The use of macroeconomics

   I have recently contacted one of my past students. Currently she is an investment advisor in a foreign country. Surprisingly, in our conversation, she mentioned: "The macroeconomic knowledge and thinking process you taught us are still beneficial for my current role in investment firms." I am surprised not because my teaching can help my students' career. But I have never expected that it is macroeconomics. Which aspects in macroeconomics taught by me can really help my students? 

   Upon reflection, it is also obvious that macroeconomics is much more relevant to understanding the current economic situation while investment advisors are normally concerned with the "current issues" as these are most important for the "current" performance of their investment portfolios (via buying and selling stocks or other financial assets). 

   But exactly how can macroeconomics help? Perhaps one recent example is about the interest rate movements. Financial investors are very much concerned with the interest rate movements as interest rate represents the cost of funding. When the cost of funds (interest rate) rises, fewer financial investors will buy financial assets (e.g. stocks) and can buy less. A smaller purchasing power implies that the prices of these assets will decline. Some asset-holders will suffer from a loss. Some asset-holders would like to sell before others sell so that they can avoid the loss of selling later than others. Macroeconomics exactly offers a framework for analyzing the interest rate movements. 

   In macroeconomics, the issue may appear to be simple enough: Central banks control the money supply, and therefore affect the interest rate, at a given level of money demand. If central banks increase money supply, interest rate will fall, and vice versa. But the question is: will central banks opt for a lower or higher interest rate (more or less money supply)? 

   Normally, we know central banks have two targets: low inflation and low unemployment rate (or high GDP). The dilemma is that often the two goals cannot be achieved at the same time. Hence, central banks have to struggle between the two goals, and analysts try hard to understand how the central banks will strike the balance. In fact, a recent problem confronting analysts is that how far the US central bank, the Fed, will increase the US interest rate, and when it will stop rising the rate. 

   Again, how does macroeconomics help us to think about the issue? Firstly, the current economic problem is that both recession and inflation happen at the same time while inflation is particularly high, once exceeding 8% in US. Macroeconomics has obviously provided us a useful framework to understand the phenomenon. By the AS-AD model, we know that AD (aggregate demand) is not the cause of such a problem (higher price as well as smaller output). It is AS (aggregate supply): when AS moves up, price will go up and output will go down. 

   Why did AS move up? Answers: The global production chains have been disturbed by the pandemic. The war between Russia and Ukraine obstructed supply of basic food. The economic sanctions imposed by the Western countries on Russia generated crisis in oil-related products. All these increases the cost of production. When production cost increases, AS moves up.

   While inflation stepped in, central banks have a mission to control it. They have a pressure to, and have already taken actions to, increase interest rate. The action to increase interest rate is equivalent to a contractionary monetary policy (decreasing money supply or slowing down its growth), which will reduce the aggregate demand for goods. This releases the pressure for price to rise (easing inflation) but add extra pressure on output contraction. 

    So far so good? But what next? Will interest rate continue to rise for a longer period (then the financial market sentiments will be much dampened), or will the rate reach the peak soon (then investors should start to buy now)? This is again about the two goals that central banks aim at attaining - output growth and inflation. When inflation is high, the central banks adopt contractionary monetary policy, raising the interest rate. But when a contractionary monetary policy is implemented, this generates pressures on output contraction. So, this jeopardizes the second target of central banks - to maintain output growth or stability. If central banks don't want GDP to slow down or even decrease, it will restrain its action to push up interest rate, or to stop pushing it up. Analysts would like to know when this will happen, and the answer depends on the output performance. 

   Hence, these months analysts have a close look at the economic performance in, say US. The sign of output stagnation is, paradoxically, interpreted as good news because this may indicate that the central bank will stop raising interest rate sooner. In case they expect the interest rate rise will plateau soon (say, in early next year), they will start accumulating financial assets (e.g. stocks) at low prices today and wait for the asset-price appreciation (due to interest rate being peaked). If they expect interest rate will not peak soon, they will wait for longer, not buying today and so asset prices will keep falling for a while. 

   Do we need to learn macroeconomics to know all these? Perhaps we don't but obviously having learned it makes us have a clearer concept and that's useful for doing analysis. 

   Furthermore, macroeconomics do really let you figure out a point clearly: if the original source of the problem is due to AS, analysts' judgments about the timing of interest rate peak should take this into account. 

   From the very beginning, the recession was not caused by the central bank's contractionary monetary policy, which depressed demand. If there was no high inflation, the central bank would not take this depressing action. The economic performances for many countries, including US, did not look too bad early this year. Many of them actually started recovering from the turbulence from pandemic. Hence, it is clear that the source of the problem is due to AS, not AD. We may call the output recession caused by AS as the primary cause of output reduction.  

   If so, then what? When we say the central bank will be mindful of the recession and will not let interest rate to raise too much, this is about AD: stopping the contractionary monetary policy will ease interest rate upward pressure and will ease also the output downward pressure at the expense of a stronger price upward pressure. In other words, AD is only a factor to aggravate the recession originated from AS.  We may call the output recession caused by AD as the secondary cause of output reduction. 

   When analysts concentrate on the central bank policy, and on when it will stop raising interest rate, their attention is paid to the secondary cause mentioned above. This concentrates on a problem that is generated by the central bank (output loss due to high interest rate) as if the central bank wants to cause a trouble to itself. But the central bank has never wanted to generate any problems to the economy from the outset. It simply responds to the economy and tries to makes things better. 

   This brings us back to the primary cause, which is really the origin of the problem and should not be ignored. If the factors contributing to the primary cause have not improved, the inflation pressure is still there and the central bank has to take care. Analysts should bear in mind that the central bank has to take the painful action (in terms of output loss) exactly because of the primary cause, which is not generated by the central bank policy but by some fundamental production disruptions as mentioned earlier. They should not simply focus on the secondary cause.  

   

The economics of small shops

   These years, news media, and perhaps the society at large, seem to pay more and more attentions to the value of small shops. 

   On the one hand, small shops are said to represent the "collective memory" as we have more small shops (e.g. a fish-ball or wonton noodles restaurant and old-style bread bakery) in the past. When we were children, we mostly shopped at these small enterprises while nowadays large scale chain shops (e.g. McDonald's or KFC) are more popular. 

