Opportunity cost, again

An example of how someone misunderstood the concept of opportunity cost (and proud of it). The article was inspired by an older article by a famous Indonesian economist/politician/former minister. Arya Gaduh has pointed out where the logic went wrong. Teguh Dartanto provided some useful data and calculations.

I feel it's still relevant to raise the issue once again and to remind people about the difference between accounting and opportunity costs.

The economist of Cinta Laura

With Sjamsu

I can forgive you if you don't know who this year Nobel Laureates were. But if you don't know who Cinta Laura is, dude... get a life. She's the Indonesian Paris Hilton, in case you wonder. No, no... don't think of the video scandal. Cinta's still innocent. And she doesn't drive, yet.

Sjamsu just circulated the famous quotes of Cinta Laura. Thanks to someone crazy enough to collect them from various tabloids and infotainment interviews. We thought that some of her comments are examples of real-world applications of economic concepts. Here are some examples. I keep the Indonesian version because, well, it's hard to translate his words in any language to be honest.

Just a note: although the comments are in Indonesian, read them in English pronunciation.

Gains from trade:
"Bahasa Indonesia saya buruk sekali, jadi Cinta will be going to Australia to improve Bahasa Indonesia Cinta."

Efficiency and constraint (the government must learn how to do that):
"Dari kecil papa sudah punya banyak mobil waktu di German kita punya 5 mobil tapi karena garagenya tidak cukup jadi papa menjual mobil-mobil itu tinggal 2. Tapi aku paling suka yang Audi A4."

Comparative advantage:
"Kamu nggak cocok pake logat english karena kamu dari kecil tinggal di Indonesia," Cinta Laura told Samuel, a teenage newcomer artist who has an 'Indo' face but was born and grew up in Indonesia.

Intertemporal optimization:
"Banyak orang-orang yang ikut dunia entertainment langsung drop out of school, itu menurut aku that's really really stupid. Soalnya mereka nggak pikirin long term."

Coner solution in utility maximization (if one good is free, one will only consume that good and set the consumption of the other one zero):
"Aku kalow di dalam negeri sukanya liburan ke Bali karna aku punya apartmen disana."

Bequest in the overlapping generation model:
"Aku udah keliling keliling dunia, ke London, German and several countries karena papaku General Manager di Hyatt."

Survival model of firms -- heterogeneity matters:
"Not all beautiful people bisa menjadi famous."

Matching definition of transfer beneficiary:
"Aku gak suka dengan istilah boyfriend... aku lebih suka disebut teman dekat..teman buat punching, running, lari lari kecil ..."

What the f@!#???:
"Cinta mengucapkan selamat puasa semuanya. Rock on..!"

A Muffin Jam

Suppose you know that for our health, shortbread is better than muffin. By that, substituting muffin with shortbread in our diet is good. Yet, many people, as they love muffin, understandably, will not alter their diet to shortbread by persuasion, even for the noble purpose such as public health.

In anticipation to that, the cafe introduces more shortbread at low price, and due its limited capacity, they can not provide you with muffin as many as before. And, it's a small wonder that muffin eaters grumble. They complain that muffin is now hard to find.

But on the second thought, wouldn't it be the perfectly predictable, and desirable, effect --to make the muffin relative price to shortbread rises? Sooner or later, they will respond and switch to shortbread, and as time goes, switching will be less painful.

Now, replace health, shortbread, muffin, the cafe, muffin relative price increase, and switching responsiveness; with travel time, the busway, driving your private car, Jakarta busy thoroughfares,traffic jam, and elasticity of substitution. I hope by now you get the idea, thanks to Econ 101.

Oh, and the muffin eaters/grumblers, they are the popular voices oftenly appear in newspapers, TVs, and, well, politicians' words. Just want to say: come off it, mates!

The Economics of Oil Muffin Price

Let's talk about a commodity, a muffin. This week the price of muffin goes up significantly and sets a new record after 20 years. People raise their eyebrow. Some point out that it is the work of muffin cartel, but it seems implausible since like any cartel, its member tends to break the agreement, produce muffin above agreed number, much more when the price is high.

