Econ101: Preference

Hi again. It’s time now for the third installment of our Econ101 series. After introducing some key concepts needed to speak the 'baby' language of economics, let’s now turn to a more structured and systematic approach. That is, we’re going to follow a text book structure, without having to religiously adopt its verbal and mathematical presentation.¹ Yes, we’re going to do it the Cafe-way (and that may as well mean irregular schedule!). Lean back and enjoy your coffee.

When we analyze an individual behavior (in making decision, or more accurately in choosing between available options, given his constraints), we need to make some assumptions with regards to his preference. The most important assumption is that the guy is rational.

What do we mean by rational in this context? We mean his preference relation is complete and transitive. Complete means you can describe the relation between any two goods that he is considering. So, if the guy is considering apple, orange, and banana, you have to be able to say whether he prefers apple to orange. Also, you have to be able to tell his preference over apple and banana, as well as banana and orange. The good thing is, telling that he likes banana as much as apple is a valid statement – we say he is indifferent between banana and apple.²

Transitive means consistent in choice ordering. If our guy prefers apple to orange and orange to banana, he should prefer apple to banana. Yes, this assumption is strong: I know a friend who likes Manchester United more than Liverpool and prefers Liverpool to AC Milan, but he loves AC Milan more than MU. That’s fine, but for now, let’s assume away such intransitivity. Don’t worry; we will relax the transitivity assumption sometime later. (That soccer freak friend of mine; he ain't crazy, he's just irrational, as we 'have to' call him).

How do we conveniently talk about preference? By assigning numbers to the preference order. In our example, the preference order of the guy is: apple-orange-banana (in decreasing order of importance). Now let’s assign some numbers. Yes, we’re assuming that we somehow can measure satisfaction. Suppose the satisfaction experienced by the guy if he consumes an apple is 10. Then, the corresponding number of an orange should be less than 10. Say 7. How about a banana? Yes, it should be less than 7. Say 5. We say, for the guy, the utility of apple, orange, and banana are 10, 7, and 5, respectively. Can we change the numbers? Yes, we can. But mind the order! So, if you like you can use 1,000-700-5, or 356,464-100-0.3. But combination like 3-5-1 or 7-4-10 is not allowed, given the guy’s preference. You see, utility function is an ordinal concept, not cardinal. That is, all that matters is the order, not the number itself. So, if we can use simple numbers as long as we keep the order, why make it complicated?

Stay tuned.

---

¹ The text I’m referring to is Mas-Colell, Winston and Green. This book is one of the most elaborate modern microeconomics text. However, it is designed for graduate course. In one of its strongest part i.e. general equilibrium analysis, it uses differential topology, so you might want to consult some graduate math texts. Many times, students find it useful to combine this text with the more compact, Varian. If you want a good text for undergraduate level, we recommend Mankiw.

² Seriously, guys, this is just an illustration. I really don't care if you happen to like orange more than apple :-)

Econ 101

Capitalism is good (even for the poor)!

Loan sharks (rentenir; tengkulak; lintah darat) are always portrayed as the enemy of the society. As the name portrays, they are fierce predators of the poor farmers or traders. In Indonesian they are called lintah darat (leeches) because they live by sucking other people's blood.

Are they really bad? As usual, we economists do not have the moral judgements. We are more interested in why they exist. Well, simply they exist because there is an excess demand of capital. There are poor village enterpreneurs with high needs of capital to start up or expand their small businesses. However, for many reasons, they can not borrow from the banks. Perhaps because they do not have anything to serve as collateral. Perhaps because the scale of their businesess is too small for the banks to make a significant margin out of it. Perhaps because there are no banks around.

Loan sharks fill this gap. They offer accessible loan with small or no collateral. In some ways, they contribue to making the local economic wheel rolling. True, when the debtors fail to pay, loan sharks turn into true sharks. But the fact that they do exist and continue to exist means the demand for their 'service' is still high. (Remember also that by lending their money, loan sharks are also subject to risk and opportunity cost of money.)

Moral of the story: what the poor enterpeneurs need is access to capital. Not that they don't know how to do business. They do - but they just don't have the necessary capital.