   On the other hand, small shops are often considered to be more humanized with closer personal relationship between the shop owners and the clients. Chain stores cannot offer these good things.

   Hence, a social sentiment has been built up, blaming market forces for its driving out these old good things associated with small shops. Such a viewpoint is shared by many people who are concerned with traditional culture. 

   Regardless of its being right or wrong, such a viewpoint involves economics as it is targeted at market forces. Therefore, if we want to answer questions in relation to small shops, we should not ignore the economics involved in this issue.
   Some people may think that the economics viewpoint is already well known: market force is good for the economy; if it drives out small shops, we have no other choices but to accept this. 

   Perhaps this is a popular perception of what economists would say on these issues involving conflicts between market force and tradition or heritage. However, this simple viewpoint cannot cover all economics viewpoints towards markets. I really want to introduce the alternative (but still 100% economics) viewpoint to the readers of this blog, widening their perspectives. My difficulty is that the economics theory involved may go beyond high-school level. I have to try my best to avoid using theory beyond that level. I hope my attempt below can achieve the goal.
   Economists are not experts in recognizing social values. However, they are not, as some people believe, someone who recognize only market values (or money values) but ignore any social values. 

   In economics, the value of small shops that cannot be attained by chain stores will be recognized (e.g. memorial and personal-relation values). Meanwhile, the value of chain stores that cannot be attained by small shops will also be recognized (e.g. fast and standardized services). Economics recognize the differentiation between small shops and chain stores, etc. If both small shops and chain stores can be kept, some extra value can be attained. If only either one (small shops or chain stores) is available, the society losses something. These values, due to product differentiation, are recognized in economics via the concept of consumer surplus.
   To put it simply, consider two types of products: products and/or services in small shop and chain store. The two products are substitutes but not perfect substitute because of the differentiated features mentioned above. If both types of products are available (people can sometimes visit small shops but sometimes visit chain stores), consumers' benefit should be represented by the total consumer surplus measured from the two types of demand curves of the two goods. If only one type of product is available (e.g. small shop is driven out from market), only the consumer surplus from one type is measured. 

   Chain stores sell standardized products, and minimize personal aspects in their products. Therefore, chain-store products are closer substitutes among themselves (Chain Store A may not be very different from Chain Store B). Small shops, however, are less close substitutes for each other (Noodle Shop A is likely much different from Noodle Shop B) as their products are not standardized. Of course, small shops are even less substitutable by chain stores. 

   When goods have many close substitutes, their demand curves are flatter (in the extreme case the demand curves for perfect substitutes are horizontal) because people will not hesitate to buy the substitutes whenever prices of a good is raised. In contrast, if goods have no close substitutes, their demand curves are steeper (in the extreme case the demand curves for irreplaceable goods are vertical) because people do not have much other options even though prices are raised. Other things being equal (i.e. at the same price and same quantity), steeper demand curves generate more consumer surplus than flatter demand curves.
   Now, when products are differentiated (more or less irreplaceable), each producer faces a downward-sloping demand curve (not a horizontal demand line as under perfect competition), the consumer enjoys the consumer surplus by paying a price lower than their maximum willingness to pay. 

   Then, how many differentiated products will survive in markets? Are there appropriate number of differentiated products available in the markets? To assess this problem, we have to understand the incentives for firms to enter (or stay in) the markets providing these products. We also want to know if the incentives for firms' entrance decision is in line with social benefit. 

   In a market with free entry, new producers (small shops or chain stores) will join the market provided that doing so is profitable. Equilibrium is attained when it is no longer profitable to join. When each of these new entrants considers whether to join or not, they consider only the prospective profit but not the consumer surplus, which is earned only by the consumers, not the producers. From the society's point of view, however, consumer surplus matters to the society's benefit and should not be ignored. As new entrants ignore something that should be counted for social benefit, too few entrants may join the market. This bias is called surplus-ignoring effect.

   On the other hand, when each new entrant considers whether it should join the market, it also ignores its impacts on other existing producers: as each new firm sells a substitute of the existing producers, the latter's business will be more or less lost to the new entrants. By ignoring this negative impact on others, or the negative externality that is generated by these new firms, too many entrants may be resulted. This bias is called business-stealing effect.
    In above, we say there is a bias of firm's entrance decision. This means that firms decide to enter the market by considering the private benefit of entry. But if the social benefit of entry is higher than the private benefit of entry, the incentive for firms to enter is too low (if you bring about $100 benefit to the society but you earn only $60, the society wants you to do more but you won't). If the social cost of entry is higher than the private cost of entry, the incentive for firms to enter is too high (if you bring about a $50 cost to the society but you bear only $30 of the cost, the society wants to you to do less but you won't). 

   Back to the impact of firm entry, we've discovered two opposing forces: surplus-ignoring effect supports too few entrants while business-stealing effect supports too many entrants. On net, whether the free market supports too few or too many firms depends on the balance of the two effects and cannot be told a priori.

    You may wonder: consumer surplus always exists and firms always compete for (and so steal) business from each other. It appears that the above effects always exist. Then, we always don't know a priori if free entry is too much or too little. But isn't economists always supporting free entry in free market? 

   Answer: they do support free entry but not always; they support only when there is perfect competition. Under perfect competition, each firm faces a horizontal demand. There is no consumer surplus associated with it. Yes, the market demand curve is still downward-sloping. But now we are concerned with the demand facing each new firm (we are discussing whether entry is profitable). Hence, it is the demand facing each firm that is relevant. Meanwhile, under perfect competition, the market is so large and each firm is so small. Each firm does not need to worry about their clients are stolen by other firms as they have plenty (in a big market).

   Thus, the framework above works for imperfect market, not for perfect competition. 

   This framework has been gradually established in the literature of imperfect (monopolistic, in particular) competition (in a 1976 paper by Micheal Spence, the Nobel prize winner, and also a 1986 paper by Greg Mankiw and Mike Whinston). It is generally not known to high-school economics students (who are familiar normally with only perfect competition). I have tried my best to make my introduction simple enough but, as mentioned, it is difficult to do so (so my explanation is lengthy). I hope readers forgive me for not being able to make things easier. The framework, complicated it may be, offers a useful perspective for us to assess if small shops are excessively driven out from market. 

