Analyzing the economies without using economics

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Think at the margin, but why? (3)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

It's about the real economy

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Chat apps and multiple equilibria

   I have introduced "multiple equilibria" in my past post. Is it worthwhile to learn this new concept? This depends on whether the concept is really useful. In my past post, I have defended that the concept is very useful as it indicates that when multiple equilibria exists, it is possible to improve the world at low cost. How wonderful this would be! Nonetheless, if multiple equilibria can almost never be found in the real world, then the concept is still not useful. So, can we find important examples in the real world?

   I have already given one example - bank run - in my last post. But that's not enough. Readers can indeed pick up more examples from the Nobel-prize winning economist Philip Dybvig's Nobel lecture paper. There, you can find that the concept is really so useful in explaining various types of phenomenon. I don't want to repeat the examples, but perhaps one example is worthy of more exploration - phone - as it relates more to students' daily life. They may not be touched by the bank run example but they may be touched by the "phone" example.

   When Dybvig mentioned "phone" in the paper, he refers to telephone or some internet-based phones. But I think the logic can also be applied to chat apps, and nowadays students may use chat apps more frequently than traditional phone. That's why I pick up this example and develop from it.

   But let's still start from traditional phone. This is a typical example in the economics of technology adoption. 

   Yes, today we all have a phone each person. So, we forget that telephone was expensive about 100 years ago when it was invented, and so persuading people to buy it was not really an easy job. In the past, telephone was expensive and only companies, not individuals, would buy it. Later, telephones were bought on family basis, not on individual basis. Mobile phone is indeed a very late invention. 

   Anyway, the logic of promoting phone use is the same, for companies, families or individuals. The cost is not insignificant. It must be valuable enough so that people may buy it. How valuable a telephone would be to a company, family, or individual? This depends on how many other people use telephone. Phone is used for calling others and receiving calls from others. If many other people use it, I can call many others, and many people may call me. If few people use it, I can call only few people, and few people may call me. 

   So, you can see: the incentives to use it is high when many have used already; but the incentive is low when not many have used it. The problem is: how can you make a thing used by many when it is newly introduced? Normally, people adopt new product only slowly and gradually. But a slow adoption path is detrimental to phone use. You don't have reasons to use it as few uses it, and so do others. Telephone did take a long period of time to become a popular device globally.

   Well, perhaps all these are history. Now all people have phones. But we may think about what happens to a similar product - chat app. There are many such products available indeed: WhatsApp, WeChat, Telegram, Line, Signal, Viber, Facebook Messenger, Snapchat, Hangouts, etc. As they are used for communications, they share the same characteristics and problems with telephone. When many people use an app, it is more valuable. When few uses it, it is not valuable. It is particularly obvious when you think about group chats, a function not normally used in phone. 

   Although one can use more than one app, actually many apps, in one location, it is normally only one or two app dominates the market. For example, WeChat is popular among Chinese while Line is popular in Japan and Korea. 

   Why is this the case? Perhaps you can now easily figure out. It is multiple equilibria. Either there are many people in a community using an app, or there are few using it. Why? It is because the app is either very useful (many use it) or not useful (few use it). So, there are two equilibria: the high-use equilibrium and low-use equilibrium. 

   Well, we have learned that the implications of multiple equilibria are great. As either good or bad equilibrium may be realized, it is important to know how the good one can be attained. Bank run is a bad equilibrium. It can be prevented. Nowadays we have much much fewer bank runs. Banking regulations and deposit insurance may be the key factors behind. 

   What about chat apps?

   From the app developer's perspective, the high-use equilibrium is a good equilibrium while the low-use equilibrium is bad. Of course, all app developers want to reach the good equilibrium but not all of them can realize their dreams. Equilibrium is self-enforcing. Once you reach it, it is difficult to move away (as adjustment normally will take you go back to it). Hence, an app developer would want its app to be used by as many people as possible at the initial stage. For common products, reducing price is a typical method to attract more users. But in the internet world, zero subscription fee is already the norm. So, it is a difficult job for app developers to attract more people. They need to introduce non-price attractive points. But anyway, as the rewards of success is also huge (dominating the market), there will be no lack of talents exploring the methods in this world.  

   

Again and again, "the law of demand, but why?"