Not that they need to be helped in paying the interests. Remember, many of them are able to repay the loan sharks' exorbitant interests. A study by LPEM-FEUI (thanks to my colleague Syarif Syahrial) showed that microfinance activities in Kuningan, West Sumba and East Sumba had no problem with unpaid loans even though they charged higher interest rate compared to the market price.

This explains why Adi Sasono's initiative when he was the Minister of Cooperatives and Small-scaled Enterprises during the Habibie administration (1998-99) failed. Assuming that SMEs were hurt by high interest rate, the government offered a subsidized interest rate for SMEs, at 13% compared with then market interest rate of 40-50%.

But people responds to incentives. Many new SMEs were established. But the motive was to be able to borrow at 13%, put it in the bank, then got the 30%+ interest margin. Who wants to do real business at that time, when the economy and security was very uncertain?

So, developing financial market and institution that reaches the poor is one important way to alleviate poverty. Since financial market is the backbone of modern capitalism, we can conclude that capitalism is good for the poor. At least, we can't conclude it is bad for the poor.

Rural finance

Nobel prize

I know this is a belated entry. But it would be ‘strange’ if we do not mention at all about this year’s Nobel Prize in economics. Columbia University’s Edmund Phelps was honored the prize in the age of 1973. Since I am no macroeconomist, I can not really comment on his works.

I know that he was among those who developed the “micro foundations of macroeconomics” approach, along with his compatriots Milton Friedman and Robert Lucas who had won the Prize much earlier. He also reshaped the understanding of Philip’s Curve and the relationship between inflation and unemployment. His other contribution was in growth theory literature: the “Golden Rule” of savings and capital accumulation. (Basically, we can’t save too much!)

Here is a summary of his work. See also a very good but concise explanation about his works in the Marginal Revolution.

A week later, the Nobel committee announced that this year’s Nobel Peace Price was honored, not our President SBY, but to Dr. Muhammad Yunus and an institution he established in 1976, the Grameen Bank. Here is my comment on that. One quote from my article:

… the Grameen business has worked not on a charity basis. Nor has it worked by eliminating market mechanisms. Many argue that market mechanisms are bad for the poor. This is an incorrect assumption. Poor people suffer because the market does not work. So the right thing to do, as the Grameen group has shown, is make the market work for the poor.

I also argued that, despite its success, don’t see Grameen Bank model or microfinance initiatives as a magic bullet for ending world’s poverty. Nothing is a magic bullet (that includes the so-many-priorities-at-the-end-it-has-none Millennium Development Goals, right Prof. Sachs?). This article has a similar tone.

Nobel | Microfinance

Bike attack...!!!

According to a Ditlantas Polri (err... how to translate this, by the way?) estimation, there are around 35 million motorcycles hitting the road in the country in 2006. That is 70 percent of total population of vehicle. The number is twice as much as that in 2002, or 2.33 times higher than that in 2001.

Yes, yes, incentives are all that matters. Traffic jam, cheaper than car, more certain than public transport, explain why more people prefer to ride motorcycles. It may also be good for the economy. Nevertheless, it explains why driving (and walking) in Jakarta becomes more and more difficult. And damn dangerous too...! In the Jakarta area alone, according to PDAT, the number of motorcycles is around 3.3 million (2003). It is estimated that the number increases by around 350 thousand per year. So in three years, motorcycle in Jakarta increases by more than a million (conservative estimation).

Traffic

Show some respect, please!

A banner in my neighborhood asked people to “respect those who are fasting” ("hormatilah orang yang berpuasa"). I tried to think, what is ‘respecting those who are fasting’? In my childhood, I was taught that it simply means not eating or drinking in front of people who fast. Perhaps if I someone who fasts sees me enjoying my meals, he or she will get tempted to break the fast.

But then, refraining yourself from eating and drinking (and smoking and having sexual relationship) during the day is the essence of fasting, isn’t it? Giving up one’s utility from eating and drinking is and individual choice. Then, respecting those who fast is a matter of respecting property rights and personal choice. When it’s a personal choice, no one is justified to force them to eat or drink during the day (or tease them or humiliate them).

Similarly, it’s an individual choice not to fast. And the non-fasting people also have the rights to remain eating, smoking or drinking. No one is justified to ask them to stop, in the name of ‘respecting the fast.’ And during the night, whether one was fasting in the day or not, one has the right to spend the night in café or pubs. The café or restaurant owners have the right to do keep their business open at any time. Nobody has any justifications to prevent anyone to go to restaurants at any time. Nobody possesses the right to force restaurants, pubs or cafes to close at any time. (Unless, of course, if the pubs create noise that prevent one from sleeping.)

