Are consumption vouchers a government's expenditure?

   During pandemic, the government wants its citizens to spend more on consumption so that the economic situation can improve. Therefore, it gives away consumption vouchers worth $5,000 to each eligible citizen. The question is: how should such vouchers be counted in GDP (gross domestic product)?   

   Actually, quite a number of students have ever asked me this question and they had different answers in their minds. In fact, I also posed this question to a layman who has never learned any economics. My conversation with the layman makes me know better why some confusions may appear. In the process of thinking about the reason why, I've also learned a lot. I would like to share with you my thoughts.

   I asked the layman: Do you think consumption vouchers should be counted as "private consumption" (C) or "government expenditure" (G)? Nonetheless, this layman has no idea about GDP and I have to briefly explain the concept first. 

   I said: GDP has five components: C, investment, G, export and (minus) import. The layman was already puzzled at this point as in this layman's impression, GDP is about growth, not about C, investment, etc. I used the simplest way to explain this point: Yes, GDP is related to production but any goods produced may be used by someone and there are five types of users -- private consumers, investors, government, etc. Hence, depending on who use the goods produced, or the purpose of producing the goods to serve which type of users, we can decompose GDP into C, G, etc. 

   Barely understanding this logic, the layman then tried to answer the question: should vouchers be counted as C or G? Both seem to be correct. The voucher is for consumption, and so it seems to be C. But it is also a government's expenditure, and so it seems to be G. Eventually, the layman chose the answer C, and explained: although the government spends the money (voucher) on consumers but it is the consumers who use the vouchers to buy goods. 

  This answer is correct but the explanation is obviously not ideal. It is correct more or less due to a random choice. But it catches a key point: the final step of the spending is made by the consumers, not the government. Why it is the final step that matters? Don't forget. GDP is about final goods. If a spending item does not affect the production and demand of the final goods, it's not GDP. So, though government "spends" on consumers, this spending action does not affect the demand for goods. Only when the consumers spends on goods, the demand for goods is affected and counted as GDP. 

   There is also another quick way to make clear the concepts involved. The point is that you have to distinguish the term with quote...unquote ("...") and without. In GDP, "the government expenditure", or G, refers to certain specific expenditure. Not all spending originated from the government is G. In GDP, G refers to a situation: the government spends and buys some goods in the economy. Now, for consumption vouchers, it is the consumers spend and buy the goods, not the government buys them. Thus, the vouchers increase "private consumption" (C) in GDP, not G. Of course, the money is given by the government to the consumers. However, the money involved in the vouchers is only the government's expenditure (spent on the consumers), but not the "government expenditure" (spent on the economy).    

   In short, the confusion is that economics use specialized terminology but people often wants to interpret a term by its common usage. "Government expenditure" does not always equal a government's expenditure. Such a difference in usage often confuse economics students. For example, "short term" in economics is not the same as short term in daily life. The former is defined by the presence of some variables that are not changed within a period (e.g. price level or fixed cost). Also, "cost" in economics is not the same as cost in the business world. The former is about opportunity cost while the latter is an accounting concept. 

   This problem is common in economics learning, or social sciences in general, but not in natural sciences. When we study the society, we use some terms that are used already in the society, or the society may soon develop a habit of using a term in a way deviating from its original specialized meaning. This problem is less common in natural science because many science objects are not normally encountered in daily life. "Black holes" will not refer to things that will be encountered in daily life. But this situation is not true in economics or in social sciences.   

   Well, this may also explain why sometimes someone who has never learned the subject before may learn it more efficiently at the initial stage than someone who has some background knowledge. This is because the former has completely no idea and has to learn the definition of everything from scratch. They will not be "misled" by their pre-knowledge of something (as they have none). On the other hand, someone who has some background knowledge will every time interpret a term with their pre-knowledge, preventing them from effectively learning new things.  

   Perhaps we will ask: Why all these troubles? Why do we need a specialized terminology instead of following simply the daily-life usage of a term? The reason is that the daily-life usage of a term is too often ambiguous. Today there is only one meaning for it. Tomorrow it may be used to refer to something else. For a scientific discourse, concepts should be made precise or communications between scientists become ineffective while scientific progress will become mission impossible. 

   Then, why don't economists and other social scientists simply create a new term to refer to a specific meaning of everything? Why should they still use the same words to refer to something but deviate from the words' daily-life usage. In facts, they have created many new terms already. Economists (or other social scientists) have created specialized terms that have not been used elsewhere (such as opportunity cost). But creating too many these specialized term may also not be effective. Imagine that every concept you learn is labeled alpha, beta, or 12357 or ZX734. Perhaps it is easier to ask students to distinguish "short term" from short term than to create so many new terms. Furthermore, if the term is used to refer to something in a society, people may also someday start to use it in daily life and sooner or later its meaning will also change over time.  

   Hence, all we can do is perhaps to point out such a blind spot in economics learning. Hopefully mindfully learners will take care and then gradually adapt. This is indeed one mission of "hi, economics".   

The danger of reading "economics" books

   As an economics teacher, I of course believe that reading more economics books is helpful for students' goal to learn economics, and of course here I mean books other than textbooks. The trouble is that, for this purpose, it is too easy to confuse a non-economics book with an economics book.
   Let me emphasize. I refer to books that help us learn some economics as a subject that we can learn in high school or university. I do not mean the books must contain materials actually taught in schools. I simply mean that the materials use the scientific knowledge of economics, as exemplified by what is taught in these schools. Hence, the economics books that are qualified must involve using the economics theories or concepts in this sense. Otherwise, readers may still learn a lot about the "economies" but not necessarily about "economics".
   Thus, what I am thinking of is books that are like popular science for economics. When we talk about pop-sci books for natural sciences, such as physics, chemistry or biology, we have a very clear idea about what these books are. But when we talk about pop-sci books for economics, my impression is that people are not so clear. It is in this sense that I say there is a danger.
   Why things are so unclear? The answer is that in the popular culture, the word "economics" is already used too loosely and broadly, referring to anything you can imagine related to the economic or business world. The word "economics" is originally used to refer only to a specialized scientific study, as a branch of social science. However, now the term is used extremely broadly. For example, the policy package of a president or government head may not have any special economics behind. But journalists frequently call them as xxx-economics, e.g. Abenomics (for the current Japan prime minister),  Clintonomics, Obamanomics, Trumponomics (for the US presidents in recent decades).
   For another example, Financial Times has identified best books of 2018 for economics. But if you read the list, you can only find that these books cannot satisfy my criterion (and many of them are only business books).  Although they may be good books and help readers acquire knowledge, they are not very helpful as pop-sci books in economics.
   Now, if students want to read some more books, helping them learn economics, how can they choose to avoid the danger as above? On the one hand, I have recommended some books in my past posts (respectively for microeconomics, macroeconomics, and game theory). On the other hand, students should also read more, if they want to have a better economics sense, and not only for the basic stuffs and fields involved in these books.
   In fact, there is a simple principle that students can use to avoid the danger mentioned in this post: choose books that are written by an economist who are still teaching economics in the department of economics in an university. The key point is, if the book is written by such an economist, they normally can teach you some economics, though not always things in current high-school or even undergraduate curriculum, but should be really about some economics concepts or principles (that might be taught in school one day). In short, you are able to learn the economics as a scientific subject from these books. Since these authors still teach economics in an economics department, it is likely they write to teach you economics, not about business (or simply business) or just about the economic world. The background of the authors can normally be found in the book. So, it is easy to implement this simple principle. But one should still notice that when an author is introduced as an economist, she or he may not be an economist in the sense mentioned above. There are many people called "economists" who work in business firms, banks, financial companies, public organizations or even a news media. Like "economics", the term "economists" is also used very loosely and broadly in the popular culture. Thus, the condition that they teach in an economics department is important. Normally those who work in an economics department would really belong to the type targeted by this post.
   Of course, those who are not "economists" in the above sense may also write a book suitable for our purpose. In fact, one book that I have recommended in the past is exactly written by a journalist, not an economist in economics department. This is certainly true. However, not too many non-economists can write the economics books satisfying my criteria. Even if we miss some of them, normally this is not a big loss. Of course, I also hope that when students read more, they can also know how to choose book themselves eventually.