It turns out that there is a sharp increase for demand of muffin coming from new growing-rich customers, Rizal and AP, while at the same time, the demand from traditional muffin eaters, the Manager and Aco, remains high. On the other hand, the muffin producer, Ujang (and his cartel gang) and Sjamsu (outside the gang), due to some technological capacity problem, can not increase the supply.

No wonder, as any Econ 101 student understands it well, the price goes up. Neither speculation nor conspiracy theory is at play.

Now, for some reason, you want the price of muffin down. One way to do that is to boost the supply, which is as we know, Sjamsu and Ujang can not make it. The alternative is then to reduce the demand of muffin. Econ 101 tells you that the rise of price will automatically bring substitution effect --Rizal and AP and Manager and Aco would somehow eat less muffin and more schone, sooner or later. The price signal itself would lead you to the new equilibrium (how much muffin, schone, and any other goods to consume) based on the new scarcity problem. It is called the market mechanism, an invisible hand.

Now, do you think an answer on how to tame soaring muffin price is to ask for a deliberate collective sacrifice from Rizal, AP, Aco and Manager to reduce their appetite for muffin; Sjamsu and Ujang to add up production, no matter what; and the Manager to stop bullying Ujang's friends: is a plausible one?

Hint: read one of op-eds in Kompas daily, page four, Monday, Oct 29, 2007. It's available online, too.

Half-baked Theory on Cooking Oil's Price Hike

And now, this is from Steven Landsburg's latest book (to avoid problem with your office's internet filter, I won't mention the title here), page 137.

When prices spike sharply upward, economic illiterates everywhere are quick to see evidence of collusion or monopoly power among the oil companies. In fact, big price spikes are evidence of exactly the opposite. Colluders and monopolists don't have to wait for changes in supply and demand to hike their prices; they squeeze us to the limit all year round. Sure changes in demand and supply give them a little more leeway, so prices still fluctuates --but only a relatively small amount.

A monopolist always has price sensitive customers --because if they're not price sensitive, he'll keep raising his prices until they are. Therefore, even when market conditions change, a monopolist can rarely afford to raise prices very much. Big price fluctuations are evidence of competition. (All of this, incidentally, is standard textbook fare.)

Now, replace "oil" with "cooking oil" , recall this media fuss (Aco has good insight on the topic, by the way), and pay attention to the statement by our House of Representative's Commission VI chairman, asking government to prosecute colluders, monopolists, and hoarders. Does he make a good sense?

Apparently, according to Landsburg, alas, no. He failed to distinguish a "rising" price from a "high" price. Monopolists could be responsible for "high" price, but not for "rising" price.

Moreover, the recent cooking oil price rise is best explained by changes in (world) supply and demand (China and India apparently cook more roast duck and chicken tandoori as they grow richer). It also tells us that the market is competitive. In a competitive market, the best way to have lower price (and to fight against hoarders) is to have more supply, hence more competition. Recall: high price attracts more producers, and vice versa.

Econ 101: Welfare Measures

Again, assume a typical consumer whose preference is rational, continuous, and locally non-satiated (I know it’s been a while, so please help yourself: refreshment is on the sidebar). We are interested in the following question: suppose there is a change in price level (say, due to a change in tax policy). Is an average consumer better off or worse off? We say he is better off if his utility now is higher than that before the change. He is worse off otherwise. Meet equivalent- and compensating variation.

Equivalent variation (EV) is the amount of money that you are indifferent to accept given that the alternative is to experience the price change. (Or, quality change – everything can be priced). Compensating variation (CV) is the money equivalent a planner (e.g. the government) compensates you with after the price change, so as to bring you back to your initial utility level. Think about Jakarta’s plan to build monorail in the city.

Suppose that you would like it if Jakarta has a monorail system. Then imagine that somebody is offering you money if you want to give up the monorail. First, you ignore the offer. Then that somebody increases the offer. Again, you refuse. He increases it again, until you become indifferent (here, if he increases it yet again, even by Rp 1, you would take the money and forget about the monorail). Then this amount of money (that makes you indifferent) is the equivalent variation. (If you hate the monorail, your EV is negative).