   So, let us come back to the small shops vs chain stores conflict. 

   As mention earlier, a small shop is generally not a close substitute to other small shops and chain stores. As such, its demand curve should be steep. The surplus-ignoring effect may also be relatively strong. 

   Furthermore, introducing one more small shop will not steal too much business from other firms as they are less substitutable for each other. The business-stealing effect may thus be smaller. 

   Hence, it is likely that the surplus-ignoring effect dominates business-stealing effect, which means there are too few small shops in a free market (and so too many chain stores). This conclusion coincides with the current social sentiment but our reasons are completely economic-theory-based.
   Yes, economics may offer more than one perspective for people to think on the issue. In the present case, I think the perspective just introduced is more relevant than the simple free-market perspective (market force drives out small shops but this is good for the economy), which is valid only in a perfectly competitive market. 

   In the real world, retail shops are competing with each other imperfectly. We should use the appropriate model to analyze the issue at hand, instead of using one model (perfect competition) to analyze everything. 

   Unfortunately, the monopolistic competition framework, involved in the present context, is much more complicated and is not very easy for understanding. This is normally not known to common people, and social advocates in particular. Therefore, these people, knowing no other economics viewpoint, may think that economists will always believe only in free market (let the small shops extinct). But this is certainly not the only conclusion economists will support.

Is online shopping really that convenient?

   Online shopping has obviously become much more popular since the pandemic. But will its popularity more or less a transitory phenomenon due to the exceptional situation these years? Will online shopping be cooled down very much when the pandemic fades? Anyway the covid-19 appears less damaging in the recent year and will eventually fade out. It's the time to reflect on this issue. 

   I've recently asked this question during interviews to students who applied to study economics. They obviously have some experiences in online shopping. Hence, regardless of their level of economics knowledge, their opinions may have some reference value. 

   To answer the question above, a key issue is that what the real advantage of online shopping over traditional retailing is. To this, students answered that online shopping is more convenient. Based on this belief, most of them also thought that online shopping will continue to prosper as this advantage will not fade even without pandemic. The current pandemic is an opportunity for people to adapt to online shopping. Most of them, before the pandemic, may not have the experience of shopping online. Hence, it was not that popular before as they didn't know it would be so convenient. But once they experienced, they would not abandon it later. 

   That's the opinion of the majority of students. For this "theory" to be valid, however, one needs to answer why recently, when the pandemic starts fading out, certain big names in online retailers have aggressively extended their physical retail networks. They rented physical stores in malls or on the streets. Originally they also have some physical shops but these were mainly points for customers' picking up their goods purchased online. Customers were even prevented from paying cash to buy goods from these stores. They wanted their stores served only the online business but not acted as other physical stores did. Nonetheless, recently these online retailers allow even payment on the spot, doing exactly the same things traditional retail shops do. So, they has become like physical shops, at least converging to them. 

   All these look to be contradictory to the hypothesis that online shopping is more convenient and will continue to prosper even after pandemic. 

   One reply to this suspicion, also from some students, is that after three years of pandemic and virus containment policies, many physical retailers suffered. Eventually landlords cut down rentals for physical shops. Still, with an uncertain prospect, not all physical retailers dared to come back at lower rents. Meanwhile, online shops are doing well. They have an incentive to expand their business. If they rent physical stores at the moment, they can take advantage of the lower rents. Furthermore, for the nature of their business, expanding the points for their customers to pick up goods purchased online help. So, their foray into the physical sector is not because they are not doing well online. By contrast, that's because they are doing well. 

   Is this reply convincing? But then why these online retailers now allow on-the-spot transactions while they did not allow in the past? Well, we may say the practice of disallowing on-the-spot trade in the past is mainly for building up consumers' habit of ordering goods online (when they were not familiar with electronic payments and sending orders). Now, many people are already familiar with the new way of shopping. Then, there is no reason to sacrifice on-the-spot trade opportunity, which generates more profit to the same firm. 

   Hence, the "theory" seems to work: it can explain what happens currently and what has happened so far. But is it really a good explanation? My concern is that it is not clear what "convenience" means when we say online shopping has this property. If we don't know the concrete meaning of "convenience", we can always say something is more convenient without being able to challenge this viewpoint. [See also my criticism of using the term "better service" in another post.] Scientifically speaking, this is not good. Furthermore, if we can't say concretely what "convenience" means, we may simply use the "result" as a criterion of discovering the "cause": whenever the result is good, we say it is due to convenience; whenever the result is not good, we say things become not so convenience as before. Obviously, this is not true explanation, and not what sciences are supposed to do. [Another post of mine has also discussed a similar issue]. 

   In fact, it is not obvious to me that online shopping is more convenient than traditional shopping. Yes, you may think that online shopping requires only a click on the button and you can do it anywhere anytime. Meanwhile, shopping at physical stores is limited to specific time periods and you need to take a tour for this. Isn't it obvious that online shopping is more convenient? But don't forget that delivery of the goods after you clicked the button takes time. In contrast, you can immediately take the goods away from physical stores. Furthermore, many goods are physical in its nature (software is an exception). Inspection of the physical goods and purchasing them happen in the same place when you are in a physical store. For online shopping, the two processes are separated. One may worry that the pictures of the goods displayed online do not reflect the reality. Returning the goods afterwards, even if it can be done quickly, is an inconvenient thing.

   So, though online shopping may be convenient, it is not so all round. In fact, the online retailers must know it very well. That's why they expand their physical store networks to complement their online service.  

   Hence, we must figure out which aspects are really convenient and which are not. Only when we can figure out, we can have a better idea of what its future would be. 

   After an interview with students who told me that online shopping was "convenient", I get that asking questions in this way could not stimulate their thinking in the right direction. Hence, when I had an opportunity to interview (another group of) students again, I revised my questions: some goods appear to be more suitable for online shopping while some other goods may not be so suitable. Could you identify which goods are suitable and which goods are not? Please also explain. Then, I got lots more answers about why online shopping in some goods might fade away. What are these goods? I think you would have your own answer upon reflection. If you haven't thought about it before, why don't you try now. 

   I think this time my question can really stimulate students think more clearly about the nature of online shopping.   