The area beneath a demand curve

   These years, one of the most frequently asked questions after class from my students is, to my surprise, what the area beneath a demand curve is about, or why the area can represent the benefit of the consumers. I am surprised as I think students should have learned this even in high-school economics class. Upon reflection, I think the problem is this. What they have learned is about consumer surplus, not exactly about the area beneath the demand curve. Though the latter is a step involved in deriving consumer surplus, students may forget the steps (or the reason behind) but remember only the conclusion. 

   Hence, to understand the meaning of the area beneath, we need to start from the beginning, and to think in steps. Put it simply. Suppose a person's demand for a good is this. To obtain the 1st unit of the good, the maximum amount the person is willing to pay is $10. But to obtain another unit, the person will pay only $8. To obtain the 3rd unit, pay $6. To obtain the 4th, pay $5, etc. Since one will never pay more than one's evaluation of the good, the above money values are the highest values one place upon the respective units of the goods. In other words, the person considers the benefit of the consuming 4 units of the good is $10+$8+$6+$5=$29. This is exactly the area beneath the "demand curve" (here, it is not exactly a curve but only a schedule; however, the logic is the same for a curve or a schedule). And so the area represents a consumer's benefit of consuming a good up to certain quantity. 

   Nonetheless, this benefit is in "gross" term. In fact, the person must pay a price for obtaining the good. Suppose that the market price of the good is $5.5. Then, the person will buy only 3 units (the 4th unit is valued only at $5, lower than the price). The "gross" benefit obtained from 3 units is $10+$8+$6=$24. The cost of obtaining it is $5.5x3=$16.5. The consumer surplus is $24-$16.5=$7.5. 

   Many students remember that the triangle area beneath the demand curve, but above the price line, is consumer surplus, which represents also consumer's benefit from obtaining the good. But they forget that it is only the net benefit, the benefit net of cost. For the net benefit concept, one must first identify the gross benefit. The latter is a more fundamental concept. 

   For learning economics, the most important part is to understand why. Remembering the conclusion without understanding is meaningless. Is the common teaching practice in high school to make sure students remember the conclusions, or to make sure students understand? If the common practice is really the former, not the latter, then this will creates a lot of difficulties to students when they learn economics in universities. Even if they do not need to learn economics in universities, understanding why is still the most important and meaningful part in economics (even if it is for high school). In "hi, economics" I write many posts with "why" (or "but why") as part of the titles: for law of demand, for aggregate demand, for think at the margin, etc. The reason why there are so many "why" here is that "why" is really important.   

Once more, "The law of demand, but why?"

   I have recently read a textbook for Edexcel AS/A Level economics, the exam supposedly to be taken by UK students or other international students following UK syllabus. I wonder how it will explain the reason why demand curve is downward sloping. There is only one point offered: the law of diminishing marginal utility. I know DSE students, or most local high-school students, no longer need to learn anything about utility. I don't think it is a must to teach utility to high-school students. However, as mentioned in my earlier post, students should be told why demand curve is downward sloping. To me, using marginal utility is one way to explain the downward sloping pattern. But it has pros and cons for this method, as mentioned in another earlier post of mine. Let us see how the textbook uses marginal utility to explain the shape of the demand curve.
   The book says: "The more buyers are offered, the less value they put on the last one bought. ...This illustrates the law of diminishing marginal utility. The value, or utility, attached to consuming the last product brought falls as more units are consumed over a given period of time. ...The law of diminishing marginal utility therefore explains why the demand curve is downward sloping. The higher the quantity bought, the lower the marginal utility (the utility from the last one) derived from consuming the product. So buyers will only pay low prices for relatively high amounts purchased..."
   I appreciate the motivation that this book (or the entire AS/AL syllabus) tries to explain the law of demand to high school students. What is not ideal is that one should not confuse "value" with "utility". From the quote above, they are treated as if they are equal (see the sentence "The value, or utility"). As I mentioned in my earlier post, utility is not monetary value of a good while price is. They are of course closely related. But to close the gap between them, we need to convert "utility" into "value" by "marginal utility of money". A good generates utility. But buying one unit of this good, you need to sacrifice some money, which is the price of this good. How much you are willing to pay? Sacrificing some money, your utility is reduced because you can buy fewer other goods. Hence, if buying one extra unit of a good gives you 4 units of utility (your marginal utility of this good) but $1 gives you 2 units of utility (your marginal utility of money), then you are willing to pay $2 for one unit of this good.
   In short, diminishing marginal utility cannot be straightforwardly translated into downward sloping demand curve. In fact, I find it not easy to explain the concept of marginal utility of money to high-school students (although I have tried it above). At high-school level, I prefer the explanation using substitution effect and income effect as suggested in my earlier post.

More on "aggregate demand curve, but why?"

   In my last post, I mention the explanation for why individual demand curve is downward sloping in a Edexel AS/AL textbook. This book also explains why aggregate demand curve is downward sloping. Interestingly, its explanation is almost the same as the version that I have criticized in my past post.
   "Demand curve is nearly always downward sloping. Why is the aggregate demand curve the same shape? One simple answer is to consider what happens to a household budget if prices rise. If a household is on a fixed income, then a rise in average prices will mean that they can buy fewer goods and services than before. The higher the price level in the economy, the less they can afford to buy. So it is with the national economy".
   In my past post, I have explained: the fixed income assumption that is valid for any single individuals may not be valid for the whole economy. Put it simply, a higher price reduces the good buyers' purchasing power with a fixed income. But a higher price also increases the purchasing power of the good seller with more sale revenue obtained. Thus, the explanation based on fixed income is not valid.
   Meanwhile, the book is not completely wrong as it immediately adds, after the above (invalid) explanation that there is a more sophisticated explanation (by assessing components of GDP: consumption, investment, government spending, and exports and imports). It turns out that these "more sophisticated" explanations do not rely on the "fixed income" assumption and are thus more likely valid. However, if the book can list out these explanations, why it chooses to mention the "fixed income" one, which is invalid?
   For the "more sophisticated" explanations, the consumption and investment reasons rely on interest rates, and so is similar to the reason offered in my past post. The government spending is unaffected by price. The export-import reason is related to competitiveness of export goods relative to imported goods, and is intuitively understandable. When discussing why consumption will be depressed by prices, it also mentions wealth effect. I have remarked in my past post that wealth effect is not a straightforward issue. The explanation about wealth effect offered in this book cannot completely clear my doubt though it is not too bad. All in all, I think there is much scope for improvement in the explanation of aggregate demand.

More on "The law of demand, but why?"

   My earlier post "The law of demand, but why?" is one of my most widely read post in this blog. On one hand, this is perhaps due to its being related to high-school economics education, which can more easily arouse students' attention. On the other hand, this is perhaps due to its really touching on some important points.
   Two (very smart) students asked me questions over the reason why demand curve is downward sloping upon reading my blog post. They raised some similar points. Let me share with you the question and my response here.
   One student said that he has learned the concept of marginal benefit (of consuming a good) although he has not learned substitution effect and income effect as introduced in my post mentioned above. The marginal benefit (MB) is the additional benefit generated by consuming one more unit of a good. MB curve is downward sloping (when one consumes one more good, the extra benefit from this good is smaller). Hence, this is an explanation of why demand curve is downward sloping.
   Is using MB curve sufficient for explaining demand curve? In my view, this is not sufficient. I do not know precisely what the student has learned about MB. Is MB the monetary value or monetary benefit that a consumer can derive from a unit of good? If so, then MB is the same, at least almost the same, as demand curve. Saying that MB is downward sloping is equivalent to say that demand curve is downward sloping. But this is not an explanation of why demand curve is downward sloping.
   If MB is NOT the monetary benefit one can derive from a good but the satisfaction derived from a good, for example, the psychological or physical benefit, then MB is not equivalent to a demand curve. But a downward-sloping MB curve CANNOT be directly translated into a downward-sloping demand curve. The units for MB is satisfaction level; the unit for demand curve is money (price). To translate the MB schedule into a demand schedule, we need something in extra, such as the substitution effect and income effect.
   The above is a relatively simple answer to the question. To answer further, it will involve economics beyond the level required by the readers of "hi, economics" (high school level). So, perhaps I am forced to stop here. Nonetheless, let me simply give you some hints for the thinking. What follows is not a rigorous analysis, which must be too technical for a blog. As I try to make a more intuitive explanation, I guess my explanation below might even be a little bit misleading when evaluated by rigorous logic. However, I hope it can serve to give you some hints.
   Why MB in satisfaction term (or in utility term in economics) is not the same as demand in money term? To make things clearer, let me call MB in satisfaction terms marginal utility (MU). MU of x is not the same as demand curve. We need to divide MU of x by the MU of money (or income) to make things measured in money term (as required by the demand curve). What is MU of money? Well, it is about how many more units of satisfaction (or utility) that can be generated by having one extra unit of money.
   To illustrate, consider a numerical example. Suppose that consuming one extra unit of x gives you 6 extra units of utility while an extra $1 gives you 2 extra units of utility. Then, you are willing to pay a price of (or sacrifice) $3 for getting this extra unit of x.  By this logic, the demand curve should be MU of x divided by MU of money (6/2), not just MU of x (6).
   Now, imagine one extra unit of x is consumed. The demand curve is, as said, about MU of x divided by MU of money. When x increases, MU of x should decline. This is the effect due to the so-called downward-sloping MB (or MU) curve. But things are not that simple. If x increases, one must reduce consumption of another good, say, good y, due to a fixed income. When y decreases, the MU of y will increase (if the MB or MU curve of y is also downward sloping). Furthermore, MU of money (income) should also change when there is a change in consumption portfolio as above. Thus, demand curve is not simply about MB or MU of a good but more factors. These factors include how far goods (x and y) can be substituted for one another (in generating utility) and the effect from income (in generating utility).
   OK, perhaps you think the last three paragraphs are complicated and makes you confused. Well, as you can see in my post "The law of demand, but why?", it is not difficult to understand the reason why demand curve is downward sloping by substitution and income effect. The troubles come only if you try to relate substitution and income effect to MB curve. As MB curve is not as proper a way to explain demand curve, I would suggest that you directly think in terms of substitution and income effect as what my past post does.