    In my post "more on the law of demand, buy why?", I outlined the difficulty of explaining the law of demand by not using the substitution effect and income effect. In particular, some people may think that the demand curve is downward sloping simply because the marginal benefit or marginal utility (MU) of a good is diminishing with the quantity consumed of the good. In that past post, I said that MU is not price or money value while the vertical axis of the demand curve diagram is price or money value. Hence, one can't jump to conclude that diminishing MU implies downward sloping demand curve. We need something more than that and the extra factors involve (eventually also) substitution and income effects. To relate MU to demand curve is not straightforward, actually quite complicated. In that post, I stop after stating these and urge my readers to simply use substitution and income effects to explain the law of demand. 

   In this post, I want to fill this gap, showing you the "complicated" explanation that relates MU to demand curve and the substitution-income effect. I write this post because readers may be curious after reading my past post, wondering how all these can be related. My presentation below borrows heavily from a discussion in the Chapter II of John Hicks' A Revision of Demand Theory. In fact, only after I read this chapter, I learn how to explain the relation between MU and substitution-income effect. 

   First, demand curve is a price-quantity relation while MU is a (marginal) utility-quantity relation. To relate the two curves, we need to convert utility into price and so an equation below: 

   The price P one is willing to pay for a unit of a good = (MU of the good)/(MU of money).

   The left side is the price involved in the demand curve of a good. The right side is related to the quantity of the good. If the right side is decreasing with quantity, we have a downward sloping demand curve. That's what we need to demonstrate. 

   Why dividing MU of a good by the MU of money? The unity of MU (of a good) is simply utility, it is not money or price. So, you need to divide it by MU of money to get a price. For example, suppose that MU of a good is 6 units (consuming one more unit of a good gives you 6 extra units of utility), and that MU of money is 2 units (giving you one more dollar, your utility increases by 2 units). So, you are willing pay $3 for getting one more unit of the good (you get 6 units of utility, which is what $3 can generate). 

   Now, although MU of the good is diminishing with the quantity of this good, the MU ratio of the good and of the money need not be diminishing with the quantity of this good. We can't jump directly from MU to price. Viewed from another perspective, if the price of a good falls, the left side of the equation is lower. To maintain the equality, the right side should also fall. But does it necessarily imply a higher quantity of the good? If MU of money is unchanged but MU of the good is diminishing with its quantity, the answer is yes. But is MU of money unchanged when the price of a good falls? Furthermore, there are extra complications involved as explained below. 

   Revisit the equation above. This is for only one good. In fact, a consumer buys more than one good. For each of these goods bought, we have an equation as above for the good. Suppose there are only three goods, X, Y and Z. We also use Px, Py, MUx, MUy, etc to denote the price of the respective good and MU of the respective good. We use MUM to stand for MU of money. Then, for X, Y, and Z, we have the equation above to be expressed respectively as

   Px = MUx/MUM,

   Py = MUy/MUM,

   Pz = MUz/MUM.

What interests us is the case where the price of one good changes, other things being equal. Let's consider that Px falls but Py and Pz are unchanged. Further, income is fixed. Given the price change, a person will change its quantity demanded to maintain the equalities above. If not, for example, Px < MUx/MUM, the person would find buying more good X brings about a benefit valued in money term higher than the price of X, he or she should buy more X (until the equality holds again). 

   In fact, if Px falls to Px' but all quantities in X, Y and Z are unchanged (such that the right sides are unchanged), exactly Px' < MUx/MUM will happen. As said, the person will be induced to buy more X. Since MUx is diminishing with the quantity of X (denoted as Qx), MUx/MUM should decline, given the same MUM, and the equality will then be resumed. This is exactly the naïve explanation of the law of demand (via only MUx). But this ignores the MUM. This assumes MUM is unchanged. 

   Is MUM constant when Px falls? Even if this is assumed, there is still certain further effect that cannot be ignored. 

   First, when one buy more X, MUy or MUz may change. For instance, if X is coffee powder and Y is tea bags, one may find MUy lower when more coffees are consumed. If Z is milk, one may find MUz higher when more powders are bought. If MUy and MUz change as described, given unchanged Py and Pz, at the same quantity of Y and Z, MUy/MUM < Py and MUz/MUM > Pz if MUM is unchanged. Adjustment in Y and Z should take place. The quantity of Y (Qy) should decrease and so MUy increases and the quantity of Z (Qz) should increase and so MUz decreases. Yet if Qy and Qz change, MUx may also change again and further adjustments take place. 