  

   

A mathematical economist's teaching style

   For generations (and also for today), economics students in their first-year education in university have been learning the necessary mathematics by reading one single book, Alpha C. Chiang's Fundamental Methods in Mathematical Economics. I was not an exception. 

   The book is easy, at least relatively speaking. It is really very suitable for those who have not much mathematics background, with only high-school level general mathematics. The book explains math concepts in detail even for certain basic concepts that a mathematician may find it unnecessary to explain (but it is necessary for laymen). It skips those technical details that may not be helpful for a student to understand certain important results (but mathematicians will find these details necessary for making the presentation complete and rigorous). Hence, it is really helpful for those who want to learn the math and have the patience to read through it. That's why the book has been used in generations and generations. 

   I have wondered who this economist is. He really knows what students' needs are and concentrate on them. Why there is no other economist doing this (at least in the past)? I believe that he must also be a very good teacher. However, Chiang's other publications are not very well known (though his math book is well known). I do not have much information about him as a researcher or teacher. 

   Recently, I find that he published a biography Tales from My First 90 Years in 2011 (the book title is already full of humor). There, I eventually find out his own description about his teaching. Expectedly, he was really that type of teachers who care about teaching very much and has his own belief in how things should be taught. Let me share with you some words from him: 

   "The teaching style that I finally decided on is one where I use a very sketchy outline of topics as a rough guide, but the lecture is always done in an extemporaneous fashion. I of course do prepare the detailed points with diligence. But I try to remember them in my mind, and not have them written down in the outline. This way, not bound by a rigidly formatted outline, I can allow myself the freedom to go with the verbal flow at the moment, making the proceedings spontaneous, even sprinkling a joke or two here and there.

   "I had long cultivated the habit of using the blackboard, because the act of writing on the blackboard (which has been replaced by 'greenboard' or even 'whiteboard' over the years) affords relief from the tedium of talking and listening. Besides, writing a few keys words on the blackboard can serve to highlight the concepts I want to emphasize. To allow full view of the blackboard, I usually remove 

the lectern from the table, perhaps also symbolically removing the 'demarcation line' between the teacher and the students. A few years into teaching, I introduced the use of colored chalks, making my classroom performance a Technicolor presentation. I intended it to be in CinemaScope, too, since I often write on the blackboard from the extreme left to the extreme right. The colored chalks proved very useful when the analysis in question calls for a graph with three or even more curves, each drawn in a different color to avoid confusion.

   "At one time, I asked myself whether I should use transparencies as some colleagues do. I decided against it because, projecting an image on the screen gives the students something not different from a 'reading,' whereas the classroom experience should in my opinion be watching a 'performance,' with an audio aspect involving pitch and intonation variations, and a visual aspect involving facial and body languages. Even in the study of a complicated graph, I want the students to construct it with me from scratch, one curve at a time, seeing how they are related to another, rather than seeing a finished picture projected onto the screen. This adds a 'do it yourself' aspect to the graphical analysis, which, I believe, strengthens the students’ understanding.

   "I have never won any teaching award. Perhaps it was because I mainly taught small classes at the graduate level, but teaching awards often go to teachers who teach large classes in big lecture halls, with many student 'voters.' But a couple of my graduate students who adopted my teaching style told me that they had won teaching awards at the colleges where they taught. I was happy for them and appreciated their trust in my teaching style."

   I admire this teaching style. In fact, if you are my past students, you know my style was quite similar to this style before the pandemic.  "Using blackboard (not slides)", "jokes", "no reading", "drawing graphs" etc are all I did in classrooms. However, pandemic prevents me from practicing these effectively and I eventually succumbed. I have now used a "mixed mode" for teaching, not purely slides and not purely blackboards. Perhaps that's the best I can do in the current "mixed" environment, not purely pandemic and not purely safe in interactions. I will see if further adjustments can be made later but I miss the old days.

   Finally, my fate also coincides with Prof Chiang's. I have never won any teaching awards. The reason why I didn't got it is quite different, however. The most obvious reason is that I am not as good as Prof Chiang as a teacher. Meanwhile, I teach large classes at undergraduate level while Chiang taught only small graduate classes. But the number of voters is not really the crucial thing in my university as in Chiang's. What matters is that you need to be nominated for going through the first step (and many more later steps). Though I am confident in my teaching quality (and I, like Chiang, got confirmations from my past students about this), nomination is normally everyone's business and nobody's business. 

Economics and history

   In one of my past posts, I said people can learn a lesson from history and economics. The example used to illustrate this point is about economic crisis and monetary policy. There is a great lesson we can learn from handling crisis in history. But in general, is learning history really useful for economics?

   In about 6 to 7 years ago, I conducted a survey in my classes, asking my students -- mainly Year-2 or Year-3 economics majors -- for their opinions about economics teaching. One such question is concerned with history and economics. The question is this.

Which of the following methods is most useful for students to learn useful facts in the real economic world? You can choose more than one aspect (in this case, write the most important aspect first, and then the second.... in the blank on the right (e.g. ABCD...)). 
A) students reading news regularly 
B) teachers mentioning news occasionally in lectures 
C) learning to handle economic data with statistical skills 

D) learning economic history  

   Students' answers can be summarized in the following table. 

	top 1	top 2	top 3
1) students reading news regularly	24%	42%	55%
2) teachers mentioning news occasionally in lectures	33%	51%	61%
3) learning to handle economic data with statistical skills	33%	54%	68%
4) learning economic history	10%	18%	26%
others.	0%	0%	0%

   To me, the most useful way to know what happens is to read news regularly. But this is not students' choice (only 24% think so). But I can understand the difficulty for students to read news themselves. They may not know which news is important and may not understand some jargon used in news. I also had this difficulty when I was a student. Thus, most students want their teachers to mention news occasionally (33%). They also express that statistics is important (33%). However, what they think least useful is history (10%). Perhaps this is due to the current economics curriculum that normally excludes history, and so they cannot see the importance of history. 

   However, this is not my impression about economics. When I was a student, many popular economists emphasize that knowing what happened in history is important for economics as economics must be built based on what happened and history is about what happened (see also some recent comments on why history is important for economics). 