The rights to perform fasting as a religious duty include the rights to tell others that it is already time to start fasting when they are OK to be told (or when they asked you to do so). Similarly, people have also the rights to remain sleeping and not being disturbed by ‘wake up calls’ from masjids or minutemen. Hence, in my opinion, those shouting ‘sahur… sahur…’ using megaphone from masjids are abusing own’s right, and violating other’s property rights. The solution is simple: use alarm clock, telephone, or if it necessary, put a sign in front of your house that you want to be waken up.

Another obvious thing, whether fasting or not, we do have the rights for a ‘petasan’ (explosives)-free environment. If we ever need the government during this Ramadhan month, it is to regulate petasan and noise from masjids. Not closing down business or night lives.

Back to the banner in my neighborhood. Usually, a banner is a signal of something. What does it possibly mean?

One, those who fast felt that they are not respected enough. Two, those who don’t fast have given enough respect, but those who do ask to be more respected. Three, it signals a kind of threat: respect us, or else…


Religion | Ramadhan

Efficient smoking

Ujang is also here in Canberra writing a cool paper on the economics of smoking. (I heard he has promised the manager "to café" some piece of it). So there we were chatting about the issue over coffee.

Ujang mentioned a study in U.S. that found that price policy can not effectively change smoking behavior in favor of health. That is, when the price of cigarette increases, the sales drop slightly, but the nicotine accumulation rate in the smokers' blood remain constant at the least. This finding seems to have bothered Ujang who hypothesized that in order to discourage smoking (and thus to promote healthy life), you simply need to increase the price of cigarette. But that study came up with the surprising conclusion. I think that's why Ujang decided to test his model on Indonesian family data.

But I guess what happened in that study was ... an increase in smoking efficiency as a response to the price change. That is, before the price increases, smokers tend to smoke inefficently: to smoke only half or three quarter of the cigarette and throw it right after, to smoke while talking at the same time (so as letting the wind contributes in consuming the cigarette), etc. When the price increases to some "decisive level" (that is, a level that can alter marginal buying), the smokers might reduce their buy. But they now become more efficient in smoking. They smoke until it really hit the filter, they don't allow "joint-smoking" with the wind, et cetera. As a result, the nicotine level in their blood stays constant. Or even higher.

A friend who was also in the chat, Dede, disagreed. He said that smoking style is hard to change. One might enjoy smoking only half of his cigarette (the taste might not evenly distributed across the cigarette). Another might like to see his cigarette burnt by the wind while he is composing a poem. And so forth. Well, being a chain smoker himself, Dede might be right, too.

Another friend, Aceh, had a better explanation. Because the cigarette becomes more expensive, smokers try to keep the smoke as much as possible inside ... their lung :-)

What do you think, smokers?

Update: Ujang just texted me. The measured substance in the smokers' blood was "cotinine" as a proxy of nicotine intake. My apologies.

Economics of smoking

Democracy: what kind do we want?

The 24th Annual Indonesia Update conference this year is themed "Democracy and the Promise of Good Governance". I've been thinking lately that the theme is too heavy. That is, the term "democracy".

What is it that we really want when we say we want democracy? The memorization machine back in primary school said: "democracy is a system where the people rule". And we took it for granted. Then there was a time when columnists thought it was more cool to say it in a latin expression: vox populi vox dei -- the voice of the people is the voice of god. Again, taken for granted.

But then. In "people" there should be many persons. It is unlikely that everybody agrees on everything. So whose voice is the voice of god? It seems, by what the memorized definition implies, that the majority's voice is. Therefore democracy means a system where the majority rules.

If that is true, I don't like democracy. Because it allows the tyranny of majority.

Better system, I believe, is the one when people are free to negotiate. Regardless of whether you are of minority or majority, as long as you can enter into negotiation without coercion, and there exists a rule of law that is respected by everyone, then any agreement that occurs should benefit both parties. Otherwise, there would never be any agreement in the first place.

Right, I'm not a political scientist. But am I that off? Or, really, what is democracy?

