The use of microeconomics

   I have written two posts on the use of macroeconomics. Why didn't I write about the use of microeconomics? In fact, I have written many, though not with a title "the use of ...". Posts that classified as "daily life" indeed use mainly microeconomics and so are a demonstration of the use of microeconomics. Thus, there may be no need to write independently about the use of microeconomics. 

   Yet, there is so far not a general discussion about the use of microeconomics. We may know that many microeconomic concepts help us understand the world. But an overall picture is lacking. Are some concepts useful but most are not? What are the useful and useless concepts? 

   At this point, we must clarify what we means by "useful" and "useless" here. It is hard to imagine that economists would develop some concepts as "useless". But what we mean here is about "useful" for common people in doing analysis relevant to them. They may be businessmen, investors or policy-makers. Of course, they could also be students who want to explain what happens in daily life. But they need not be economists. 

   From this perspective, we may ask ourselves another question first. This is related to how useful the microeconomics would be. The question is: historically, is the development of microeconomics mainly made from a businessmen's perspective, investors' perspective, policy-makers' perspective, or just a common person's perspective?  

   You may say none is true as it must be made from a scientist's perspective. We can never deny that economists use scientific methods to study the world. But economics is not like physics. Our concern about society is not comparable with our concern about the physical world. Furthermore, the world (or society) is big (many phenomenon exist). Studying which aspects in it first must involve a choice. The solutions must meet some expectations first. So, at least for the initial stage of a subject, the focus must be more narrowly set so as to serve certain purposes. Well, once the initial stage is set, sometimes its influence can last for very long, even if its initial concern is no longer primary. 

   Then, back to the original question: which perspective? You may think it is businessmen's. But that's not quite true. Though David Ricardo, perhaps the second father of economics next to Adam Smith, is a businessman, I can't see his theory of comparative advantage is made from a businessman's perspective. It is more about a nation's interest than businessmen's interest. 

   I am not an expert in economic thoughts, but I can assess based on what we will teach in microeconomics textbooks today and trace its source of development. Along this line, it won't be difficult to discover that the theories are mainly made from policy-makers' perspective. 

   Perhaps this surprises you as your impression about economics is that it is about business. Perhaps you study economics as you study business. But the fact is: the use of economics in business is a much more recent phenomenon than its use in policymaking. Until at least the second half of the 20th century, most economists are still much more keen to suggest policies to the governments than serving the business sector. Of course, today this may not be true. But what was true initially may have a much greater impact on the later stage than you may expect. 

   Perhaps you suspect the microeconomics that you have learned is really made from a policy-maker's perspective. Your first micro topic is about consumer's choice. What is it related to policymaking? Then, you encounter the theory of firm and the mode of market competition. Wouldn't it be related to business much more than policies? 

   I won't say these topics are not related to business. Of course, they are. But let me explain my point.

   First, the consumer theory aims mainly at explaining the consumer behaviours. Wouldn't it be more about business than policymaking? Aha, I think you have made a mistake. Have you noticed that actually there is a course known as "consumer behaviours" offered in the department of marketing. If you have ever taken such a course, you will know the course is not about economics. It is truly about business. 

   So, what consumer behaviours will be explained in a microeconomics course? The major focus is the law of demand but of course other issues may also be involved. Well, the law of demand is only about the negative relation between price and quantity. Mentioning this needs only one minute. Not much can be taught! No, it is about explanation. It is about substitution effect and income effect. So, it is not that straightforward. 

   But the foundation of substitution effect and income effect (and any other effects) is indeed "rational choice". Consumers are assumed to be making rational choice. In essence, it is about purposeful choice, not purposeless action. Rational consumers will choose the means to maximize the attainment of one's purpose (technically known as "utility"). 