Mankiw and DSE syllabus

   After writing the last two posts, I picked up a popular university textbook for first-year economics students, Gregory Mankiw's Principles of Economics, and had a look. I am not familiar with this book because I am not responsible for teaching principles of economics (the first economics course) in my university. I actually got the book from a former colleague. When he left, he gave me as a gift.
   I surprisingly discovered that the treatments of demand curves in DSE economics syllabus can be exactly found in this (authoritative) textbook. First, it introduces the law of demand without explaining it. Second, it explains why aggregate demand (AD) curve is downward-sloping exactly by the three reasons required by the DSE syllabus: wealth effect, interest rate and export. I wonder, especially for AD, DSE simply follows this authoritative textbook's treatments. Thus, perhaps I shouldn't blame the DSE syllabus. It simply follows what the authority does.
   Even so, I still think DSE should explain the reasons behind the law of demand in microeconomics. I will not be deterred by Mankiw's authority in economics teaching so as to change my view in this aspect. I still think the law of demand should be explained and there are ways to explain it in a non-technical manner. For example, written also for principles courses, Robert H. Frank and Ben S. Bernanke's Principles of Economics explains the law of demand in a very simple manner in its Chapter 3. Basically, it is still substitution effect and income effect:
   "Thus, as pizza becomes more expensive, a consumer may switch to chicken sandwiches, hamburgers, or other foods that substitute for pizza. This is called the substitution effect of a price change. In addition, a price increase reduces the quantity demanded because it reduces purchasing power: A consumer simply can't afford to buy as many slices of pizza at higher prices as at lower prices. This is called the income effect of a price change." (p.61)
    You can see: the reasons why demand curve is downward-sloping are as simple as such.
    The Frank's and Bernanke's book actually has given the third reason, also very intuitive: everyone has a reservation price for the good a person may buy. If the actual price is higher than one's reservation price, one thinks it is not worthwhile for buying the good. When the price of a good rises, fewer people's reservation prices are higher than the actual price. So, fewer people will buy.
   Yes, Frank's and Bernanke's book is slightly more advanced than Mankiw's. In Chapter 5 of the former book, it actually introduces a more detailed analysis of demand, using concepts of marginal utility. I think high schools need not go through the more advanced (or abstract) concepts like marginal utility. I think high schools need only to introduce something like Chapter 3 of the book, and it is sufficient to introduce only substitution and income effects as brief as above. The fact that Mankiw has not explained the law of demand so does not mean we don't need to. The fact that Frank and Bernanke is a slightly more advanced book does not mean that we should avoid following it in some selective aspects.
   Of course, no any textbooks are perfect. I also will not rely on only one book for my comments. For example, Frank and Bernanke introduces a very peculiar AD curve, which plots inflation rate (not price level) against output. This is not the usual AD curve concept, which links price level with output. To me, which aspect should be taught should not be based purely on authority, but on some carefully thought reasons. I hope that when the DSE syllabus is under review one day, the law of demand is given some explanations. 

Aggregate demand curve, why?

   The economics syllabus in the DSE programme of Hong Kong requires textbooks and teachers to explain why aggregate demand (AD) curve is downward-sloping in macroeconomics. Furthermore, three reasons are cited: wealth effect, interest rate, and export.
   To me, explaining why AD curve is downward-sloping is not an easy task, at least more complicated than explaining demand curve in microeconomics. But what DSE requires is the opposite: demand in micro is unexplained but AD in macro must be explained.
   Even so, I support explaining to students for why AD takes certain shapes. As mentioned in my last post, scientists look for explanations. We should teach our students by taking this attitude seriously.
   It should be explained is one issue. How it should be explained is another issue. The suggested three reasons cited above, to me, are rather complicated, not easy for explanation, and even (potentially) problematic for some of them. In particular, I think wealth effect is not a straightforward concept. If you ask me to explain it (properly) to high-school students, I would find it a difficult task.
   To appreciate the difficulty involved in understanding wealth effect, one need only to know that this effect must be distinguished from the income effect that is mentioned in the last post. In other words, apart from income effect, there is another effect from price through wealth that affects the aggregate demand. This important point is perhaps not noticed by some textbook authors. I have read some books' explanation on wealth effect, which is essentially about income effect. But this is not so appropriate.
   Why it is problematic to confuse income effect with wealth effect? This is because, on aggregate, there is no income effect! Why does income effect reduce demand when prices of goods are higher? If one has a fixed income, but the prices of goods are higher, this person can buy fewer goods with the same income. But this is an individual's case and a microeconomic aspect. For the whole society, if prices are higher, although buyers cannot buy more, sellers selling more expensive goods earn more. In other words, some people's income is higher (not fixed), and they may buy more goods. Hence, while some people may buy less, some people may buy more. Taken as a whole, there need not always be income effect from prices.
   Thus, if we say prices on aggregate generate wealth effect, this effect must be something independent of the income effect conditional on a fixed income for everyone.
   If wealth effect is a straightforward concept, more university textbooks should perhaps be willing to mention it. The concept seems to appear often in newspapers or non-technical economics reports (perhaps that's the reason why DSE syllabus requires teachers to teach it). But some serious textbooks choose to avoid this concept. I haven't read all macroeconomics university textbooks. However, the two most popular ones, Gregory Mankiw's Intermediate Macroeconomics and Olivier Blanchard's Macroeconomics, do not cover the term.
   Although another textbook, Robert H. Frank and Ben S. Bernanke's Principles of Macroeconomics, has covered it, this book emphasizes intuitions instead of logical rigor, and so teaches in a style very much similar to DSE syllabus.
   Would logically rigorous textbooks cover it? Interestingly, I find older textbooks like William Branson's Macroeconomic Theory and Policy and Rudiger Dornbusch and Stanley Fischer's Macroeconomics do cover. Both books introduce the term in the context of the life-cycle consumption theory as introduced by Albert Ando and Franco Modignianli (Nobel prize winner). To require high-school students to understand the life-cycle theory is not appropriate. Even if they are able to understand it, I would rather teach them other topics in macroeconomics.
   Hence, what happen is: popular and rigorously written university textbooks avoid wealth effect. Meanwhile, a high-school syllabus explicitly suggest using it while avoiding the more intuitive explanation of law of demand in micro. I know there must be some (perhaps good) reasons behind this treatment. But if I can choose, I will not design the syllabus in this way.

The law of demand, but why?