   Furthermore, when I was a student, most high-school economics students would also take either Chinese or World History as most such students belong to the Arts Scream. I guess most economics students at that time can master certain basic knowledge in history. They would also have interests in history and wanted to know how economics help us understand history. Today, this is of course not true as most economics students belong to Business Stream, where history is not a subject. 

   Unfortunately, when I was an undergraduate economic student, it would be difficult for me or other students to apply economics in history. There was a course known as Western Economic History, taught by an economist in the department, but it was NOT about applying economics in history. It was only about (economic) history. In other economics courses, history was rarely mentioned. Yes, some popular economists emphasize the importance of knowing history for economics. But the economics curriculum was not designed in this way. Neither is today's. 

   Today, I am an economics teacher. Though I do not know sufficiently about history, I sort of know what role history plays in modern economics. I mean "modern economics" or the economics that has been mathematized. The pre-mathematized economics is narrative and old-schooled. The old style of economics is much closer to historical studies but the modern style is not. How the two fields come together or help each other? 

   As far as I know, there are three areas where history and economics come together. The first area is exactly about monetary policy or money that has been mentioned in my past post. How money or monetary systems work in human history? This area is concerned with this issue. Milton Friedman's and Anna Schwartz' A Monetary History of United States is a representative and a pioneering work in this area. Nonetheless, this is a relatively narrow area. Even those who work in monetary economics may not be engaged in such a historical investigation, nor they must consider these historical facts very essential for understanding monetary policies. But there are some (important) economists working in this area. 

   The second area is related to institutional economics. It covers property-rights economics but perhaps covers more than that. Institutional economists believe that good (bad) institutions are a significant factor in determining economic performance. The most well known figure is the Nobel-prize winner economic historian Douglas North. After him, there is actually a subfield known as New Institutional Economics (NIE). The field is not necessary about history. It also emphasize theory. But to demonstrate the propositions suggested by them -- institutions matter to economic performance, they have to documented evidence. NIE often finds the evidence in history. Institutions develop over time and over a long period of time. Hence, the evidence should be found in a sufficiently long period of time. That's history. By assessing what happened in history, NIE can somehow demonstrate their claimed proposition. 

   The third area is related to development economics and the economics of growth. In fact, it is also related to NIE, the emphasis on institutions. But the New Growth Theory (NGT) has its own path. Economists lost much interest in the theory of growth until 1980 when a new theory emerge, the NGT. Initially, it is quite conventional in its method -- developing theories and testing the theories by data. After a while, it turns also to history as it turns to the idea that institutions matter to economic performance. Nonetheless, NGT economists emphasizes data. When they take history seriously, they dig out data in historical contexts. They are not narrative as traditional historians do. 

   In fact, NGT economists often use historical data innovatively: they use data that are not normally connected to growth but they can use highly technical econometric methods to demonstrate some connections. 

   One famous example is a study led by Daron Acemoglu, a famous MIT economist, on how different types of colonial systems affect the long-term economic performances. Unimaginably, the study uses disease data to demonstrate the point: When Europeans settled in a colony with disease environment not favourable to them, they will not establish good institutions there and so the economic performance in the long term is not good. The disease environment is not a long-lasting factor but institution is (once established, institution can't be easily changed). Meanwhile, how good a institution is can't be easily measured but disease data can be easily collected. Thus, they can use disease as a proxy for good/bad institution and demonstrate a proposition that can't be easily demonstrated: institution matters to long-term growth. 

   While NGT economists need not study history, many economic historians (those who work at economics department, not at history department) are mainly concerned with growth, using both historical data and other historical evidence for their investigation. I am not a regular reader of their works. I am only a occasion reader. But I feel that their works are very scientific in a way that I can't even usually find in other economics works: They often suggest an explanation for what happened. Take it as a hypothesis but then tried to refute their proposed explanation by inspecting various counter-arguments and potentially unfavourable data or evidence. They will (tentatively) accept their own explanation only after this process. Today history is still not a popular subject in economics. But I think their works are very respectable and valuable. 

   At this point, let me make some concluding remarks. I do think history is really important for economics especially when you are studying growth or development. Modern works on economic history are indeed very scientifically rigorous, and deserve our attention. Nevertheless, the methods used are usually not mastered by common economics students (be it at undergraduate or postgraduate level). This may explain why the field is still not a very popular field in economics and many students may not feel the importance of it. However, I think serious students should pay some attentions to these works. They can be a reader, though not a researcher, in the field.  

Will consumption vouchers promote consumption (or not)?

   Due to the worsening pandemic, the government has decided to launch the consumption voucher scheme the second time. The first round of this scheme was launched in 2021. Almost all citizens are given $5000 each. The second round will be kick-started in April 2022. This time, $10,000 will be given to each citizen. 

   I have discussed an issue involved in consumption voucher in another post of this blog -- how the voucher should be counted in GDP. In this present post, I would like to discuss another issue involved. 

   One feature of these schemes is that people are not given cash or a sum deposited in bank accounts for free disposal. The vouchers must be spent within months or their values will be lost. Another feature is that people must use electronic payment devices (Octopus or an online payment app) for the scheme. Citizens who have never used any electronic payment devices (if they use only cash or cheque) need to apply for at least one such a device then. 

   If you are given $5000, will you spend it? If you are given a cash or money of $5000, perhaps you will save it, not spending it. But this scheme is not about cash or money. People must spend the money within months. So, it seems obvious that the scheme will generate more consumption expenditure. Why should anyone doubt that consumption may not be stimulated by such a scheme? 

   But there are exactly some doubts over this issue. Economists, or someone who think like an economist, do indeed have such a doubt. They think that the answers should be sought via empirical studies. Nonetheless, if the answer is obvious, empirical studies are of secondary importance. So, why the answer is not obvious? 

   In fact, when the first round of the scheme was announced in 2021, a newspaper columnist had used an economics concept to predict that the vouchers are useless: people's consumption expenditure will not increase due to it, and so the scheme is simply a trouble caused to citizens. 

   The economics concept this columnist used is "consumption smoothing". This is not a concept that every economics student has ever learned. But the idea is not difficult: people's income may go up and down but people's consumption will not fluctuated as much as income; consumption is stable over time; people will smooth out their consumption expenditure over time as they prefer to do so. 

