment. It is also about the difficulty of solving the problem. 

   High real interest rate, but so what? Why can't we simply make it lower? News reports frequently mention interest rate cuts. That seems to be an obvious method to solve the problem due to high rate. 

   But this method can solve the problem of high rate only if inflation rate is positive. It can't when inflation rate is negative. When deflation occurs, the real interest rate could be high even if nominal rate is low. To reduce the real rate, of course, cutting the nominal interest rate may help. But there is a limit for this: when nominal interest rate is already closer to zero, it can't be cut anymore. The lower limit of nominal interest rate is zero. It can't be cut to be negative. 

   What does it mean by a negative nominal interest rate? At positive rate, this means the borrower has to pay back more than what he has borrowed. At negative rate, this means the borrower has to pay less than what he has borrowed. Well, this looks good to the borrower. But don't forget that no one can borrow if no one will lend. So, who will lend at a negative nominal rate? If someone has money more than what she needs to spend at the moment, she may lend. Doing so she expects to get back some more money in future. But if nominal rate is negative, she is required to pay the borrower for borrowing her spare money. So, why should she do this? Why doesn't she hold the money, not lending it out? 

   Thus, it is clear that nominal rate can at most be cut to be close to zero. At a near zero rate, people will already simply hold money, not to lend or hold debt-equivalent assets (bonds) that give only zero (nominal) return. But if nominal rate is not negative, and real interest rate is high, given deflation, investors may not want to invest. That's exactly the problem in Japan. Japan's nominal rate was still positive in early 1990s. But then it was cut down, and since mid-1990s it approached zero, and stayed around zero for more than 20 years. 

   If nominal rate can't be cut down further, what about bringing positive inflation rate back to Japan? How? Again, from economics, we learn that increasing aggregate demand will do. Prices will keep rising if demand for goods keeps increasing. But how could we generate a growing demand? The prices are declining (deflation) exactly because demand was weak at the outset. 

   A conventional thinking in macroeconomics is that if the market is weak, the government may do something to counteract. There are mainly two ways for the government to stimulate an economy. The fiscal policy involves the government spending more, and more. This was indeed done by the Japanese government. But that was not sufficient in stimulating the weak demand. Furthermore, by spending more without taxing much more, the government deficits expanded dramatically since 1990s. Its government must consider the deficit problem when borrow to spend.  

   Another major method is monetary policy. But this policy is even more limited. Why monetary policy can stimulate an economy? Answer: as more money is supplied, given the same demand for money, nominal interest rate will fall, and so will the real rate. This will supposedly stimulate investment. But nominal interest rate was already close to zero in Japan and the rate couldn't be pushed down to be negative. If nominal rate couldn't be pushed down further, how could it stimulate demand so as to generate a positive inflation? So, we are back to the original problem mentioned above.  

   At this point, you can see what an analysis without using economics is about, and what an analysis using economics is about, in the case of Japan economy. The later may be more complicated but it touches more on the key point. The point is not only about deflation, which is bad for the demand, but also why the problem can't be easily disposed. In a way, we all should appreciate that common-sense-based analyses without using economics is useful as it is accessible by the common people so that they can learn something from it. But this doesn't mean that we can substitute non-economics for economics. If there is really something we can learn from Japan's experience, that should be the economics usable in analyzing its problems. Just using common sense, we will miss so many important factors involved. 

Think at the margin, but why? (3)

    I have already written two posts, (1) and (2), on "think at the margin", an important principle in economics. I basically have doubts on the applicability or the usefulness of this principle. I do not doubt that the principle is useful but just suspect how useful it is. In my view, its importance is over-stated. It is not as supremely important as what have been stated in textbooks. 

   I can understand why textbooks authors think that the marginal principle is important. The point is that maximization (of consumer's benefit or firm's profit) is a core problem in economics but the solutions to a maximization problem requires certain marginal conditions to be satisfied (a result perhaps surprising to those lacking the mathematics knowledge). For instance, marginal cost (MC) should equal marginal revenue (MR), and the marginal values (marginal utility over price) of consuming different goods should be equal. 