   So, maximum satisfaction is the foundation. But won't you ever wonder why it must be maximum? In fact, some economists (notably the Nobel prize winner Herbert Simon and others) have tried to introduce an alternative, saying that people simply try to be "satisficing", a word combining "satisfy" and "suffice". It assumes that attaining certain level of satisfaction will suffice; maximum satisfaction is not what choosers pursue. In other words, it is only about bounded rationality, not perfect rationality.   

   Alternative models like above have caught some attentions but have never been more popular than the rational choice model of maximum satisfaction. Why? Perhaps the latter's predictive power is higher or the latter is simpler. But let me share with you an observation from another Nobel prize winner, Roger Myerson. In a lecture given in 2002, he said:

   "Perfect rationality is certainly an imperfect description of real people's behavior. But our goal is not just to predict human behavior, but to analyze social institutions and evaluate proposals for institutional reform. To look for potential flaws in an institution, it can be helpful to analyze the institution under the assumption that the individuals in it are not themselves flawed, because otherwise arguments for institutional reform become confused with arguments for reeducation of individuals....

   "If individuals are not motivated to maximize their own welfare (as measured in our model) or if they do not understand their environment (as predicted in our analysis) then any loss of welfare that is predicted in our analysis may be blamed on such dysfunctional or misinformed individual behavior, rather than on the structure of social institutions...."

   This is not to say people are not truly rational but we have to artificially assumed that they are. This is to say that perfect rational model can produce reliable predictions but other models may also do this. So, the point is: it is not just to predict human behavior. Even if there are alternative models that can also predict behaviours well, choosing the rational choice model has an extra advantage: we can focus on finding what's wrong in the institutions. Hence, finding what's wrong with individuals is for long not a focus of economics (but a focus of psychology). Today, this attitude has changed a little (behavioural economics embraces these individual flaws). But that's another issue. 

   Hence, the point is: economics choose a model (rational choice) that can both predict behaviours well and suitable for finding flaws in the institutions. The later motivation is clearly made from a policy-makers' perspective. 

   Another important point from consumer theory is consumer surplus. Have you ever wonder why you should learn such a concept? Do consumers need to measure the consumer surplus from a deal so as to decide if one should accept a deal? Of course, they don't. Do businessmen measure consumer surplus so as to decide their pricing strategies? I don't think so. They may be interested in the shape of the demand curve and so set prices based on the shape. But consumer surplus is not their focus. 

   Yet, from a policy-maker's perspective, measuring consumer surplus is needed. Of course, producer surplus is also needed. Combined together, social welfare is measured by them. If a policy changes the combined consumer surplus and producer surplus, how big is it? Is it worthwhile to change it? That's what a policy-maker needs to know. 

   This naturally leads to the theory of firm and the mode of competition. The theories contain many details but the intention is not to teach businessmen how to do their own business well. Economists have to go through these details first but eventually what do they want to know? They demonstrate that perfect competition is better than other market structures, in particular, monopoly. How do they know? Yes, by consumer surplus and producer surplus. Perfection competition generates more while monopoly generates less. 

   At this point, I hope you are now convinced that microeconomics, at least for its basic part that has been established mainly in its initial stage, is constructed mainly from a policy-maker's perspective. 

   Of course, this is not our major concern in this post. The major concern is the use of microeconomics. But settling the question about the perspective can easily lead to the question about the use. The use is exactly for giving advices to policy-makers. From the discussion above, you may already appreciate how useful it would be for microeconomics to give policy advices. Yet there are also many other microeconomics concepts and theories that haven't been covered above but they are useful for policy advising. 

   At this point, I hope you won't be too disappointing. I am quite sure that students in my microeconomics class are mainly not interested in policy advising. They most likely want to know how economics can inform business decisions or can be used to analyze daily life issues. For the latter, as mentioned above, I have written some pieces but perhaps it lacks a systematic discussion. For the former, another post may be needed to handle the issue. 