Now, suppose as the monorail project is completed, Governor Sutiyoso is to take you back to your initial situation, i.e. to your utility level before the realization of the monorail. The natural question here would be: why in the world would he take us back to the lower utility? Don’t worry, this is hypothetical. We just want to imagine that there is an amount of money as net revenue of Governor Sutiyoso the planner. It is like a money equivalent of his success to make you happier, by providing the monorail. This is the compensating variation. (Again, if you dislike the monorail, the CV would be negative).

Why do we need these measures? We might not really need them. But the government sure does. If the government is planning to impose a policy (new tax, subsidy, etc.), then it needs to be able to anticipate the effect. Think about compensation scheme like cash transfer, raskin, etc. These measures help figure out, say, the right level of compensation.

But why two measures? Because in reality you can’t really know the exact level of compensation. The EV and CV give a range where the true measure might be. Can the two be the same, though? Yes, if the change induced by the policy does not affect your wealth. In such a case, the EV is equivalent to CV, and they both are equivalent to another measure, namely the change in consumer’s surplus. The latter is defined as the change in the difference between the total amount you are willing to pay and the total amount you actually end up paying.

Note: EV and CV are due to Hicks (1939), consumer’s surplus is due to Marshall (1920).

Econ 101: Demand Part 2

Last time we talked about measuring preference using utility concept and then maximizing the utility subject to choice- and budget constraints. Let’s continue. (For those who just joined, The Manager has kindly put the series in order of appearances on the sidebar).

The utility that is a function of the things we consume (apple, orange and all that) is called direct utility function (DUF). That is, you infer my utility function by looking at how many apples I decide to eat. Many times, you can just infer one’s utility function by knowing how he usually responds to a given income level and the existing prices of goods considered. This is called indirect utility function (IUF). These two concepts are very closely linked. Your satisfaction from apple depends on how many apples you consume. But how many apples you consume depends on how much money you have and how much one apple costs. So, representing utility using information on prices and income level is identical to representing utility using consumption level. This is the first magic.

Both DUF and IUF are maximizing functions: you maximize your utility given your income. That is, you are answering the question of “what is the maximal level of utility you can get with your given income”. What if the question instead is “what is the minimal level of income needed to reach a given utility level”? Then you do it the other way around: you minimize your expenditure given the utility level you want to achieve. The first approach is called utility maximization problem (UMP), and the second is expenditure minimization problem (EMP). Now here is the second magic: if you want to know the optimal level of one’s consumption, you can go either way: UMP or EMP. We say, one is the dual to the other.

Note again that in UMP we try to find the optimal level of consumption by varying utility to match a given income level. The resulting demand function is called Walrasian demand function.¹ In the EMP approach, we try to find the optimal level of consumption by varying income level to match a given utility level. The resulting demand function is called Hicksian demand function.² This latter function is also called compensated demand function because in fact we imagine the individual as if we keep adjusting (‘compensating’) his income so as to let him be in the same level of satisfaction. (So you know why the former is also called uncompensated demand function).

Now we are ready for the most celebrated Law of Demand: “If the price of a good goes up, the demand for it goes down...” – many textbooks stop here; nevertheless, it should really continue with “... if the price changes are accompanied by income compensation”. This is the property of Hicksian demand. On the other hand, it is possible that when a good’s price falls, the demand for it ... decrases. This can happen with Walrasian demand, an example of which is a Giffen good.

Stay tuned for the welfare analysis of consumer demand.

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¹ After Leon Walras, 1874. Many textbooks inaccurately call this Marshallian demand function (after Alfred Marshall, 1920).

² After John R. Hicks, 1939.

Econ 101

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

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

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

Econ101: Marginal and Relative Analysis

Economists -- at least your Café economists here -- don’t really care about big changes. We are into details. Meaning, we are more interested in small changes. What happens if I blog one more hour? Am I still as good as the last entry? How many minutes do I need to write one more posting? What do I have to sacrifice, in minute-equivalent?

People make decision based on marginal analysis. No? Well, yes, although you might not realize it. Remember when you were eating nasi goreng and chicken nuggets? You took a portion of nasi goreng and some, say four pieces of nugget. Then you were running out of the nasi while you still had one nugget remaining. And you were not full yet. So you decided to add nasi -- just enough to go with the lonely nugget. Then you’re satisfied. Sounds trivial. But congratulations, you just ran a marginal analysis. The “just enough” is the key there.

