Is economics a social science or business subject?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The danger of reading economics books (2)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Shops shut down but rents still stand firm?

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

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

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

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

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

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

   Here is how this hypothesis says. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Producer's vs consumer's perspective in economics

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

   Why is this practice justified? 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

   It is simply about income effect. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Think at the margin, but why? (4)

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

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

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

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

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

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

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

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

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