   What I want to say in this post is: if you think economics should be useful for policy advising, like what students in certain high-flying programme known as "Philosophy, Politics and Economics" do, then you will get a positive answer from this post. If not, and you think the microeconomics that you have learned is not useful, then you have to understand that its initial purpose is more for policy advising. This enables you to understand microeconomics better. Yet, time has changed and now people want to use microeconomics for many other issues. But its basic part is more about policy. 

   Perhaps you may ask: can I just skip the basic part and jump directly to other applied parts of microeconomics? My answer is: if you are so impatient, you should not choose economics as your major. You should go to the business school and there you can also learn some economics, with fewer foundations and more applied parts. For economics, we value solid foundations, not simply applications. 

   Anyway, the use of microeconomics is not limited to policy advising. But to go through these other "uses", I think I need to write another post. 

   

   

The use of macroeconomics, again

    I have recently encountered an analysis made by an investment advisor working in a big bank. I heard a very odd point: if Japan raises its interest rate, it may encourage more investment in this country. I don't know if you have learned some basic macroeconomics. If yes, I guess you will also find this assertion odd as all we have learned from macro is that interest rate will discourage investment, not encourage it. 

   So, why this investment advisor makes the point above? Obviously he is not someone ignorant of basic macro, or he will not be qualified for his job. We can't just say: he must be wrong. So, let's first assess what he has said. 

   His point is this. Japan has long adopted a policy of low interest rate, actually nearly zero interest rate. This policy drives out a lot of Japanese money, which would rather invest overseas for a higher return. Now, Japan has prepared to increase its interest rate. This hasn't happened for a long time already. This will attract investors back to Japan as they now can enjoy a higher return, at least not zero return. Therefore, they may invest in Japan and the economy may be stimulated. In fact, this investment advisor has used this point to explain why Japan would allow interest rate to go up when its economy is bad. His point is that raising interest rate may have a positive impact due to the above reason (though other factors may also matter). 

   Hence, do you think this investment advisor has made a sensible point, if you have some basic macro knowledge? Perhaps you do. Then, how can we reconcile the two perspectives, the advisor's and the macro's?

   Perhaps it is simply that the investment advisor has used different terminologies from that are used in our basic macro courses. 

   If you still remember, in macro, investment refers to capital investment or physical investment. Under this definition, more investments means that extra machines have been used and more factory buildings are built. In macro, for investments, we mainly refers to capital goods like these. Investment is about additional capital goods used.    

   On the other hand, the investment advisor, I believe, refers "investment" to fund flows, or financial investment, such as money spent on (or "invested" in) buying stocks, bonds, mutual funds, etc. Why do I say this? Why do I think he should refer mainly to "financial investment" instead of "capital investment"? This is because only financial investment will increase with interest rate. Capital investment will not. For example, bond yield is the interest rate on bonds. If it is higher, "investors" want to hold more bonds for its higher return. This is what we have learned from macro. In contrast, when a company needs to buy a machine (makes capital investment), it may need to borrow new money by issuing corporate bonds. But if bond interest rate is higher, the company will hesitate as it needs to pay back more money when the bonds mature. 

   Thus, the investment advisor's point is sensible? He is just not using terms same as ours? 

   Well, there is still a problem. If he refers to "financial investment" only, how can he say that a higher interest rate can help stimulate the economy? Capital investment can stimulate the economy. It is a component in GDP. But financial investment is not part of GDP. More financial investment may make the stock market price go higher. But the economy may still be bad. It is common that stock market is hot but the real economy is not. 

   Well, perhaps he means that when the financial market is hot, the real economy will be eventually stimulated. It seems that many laymen also have this idea in mind: if the financial markets perform well, the real economy will also eventually perform well as people profiting from their financial investment will consume, or even invest, more in the real economy. 

   This may be a folk wisdom. Is this true? It does not seem to be often true. For US, I guess this is by and large true. But this is not quite true for China, in which its GDP high-growth period is often accompanied with a stagnated stock market. Will this be true for Japan? Is the investment advisor's analysis based on his study in Japanese economy? I guess not. Of course, I don't have evidence. But at least he hasn't indicated there is such a relation in his analysis. 

