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.

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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.

Econ 101

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?

Econ Fallacy

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.

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.

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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.

Econ 101

Childrenomics part 3 - household decision making

Another aspect that determines the outcome of children's health, education and other things is who makes the decision in the household (who decides what, and what's the relative 'voice' of each decision maker). Let's now narrow the decision makers to mother and father. We'll deal with another person (i.e. in-laws) later. Two extreme cases: 1) unitary model of household decision making, and 2) collective model.

In the first case, household acts as if there is only one decision maker. So, consumption/spending decisions are only affected by total household income. In the second case, imagine that the two parties (mom and dad) are 'bargaining' over what/how much to spend. The question is what determines each party's bargaining power?

The traditional approach on this is to assume that the bargaining power is determined by how much each party earns money. We can think of the other variants, such as relative 'assets ' (financial, social) brought when both got married, etc. We can think of an extreme situation in which only one party earns money, so he or she has all the voice over household decision. In this case, we are back to the first case.

Of course this is not the perfect approach. After all, we see a lot of cases where the wife does not earn antything but she takes full controls over everything. Welcome to the 'Dictated Husband Association' (Ikatan Suami Takut Istri, ISTI), guys!

Many studies found that when mother has greater say in household spending, it leads to better outcome of children's health. An example is a study by Duncan Thomas (1994), using log calorie intake, log protein intake, survival rate, weight for height and height for age. I can not recall which studies, but I also remembered similar results for mortality rate and low birth weight.

What about the decision made by other parties in the household? For now, I don't have any studies to quote. But we are having a real world experience with the issue...

Childrenomics part 2 - gender preference

Some societies have preference over boys. Perhaps because boys will carry the family's name, but also because they can rely on their boys to do heavy works. Other societies prefer to have girls; because in their cultures girls are responsible to take care of their parents in the old days. Or, parents may not have any preference over a certain gender, but they want to have both genders in the family. Each preference will have implications in the size and resource allocation of the family.

One implication of gender preference is gender discrimination - in terms of within-household resource allocation. Deaton (1989) measured the boy-girl discrimination in terms of the 'reduction of household expenditure on adult goods.' (Adult goods: tobacco, adult clothing, alcohol, eating out, etc.). When a kid is valued more, parents will be more willing to reduce their spending on adult goods. He found no evidence of gender discrimination in Cote d'Ivoire, and a small and insignificant bias in favor of boys in Thailand.

We can also measure boy-girl discrimination in terms of health outcome. Using data from rural Punjab, India, Monica Das Gupta (1987) found that the mortality rate of children below one month is higher for boys. However, as the children gets older, girls mortality rate surpasses boys. Child mortality rate is also much higher for girls who were born as the second child and over.

The fact that boys have higher probability to die within a month after birth is quite logical. Boys have the XY chromosome, while girls have XX. Remember that the Y chromosome is a 'mutated' version of the X - means that boys are by nature mutants (the 'defect' version of girls). That makes boys are more prone to death, which explains the higher rate of postnatal mortality rate. The higher rate of girl mortality rate at the older age reflects the different treatment of parents. For example, girls receive lower nutrition, less clothing etc. And the value of girls is even less when parents have already had more survived children.

My professor at Harvard, Robert Jensen (2006) raised another issue. Parents may not necessarily discriminate against girls (or boys). But they may still prefer a certain gender (let's say, boy). When the first child is a girl, parents is more likely to have another one. When the second one is still a girl, it is more likely for them to have a third one, and so forth. As the result, girls tend to come from big families. Even though parents don't discriminate, coming from big families, girls will have smaller allocation of household resources ("equal treatment, unequal outcome").

How true is that? The answer can't be theoretical - it should be empirical. That may also depend on where do we do the research. But according to his preliminary finding, some Indian states where preference over boys are strong tend to confirm this results.

Childrenomics | Gender

Childrenomics part 1 - fertility decision

Introduction: Having a baby makes me more exposed to children-related economic research. Or, perhaps it is the reverse: having been exposed to children-related research makes me (want to be) having a baby. Nevermind. Here are some literature review of some research in the topic.

Why do people decide to have kids? Is it driven by preference or constraint? Earlier, I raised the debate between the 'family-planning' vs. 'desired demand' hypothesis of fertility. The former argued that people have (many) children because of constrained access to contraceptive. The latter argued that people have many children because they do want to have many children.

I'm leaning towards the 'desired demand' hypothesis. Having children is a rational choice (although for some people, it may be an 'accident' - no judgement on that). Rational means parents calculate the benefits of having kids compared to its costs. The benefts and costs do not have to be perfectly known, nor they should always be measured in financial terms. The bottom line is, economic theory also allows us to predict human behavior in terms of fertility decision.

What's behind the demand (desire) to have kids? In Indonesia, we know the term 'more children, more prosper' ('banyak anak banyak rejeki'). Behind the old saying, there are economic rationales.

First, old-age security. Parents expect their children to take care of them when they are old. Missing market, in this case the market of pension fund and senior citizen care gives the reason for this view.

Second, family (cheap) labor, usually for rural agriculture households. Again, this happens because of the missing or imperfect market for labor, as well as market for goods; so households will have to rely on own production.

Hence, missing markets help explain why people have many children.

In addition to that, parents may decide to have many kids to increase the number of survived kids. This may happen when the health situation and infrastructure is poor. By having many kids, parents can achive their 'targeted' number of kids. Lastly, number of children may also be affected by gender preference. The probability of having a second, third and next child is greater if parents has a preference over a certain gender (more on this).

Childrenomics | Fertility

From the Manager

Happy (belated) birthday to ... us :-)
.... It's really been a year?

New member

We'd like to proudly announce the newest addition to the Café Salemba family: Cemara Perdana.

P.S. Regardless of your opinion about population control, please note that my wife and I did not contribute to the population growth. In fact, we were adjusting the supply and demand for children disequilibrium.

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.

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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