   But that's exactly where I will have doubts: These mathematical marginal conditions are right but the examples used by economists (to illustrate how marginals are important) can't be straightforwardly applied in these math conditions. Meanwhile, the examples illustrating the importance of marginal analysis are right but it is doubtful that they can illustrate how the math conditions can be used.

   Recently I come across an old textbook, William Baumol's Economic Theory and Operations Analysis (I read the 4th edition, which was published in 1977). Unlike newer textbooks, it devotes much more efforts to explain the marginal analysis (at least one chapter has been written for this). I have learned something from it but I don't think I will change my mind regarding my above comments on the marginal principles. Nonetheless, let me share with you some lessons from it.

   First of all, I got a new example for illustrating why marginal thinking is important from it: 

   "A manager is empowered to hire an additional salesman. He decides to send this man to St. Louis rather than to Cleveland because last year's orders per salesman were $60,000 in St. Louis and $43,000 in Cleveland. But it is possible that the difference in returns per salesman in the two cities occurred just because the size of the sales force in the former was well adapted to the number of retailers whereas the sales force in the latter was spread too thinly. If so, the new salesman may add little, if anything, to the company's orders in the salesman-saturated St. Louis market, but in Cleveland he might produce a substantial increase in sales. Clearly, if the firm's objective is to maximize its orders, it would in this case be better to send the man to Cleveland.

   "The figure giving the size of orders per salesman is referred to as the average return per salesman, whereas the increase in sales which results from the presence of an additional salesman is called the marginal return. The manager in the illustration was (inadvertently) acting contrary to the firm's interests by sending a salesman to the city where the average return per salesman was higher rather than to the area where his marginal return (the amount he could add to company sales) was higher. " (pp.21-22)   

   This example emphasizes the different messages from average values and marginal values. The average values are not a good indicator for what we should do. What we should do is to consider or estimate the marginal values. In a way, this example simply shows what should be obviously true (but easily forgot by decision-makers): what we are going to decide is the new thing (the new salesman's sale); so, we should estimate what the new thing will be (the marginal value); the old value (average value) may not be relevant. How could we have a more obvious principle like this: when deciding for new thing, estimate the value from the new thing? Well, normal people exactly often forget what should be obvious (they use average values for decisions). That's why reminding people to think at the margin is important.

   But perhaps the problem is not that people forget the marginal way of thinking but that in practice it is hard to obtain the data for marginal values. Baumol's book pays particular attention to this difficulty. In Section 7, Chapter 3, Baumol describes the problem (p. 34):

   "1. Almost all accounting information is in the form of average or total rather than marginal figures. Tax computations and a number of other uses of accounting data require that this be so....

   "2. By its very nature, marginal information often represents the answers to hypothetical questions -- information beyond the range of the firm's actual experience. One must ask, for example, what will be the effect on the firm's profits of an increase in expenditure..., whether or not the firm has ever tried it....

   "3. Even where some relevant data are available..., it is much easier to collect the statistics required for average than for marginal figures. A single observation, that the total cost of producing 500 units of some output is $15,000, yields the information that its average cost is $15,000/500 = $30. But it takes at least one more observation, say, that the total cost of 510 units is $15,050, to yield the guess 

that the marginal cost is $5... And, in practice, many more than two observations will usually be required for any sort of reliable guess on marginal magnitudes."

   Baumol's observations above perhaps explain why economists have to emphasize so much about the marginal principle. It is difficult to apply it but still you must. 

    Well, Baumol also gives us some advises. We can approximate marginal values by average values via a well-known rule: If average value is increasing (decreasing) with the units, marginal value must be higher (lower) than the average. So, if you have a set of average data, you can guess the range of the marginal data by this rule. In a normal microeconomics course, this rule has been covered. The logic in it is, however, completely arithmetic: if the new data is higher than the average, the new average after adding the new data must be higher than before. 

