Sunday, November 26, 2006

Econ 101: Demand Part 1

Recall our assumption of rationality? Yes, by rationality we mean people’s preference relations are complete and transitive. In order to talk about demand, we now need two more (sorry, guys) assumptions, namely desirability and convexity.

Desirability simply means you prefer more to less. It is represented by the property of monotonicity that means if I ask you to choose between 3.1 apples and 3 apples given the same constraints, you opt for the former. Wait a minute, you say. What if it is not an apple, but something bad, like trash? Well, simply modify the offer statement: 3.1-unit reduction of trash and 3-unit reduction of trash.1

Convexity (of preference relation) means your willingness to give up a unit of a particular good in order to get another unit of different good in exchange given your constraints is increasing the more you have the former and the less the latter. (Note: our definition of convexity in the consumption and budget set still hold). This is called diminishing marginal rate of substitution.

So far we have been talking about preference. How do we really analyze it? We usually use a tool called utility function. This is simply a means to express how you would respond when facing a set of goods given the prices and your income. In order for us to represent preference relation with a utility function, we need (oh, shoot!) to assume continuity. It says, if you prefer 1 apple to 1 orange, 2 apples to 2 oranges, you can’t suddenly, out of blue, prefer 3 apples to 3 oranges.2

How do we put the utility function into use, then? By solving a maximization problem. That is, we suppose an individual is trying to maximize his satisfaction (i.e. utility) given his choice set and budget set. By maximizing we mean, he will use up all his income to consume the goods of interest (saving can be a form of a good; I see your eyebrows rising). We would continue on this.

Stay tuned.


1 But hold on, you say. You’re craving for ice cream. I give you one cone, you ask two. I give you two and offer a third. You start to look less eager, but you still take it. I offer a fourth; you give me a no-thanks-I’m-fine. This is called diminishing marginal utility. It is not contradictory to the monotonicity assumption of the preference relation. You can still prefer more to less, but the additional satisfaction the ‘more’ gives you is becoming less and less as the quantity grows. Four cones of ice cream are too much already for you; you prefer three. Remember that we have constraints that limit preference? Yes, one of the physical constraints is quantity that might be bound to taste (or well, your stomach capacity). In this case we can say that your set of ice cream is limited to three. But don’t take this anecdote very seriously; rather, we usually go around such problem with a weaker restriction called local non-satiation – you’re never satisfied, 'locally'. Meaning, you can still prefer 2.999999999999999-unit of apples to 3 apples and at the same time, prefer 3.000000000000001-unit of apples to 3 apples. But let’s not dwell into this technical necessity. We’re safe for now.

2 Again, do not take the numbers too seriously. It is the order that matters.

Thursday, November 23, 2006

When excess supply is a win-win

This is hillarious. According to The Jakarta Post here,

Minimum wage rise [is] a compromise of supply, demand

Let's see:

  1. Policy is supposed to be effective, agree? (Otherwise, what's the point of making a policy?)
  2. Now, for a minimum wage policy. What is 'effective'? Effective minimum wage is when wage can not go lower than that, agree?
  3. What is 'compromise' between supply and demand? It is a situation where supply meets the demand (or demand meets the supply, whatever), no? Economists call it 'equilibrium'.
  4. Now, if supply and demand meet, is there any excess? No. Because if there is, it is not an equilibrium. Not a 'compromise'.
  5. So, in order to be effective, a minimum wage should be higher than equilibrium wage. That means, it should be such that an excess supply is in effect.
  6. In other words, the title of the news is at best, misleading.

More coffee, please?

Friday, November 17, 2006

RIP: Milton Friedman

May Milton find markets less distorted up there.

Here's from The NYTimes. Here's from the newly launched The Economist's blog.

Saturday, November 11, 2006

Econ101: Consumer Choice

Remember our own definition of economics? Yes, choice. Let’s now talk about what an individual actually does when we say "he chooses”. We’re going to talk about a typical consumer. Consumer is the most fundamental decision unit. (Or put it this way: every producer is also a consumer, but not the other way around).1 Understanding what a consumer does helps us understand what the other units do.

What is it that consumer choose over? Anything you can want: food, books, coffee, music, boyfriends, identity, clean air, sex, religion, justice, blog templates, et cetera. We call them commodities.2 Can we have them all? As much as we want? No, because there are constraints. The explanation to Mick Jagger’s “you can’t always get what you want” is because we face restriction(s). And that’s why we have to make a choice.

The first limitation is the physical constraint. This includes time, quantity, place, taste, and institution. We can’t choose a durian simply because it is not a durian season: no one is selling it. We can’t have leisure 25 hours in one day, because one day is only 24 hours, unfortunately. We can’t buy half a car, because the smallest quantity sold is one. We can’t eat u-dong in Seoul and Jakarta at the same time -- and at either place, we're bound to our taste. We can’t drive and drink because the law doesn’t allow us. Given all these restrictions, whatever left you can choose from is called the consumption set.

The second limitation is the budget constraint. This is a matter of affordability that in turns depends on the level of your wealth – usually represented by income. For now we will have to employ two assumptions. First, all the commodities have a price and everybody knows it. Second, no one can affect the price, or more accurately: your individual act of buying doesn’t really affect what is going on in the market.3 Given the prices and your income, your feasible consumption bundles are now captured by what we call your budget set.

Another important assumption is that both the constraints are “convex”. This means, when your consumption set includes bundle A and bundle B, then it should also include any combination of the two bundles (e.g half of bundle A and half of bundle B, rather than A only or B only). Similarly, if both bundles are included in the budget set, so is any combination of them.

When finally you decide to make a choice given the consumption set and the budget set, we say you’re revealing your demand function. That’s the topic of our next talk.

Stay tuned.


1 This principle is very powerful to attack all the pathetic protection asked by producers. And to debunk all the harsh attack on consumerism. How so?

2 Try telling a girl that she is a commodity. If she is flattered ("Oh that so sweet, you’re telling me I’m valuable!"), she might have learned this stuff.

3 This is sometimes called ‘price-taking’ behavior. It doesn’t mean you can’t bargain at all. You can bargain, but whatever the price you and the seller agree doesn’t translate into the same change in the market.