Still remember our first discussion? Yes, we talked about cost and benefit. We said, people do something when the total benefit of doing it outweigh the total cost. How does that relate to our marginal analysis? Here is the mantra: You do not stop doing whatever you are doing until the “marginal benefit” equals “marginal cost”. (At this point I’m tempted to use graphs and math – much easier; but let’s just talk – more fun).

You are doing two things at the same time.¹ You’re assigned to organize a seminar. It is time now to call participants. But as usual, you just activated your yahoo messenger – you are now e-chatting with that cute someone out there. We can look at this from either side: your calling the seminar participants or your chatting with that guy. Believe me, the result will be exactly the same, but let’s just take the latter.

What is the cost of your chatting? This is the time you’re supposed to apply your opportunity cost concept. Yes, the cost of your chatting is the next best alternative use of your time. Since you have to work to earn money, the "cost" here is therefore the number of calls you don’t do. Now let’s do the game. If writing one more sentence to him and making one less call to participants makes you happier, you will rationally delay the call and do the chatting. You will keep doing this until you start “feeling guilty” of not doing your work (calling seminar participants).² Until you are indifferent between chatting and calling. The additional pleasure of chatting is fully compensated with a guilty feeling of not-calling. Economists call this a situation where “marginal benefit equals marginal cost” (Forgive my abbrev: MB = MC). Since you will keep chatting if the marginal benefit of chatting outweighs the marginal cost of chatting (or: You will keep calling if the marginal benefit of calling exceeds the marginal cost of calling – See? It runs both ways!), this state of “MB = MC” is therefore optimal.³

Now I’d like to add one more thing. We prefer relative- to absolute measures. Everything absolute that stands alone (that is, without benchmark) is useless.⁴ We are impatient with people talking in absolute tones: “What is the 2005 Indonesian GDP?”,⁵ “How much is the Manager’s salary?”, “What are we good at?”, or “How many Indonesians are poor?”. Rather, we ask: “What is the growth rate of Indonesian economy?”, “How much raise did the Manager get?”, “What is our comparative advantage against Malaysia?”⁶, or “What is the poverty rate now?”. Relative analysis allows you to mentally picture what is really going on.

Stay tuned.

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¹ Of course, in super marginal world, you can’t really do two things at really the same time. Only that guy in StarTrek can do that.

² This is a term to actually say, your cost is increasing.

³ More on this yet another key concept, later. (Man, I keep promising…Sorry...)

⁴ Of course, two absolutes qualify for a comparison, which is good enough.

⁵ GDP stands for gross domestic product. It is also called national output, national expenditure, or national income. Please be patient with this confusion. More on this later.

⁶ Saying something like “Indonesia has a comparative advantage in palm oil” is meaningless. Compared to whom?

Econ 101

Econ101: A Starter

What is economics? It's all about choice and choosing. Things are scarce. So we make choices. Economics¹ is a way to explain why some guy chooses a banana over an orange, given the money in his pocket.² That's all. Never mind the long and boring definitions in the textbooks. When somebody wakes you up in the middle of the night and ask what economics is, just remember one word: CHOICE.

What is the implication of scarcity and the act of choosing? Tradeoff. When our guy chooses the banana, he gives up the opportunity of having the orange. We say, the opportunity cost of his having the banana is his foregoing the orange.³

How does he choose? By comparing the benefit and cost of the action.⁴ What does it tell us when we see the guy ends up eating the banana? It tells us that for that guy at that time, the benefits of eating banana exceeds the costs.

When "the guy ends up eating the banana", he is revealing his preference. That is, without telling us anything, we have an information about his preference. This is called revealed preference (RP). Or, it can be that he just tells us that he prefers banana over orange. This is stated preference (SP). We tend to believe RP more than SP. Whenever what you do contradicts what you say, we believe the former.

But why do we rely our analysis on what people do? Because we assume people are rational. That is, people do whatever best for him at any given time. Is the assumption alright? Think about a person playing billiard. Is it alright to assume he is rational? That is, is it safe to assume that what he would do is consistent with the physics dictum that "the angle of incidence equals the angle of reflection"? We think it is safe. But there are crazy people, no? Yes, but there are definitely more non-crazy people out there then the crazy ones. So we're fine.