   How can people smooth out their consumption when their income fluctuate? People can do this mainly because they can save more when their incomes are high, and when their incomes go down, they use up part of their saving to keep their consumption unabated. If saving is not sufficient for smoothing out consumption, external finance (borrowing) may also be used by someone. 

   The columnist then analyzed the effect of voucher as this. Since people will smooth out their consumption, they will not spend more even if they are given a voucher of $5000. The voucher must be spent within months but people will buy only the goods that they originally intend to buy. Without the voucher, they simply use their own income to pay for it. With the voucher, they pay it by the vouchers. But total consumption expenditure will not be affected by the voucher. 

   When I read this analysis made by the columnist, I doubt if this prediction will come true. Although I know the economics concept "consumption smoothing", I doubt it has a significant effect in the issue. 

    A recent study shows that vouchers used via one of the electronic payment devices do increase consumption expenditure: a voucher of $5000 can generate a consumption of $5400. This empirical result shows that there is no significant substitution between payment methods in the case of voucher. 

   If people simply replace cash payments by vouchers, their expenditure will not increase. It is simply using one payment method instead of another. But we observe an increase in expenditure, at least for one payment method. Why do people not substitute their cash payments by vouchers? Certainly more empirical investigations are needed for answering this question. However, one can still imagine why there may be a lack of significant substitution between payment methods. 

   First, payment methods are different. If they are the same, they are perfect substitutes. If they are not perfect substitutes, different features (advantages, disadvantages, convenience, acceptability, and cost of using them, etc) must be involved. For example, one may find it less convenient to bring too much cash out for purchase. By contrast, electronic payments are convenient for purchase even for large-value consumption. 

   Second, the voucher scheme requires citizens to receive and spend the $5000 via electronic payments. The agenda behind is to promote the use of electronic payments. If electronic payments are already very popular, perhaps it does not need to be promoted. Now, if quite a number of citizens may have never used electronic payments, or rarely use them, before the voucher scheme, they are more likely those who consider electronic payments are not close substitutes for cash. If they consider both payment methods equally convenient, they may have used electronic payments before. But they haven't. So, they may consider electronic payments a method quite distinct from cash. Now, they have no choice but to use electronic payments under the voucher scheme. It is likely that they don't use it to substitute cash but simply use it for buying goods that they won't buy before. 

   Third, for the first round of the voucher scheme, the money will be given in two phases and the money must be spent within three to five months, depending on the phases involved. Due to the urgency of spending in short term, one may spend the money on larger-value item or on extra goods that will not be purchased without the vouchers in order to use up the voucher more quickly. 

   Now, it is clear that the effectiveness of the voucher in stimulating consumption depends on the design of the scheme. Suppose the voucher is simply a deposit of money in citizens' bank account. This will make the voucher a very close substitute (if not perfect substitute) for cash. In a way, voucher via Octopus is also closer to cash. If it is not due to the third point above, Octopus users may not spend more. 

   Let's turn back to the point of "consumption smoothing". The idea can now be expressed as this. Consumption expenditure by different types are denoted C1 and C2. If C1 and C2 are perfect substitutes, then utility is affected by C1+C2. It does not matter if C1 is higher or C2 is higher, given the same C1+C2. In the case of (perfectly) consumption smoothing, any increase in C1 will be accompanied with the same amount of reduction in C2. However, if C1 and C2 are not perfect substitutes, utility is affected by C1 as well as C2 independently, not C1+C2. Using a little bit more math notations, the model is U(C1,C2) instead of U(C1+C2). The newspaper columnist above may simply jump too soon to the conclusion that the model is U(C1+C2), not U(C1,C2). 

   So, the key point is not consumption smoothing. The key point is why consumption smoothing can be attained. The columnist may understand the concept of consumption smoothing very well. But the columnist may fail to figure out the reason why smoothing may or may not be attained. There must be some conditions for smoothing to be attained (or not) and attained at what degree. It is not always fully attained. The difficulty of applying economics concept is that not only one need to understand the concept well, but also need to understand the reason why the concept may or may not be applicable. This is exactly a point that is repeatedly emphasized in "hi, economics" (including, not limited to, my last post on voucher and the post on decreasing returns). 

   Anyway, the success of the first-round voucher scheme may be a surprise to some economists (as substitution is low in this round). Now, the second round of the scheme will be launched in April. The amount is substantially increased to $10,000. Will this increase consumption as the first round did? Well, if our above analytical framework is valid, we will find that the significance of all the three points above are weakened in the second-round arrangement. You may figure out the details of the second-round arrangement and assess how the new arrangement will weaken the three features above. Given your assessments, what will you predict?

Teaching the assumptions in economics

   If you are my students, you may have noticed that my teaching style is quite different from other teachers'. Yes, I had avoided using PPT for class presentation for a long time until pandemic prevented me from avoiding it. But that's not my point. I mean I spend so much time on explaining the assumptions involved in a theory or model. This style is not very usually adopted.

   For example, in my macroeconomics class, when teaching the government multiplier effect, I emphasize that there are some assumptions responsible for the validity of the multiplier effect as presented in class. I explain them and warn students that if these assumptions are not satisfied, you don't have the multiplier effect as calculated by the formula presented. I then explain when these assumptions may be satisfied. Most textbooks or teachers will not do so. At least I was not taught these assumptions when I was a student. 

   I believe that my style of teaching has its value. But I am also aware of its cost: it occupies so much time that I can't cover many topics as other teachers do. Perhaps that's the reason why other teachers don't choose to spend time on explaining assumptions. My choice reflects my teaching philosophy and others' choice reflects their teaching philosophy. 

   I know my choice is not a popular choice. But recently I encounter a book that shares with my philosophy somewhat. At least I know that I am not so alone. 

   The book is entitled Microeconomic Theory for The Social Sciences, written by Takashi Hayashi. This is a very unusual textbook for intermediate/advanced microeconomics. [Very unusual partly because it shares with my teaching philosophy, which is not usually adopted.] I find it interesting. It speaks something that I want to say for long.  