   I have recently met with a first-year student who has a fresh knowledge of high-school economics, and has not yet been affected by university teaching of economics (as the semester has just begun). He got 5** (the highest grade) in economics from DSE, the Hong Kong's high-school public exam. He can also answer questions in exactly the same way as what the textbook brought by him says. Hence, I trust what he says is what is taught in DSE economics.
   To my surprise, I have learned from him that, in the DSE syllabus, there is no explanation given for why the demand curve of an individual good is downward-sloping. It simply says that this is the law of demand. By contrast, why aggregate demand curve is downward-sloping will be explained as required by the syllabus.
   I do not think we should avoid explaining why demand curve is downward-sloping in microeconomics in high school. We may not need a complicated or technical explanation at high-school level. But we had better give some intuitive reasons. Furthermore, not explaining it in micro but explaining it in macro, to me, is odd.
   The law of demand is a very important part in basic economics. If no explanation is given for this law, the syllabus misses something very important. Economics is a social science, and one primary task of science is to explain what happens. If you ask me simply to believe in something that is true, I will be very frustrated and doubt whether this is what a scientist normally would do. Of course, if we cannot explain something, honestly admitting this is still what a scientist should do. But obviously economics can explain the law of demand.
   Perhaps one could argue further in this way: Science does not explain everything. At some point, you must accept that something are unexplained. If something must be unexplained, perhaps we can also choose which is to be explained and which is not to be explained (like what a mathematician chooses axioms). We can choose not to explain the law of demand but use the law as a basis to explain everything else.
   I am not sure if this is the reason behind the DSE syllabus. If so, I think this is also not a good way to handle (delete) the explanation of the law of demand. First, I am not aware of anywhere else that will adopt this justification in designing high-school syllabus, especially this involves a rather non-straightforward methodological viewpoint. Second, though I know there may be a few economists holding a similar methodological viewpoint, this is not a viewpoint that most other economists in the world hold. Obviously, the global viewpoint (reflected in tremendous amount of textbooks) is that the law of demand can be explained and has been explained. I see no reason why a barely accepted methodological viewpoint should be accepted for designing high-school syllabus.
   Given all these, I must say I do not think DSE should avoid explaining the law of demand.
   Furthermore, if DSE syllabus designers think that aggregate demand can be explained at the high school level, they should also think that demand curve in micro can be explained. It is not more difficult to explain the micro demand curve. I will touch on aggregate demand later by writing another post. At the moment, I simply want to emphasize that explaining the law of demand never involves complicated highbrow technique, and there is already a standard answer, a universally accepted answer in university textbooks. What teachers need is only to explain the two reasons behind in intuitive terms (not in technical terms as in university textbook): substitution effect and income effect.
   The idea is in fact quite intuitive. Any conscious consumer will buy goods with a goal to achieve (e.g. attaining certain level of satisfaction from consumption) and with a constraint restricting her choice (e.g. a fixed income for use in a period). If the price of a good (e.g. apple) falls (say, from $5 each to $4 each), other things (e.g. orange price at $5, income at $100) being equal, then one can spend less ($90 instead of $100) and can still buy the same basket of goods as before (e.g. 10 applies and 10 oranges a month). Given the same income ($100) as before, there is some money unspent ($10), and can be used for buying extra goods. Hence, although the consumer's income is unchanged (at $100), the consumer still has extra money ($10) for use (even if she buys the same basket of goods as before). The situation is equivalent to an increase in the consumer's income (by $10). Though her income is unchanged, the purchasing power of her income increases (when price of a good falls). This is the so called income effect.
   How will income effect affect the quantity purchased? Normally, when income increases, individuals buy more goods. Thus, we expect she buys more apples due to the income effect (i.e. due to the extra money she can use even after buying the same basket of goods as before).
   Meanwhile, a lower price of a good (apple) also generates a substitution effect. As we have mentioned, a conscious consumer buys goods with a goal to achieve. Different goods may help her achieve the same goal in a different manner. In this sense, goods are substitutes. For example, both apple and orange enables one to absorb similar nutrients. Though they are not perfect substitutes, and one apple is not exactly equivalent to one orange, they can be replaced by each other to a certain extent. People want to achieve the same goal at lowest cost. Thus, when apple price falls, a consumer will tend to replace (some) oranges by (some) apples. Doing so enables her to achieve her goal at a lower cost.
   In other words, both income effect and substitution effect support the law of demand: when the price of a good falls, the quantity demanded of the good increases. The reason is as simple as this. When students move on to study economics in university, they can be taught the same reasons (substitution effect and income effect) using technical terms (e.g. utility) and with some variants or exceptions (e.g. Giffen goods). The case will become not very simple at that time but these need not be the concern of high schools. However, at the high-school level, the easier version (without technical terms) of the explanation should be understandable to students, and should not be avoided. 

"New" macroeconomics (3)

   In my last post for this series, I have introduced Paul Krugman's 1979 paper on international trade. This is perhaps the first paper that re-ignited economists' interest in increasing returns at the macroeconomic level. As scale economy can explain the prevalent trade pattern -- intra-industry trade -- better than traditional theory, one may start to wonder the world is more suitably described by models featuring increasing returns.
   The explanatory power of scale economy for macroeconomic phenomenon was soon confirmed by another theory innovation -- Paul Romer's endogenous growth theory or "new" growth theory.
   Why do we need a "new" growth theory? What is "endogenous" in this theory? This is related to what traditional growth theory says. Put it simply. Growth is either fueled by employing more inputs or by technology improvement, which means the same quantities of inputs can produce more. Broadly speaking, labour and capital are two major inputs for production. Empirically, most advanced countries' population growth, thus labour input growth, is stable at a low rate. Then, can growth be sustained by employing more capital (more investments)? If capital actually grows faster than labour, the law of diminishing marginal returns applies. As extra output is smaller and smaller, output growth will then be declining over time. Thus, investing too much is not a way to obtain a sustainable stable growth rate. In fact, capital growth and investment normally simply keeps the pace of labour.
   Now, if production exhibits constant returns to scale, and if both labour and capital grow at the same rate, output can only grow at the same rate. As output and labour move at the same pace, GDP per capita (or per worker) will stagnate. But that's also not realistic -- in the real world, almost all advanced countries record stable (though low) growth in GDP per capita. Living standard per person is indeed improving over time.
   Now, it is clear that, to explain the real-world growth pattern, one must resort to technology (or productivity) improvement. This is the major conclusion of traditional growth theory, or what may be called the Solow model as the theory is due to economist Robert Solow, who won the Nobel prize in 1987.
   While the theory is insightful, what Solow left unanswered is why technology may keep growing? Solow simply sets this question aside. As such, technology is an unexplained factor in his model, and thus an "exogenous" variable (in economics terminology). The task of "new" and "endogenous" growth theory is exactly to explain technology or productivity improvement.
   Why does technology improve over time? The answer is more or less the same as why capital grows: people invest in innovations that fuel technology improvements. Investors' behaviours are again explainable by cost and benefit involved in it. So, the "new" theory is simply applying these old theory to the new area -- the invention sector. But is it? If this is so, the above problem cannot be solved indeed. Normally diminishing marginal returns applies to any input-output relation. If innovation is a normal product, eventually its marginal returns will be declining, other things being equal. We cannot rescue the traditional growth theory simply by introducing a new investment activity subject also to the same pattern of diminishing marginal returns and constant returns to scale.
   At this point, we can see why increasing return is an important factor for growth. If investment in technology exhibits increasing returns, it can sustain a stable GDP per capita growth. But is there increasing return? In fact, there is a good reason why increasing return exists. Technology improvement is due to new ideas, which are knowledge and which are, in economics terminology, public goods. To obtain a new idea, we need investments. But once a new good idea is found, it can let as many people as possible make use of the idea without extra resource incurred. Increasing returns are then possible. But the situation is also not that simple because we need to explain why there are private investments in public goods. For a public good like an idea, if you cannot prevent others from enjoying the idea for free, there is no reason why you will devote efforts and resource to inventing it. Hence, the whole point is not public good but excludable public good: you can prevent others from enjoying it if they don't pay you; you can get the reward of invention although the good can be shared by many people without extra resource incurred. Patents and intellectual properties are a key element involved for making the invention business profitable. The idea can be shared but you have to pay for it first.
   Either we need a policy that can properly protect private property (invention) rights or we need an environment that can encourage (private or public) innovations. These are the key to sustainable economic growth in this "new" theory. Paul Romer's contribution is to re-discover these (perhaps old) concepts about public goods and increasing returns, relate them to growth, and construct appropriate mathematical models for the mechanism. For this contribution, he got the Nobel prize in economics in 2018.