   Of course, financial markets are not limited to the stock market. Broadly speaking, real estate market is also included. In fact, real estate market, instead of stock market, may have a closer relation with the real economy. How closely stock and the economy are related may depend on how widely stocks are held by people in the economy. We know stocks may not be widely held in some economies, and this may matter to why the market is not closely related to the real economy. But real estates, especially residential properties, are often widely held by a majority of people. This also explains why the market is closely related to the economy. 

   Yet, what may be true in many economies may not be true in Japan. It is well known that real estate market in Japan is not good. Can a higher interest rate help it? If you ask this question, I think even the investment advisor above will say no. In fact, most likely he will say the contrary: a higher interest rate simply increases the burden of real estate mortgages and will discourage buyers. 

   Hence, I don't think the investment advisor above refers to real estates when saying a higher interest rate may help the Japanese economy. I believe he simply thinks casually like most other people: more fund flows to Japanese can make the financial markets, especially stock market, perform better and so will the economy. But as I analyzed above (I have also pointed out the fund-flow mistake elsewhere), I think this is wrong. 

   Yes, my conclusion is that you can't reconcile the advisor's viewpoint and the macroeconomics viewpoint. And I think the advisor is wrong. He simply takes some casual, and laymen, belief for granted without thinking deeply about the validity of the folk wisdom. I think a higher interest rate actually will harm (capital) investment and so the real economy in Japan. However, the central bank of Japan has to cope with the inflation problem and must take some actions (higher interest rate) to release the problem. It will take the action not because it thinks interest rate can help stimulate the economy. Eventually, other factors may help the economy but it is not interest rate that does this. 

   In fact, the investment advisor may also make another mistake: confusing the effect of interest rate on investment and saving. In macro, we know in equilibrium investment equals saving. Meanwhile, we know interest rate discourages investment (as investors borrow funds and bear the interest cost). But savers, those who provides funds for investment, will like a higher interest rate (as they earn interest income). 

   Hence, what a higher interest rate will attract is the savers' funds (financial investors' funds), not capital investors' demand for funds. Yet, in equilibrium, investment equals saving. So, people may easily confuse the effect on one side of the equation with another side of the equation. Yes, a higher interest rate will promote more saving. But will this automatically promote more capital investment? It won't. If the interest rate falls due to more fundings tracing few borrowers, capital investment will increase. But this is not a phenomenon the advisor intends to analyze. He refers to a higher interest rate facilitated by the central bank as a result of the monetary policy. He doesn't refer to a lower interest rate due to more saving. 

   In fact, from macro, we know when a higher interest rate will be accompanied with more investment: it should be investment to increase first, and then the higher demand for funds bids up interest rate. It is not the other way round, i.e. a higher interest rate causes more investment. 

   At this point, I hope you are convinced that the macro you have learned are useful. I use only basic macro concepts in all the analysis above. I think I offers a clearer and more likely truer analysis than the advisor. 

The economics of retail shops

    I have recently re-read my post "Shops shut down but rents still stand firm?". Suddenly, I realize that I may have established a framework for analyzing retail property values based on the economics concept of externality. This framework is not limited to the retail shops on streets like what has been analyzed in the above blog. It is also applicable to all retail shops. Be it located in a shopping mail or on streets. 

   First, let's revisit the analysis done in the above blog post: "The value of a retail property ... depends crucially on the business revenue that can be generated from the shop. ... 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. ... 

   "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..."

   In the analysis above, externality is the key factor involved. Externality is not explicitly mentioned above but it is implicitly used. 

   What is externality? It refers to situations where a party takes certain actions that affect another party. The affected party does not take the action to affect oneself. It is another party that takes the action. So, from the affected party's perspective, the effect is out of control. It is external to this party. 