   In the book above, Hayashi says (in its Preface): 

   "Professional work in economic theory is presented as a sequence of definitions, assumptions and their implications. Its result is presented as a theorem, which is a statement in the form 'If A is true, then B is true.' It is not 'B is true.' It is vital for theorists to share the understanding of what assumptions the present theory is relying on, because there is no conclusion without an assumption. If you think you are free from any assumption, it must either be that you don’t know what assumption your argument is relying on or that you know it and you are hiding it. 

   "Introductory teaching of economics, on the other hand, tends to omit giving thorough explanations of underlying assumptions and reservations. There is a good educational reason to do so, because teachers don’t want to make their students bored before getting into 'useful' stuff. This causes a danger, however, that learners do not care about the underlying assumptions and the logical process of how assumptions lead to a conclusion. As a result, learners quite often abuse a theory by applying it to situations in which its assumption does not hold, or criticize a theory on the ground that its conclusion is wrong again by applying it to situations in which its assumption does not hold."

   This is the words that I want to say, especially the last sentence about abusing a theory by applying it to where it should not be applied. This is a mistake often made by students. I truly want them to avoid this mistake and so I would rather sacrifice the time that could be used for teaching more stuffs. I would rather they know little but truly know how to use what they have learned.

   Some students may be aware that I like microeconomics more than macroeconomics (though I now teach macro). But one of the joyful thing from teaching macro is that this subject uses a lot of unrealistic assumptions. Macro models are a big abstraction from the whole economy and as such it is unavoidable to adopt greatly simplifying assumptions (otherwise, the model must be very complicated to prevent from understanding). Meanwhile, macro models are often logically simpler than micro models. Hence, I I have time to explain the assumptions (as it is logically simpler) and there is a great need for explaining these unrealistic assumptions to students (as macro unavoidably uses many such assumptions). I am happy to do this and I hope I have done something good for students in this regard.

Think at the margin, but why? (2)

   Economists think at the margin. But how to justify this way of thinking? I find many justifications not obviously persuasive to me. Hence, I have written a post to express my reservation, and offer my own answer to explain why we should think at the margin. 

   Having done this, I remember that Gregory Mankiw's popular textbook Principles of Economics has listed out ten important principles of economics (in Chapter 1), and the third one is "rational people think at the margin". I read it and find some new arguments or examples to support the principle. On the whole, Mankiw did give better examples/arguments than what my past post has used (from another book). But I still have problems. 

   Anyway, let me first share with you what I think are better examples. 

1. Phone call. "[S]uppose you are considering calling a friend on your cell phone ....talking with her for 10 minutes would give you a benefit...at about $7. Your cell phone service costs you $40 per month plus $0.50 per minute.... You usually talk for 100 minutes a month, so your total monthly bill is $90. ... You might be tempted to reason as follows: 'Because I pay $90 for 100 minutes of calling each month, the average minute on the phone costs me $0.90. So a 10-minute call costs $9. Because that $9 cost is greater than the $7 benefit, I am going to skip the call.' That conclusion is wrong, however. Although the average cost of a 10-minute call is $9, the marginal cost—the amount your bill increases if you make the extra call—is only $5....Because the marginal benefit of $7 is greater than the marginal cost of $5, you should make the call."
2. Airline ticket. "Consider an airline deciding how much to charge passengers who fly standby. Suppose that flying a 200-seat plane across the United States costs the airline $100,000. ...the average cost of each seat... is $500. ...Imagine that a plane is about to take off with 10 empty seats and a standby passenger waiting at the gate is willing to pay $300 for a seat. ...If the plane has empty seats, the cost of adding one more passenger is tiny. The average cost of flying a passenger is $500, but the marginal cost is merely the cost of the can of soda that the extra passenger will consume. As long as the standby passenger pays more than the marginal cost, selling the ticket is profitable."

   In my past post, I use an example given by another book: one should not drink one more coke with a marginal benefit lower than marginal cost although the average benefit of this coke is still higher than the average cost. I argue that this example involves a sequential decision: after I drink one coke, I am considering should I drink one more. In the real world, sequence in decision is often not involved. If so, thinking at the margin may not be obviously necessary. 

   Nevertheless, in Mankiw's examples, thinking at the margin is necessary. Failure to do so will lead to fallacies. The reason why is that, in both examples, fixed cost (sunk cost indeed) is involved. The $40 monthly cost of telephone service is fixed regardless of how many minutes of calls are made. The $40 has also been paid and will never be refunded. Thus, you should not consider this $40 when receiving calls. Only the marginal cost of receiving an extra call is relevant. Similarly, $100,000 is a fixed cost of running a flight. With or without extra passengers, this $100,000 is not changed, has been paid (once the plane takes off), and will not be recovered. Hence, this fixed and sunk cost should not be considered when deciding to add one more passenger or not. 

   Arguably, these problems also involve a decision sequence. The first step is to consider paying the $40 or not, and flying or not (thus incurring $100,000). The next step is to consider receiving a call or not, and adding one more passenger or not. The next-step decision should be sort out by thinking at the margin. The sequence is generated because of fixed and sunk cost. Such cost is present in many real-world situations. So, thinking at the margin is relevant. Mankiw's examples are better as he leads us to a context where decision in sequence is relevant. 

   However, when we say firms should produce at where MR=MC, there is no actual sequence involved. The firm will not stop the machine and decide if one more product should be produced. The sequence, at best, exists only in the firm owner's mind. The owner can sort out from the very beginning by comparing different production plans with different outputs. He or she should choose the plan that gives rise to the highest total profit. Thinking in the total is equally effective and is perhaps a more intuitive way of thinking. 

   Mankiw has also given another illuminating example -- the paradox of diamond and water -- to illustrate the important of thinking at margin. 

   "Why is water so cheap, while diamonds are so expensive? Humans need water to survive, while diamonds are unnecessary.  Yet people are willing to pay much more for a diamond than for a cup of water. The reason is that a person’s willingness to pay for a good is based on the marginal benefit that an extra unit of the good would yield. The marginal benefit, in turn, depends on how many units a person already has. Water is essential, but the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large."

   This is of course a right example. But it reveals a completely different type of reasons why one should think at the margin. 

   For the phone call/airline example, not to think at the margin leads to unwise decision -- you haven't done what's best for you. For the diamond/water example, it has nothing to do with wrong decision. It is an explanation of why something happens -- diamond is expensive while water is cheap. 