"New" macroeconomics (2)

   In 1979, Paul Krugman, now a Nobel prize-winning economist, was only a very young economist, graduated from MIT with PhD for about two to three years. He also found it hard to publish one of his most influential papers in his life -- a paper entitled "Increasing returns, monopolistic competition, and international trade". Top economists' best papers are mostly published in top five economics journals, which can attract the widest attentions from readers. But this paper is not accepted by the top five. Eventually, it was published in a top field journal Journal of International Economics. Field journals are specialized journals. For example, the journal above is about trade. Since field journals' readership is narrower, it is considered to be less prestigious than top five. [The stories of how influential papers rejected by famous journals are recorded in an interesting book Rejected.]
   Anyway, Krugman's paper, though published in a less influential journal, did kick-start the "new" trade theory, which explains the patterns of trade not by comparative advantage but by increasing returns or scale economies.
   Traditionally, economists consider comparative advantage as a major reason for international trade. The concept is well known even among high-school economics students: Suppose England can produce 1 unit of cloth by sacrificing 1/2 unit of wine while Portugal can produce 1/2 unit of cloth by sacrificing 1 unit of wine. Then, England has a comparative advantage in producing cloth while Portugal in wine. As such, England should specialize in producing cloth while Portugal in wine. Doing so maximize the total output of both goods. Meanwhile, England can buy wines from Portugal, which can buy cloth from England. Both countries can then get both goods at a higher quantity. Specialization and trade thus are mutually beneficial to both countries.
   This traditional theory predicts that international trades should be most frequently made between rich and poor countries because each side has an opposite comparative advantage: rich countries possess more capital and master better technologies while poor countries possess plentiful low-skill workers. Hence, it is ideal for rich countries to specialize in capital-intensive and skill-intensive products while poor countries in labour-intensive products.
   Is this prediction correct? In the decades before Krugman's paper, this prediction was particularly at odd with facts. With the rise of European Common Market and European Union, trades were particularly intensive between rich countries, such as between European countries. Furthermore, the pattern of trade was also not based on comparative advantage. For example, France exported Renault to, while at the same time imported BMW from, Germany. As both products are cars, there is no question about which country has comparative advantage of a product (car) over another product (car).
   These examples about intra-industry trades are important in the real world but the traditional theory cannot explain them. Krugman's paper offers a convincing answer: scale economy and monopolistic competition.
   Take car again as an example for illustration. Its production involves scale economy: more is produced, the lower the average cost of producing it. Hence, if the Renault producer can sell more products, its cost is low and the price is also lower. Suppose that originally there is a large number of competitors in France which also produce cars similar to Renault but it cannot sell many cars as France's domestic demand for cars are limited. Failing to tap the benefit of scale economy, the firms competing with Renault face a high unit cost and has to charge a high price. French consumers will tend to buy Renault and avoid its substitutes. Eventually some firms will bankrupt and only few survive. There is thus a trade-off involved: scale economy and product variety. Scale is obtained at the expense of little variety (as Renault's substitutes will be driven out from markets).
   Nevertheless, international trade resolves this conflict, increasing both scale and variety. The point is that if the market demand is not large enough, the total sale of car is limited and the scale economy enjoyed by each firm in a country is limited. Trade essentially enlarge the market demand. Each firm in each country can sell its products not only to domestic customers but also to foreign ones. Renault can sell more cars as some goes to Germany, exploiting scale economy at a higher degree. Meanwhile, France consumers can also buy BMW, not only Renault, enjoying more varieties of cars. The rise of European Common Market reduced trade barriers between countries, facilitating more trades, and increasing both scale and variety as described above.
   Krugman's contribution is to create a suitable economics model that captures effects outlined above. The model is a simple one but tells a big story. It is not exaggerating to say that, since then, all new trade theory is simply an extension of this idea: monopolistic competition, scale economy, and trade.
 

"New" macroeconomics (1)

   In "hi, economics", I have written articles using various economics concepts. But regular readers may have noticed -- I use or analyze much more microeconomic concepts than macroeconomic (yet due to the pandemic, I have written several pieces on macro). Other readers may also get this from other occasions: I had ever taught microeconomics and now I mainly teach macroeconomics although I like microeconomics more than macroeconomics.
   Having said that, I don't dislike macro but my interest in macro, especially the basic level of macro, is lower than micro. However, I in fact like the more advanced level of macro -- the "new" macroeconomics developed since late 1970s. Sadly, "new" macro is not taught at the basic course even though it is extremely influential in macroeconomists' mind. All new economics PhDs simply learn "new" macro in graduate school, almost no any "old" macro as what readers of "hi, economics" are normally familiar with.  Due to this reason, I would like to briefly introduce some concepts of "new" macro to the readers of "hi, economics".
   Roughly speaking, "new" macro started from late 1970s and includes three major developments: "new" trade theory, "new" growth theory and "new" economic geography. All the three major developments are due to the realization of scale economy at the macroeconomic level. So, you can see: scale economy is a microeconomic concept but its application in macro is profound. That's also the reason why I like "new" macro: I like micro and "new" macro is an exploration of a micro concept in macro.
   Let us revisit the concept of scale economy or increasing returns to scale. If we produce more but the per unit cost of the producing the good is declining, there is scale economy. Why there is a scale economy? Increasing return is an important reason. If we increase the employment of all inputs by the same proportion but output will increase by more than this proportion, there is an increasing return to scale.
   At the micro level, we can have scale economies for some goods. For example, suppose the average cost curve is U-shaped. For those goods where production is at the downward sloping side of the curve, there exist scale economy for these goods. At the macro level, however, we may not think that scale economy is a relevant concept. If the concept is relevant for macro, this means that most goods in the economy exhibit scale economy. Nevertheless, if so many goods involve scale economies, the whole economy's output can be greatly improved simply by employing more resource. Why don't we, then, do this (employing more resource) exactly? Failing to exploit this gain, the economy is indeed at a state of massive waste of resource. Traditional economists do not believe that this is a realistic situation as market competition in the real world is intensive. With keen competition, economists believe that there should be no massive waste of resource (although some wastes are possible). Meanwhile, we also do not see aggregate output can be so easily greatly increased by increasing some more resource employed. Taken together, scale economy must not be relevant at the macro level (though may exist at micro level).
   This traditional belief started to change since late 1970s. What happened in late 1970s? There might be many things happening that changed economists' belief. But now it is not controversial to agree that Paul Krguman's (Nobel prize for economics in 2008) paper in 1979 on international trade is a truly influential one that helps reverse economists' belief. What this paper is about? I will touch on this in the next post.

"Micro"-economics of minimum wage laws

    I have written a post on minimum wage law and unemployment, stating that unemployment was not obviously increased whenever the minimum wage was raised in Hong Kong. The post intends to explain one idea: other things being equal. If other things are not equal when you assess the impact of a policy, you have to find a way (such as statistical method) to control these other things first, or your assessments are simply invalid. 
   In this post, I want to discuss another blind spot involved in these analyses, minimum wage law or the like, frequently adopted in high-school economics education. The unemployment implication is drawn by referring to a demand-supply diagram. There is, perhaps, nothing wrong. The danger is that the demand and supply curves are drawn for one labour market as if there is only one type of labour service involved in the market. Of course, we know that in the real world labour services are of various types. The services offered by a barber are greatly different from that offered by a chef. Hence, one demand-supply diagram of aggregate labour service obviously over-simplifies the issue at hand. 

   How will the employment analysis be affected if labour services are broken down into different types when one single minimum wage law is introduced? 

   First, of course, we should consider different markets for different types of labour services. In each market, a different demand-supply diagram should be drawn. 

   Second, when this is done, it is obvious that we will find only some types of labour services are affected while some will not. Unskilled workers with low wages are affected. Skilled workers with high wages will not. Unemployment, if any, should be generated only in the affected sectors. In the situation of Hong Kong, before the introduction of minimum wage law (in 2011), the government had identified two industries, cleaning and security guards, as potentially the sectors that require wage protection and would be affected. 

   Third, this is not the end of the story, however. And this is exactly where multi-sector analysis can offer extra insights. Sectors are inter-related. If one sector is directly affected by the minimum wage, another sector will be indirectly affected, not because the wage of this sector is below the legal requirement, but because this sector will be affected by the affected sector. For example, a worker may work as a salesperson or a security guard. Salesperson's salary is above the minimum wage, and so this sector is not directly affected. However, a salesperson may change job, becoming a security guard as the salary of the latter is improved by the law while other working conditions, such as job stability, work intensities etc, are perhaps better. These inter-sector effects are probably the more pronounced impact of the minimum wage law. 