And Canberra is still cold.

Democracy

The 2006 Economic Freedom Index

Let me begin by reporting that Aco had just stolen the show of the 2006 Conference of the Economic Freedom Network Asia in Kuala Lumpur. By arguing that Free Trade Areas or Preferential Trade Areas are basically an impediment for the real free trade, he was crowned as the true liberal in the forum of Asian liberals. OK, I am exaggerating. There was no crowning ceremony. But at least, in the forum Aco was called an (liberal) activist. Not only liberal economist, but activist...

Also in the conference was the launching of the 2006 Economic Freedom of the World Report and Index. According to its official publication, the Economic Freedom Index was based on Milton Friedman's concept of economic freedom:

[it] measures the degree to which the policies and institutions of countries are supportive of economic freedom. The cornerstones of economic freedom are personal choice, voluntary exchange, freedom to compete, and security of privately owned property. Thirty-eight data points are used to construct a summary index and to measure the degree of economic freedom in five areas: (1) size of government; (2) legal structure and security of property rights; (3) access to sound money; (4) freedom to trade internationally; and (5) regulation of credit, labour and business.

One hundred and thirty eight countries was surveyed in the 2006 publication (the 2006 report publishes the data in 2004). The index takes value of zero to ten; zero means completely unfree, and ten means completely free. The overall index is based on 38 data points measuring the five components. In each component, each country also received the 0-10 score. The index is constructed from various secondary data. So it is not a direct survey of perception or a panel expert.

As the other indices (Human Development Index, Freedom House Political and Civil Liverty, Polity Index of Democratization, even Consumer Price Index), of course the Economic Freedom Index may suffer from the typical problems: measurement error, construction, defintion, level of aggregation etc. But still, it is worth having it as a quantitative measurement of quality of economic institution. The thing is, we need to be cautious in interpreting the data and translating into policy action. But let's just have fun and see what it says.

Hong Kong and Singapore are the two most free economies in the world, followed by Switzerland, New Zealand and the United States. Venezuela, two Congos, Myanmar and Zimbabwe are in the bottom five. Although Hong Kong and Singapore tops the overall score, they are not always the first in each categories. For example, El Savador ranks first in the 'government size' category; Denmark in the 'legal system and property rights'; Sweden (access to sound money) and Iceland (regulatory).

Taking a cross-country analysis, the Economic Freedom Index score is positively correlated with Human Development Index, life expectancy, income level of the poorest 10%, environmental quality and access to improved water sources. Meanwhile, it is negatively correlated with infant mortality, unemployment, share of children in the labor force and corruption. Of course, we can't imply anything from this correlation because it suffers from the usual reverse causality and omitted variable problems. But these simple correlations can at least challenge a popular perception: that liberalizing the economy is bad for the poor and quality of life in general.

Generally, countries with better EF Index also score better in the Freedom House' civil and political liberties. But we may see countries like Singapore, United Arab Emirates or Kuwait who are under the 'partially or totally unfree' politically score well in the EF Index. (We can also add Hong Kong in the list if we consider it is part of China now.) However, those who economically are not free are consistently not free politically. Note that we are still unable to answer what causes what. Whether economic freedom causes political freedom or vice versa, or nothing causes anything, is still an open field to disagree.

What about Indonesia?

The country's overall score in 2004 is 6.0 -- it ranks 83 out of 132 countries in the survey. Lower than Malaysia, Thailand, the Philippines, even Egypt and Iran (!). Well, at least Indonesia ranks better than the likes of Vietnam, Brazil, Turkey or Fiji.

The country's score in 2004 is lower than that in 2003, in which it ranked 73. Breaking down by components, the country's government size score is not different from that in 1985, the period when Indonesia just started the deregulation (and worse, means bigger, than that in 1990-2000). Regulation quality score is worse compared to 1990, and virtually unchanged during the 2000s. Legal system and property rights is also worse than that in 1985, 1990 and 2003 (although higher than that in 2000 -- if that's something to cheer about). The country also scores lower in the access to sound money category compared with 1985-90. Although in terms of freedom to trade internationally, the situation in 2004 is much better than in 1985-90, althogh worse than that in 2000.

So who says that our economy is getting freer and more liberal?