   Further, don't forget these changes in quantities can't involve a total expenditure higher than the income. The quantity changes are constrained by no change in the total expenditure (given fixed income). The quantity changes that can keep the total expenditure unchanged are unlikely to be the same as the quantities that can restore the equalities between prices and MU-ratios for the three goods if MUM keeps unchanged.  

   Hence, for most cases, it is only reasonable to assume that MUM will change when Px changes. Well, if MUM changes, all the three equations above will be affected. It is not that only MUx matters (via diminishing MUx) but MUM also matters (as it will change) to the slope of the demand curve.

   Although the whole process involves changes in MUx and MUM, we may still divide it into two steps. 

   In the first step, when Px falls, we analyze as if MUM is fixed. Though MUM generally will change when the price and the quantities consumed of goods change, we can keep it fix by assuming that there is a hypothetical reduction in income such that, the price and income change combined generate an unchanged MUM. If MUM is fixed, we can concentrate on how MUx (together with MUy and MUz) changes is associated with the Qx change. The effect of Px on Qx in this step is indeed about substitution effect: the price of X triggers rearrangement of quantities in X,Y,Z while the income is varied to keep MUM fixed. 

   In the second step, the hypothetical reduction income to keep MUM fixed as Px falls is (hypothetically) returned. Then, there is an effect on the quantities from this income rise and MUM change. This is about the income effect indeed.  

   Now, we return to the familiar substitution effect and income effect though we present them in a rather different (and more complicated) manner so as to relate them to MU of goods and MUM. Perhaps, as a regular reader of hi,economics, you are interested in this (complicated) relation. But the point I want to make is: Sometimes we are tempted to use simple explanation. Using MU to explain the law of demand is exactly one such occasion. However, opting for simplicity may sometimes generate more confusions. What looks to be a simple explanation may be just a naive explanation.  

   Hence, as concluded earlier, for explaining the law of demand, I think one should use substitution and income effects, instead of using diminishing MU. Don't think the latter is an easier explanation. 

Bank runs and multiple equilibria

   Equilibrium is a central concept in economics. But what is multiple equilibria? In high school or even university economics courses, students may not ever encounter multiple equilibria though the concept, in my view, is very useful. Let me introduce some very rough idea about it in this post. 

   First, students encounter equilibrium this concept almost only when they learn demand and supply analysis. In such an analysis, equilibrium is the intersection point of the demand curve and supply curve. Other than this, perhaps they may not know more concretely what equilibrium is about. 

   In fact, equilibrium may be better understood via adjustments or movements. In equilibrium, no (further) adjustment will take place, or no movement away from it is expected to take place, given that no new factors appear. Not in equilibrium, adjustment will, or is expected to, take place. The reason why the demand-supply intersection point is an equilibrium is exactly this. At the intersection point, demand equals supply and so price will not adjust. Not at the intersection point, either quantity demanded exceeds supplied (so price will go up), or quantity supplied exceeds demanded (so price will move down). In other words, adjustments will take place. 

   Of course, this example is only about market equilibrium. There are equilibrium concepts other than market equilibrium in economics. For example, game theory uses the concept called Nash equilibrium, which is often not about the whole market but an intersection result in small group of people. Anyway, equilibrium is normally related to the choice of more than one person. These people each choose to do something, given what others will do or have done. Equilibrium is a state where all people would rather stop but not move away from it. 

   Normally, the demand curve and supply curve will intersect at only one point, not more than one point, as demand curve is downward sloping while supply is upward sloping. So, this is a single or unique equilibrium case, not multiple equilibria. But you can easily imagine that there may be some special cases in which demand and supply intersect at more than one point. 

   Consider this example. Recall a past post: labour supply curve is often found to be backward bending. This means the supply curve is upward sloping when price (wage) is low, but is downward sloping when price (wage) is high. Meanwhile, the labour demand curve is downward sloping. Then, it is possible that labour demand and supply curves intersect at two points: one at where supply is downward sloping, and one at where supply is upward sloping. (You may draw a diagram to show this.)

   The fact that there could be two equilibrium points in labour market does not mean that both equilibria will be realized. In fact, what is realized is only one point. But both points could possibly be realized. Which point will be realized? This is a difficult aspect. 