   In fact, casual observation confirms this. In Hong Kong, security guard for residential properties is one of the most affected sector by the law. Before the law, wages were too low for this sector and most workers were old male retirees. Now, much more different types of people are willing to work in this sector. A very clear change is that female security guards are no longer an exception. Younger guards are also occasionally found. 

   Is there (more) unemployment in this sector due to the law? If we use a simple and single demand-supply diagram for analysis, the answer should be positive. But don't forget that we have many demand-supply diagrams for many sectors. A salesperson is still an employed salesperson before he or she can change job to become a security guard. They don't first quit the jobs and then wait for the security guard industry to employ them, and so in the meantime they are unemployed. What happens may only be the potential supply of security guards is higher than demand, but these excess supply is reflected in many people waiting for job offers from this sector (security guard) while they are currently employed in a less ideal sector (salesperson). Another new source of worker supply may be the household wives. They may not consider working in the past as jobs that they can work may not offer a wage high enough. But they may now consider working. Nonetheless, they may not be counted in the labour force before they find a job (they will not register themselves as job seekers when they are household wives) and they are not counted as unemployed (they work as household wives). Hence, overall increase in unemployment rate may not be observed. But there could be misallocation of labour resource: workers and jobs may not be best matched. 

   Meanwhile, the indirectly affected sector, say salesperson, may have a pressure to raise the wage (though the original wage is already above the minimum wage level). They may not immediately find a job as security guards because the job offers are not sufficient. But their bosses may notice that the outside opportunities for their salespersons are wider. The employors may feel a pressure to increase salary or they may lose workers in an unwanted way. 

   Finally, another industry supposedly significantly affected by the law is cleaning. I am not so sure what have been happening to cleaning workers' situation after the law. I can easily observe employment situation for security guards at residential properties but not also clearly about cleaning workers' situation. My casual observation is that there is not much change in cleaning workers' situation (but if I am wrong, let me know). The sector is still dominated by older female workers. If this is true, why? I think this is due to the sectorial characteristics. Perhaps cleaning is a low-skill job but it is also a very unpleasant job. In a sense, unpleasant job is similar to skilled job. A hurdle has to be overcome before you can work in these industries, and not every one can overcome the hurdle. True, money matters. When salary is increased to a sufficiently high level, more people will try and overcome the hurdle. But does minimum wage law increase wage to the required level as to change people's perception for cleaning job? I think you must have your own answer in mind.  

   As mentioned above, simple analysis of demand and supply in high-school economics has a blind spot. The point is not that demand-supply model is insufficient for analyzing things that happen in the real world. The point is that only one demand-supply diagram is drawn, ignoring inter-sector effects, or different demand-supply diagrams should be drawn to show how one diagram is affecting another. In economics, this is about partial equilibrium versus general equilibrium analysis. Simple economics concentrates almost exclusively on partial equilibrium analysis. But, as shown in this post, general equilibrium perspective is often important. 

Minimum wage law and unemployment

   Minimum wage law has been adopted in most advanced economies for a very long period of time. However, to Hong Kong people, this is a relatively new issue. We adopt it only since May 2011. Before it was introduced, there was a very hot debate especially in related to its impact on unemployment.
   Even high-school economics students know that minimum wage law will generate unemployment as this is a very useful way to introduce one key concept in economics: equilibrium (versus disequilibrium). The introduction of minimum wage law prevents prices from freely adjusting to achieve equilibrium in a demand-supply diagram. The result is that quantity supplied of labour is higher than the quantity demanded of labour and so unemployment is produced. This is the textbook treatment of minimum wage law and has been used for many many years. Beyond textbooks, there are some dissenting opinions (notably the findings due to a 1993 paper by Card and Krueger) but perhaps there are still more professional economists believing in the textbook case.
   This post is not concerned with the academic debates mentioned above. Let's consider if the textbook case of minimum wage law is correct. Then, look at the figures. We can find little evidence, if any, for the hypothesis that minimum wages are to increase unemployment in Hong Kong.

	2010	2011	2012	2013	2014	2015	2016	2017
Hong Kong unemployment rate (%)	4.3	3.4	3.3	3.4	3.3	3.3	3.4	3.1
minimum hourly wage	0	28	28	28-30	30	30-32.5	32.5	32.5

   The most dramatic counter-evidence is that unemployment rate decreased from 2010 (when minimum wage was not effective) to 2011 (when it became effective). The drop is so sharp: from 4.3% to 3.4%. Next, since May 2013, the minimum wage raise from $28 to $30. But unemployment actually fell from 2013 to 2014. Then, since May 2015, the minimum wage raise from $30 to $32.5. This time, unemployment rate slightly went up from 3.3% to 3.4%. Taken as whole, how can we say minimum wage law bring about unemployment? The data is simply not supportive to this hypothesis.

   In fact, around 2010 and 2011, when minimum wage law was first introduced and so this was a hot topic in the society, I often asked students during interview: The data of unemployment rate is not consistent with the prediction by economics. Does it mean the economic theory is wrong? Notice that this was a question given to high-school students. Thus, what I asked for is an answer made based on high-school level economics. But most students did not know how to cope with such a question. Perhaps they was accustomed to learning what has been taught but not to thinking upon what has been taught. Some students, being not able to explain the inconsistency between data and theory, simply replied: perhaps the theory is wrong. But that's also not my expected answer. I didn't try to criticize the conventional theory during interviews (it would be unfair to require students to think beyond the conventional theory but it is fair to require them to truly understand the conventional theory they learn). 

   The answer should be so simple, and is exactly what is the topic of my last post: ceteris paribus or other things being equal. Even if the theory of minimum wage law is correct, it is correct only when other things being equal. If the demand and supply curves do not shift, but the minimum wage is imposed, then unemployment is created. However, if demand curve shifts (say, the economy grows strongly so as to increase labour demand) or supply curve shifts, there need not be (extra) unemployment to be created by the law. We have to know what happen during 2010-2011, 2013-14 and 2015-16 when the wages were increased. Perhaps the economies were good (or bad) at that time. We can never jump to the conclusion that the theory is wrong. Thus, what we need is a model to take account of those relevant factors that affect unemployment rate, such as GDP, labour force change, etc. Only when we control these other factors (by an econometric or a statistical model), we can then assess if minimum wage has extra effect on unemployment. If we have already controlled these other (relevant) factors, and we still find that unemployment rate is not increased, then we can conclude that the minimum wages do not matter. 

Misunderstand "other things being equal"