   In many aspects I think Baumol's treatment of marginal analysis is careful and good. But still this can't convince me. I still think the examples offered by economists are good for illustrating why marginals are important but these examples are a different matter for the mathematical conditions in an optimization problem. The conditions for validating the examples used by these economists and the optimization problems are rather (if not vastly) different. In fact, a case used by Baumol (Chapter 4) for illustrating the relation between differential calculus and marginal analysis reveals this non-equivalence (though Baumol indeed wants to use the case to illustrate why the two things are closely linked). 

   Baumol considers a case of advertising. The first $1000 on ads can generate extra sales of $40000 but the second $1000 generates no effect while a further $1000 actually reduces sales by $10000. The marginal effect of ads on sales is the change in sales divided by the change in ads. But what should the change in ads be measured? If it is just $1000, then the marginal effect is 40 (=$40000/$1000). If it is $2000, then the marginal effect is 20 [=($40000+$0)/$2000]. If it is $3000, then the effect is 10 [=($40000+$0-$10000)/$3000]. Then, the marginal values could be quite misleading. If we choose $3000 as the unit for measuring the change in ads, the marginal effect is found as 10. It is positive and so it suggests that the money ($3000) should be spent. But actually only $1000 should be spent as spending more generates no extra sales or even negative sales.

   The lesson that we can learn from this case, Baumol thinks, is that the unit of change should be as small as possible, or we may be misled by something like above (an example with large change as a unit). This is the reason why differential calculus is relevant for marginal analysis as it exactly considers the smallest possible change (infinitesimal change). 

   Well, perhaps Baumol is right. Using a smaller unit is less likely to make things wrong. But is this lesson relevant for what is supposed to be illustrated by the case of ads as above? 

   Yes, we should spend $1000 instead of $2000 or $3000. But, if smaller is more appropriate, should we spend $1 first (and spend more if the marginal effect is positive), or $10 first or $100 first? It seems that spending $1 first is more careful than spending $10 first, or $100 first, or $1000 first. But spending $1 first is often not right as it is not practical to spend so small. Furthermore, if we know already that the marginal effect is 40 from $1 to $1000 and beyond $1000 it will drop to be zero, we can simply spend $1000 instead of trying $1, $10 or $100. 

   So, in my view, marginal analysis that opts for small changes is indeed useful. But it is only sometimes useful, not always. Whether it is useful or not depends on the information mastered by the decision-makers. If we know too much, such a marginal analysis is redundant. In the example above, we know so much already. So, we should choose $1000 directly. We don't need to consider whether the marginal effect is positive at $1, $10 or $100.  

   Nevertheless, if we don't know much -- we know that the marginal effect is diminishing with units, we know it will be positive at first but then decline to zero or even negative, but we don't know at what units the effect will become zero and negative, then, in such a case, marginal analysis is truly useful. In such a case, we should try at the margin: take a small step to see if positive marginal effect will be resulted. If so, go on and try more until we meet the zero marginal effect. We don't need to try further as we know the effect is diminishing (once it hits zero, it won't bounce back). 

   So, when we know the pattern of the marginal effect (diminishing or not) but not the exactly values of these effects (non-positive when spent more than $1000), marginal analysis is particularly important. Marginal analysis is truly useful only when we know something but not everything. This is a point that I have already made in my first post in this series (see the example of climbing mountain). I still hold this point. Having read Baumol's insight discussion, I still won't change my mind. 

It's about the real economy

   What have we learned from economics? You may say: of course, we have learned how the economy works. But many people without learning economics also seem to know much about how the economy works. Notably, businessmen often think that they know better than economists in this aspect. Occasionally government officials, stock analysts, etc. may also think that they know better, despite their lack of formal economics training. Hence, the point is: what things that we really have learned from economics, but not from elsewhere, can make us have a better understanding of the economy.    

   I have been thinking about this question for long. In fact, I thought about this even when I was an undergraduate student (a long time ago). I studied economics but I was, and am still, critical: I wondered what I had learned from my teachers was really useful. 

   At that time I was struck by an approach used, or a perspective adopted, in economics (but often not elsewhere), and I truly thought that the approach was not only striking but also truly important. Today I am an economics teacher. I still think that approach or perspective is truly important and sound. 

   What is that approach? Answer: The economy is not about money. It is about the real activities in it. To understand it, one must see behind the veil of money. 