   In fact, there is an ambiguity involved in the term "margin" in this example. Does it mean the last unit or an additional unit? Water is cheap because the last unit of it is not very valuable, provided that we have had plenty already. But one more unit of water may be very valuable if we are very thirsty, without already consuming a plenty of it. 

   Hence, you may imagine that if water was supplied by a monopolist and the monopolist might price-discriminate -- for the initial units you buy, it charges you a high price; for the subsequent units you buy, it charges you a lower price. Then, not only the "last unit" (marginal unit) matters to the price of water, the units before the last unit also matter (prices are different at different marginal units). When we are taught to "think at the margin", which margin (last or additional) we are talking about? What attitude we should have (to ensure we make the best decision or to understand what happens)? 

   I do not intend to criticize Mankiw in this post. As you have seen, I basically appreciate his better example. However, I think we must think more about the principle of "think at the margin". 

   My point is, "think at the margin" is certainly an important principle in economics. But we must be aware what this principle is really about and why this principle is useful. This principle may be ambiguous in some cases and we have to figure out what it means before embracing it. Also, instead of sticking to the principle , "understanding why" is more important. The principle of thinking that is truly important in economics is: understanding the definitions and understanding why. It is not simply to think at the margin.

Think at the margin. But why?

    In economics, "marginal" is an important concept. Various results are formulated in marginal terms. For example, when marginal revenue (MR) is equal to zero, total revenue is maximized; when MR is equal to marginal cost (MC), profit is maximized. 

   However, why marginal terms are so essential? It is also not very intuitive. Common people think in total terms: if total benefit is higher than total cost, that's good, and we want total benefit exceeds total cost as much as possible. Why marginal? 

    In fact, this is a point that should be explained in basic or even elementary economics course, but I am not responsible for such courses. Hence, I haven't prepared much for this. If suddenly I am asked to explain it, I doubt I can do this job properly. 

    Recently, I have had a look of a book which offers an intuitive explanation. I am glad to share with you: 

   "A less obvious but equally important implication of the logic of rational choice theory is that rationality requires us to think at the margin. Economists say an action is rational if the benefits are equal to or greater than the costs. So if a can of soft drink costs $2 (the cost) and gives you $5 worth of satisfaction (the benefit), it would be rational to buy and drink it. But suppose that after finishing the first can you remain somewhat thirsty and need to decide whether to buy a second can for the same price of $2. If you value the second can at $1 and think about the costs and benefits of the two cans jointly, you might conclude that it is worthwhile buying the two cans, since the benefits ($5 for the first 

can and $1 for the second = $6) exceed the costs ($2 for each can = $4). However, by the time you are deciding whether to buy the second can, you have already enjoyed the benefits and paid the costs of the first. These are no longer relevant to your decision and you should focus only on whether the additional (i.e. marginal) benefit you receive is as large as the additional (i.e. marginal) cost. The extra cost of the second can is $2 and the extra benefit only $1. By thinking at the margin, we can see that this is not a rational choice and we should not buy the second can." (pp.8-9, Economic Perspectives on Government, by Keith Dowding and Brad R. Taylor). 

   This example is good in illustrating that why and when the total is not necessarily a proper indicator of choice. The total benefit of $6 is still higher than the total cost of $4 if 2 cans of soft drink are bought. So, why not 2 cans? The point is that it is not the maximum. $5-$2 is higher than $6-$4 in total terms. So, total is the concern. But to find out the maximum of the total, you should think at the margin. 

   But there is a problem with examples like this. Implicitly, a decision sequence is involved: you firstly take one can of soft drink and then decide if you should take one more. Sequential decision-making is of course often involved but it is not necessarily involved. If, for example, a firm has to decide a quantity to produce from the very beginning, and once it is determined, it cannot change the quantity later, then is thinking at the margin still necessary or relevant? Economists will say it is still necessary because MR=MC is where profit is maximized. They can also prove MR=MC mathematically. But that's not an intuitive explanation of the importance of the "marginal". Without sequential decisions, why "marginal" is important? 

    Perhaps the answer is that the sequence for decisions is not about actual steps to be taken but a steps in one's mind to figure out what is the best position. A consumer simply needs to figure out: By drinking one more can, will I be better off?  A firm simply needs to figure out: By producing one more unit, will profit be increased? So, what they need is to think at the margin. 

    Mathematically, this can never be false: if marginal benefit is higher than marginal cost, then profit will increase, and so profit is not maximized. But why don't we work out the maximum point differently? For example, we have 10 production plans, each with a total benefit and total cost value. We can simply compare the 10 plans to pick up the one with highest profit. We don't need to think at the margin. 

   But economists will tell you that this method works only if the number of production plans is finite. If there is an infinite number of plans (because quantity can take any values between 0 and 100, and there are infinite points between 0 and 100), the method above does not work. True, but why thinking at the margin can solve the problem when there is an infinite number of plans while the total cannot. In fact, it appears that either both methods do not work or both can work. For example, if we can draw total profit as a curve with respect to quantity, the peak point of the curve is the maximum point. Alternatively, we can draw MR and MC curve. The intersection point is the maximum point for profit. 

   Hence, while mathematically MR=MC is a condition for maximizing total profit, intuitively, we lack an interpretation for why thinking at the margin is important. 

   Here is an interpretation I can think of. I am not sure if it captures the key point. But you may take it for reference. 

   The issue is like climbing mountain for the peak (maximum). If the environment is clear, under a blue sky, when you reach the peak, looking around, you know no anywhere surrounding is above you. That's the peak. But the environment may not be clear. This is a misty day. You can't see clearly even if you are on the peak. But you know that the mountain has only one peak, not like some with several peaks where some are lower and some are higher. Then, what you can do is to keep climbing. You know whether you are climbing up or climbing down. If you are climbing up, keep climbing. If you reach a point where going further will move you down, then go back. The peak point is where you can climb up before it and you will climb down after it. That's thinking at the margin. Essentially, it is a method using local information (moving more or less) to judge if a global peak is reached. But if you have the global information (whole picture is clear), you don't need this method. The marginal method is a rule of thumb for reaching the maximum in case local information is available but global information (whole picture) is hard to find while some pattern (single-peakedness) is known.