   In the past summer, I have interviewed many high-school students wanting to study economics in university. As I mentioned in my earlier post, interviews is a useful source for me to know what students have learned in economics.
   In one case, a student (a pretty good one) gave us (I and another interviewer) a question: In economics, a usual assumption made is "ceteris paribus" or "other things being equal". However, in the real world, other things are always not equal, Then, how can we apply the economic theory for analyzing the real world? The theory may never be useful.
   I guess that not only this student but also many laymen may have the same feeling about this assumption used in economics. However, most doubts cast on this assumption is due to a misunderstanding. There is a need to clear up these doubts and remove the misunderstanding if we want to properly learn economics.
   At that time, I gave another answer to thus student. Upon reflection, there is an easier way and more constructive way to answer this student so that he can understand why his suspicion involves a misinterpretation of the "other things equal" assumption. Hence, let me answer his question (again) here.
   For example, when income increases, economic theory (demand and supply) will say that, other things being equal, the demand curve for a normal good will shift rightwards while the supply curve is unchanged. So, both the price and the quantity traded of the good will go up. However, other things are always not equal. But does it mean our analysis is not useful? Certainly not. If we know what "other things" change when income increases, then the economic analysis should simply take also this into account. For instance, if we also know that the cost of production decreases when income increases, then the theory tells us that supply curve will shift down when demand curve shift rightwards. The result: quantity traded certainly increases although price may go up or down. If we want to know whether the price will go up or down, then we have to know some more about the facts: the income increases by how much and the cost goes down by how much and what is the income elasticity of demand and cost elasticity of supply.
   Hence, you can see: The theory is useful. It can predict what happen even if "other things are not equal". But the more complex the event is about (only income increases or cost also changes), the more information (income and cost elasticities) we need for an analysis.
   So, "other things being equal" does not really prevent us from using the theory to analyze the real world. But then you may wonder: if so, why "other things being equal" is assumed? It seems that the assumption of "other things being equal" has not been satisfied and adopted in the case of "income increases while cost also goes down".
   The situation is: the assumption has really been used in the analysis above. When a demand curve shifts, say, from D1 to D2, other things are assumed to be equal. Only income increases and so the demand curve shifts to the right. When a supply curve shifts, say, from S1 to S2, other things are assumed to be equal. Only cost goes down and so the supply curve shifts down. Well, when both things (income increases and cost goes down) happen, wouldn't it be wrong to say "other things being equal"? No. You have to understand that a conducive approach to analyze anything is to analyze things step by step, instead of messing up everything together. To make step-by-step analysis possible, in each step, you had better consider only one thing to change (or you may mess too many things up). So, when you want to know what happens to the demand side, consider only demand factor (income). Other things (cost) are assumed equal. When you move on to the next step - the supply side, consider only supply factor (cost). Now the income has been considered to have increased to the new level already and no longer change further. Other things (income) are equal.
   From this example, you can see that "other things being equal" should not be misinterpreted as really assuming everything else unchanged in the real world. It is, however, necessary for analysis in steps, not messing things up.
   Well, you may still find this interpretation not convincing enough. You may say: when income increases, if other demand factors are also not constant, the demand curve may not shift to the right. Thus, we need to assume unrealistically that other demand factors are equal when predicting a rightward shift in demand curve. But this does not affect my interpretation above: "other things being equal" is assumed for any step-by-step analysis.
   In economics, we often express demand as an equation like this:
Quantity = 100 + 0.8(average personal income) - 1.2(price of the good) + 0.2(price of substitutes) - 0.15(price of complements) + 0.06(other factors)
   Demand equation can be estimated when economists got sufficient data about consumers' choices under different prices, income levels, etc. The above suspicion is like saying that we cannot be sure the demand curve shifts to the right when income increases by 1 unit as price of substitute may fall by more than 4 units at the same time (other things not equal), offsetting the effects from income.
   There are two responses to this suspicion: First, when we say the demand curve shifts rightwards, we have to make sure the income effect will not be offset by "other things" such as price reduction of substitutes. But it is still true that if "other things being equal", income will shift demand to the right. In fact, the parameter 0.8 for income effect says exactly that if "other things are equal", 1 unit increase in income increases quantity demanded by 0.8. It is meaningless to talk about 0.8 if "other things are not equal". If we do not have the parameter 0.8, we cannot even tell that when income increases by 1 unit while the price of substitute reduces by 4 units ("other things not equal") demand will be unchanged. Meanwhile, if we do not know what happen when "other things are equal" (0.8 parameter), we cannot know what happen when "other things are not equal" (both income and price of substitute change). There is nothing paradoxical involved. As mentioned, "other things being equal" is simply an assumption adopted to facilitate the step-by-step analysis. If we cannot divide things in steps and know in each step what would happen (know what would happen "when other things are equal"), we also cannot know what would happen when all steps are taken.
   Second, perhaps someone may concentrate on the last item in the demand equation above. There are always other things other than the factors identified as price of substitutes/complement, and so on, in a model (of demand in this case). In fact, when someone criticize the "other things being equal" assumption, I suspect that most of them have exactly this type of criticism in mind. They may think: there are so many factors in the real world and so how can we not miss some factors? But this problem is not unique to economics. For example, when scientists predict the weather of tomorrow, there must always be some factors other than those that have been identified in their weather model. That's one reason why scientific predictions may sometimes fail. Scientists can only try their best in identifying as many relevant factors as possible. There is nothing wrong and special about this. Of course, social scientists, economists in particular, may find their task of this identifying jobs particularly difficult as society/economy is a complex thing. As scientists, or economists, or even economics students, one should not therefore blame the theory, saying that "other things being  equal" prevents them from doing a good job. If we haven't tried to identify as many relevant factors as possible, it is our fault, not the theory.  

The economics in European Super League

    The rise and fall of the European Super League (ESL) within a few days must be one of the most important sports news this year. On 18th April 2021, it was confirmed that 12 most prestigious European football teams, from Spanish, Italy, and UK, will form the ESL. The new league, if succeeds, will become a competitor of the existing football organizer in Europe, the Union of European Football Associations (UEFA), which organizes the important UEFA European Championship and various leagues and cups. As a unique organizer (the only association of all football associations in Europe), it serves as a governing body of European football, controlling the prize money, regulations and media rights in these competitions. Hence, it is expected that UEFA strongly opposed to the idea of ESL and threatened to punish those teams and footballers who may join ESL. What is less expected is that others also reacted strongly, including UK prime minister and France president. Eventually, within 48 hours, the plan of ESL was doomed to fail as UK teams first announced that they would withdraw. Other teams also withdrew later and 3 teams remained at the time when this post is written.

   When I heard the news of the establishment of ESL, I immediately sensed that there must be some interesting economics in this issue. However, I am not a fan for football and really ignorant of the current situation of European football games. Thus, at that time I did not have concrete idea of the issue. My initial thinking is that the issue is likely related to the business downturn due to pandemic. It is about money. Those who form ESL want more money. In the past, they already want it. But when football business is in its good days, people normally can be more tolerant. When bad days come, people can no longer tolerate the original scheme that disables those super teams in earning more or sharing more of the profit. That's why ESL was formed. 

   It turns out that this initial thinking can at best be partly true, or represents only a minor point in the whole issue. Later, I read some comments made by those who know football. The following points are a summary of these comments that I read:

1. The issue is related to the differences in sport cultures and sport business models between Europe and US. In US, the four biggest sport leagues are a franchise system: there is no promotion or demotion of a team to or from the league. The team which ranks last can also retain in the league and expects to share TV broadcasting revenue. New teams must obtain all existing teams' agreement for joining the league. But once they join, they can simply get the revenue without worrying being kicked out. In Europe, that's not true. One must win sufficiently to remain in the league or it may be demoted. 
2. It happens that many owners of European football clubs are also owners of US sport teams. In particular, most ESL teams are owned by businessmen who do not pay too much attention to the sport "tradition" but are primarily concerned with profits. They think the European system is uncertain (over promotion/demotion and so one has to work hard for this), not ideal for profit-making, and so prefer switching to a US system, which is exactly what ESL is about. 
3. UEFA has recently launched more football games and leagues for more profits. But then the prestigious teams, notably those who want to join ESL, have to participate in more competitions with weaker teams, and do not expect to earn much more from these extra competitions. Their footballers have too little time for a rest and are more likely to get injured. All these costs will be borne by team owners, not UEFA. In US, a rest of 4 to 5 months is normal but in Europe, only 2 months is available.
4. The success of sport games requires that teams with similar strengths compete with each other. A game played by a very strong team and a very weak team, resulting in say 10-to-0, is not attractive. This is the so-called competitive balance in sports economics. ESL collects teams with similar strengths. In this sense, this helps achieve the competitive balance. However, ESL is also anti-competitive: teams joining ESL do not need to worry about demotion. Over time, this may induce some teams not to keep themselves in the best condition, which is bad.  

With these comments from someone knowing football and sport economics, now I know more about the situation. What are the economics in the issue, then? In essence, it is monopoly and competition. UEFA is monopoly. ESL wants to become a competitor. Eventually, the existing monopolist wins. But is thing that simple? 

   High-school economics has already taught us some basic theory of monopoly. Monopoly is bad. Competition is good. If more competitors can be introduced, that's good. If the market can only accommodate one player -- notably due to the natural monopoly situation, then at least monopoly should be regulated. That's what we have learned. But a straightforward application of such a basic theory to this sport issue is not good. In fact, besides sports, sometimes economists may accept (at least do not disagree) that monopoly is not bad. 

   For example, stock exchange is often also a monopoly in the real world (Hong Kong is an example). Why not having several exchanges and let them compete with each other? In fact, before 2000, there were four stock exchanges in Hong Kong. However, one disadvantage of having several exchanges is that small stock investors will find it less convenient to trade. More important, different exchanges may adopt different standards in approving a company to list on their exchanges. You may imagine: a company that is deemed to be not qualified for listing on Exchange A may be deemed to be qualified on Exchange B. Which Exchange is right? It is not easy to assess. But one thing is true: Exchange A will lose the business of the company going to Exchange B. Then, Exchange A may have incentives to lower the standard of listing, and this is not good from small investors' viewpoint. 