   Economists normally use the equilibrium concept to explain what things will happen. They say things will happen in equilibrium (so price will be determined in the demand-supply intersection point). But now if there are more than one equilibrium, economists need something extra to tell what will happen, or which equilibrium will be realized. One obvious hint is the so-called initial condition: which equilibrium will be realized depends on what is the staring point. For example, if price starts at a low level, the intersection point of demand and the upward sloping segment of supply will be realized. If price starts at a high level, the intersection point of demand and the downward sloping segment of supply will be realized. 

   Now there is a very important implication that economists can draw from such a multiple equilibria analysis. First, if there are two (or more than one) equilibrium points, perhaps we can tell which one is better. For example, a high-wage equilibrium may be considered better (for workers) and a low-wage equilibrium may be considered worse. Second, if both good and bad equilibrium points may be realized, we may not need to accept what has been realized (bad equilibrium) but can try to do something to realize the good equilibrium. Third, since equilibrium is self-enforcing (inducing adjustments when not in equilibrium) once the conditions are right, moving the equilibrium from bad to good need not involve great efforts (or high cost). All we need to do may simply be to change the initial conditions (or some other conditions). Once the adjustment process takes place towards the good equilibrium, no further effort is needed. 

   So, if multiple equilibria exist in the real world, policies to improve the world may not be as difficult or costly as we originally think. The question is whether multiple equilibria really exist. 

   Yes, we will be happy if the world can be improved at low cost (when multiple equilibria exist). But, as dismal scientists, economists are normally skeptical of the existence of a wonderful world. Some economists indeed have doubts on the multiple equilibria concept. I don't want to go through their arguments in this blog post. I just want to let you know that this concept is still a little bit controversial in the economics circle. If we want more people, economists in particular, to embrace it, we need some or more convincing examples. The labour market example above is not such an example. This is only an example, I think, students can easily understand and so useful for illustrating the multiple equilibria concept. 

   I encountered multiple equilibria concept many years ago when I learned some development economics. That's the first time I learned this concept. The idea is this. We know in the real world many countries are poor but many are rich. Not all poor countries are lack of resources but they are still poor, just that they fail to develop. Some rich countries are also lack of resources but they are still rich, just that they can develop. Why? Of course, there could be different explanations. But one is multiple equilibria. The poor countries are trapped in a bad equilibrium while the rich countries can reach the good equilibrium. I was amazed by this idea the first time encountering it. But then I know many economists are skeptical, and for development, there could be different convincing explanations. They need not choose the multiple equilibria hypothesis if they can choose others. 

   Are there convincing examples in which multiple equilibria is almost unavoidable? I think there is. The example is convincing because we, with or without learning multiple equilibria, have already thought in the same way. The example is bank runs. 

   What is the crucial issues involved in bank run? 

   First, the reason why there may be runs on banks is that banks receive deposits but deposits can be withdrawn at very short notice while banks lend money to businessmen on a much longer term. If deposits can't be withdrawn at short notice, without the flexibility, people may not want to deposit money in banks (why don't they invest in something else). If banks recall loans at short notice, the businessmen might bankrupt, the investment projects undertaken by the businessmen may not be mature enough to generate returns, and so such a recall will not give banks much.  

   Second, banks will keep only a small percentage of their deposits as reserves. The rest will be lent for earning interest income. So, if too many depositors withdraw at the same time, banks never have sufficient reserves to cope with these withdrawal demands. If banks recall loans that support investment projects that are mature, banks can't get back too much and will make loss. So, the crucial thing for the banking business to work is that depositors won't withdraw at the same time.   

   Third, if depositors believe that a bank works well, there is no reason to withdraw immediately. But even if a bank work well, when many depositors withdraw, the bank still doesn't have sufficient reserves to return the money. They may be forced to recall a long-term loan back and makes a loss. When the loss (unnecessary if no withdrawal happens) is realized, banks may not be able to return the deposits to someone who withdraws it too late. So, it is wise to withdraw early if others are also in a rush to withdraw. 

   The result is well known: either all depositors are calm and won't withdraw at the same time, or all depositors fear and withdraw at the same time (bank run). 

   We, economists in particular, all know that this is what banking business is about. But before 1980s,  economists are not aware that this is exactly about multiple equilibria. In the good equilibrium, no one withdraw in a rush; in the bad equilibrium, depositors run on their banks. Douglas Diamond and Philip Dybvig have written a paper on this in 1983 (the Nobel lecture can be found here). It is this paper that makes them win the Nobel prize in economics in 2022.