   Well, this perspective is exactly the contrary of what normal people see the economy: they always think in terms of money. 

   From which topics in economics we learned that the economy is about the real, but not the money? In fact, this proposition has permeated everywhere but we may not be aware of it. In microeconomics, we discuss resource allocation via markets. It is not about money gain or loss but about how different goods and services are used by people such that efficiency is attained. Well, we may not be very much aware that the terms are not money, but real values. In macroeconomics, however, the distinction between real values and nominal values is made explicit. So, students must be aware of it.

   Then, what is real? What is nominal? Is that really an important distinction? 

   Perhaps a little bit paradoxically, real variables are not the so "real". We can't directly observe a real value. It is more an artificial construct that is obtained by purging price effects from a nominal value. The data that statisticians collected is about nominal GDP, nominal consumption expenditure, etc. The former is the money for which the output of final goods can be sold. The latter is the money spent on consumable goods. They are the true data encountered by businessmen, producers or consumers, who either actually incur the expense or estimate it. 

   The real values, real GDP or real consumption, however, are not the true data as used or estimated by these businessmen, producers or consumers. The real GDP is obtained by dividing the nominal GDP by the price index. Similarly, the real consumption expenditure is obtained by deflating the nominal consumption expenditure. They are not the data handled or estimated by the original data generators, i.e. the businessmen, producers, or consumers. Of course, each of these people knows how many units of goods each produces or consumes. But the real value of an aggregate variable involves adding the money (nominal values) generated from these units (real values) and then deflate the total value by the price index. In the process, the data of individual units (real) is no longer preserved. 

   Perhaps because real values in macroeconomics are an artificial construct, and perhaps because businessmen never handle these real values, they tend to ignore the reals, they simply think in terms of money, and they can't appreciate the economics way of thinking (think in terms of reals). From the discussion above, you should also know why the situation is worse in macroeconomic issues than in microeconomic issues. 

   Let me use two examples to illustrate why thinking in terms of reals is correct while thinking in terms of money can lead to mistakes. 

   The first mistake is made by an "economist". I say "economist", not economist (without quotation marks) because the person I mention is in fact not an economist, though media often misuses the term "economist" and call the person concerned, actually without formal training in economics, an "economist" simply because the person is a scholar who often wants to comment on the economy. But even a historian can comment on the current economy though the person is not, and should not be called, an economist. 

   Anyway, what this "economist" said? He said buying stocks is always a wise move in the long term because central banks everywhere keep printing more money in the long term. This generates inflation. Money value is depreciating in the long term and so holding money simply loses out. 

   I must admit that my first feeling when encountering this argument was: it looked reasonable and smart. Upon reflection, I know my first feeling came by because at that time I forgot what an economist should think and used businessmen's way of thinking. But economists should not be confused by money value. We should look at the reals. 

   What the mistake has this "economist" made? I must make clear that I don't dispute that holding stocks is in the long term a wise move (I won't say it is wise or not; I simply won't dispute this claim). But it is not because printing money generates inflation. It should be due to holding stocks is worthwhile for its own good. If inflation is all that matters, then any financial assets (not only stocks) must deserve holding in the long term. But that's clearly not true. 

   Take a simple example. Gold price sharply declined from 1980s to 2000s for about 20 years. During the same period, global inflation rate is high while the rate for advanced countries is also high on average, especially during 1980s where gold price declined particularly sharply. Then, was holding gold a wise move during 1980s to 2000s? True, money value depreciated with inflation. But holding gold was worse. Obviously, the demand and supply situation in gold market generated this worse situation. Inflation couldn't help boost gold value. 

   In fact, even holding stocks are not necessarily a wise move. Though most stock markets perform well in the long term, some markets didn't, For example, France stock market fell between 2000 and 2012. Then, it took about 10 more years to recover the loss (reach the peak level achieved in 2000 again). In the meantime, inflation rate was positive at between 1 to 2 percent. For another example, Italy's market is even worse. Its index is still below the peak achieved in 2000 while its inflation rate was mostly about 2 percent or above. For these markets at least, holding stocks didn't seem to be wise for 20 years or even longer. 