    In sports, a similar situation happens. A league organizer is also a standard setter. As Point 4 above mentioned, attractive sports games require matching good teams with good teams. For this, we need someone to set and keep the standard. Is competition between league organizer conducive to holding the standard? I am not sure. But at least we need to be more suspicious, given the example of stock exchanges. A monopoly will be free from the pressure of lowering standard. That is one reason why monopoly may be supportable. But, of course, things are also not that straightforward. Point 3 above also illustrates that a monopoly may have a tendency to profit itself, introducing something not really good for sports at others' expense. In fact, a potential rival, like ESL, may serve as an alarming call -- people may not always tolerate a monopoly even if there is a good reason for its existence. A potential rival, success or failure, may prompt a monopoly to reform itself so as to serve its original purpose (the reason why people allow you to monopolize) better. Of course, as to how fast the existing monopoly will learn the lesson, we have to wait and see. 

Recommended reading (4): Thinking strategically (or its sequel)

   I belong to the generation of (past) economics students who did not have a game theory course offered in the undergraduate curriculum. Hence, for all the game theory I know, I learned it either from graduate school or through self-learning. As I have explained in a past post, what we have learned earlier may have an unexpectedly high influence on our knowledge. I also suffer from this starting-point difficulty: I never think my understanding in game theory is good enough, at least not as good as my understanding of economics in other fields. Of course, it is not an excuse to blame your schools for what you are not taught. Otherwise, my students can also blame me without resorting to self-learning. Unfortunately, in graduate school, game theory is again not my major area of research. The result is that I always think that game theory is one of my weakest link.
   For this reason, I hesitate to recommend any game theory books to you. This is of course not ideal as the theory has now occupied a very important role in economics. Furthermore, due to its values in business and many other areas involving competition (including military), the theory is currently one of the most well known part of economics among common people. Nonetheless, I cannot recommend books to you if I don't really like it. Actually, I didn't read many game theory books for the reasons mentioned above.
   Fortunately, I did read a game theory book that fascinated me very much, and I think this is really a very good book for learning some game theory informally. It tells stories but is also of high quality from an academic viewpoint. I am very much willing to recommend you the book written by Avanish Dixit's and Barry Nalebuff's Thinking Strategically. In fact, I guess my recommending words can be applied in another book of the same authors, The Art of Strategy. Dixit and Nalebuff originally wanted to write a revised and expanded edition of Thinking Strategically. However, eventually they come up with a new book as so many new stuffs have been written. But you can see: the second book is basically written with the same intention as the first: introducing game theory with useful and interesting real cases documented. Thus, I guess the second book is also recommendable. However, I haven't read the second book yet. As such, in this blog, I formally only recommend the first one. But you can try the second.
   The academic status of Dixit and Nalebuff is very high. Dixit knows (and is good at) almost every field in economics, including of course game theory. He was also a visiting professor at Lingnan University. Nalebuff is an authoritative game theorist. Hence, there is no doubt about the academic quality of their works. What is surprising is, however, that they know so much about applications and real world examples. Reading this book is surely enjoyable though some parts of it would need you to pay attention and think.
   This book shows you that game theory can be applied in so many different areas, not only for economic or business area, but also, sports, politics, and military areas, etc. Hence, it will certainly widen your perspective. I was particularly impressed by two parts of it.
   In game theory, there is a term called mixed strategy. Strategy is normally about an action plan: when something happens, you do this; but when something else happens, you do that. Mixed strategy is more complicated. It involves choosing a probability such that you do something at a chance and do some other things at other values of chances. Students who are enrolled in a game theory course will all be taught this concept. We can understand it but we may simply consider it as a formal concept and not to treat it very seriously. Dixit and Nalebuff told us that mixed strategy can be very practical. For example, in basket ball games, players may take action not at a fixed direction but do something at a chance to confuse their rivals. You can imagine this strategy is of course very useful in sports games: your fixed action may be easily detected by rivals and this lead to loss. So, you have to randomize.
   Another impressive stuff is about brinkmanship: it is about deliberate creation of risk. Yes, it is to deliberately create risk although normally most of us don't like risk. The creator of risk also does not like risk but sometimes creating it can gain certain strategic advantages. Well, it sounds not so intuitive but reading the book will let you know why this is so. Brinkmanship is a very realistic thing especially in these years: the North Korea crisis is actually an example of brinkmanship perhaps created by both sides, North Korea and US. Crisis happens on and off in the real world. If you understand brinkmanship as a strategy, you might be able to help yourself figure out what really happens and stay calm. Whatever you want to do, managing investments or simply seeking a peaceful mind, the knowledge about this is important.

Recommended reading (3): Peddling Prosperity

   So far, I have recommended two books for learning microeconomics. Now, let us turn to macroeconomics. However, this is much more difficult. On the one hand, macroeconomics theory is less unified as microeconomics. Even for textbooks, different authors may present you rather different frameworks. On the other hand, a popular book that is a good complement to formal teaching can rarely be found. Normally popular book writers simply focus on the macroeconomic issues that they think are important. They may not bother introducing much about the theories or concepts behind.
    For this reason, I cannot recommend a book as a good textbook complement as what I can do for microeconomics. What I can find is a book that is conducive to learning some important macroeconomics concepts. Though not all of these concepts are taught in a basic course, I think it is worth your while to learn these concepts.
   OK, what is this book? First, the author. He is globally famous for his popular economics writing − Paul Krugman, the Nobel Prize winner in economics in 2008. But he is also a controversial guy. Professor Krugman has recently been recognized by some people, including economists, as a radical. He is accused to be too biased toward the leftist viewpoint (which tends to be more suspicious of the function of free market). Even if he may be biased today, his writings in the past are not, at least not very, biased. In fact, I intend only to recommend one of his earlier books here.
   Krugman has a special talent in explaining difficult economics concepts in an understandable manner. His book The Return of Depression Economics is a good demonstration of applied economics in financial crisis. This book is also recommendable but I personally like his Peddling Prosperity, an older book of his, more.
   This book has indeed introduced some basic macroeconomics that students may have learned in high school or the first year in university. In particular, Chapter 1 is an introduction to those traditional debates among Keynesians, Monetarism and others. Krugman is perhaps biased towards Keynesians but he still did a good job in telling you what rival theories say. If you cautiously ignore the harsh words he uses to attack rivals to Keynesians, you can enjoy the core part - Krugman's excellent skill in explaining difficult theories with simple illustrations or stories. For example, the reason why there are recessions is not explained by dry theory but a major metaphor - it is like what happens in a baby-sitting club. If you already have some basic ideas about macro, reading this chapter can make you feel that you now really understand what these theories say. If you have not learned anything about macro, this chapter may also enlighten your macro sense. If you won't be bothered by Krugman's critical and cynical attitudes, this part can still be considered as a good complement of traditional macro textbook. Of course, you have to be cautious, as I mentioned earlier. 
   However, what fascinates me most by this book is not its introduction of traditional macro (though this part is also good). It is the new ideas about macro, the part that borrows from micro.
   In microeconomics, we will learn a concept called “increasing returns to scale”. This is only one of the many important concepts in microeconomics. But the recent development in macroeconomics is mainly triggered by an intensive application of the concept of increasing returns. Many traditional beliefs on trade, geography and growth are rewritten.
   In Part III, the last part of this book, it introduces the application of this concept in the macroeconomics interestingly. In fact, before I read this book (at that time I was not an economist yet), the macroeconomics that I knew was still some theories either labelled Keynesian or Monetarist and they were mainly about economic fluctuations or short term policies (exactly the topic discussed in Chapter 1 of this book). The world of macroeconomics was already much broader than that but I was so ignorant. Reading Krugman woke me up. This book enables me to understand that macroeconomics is also concerned with something fundamental in the long term. Furthermore, it is amazing that "increasing returns" are so important at macro level. I have really learned a lot from this book. Actually, Krugman himself is exactly the one who triggered the whole wave of new macro theories: his 1970s paper in trade theory with increasing returns kick-started the whole field of new trade theory. In 1990s, his another paper initiated another whole new field - integrating geography and increasing returns into macro. That's the reason why he got the 2008 Nobel prize. Reading this book, you can learn directly these ideas from one of the most authoritative experts in this field.
   Therefore, though reading this book may not help you cope with your exams in macro, this book is recommendable if you intend to learn some important macro things, or learn how to explain difficult things in simple terms.