Economic Freedom Index

Discriminatory trade arrangements

Yes, that is what the Free Trade Areas (FTA) should be called. An FTA is not free trade. It is a PTA, preferential trade agreement/arrangement. And "preferential" means discrimination. Suppose we have JFTA -- Jakarta Free Trade Area. Goods exported by West Jakarta to North Jakarta are tariff-free. But goods from Depok, Tangerang, and Bekasi are imposed some tariff if to be sold in Jakarta area. As a result, they can't compete with goods made in Jakarta. What do you call this, free trade? Nope. It's discrimination.

Suppose again, labor from Tangerang are cheaper than those of West Jakarta in producing hats (I use hats here, so that I can assume similar technology, no?). In the absence of tariff, Tangerang-made hats should be cheaper than West Jakarta-made ones. In the meantime East Jakarta doesn't produce hats. But their people like hats. Which hats they would rationally buy? Tangerang hats, of course. But what is the main goal of JFTA? To make the Tangerang-made hats less competitive. That is, by imposing the damn tariff, JFTA makes the Jakarta-made hats cheaper. Or more precisely, deceptively cheaper. East Jakartans now are buying hats from the inefficient West Jakarta's producers. And you're calling this free trade? Give me a break.

That was the main point in my presentation this morning in Kuala Lumpur for the 8th Annual Conference of Economic Freedom Network Asia. The theme this year is "Preferential Trade Agreements: Local Solutions for Global Free Trade?". Of course I wasn't talking about my imaginary JFTA. I was concerned with all the current movements in the region toward PTAs (and other type of discrimination, bilateral trade agreements, BTAs). I know WTO's Doha Agenda was fractured. But at least, if you really have to have some kind of "clubbing", do it on MFN (most-favored nations) principle. That is, a non-discriminatory way. And if you don't want the "spaghetti bowl effect" (boy it's messy), try unilateral improvements at home. While waiting for the WTO's major surgery.

Oh by the way, the Network also launched the 2006 Annual Report of Economic Freedom of the World. As usual, the Report has some interesting stuff inside, including of course the Economic Freedom Index; and now with a special chapter by William Easterly. Ape, who's also here will be talking about that. Ape, the floor is yours.

FTA | PTA | WTO | Economic Freedom Index

More on education and contraception

Now I've found an interesting pattern. Discussing polygamy or condoms is how to get many comments and hit rate.. :-) Many thanks for the comments on my previous posting. I was about to make a response to some comments, until I realize my reply worth a separate entry.

Then Yudo mentioned about the need to estimate the effect of education on different contraceptive methods. Actually, that was what I did. In addition to 'any modern method'* I estimated four different methods: 1) birth pills, 2) IUD, 3) periodic abstinence, and 4) condom. There four represents different 'levels of difficulty.'

In terms of difficulty, birth pills are moderate. It is easy to use, but requires some careful attention and understanding on how to effectively use it. IUD is easier -- you just come to the clinic and let the doctor do that for you. But on the same time, you need to have knowledge or awareness and access to the clinic. Periodic abstinence is, well, difficult. A lot of careful calculation is required. Condoms, on the other hand, is no rocket science.

My prior hypothesis is that the more difficult a contraceptive method is, the higher is the impact of education on the probability of using it. So, this is another way to estimate the return on education. But, as I mentioned earlier, I found no statistically significant impact of education on the probability of using the first three. The reason was because the family planning program in Indonesia has been quite successful. So regardless of education and wealth, Indonesian women has relatively had high knowledge and access to contraception.

Interestingly, for condoms -- the easiest method of those four -- the coefficient is (marginally) significant. Meaning that the probability of using condoms still depends on the level of education. This opens the room for more exploration.

Remember that unlike pills, injections or IUD, the use of condoms put the responsibility on men (husbands).** Remember also the unbalanced relative position between men and women in terms of sexual relationship and behavior (read: men are less responsible). For women, more schooling may mean two things: 1) more bargaining position in the household, and 2) higher chance of getting a more educated, more responsible husband.


* Modern method = the term to distinguish 'traditional' or 'folklore' contraceptive method. Boys, please be informed that asking your girlfriend to drink Sprite or jump up and down after having sex is not a modern contraceptive method! It is not even a method...!

** Still yet to find the story for periodic abstinence.

Fertility | Education