   Now, in above, the coffee shop 1's business is affected coffee shop 2's business. Coffee shop 1 can't affect coffee shop 2's actions. In this, the externality is negative as each affects another's business negatively. In the example of bubble tea shops, the effect may be positive if a cluster of bubble tea shops in the same area attracts more people to come. There is a positive externality in this case. 

   When we mention externalities, normally the example used is pollution, etc. But my analysis above shows that retail shops also create externalities to each other. 

   Yet, the externality is not limited to shops on the streets. Think about a large shopping mall. There are some shops in a mall that is normally considered to be anchor tenants. For example, a big ice rink can attract a lot of players to go skating on it. Perhaps a 3D movie theater can also attract a lot of visitors. For local shopping mall, perhaps a huge supermarket can have the same influence: people go to the mall because this store is located there. 

   The point is: while anchor tenants attract visitors to go the mall, these visitors will not simply visit the anchor stores only; they will also visit other stores in the same mall, such as its restaurants, fashion shops, etc. The anchor tenants bring more clients to other stores in the same mall. They generate positive externalities. 

   Meanwhile, if there are too many restaurants of the same type in the same shopping mall, they may simply compete for the same pool of clients. Each restaurant can't have much business. This is a negative externality case.

   So far, it looks not so different from what we have described about street shops: both involves shops affecting each other's businesses. But there is a big difference. 

   There is a "central planner" in the shopping mall while there is none for street shops. The landlord owns all shopping spaces in a mall and so can decide to incorporate anchor tenants into the mall, and avoid renting spaces to shops selling too similar products. This can help the whole mall earn a maximum amount of businesses and rents. 

   Street shops are separately owned by different landlords, however. Each landlord decides which tenant can rent the shop. There is normally not a single landlord to own all shops along the same street and so no "central planner". In this situation, deliberately introducing an anchor tenant to a street will not be done. Yes, when coffee shop 1 is already located, coffee shop 2 will not come to the same street, avoiding the negative externality. But perhaps coffee shop 2 is more suitable for this street. But it will be scared off by the early arrival of coffee shop 1. There is no "central planner" who will coordinate and choose the most valuable shop for a street. 

   Hence, in a shopping mall, the landlord makes use of the externalities generated between the stores in the same mall to decide a mix of stores so as to maximize the benefit. On a street, the externalities just happen. No design, no coordination, no organization. The retail value of the whole street can't be expected to be maximized. 

   Of course, I won't say street shops are worse than mall stores. The advantages of street shops are convenience. People just pass. They don't need to enter a covered space with doors. Passenger flows are normally higher on popular streets than popular malls. Hence, street shops can survive and even thrive. The point is: the retail value on the whole may not be maximized. Of course, no one cares as each landlord will care only about the value for one's own shop, not the value on the whole. 

   Economists care about value on the whole. They say it is inefficient if the value on whole is not maximized. Though inefficient, we also may not need to worry about the situation of street shops. The inefficiency is a static phenomenon, or the situation for a point of time. Sometimes we may wish to take a dynamic perspective. 

   Street shop ownership is not concentrated. Each landlord decides which tenants can rent. As such, it is closer to a free entry situation than shopping mall, whose landlords have a much tighter control for which tenants can come. Therefore, street shops have more diversity and can catch up with market changes more easily. 

   Yes, what people want may change over time. It may need to be discovered by entrepreneurs. It is not a fixed list simply awaiting for retailers to supply. From this perspective, we should value the mechanisms that are more flexible and responsive to market changes. 

   Shopping mall landlords may be smart and can be responsive to market changes quickly. But they cannot be more market-responsive than millions of the individual landlords of street shops taken together, with each having one's own market shrewdness. That's a notable advantage of free market. But of course mall owners will also learn from the streets. When what are popular become clear on the streets, shopping malls sooner or later will also introduce them into the malls. 

   So, you can see: the efficiency and inefficiency of mall versus street in static and dynamic aspect are actually complementary to each other.