   These examples illustrate that holding stocks could still be bad in spite of inflation. The "economist" mentioned above can't be right in general. Perhaps he is right for the stock markets that normally he would invest. But that is because the stocks he invested have merits in themselves. That's not simply because of inflation. 

   More importantly, the economics logic involved in this "economic" argument is not right. Yes, as stock price is increasing in the long term, holding stocks could normally give the investor more money. But don't forget money becomes less valuable, given inflation. So, having more money is not sufficient. The stock market return must at least beats inflation, or the purchasing power of the stock holders may not become higher over time. Even if it is higher, don't forget that, holding stocks, one sacrificed the goods that could be bought by the money for stocks, and also borne investment risks. 

   Just looking at money and forgetting the reals (the goods sacrificed and the risks) is the crucial mistake involved in the "economist's" argument for stocks. Such a perspective diverts our attentions from analyzing the demand and supply factors in stock markets (the reals). But it is the reals that matter, not the money. 

   Now, we turn to the second mistake of thinking in terms of money. Interestingly, the mistake was also made by a person who considers himself as someone "knowing economics" (though he seldom calls himself economist). He is a columnist who writes on some international economic issues and investment advising.

   In a case, he analyzed why UK can have a good economic performance since 1990s until before 2008 (where global financial tsunami occurred). His point is mainly that the UK policy and some other events attracted investment inflows from Europe and elsewhere. His point concentrates on exploring factors that can attract these fund flows. 

   Again, this is a point reflecting how businessmen understand the economy. Businessmen run their companies. They want to attract more money inflows to their companies. If they succeed in doing so, their companies can prosper. Naturally, they may also apply the same logic in analyzing the whole economy. If an economy can attract fund inflows, it can prosper. 

   Again, my first feeling when encountering his point was that this analysis looked reasonable and smart. But, upon reflection, the argument can't be right. The argument associates an economy's wealth with fund flows. But fund flows is a zero-sum game. When a country gets more funds from other countries, others get less. So, there is no way for different countries to enjoy mutual gain. Of course, this is exactly what many businessmen would think for the economy. They want their own countries perform well and they fear losing out to other countries. 

   Why such an analysis can't be right? Well, from the very beginning, economics refutes such zero-sum based analysis. Economic prosperity is not about more funds. It is about more outputs that can be produced as this is truly beneficial to people living in a country. Even if people have more money or funds in their bank accounts, they won't be better when money can't be converted into more goods. In contrast, more goods for use can benefit them. But this needs more production.  

   Yes, fund inflows may enable a country to use more resources and so more goods can be produced. But why would funds flow in a country? Meanwhile, at given resource, more goods can still be produced if productivity is improved or resources are used more efficiently. In fact, when these two things happen, funds will flow in as fund holders find their resources can be better utilized in a such country.  

   So, things must be done better in real term: productivity and efficiency. Of course, one way to improve is well known now (though may still be forgot). It is (almost) the first principle in economics. It is about trade and specialization: by international trade, countries can specialize in what they can perform best, and so produce more for both trading countries. Trade and specialization is about the reals, not about money gain or loss (trade surplus or deficit). 

   So, by concentrating on fund flows (the money), the above economic analyst ignores the first principle in economics (the reals). If he is right, there is no mutual gain in trade or even in interactions between countries (via fund flows, etc). If he is right, the whole framework of economics collapses. 

   Well, since 1990s, the whole world has seen global trades rising rapidly and the world economy prospering rapidly. What is most undisputed in these decades is the wonderful effect from trade. The gain is quite obvious. Yet, if we look at the money, we may interpret that when the money earned by foreign countries (trade deficit) is big, it must be bad for a country. But what we should look at is the reals: the goods that a country can get via trade (one get more than goods from foreign countries when deficits occur) is increasing. 

   From the two examples above, the lesson is that what truly matters to us (a person or a country) is the goods one can get (the reals), not the money counted. If we confuse them, we make either bad investment policy or bad economic policy. In fact, one important task of economics is to remove the clouds, letting people see through the veil of money.