Should the guy eat the banana? We don't know. What we do know, by way of inference, is the guy prefers banana to orange. And as a rational person, he eats the banana. So, when you offer him to choose between the two, he would take the banana. This is a positive approach to economics, as opposed to normative approach. Positive approach is all about "what is" or "if X then Y". Normative approach is a matter of "what should be". We are more confident in positive approach. In fact, we try not to do normative approach. And we encourage you not to believe economic analysis with too many "should"s in it.

Stay tuned.

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¹ In this Econ101 series, all economics keywords/phrases will be highlighted like this.
² From now on, we will be using masculine pronouns. Blame the convention.
³ This is a brutal simplification. The guy can choose to have half banana and half orange. Or the story might as well be: choosing between sweet orange and sour orange, the latter being cheaper for an obvious reason. But don't worry about this complication now. Opportunity cost is central to economics, so we will devote another whole posting for it sometime later.
⁴ You might say, "Well, no, I don't do that". Trust us, you do -- in one way or another.

Econ 101

Is Bakwan Giffen?

Ujang has been provoking us to construct an index that can beat Big Mac Index. Many suggestions are noted. Coconut, latte, bread, maid, so forth. I’m not going to suggest another one now, but I’m interested in the common characteristic of all those goods mentioned. They are normal (which is necessary, should you create an index).

By normal good, we mean, when your income increases, your demand for it also increases. Of course, the term “normal” is an operative word: a lot of goods are like that. Or, put it another way, there are exceptions. Back in my college years, I used to eat in cheap warteg not because it tasted really good, but because I couldn’t afford fancier restaurants. I still ate at cheap, typical warteg when I already had my first job: with my salary, mall restaurant was still a luxury. Then I got a raise. Suddenly I could afford “more expensive” meals. My demand for warteg decreased.

In economics, we call the good that resembles my warteg story (demand decreases when income increases) inferior good. (No, we don’t have “superior good” – economists are lousy in picking up terms). There are some goods that are inferior. But among inferior goods some say there is yet another distinct species. It’s called "Giffen good".

Giffen good is an inferior good that is demanded more when its price increases. This is against the Law of Demand (when price of a good increases, the demand for it decreases) and that is why it is called (Giffen) paradox (after Robert Giffen, an English economist who observed this phenomenon in Irish potato consumption back in early 19^th century).

Note that I just said “some say”. That's because I never really buy this idea of Giffen paradox. I probably will buy more warteg meal when its nominal price increase (that is, the money I pay for it). But take a further look, it’s not the same meal anymore. It’s now served in cleaner plates, packed in a fancier wrap, or fried in fresher oil, so forth. For this different, better quality meal, I am willing to pay more.

That’s why I usually don’t spend too much time explaining Giffen paradox in my microeconomics classes. But many teachers, especially those only rely on Samuelson or Lipsey seem to think Giffen paradox is important (and they put it in exam). I beg to differ. Law of Demand prevails.

Do you know any good that is Giffen?

For students: If you are interested in studying this subject (maybe a skripsi with intriguing title like: Is Bakwan Giffen?), here’s how you would do it.

Econ 101 | bakwan | warteg | Giffen

Opp cost and Agnes Monica

Wecome to the class, I hope we’ll have fun this semester. Your syllabus and all that is on my web. You’re welcome to disagree with me in anything. Keep those damn hand phones silent during my class, or you talk outside. You can cheat during your homework or exam, but make sure you outsmart me, because I will catch you and boy, the punishment, is no fun, I guarantee you. I don’t care with attendance, it’s you who’ll miss, not me. Questions, comments, objections? No? Let’s do the first quizz...

That’s how I usually start my classes. I give first quizz in the first day, to “test the water”. I need to get the feel of who are in the room and what’s the variation within. Here’s an example question. It’s about the “opportunity cost”, the backbone concept of economics. It’s a version of Ferraro-Taylor test for economists, reported in their shocking paper (here is Bob Frank’s column about it in the NYTimes, and here is Tyler Cowen’s posting on it). Applying this quiz to three classes in different levels, I confirmed the Ferraro-Taylor’s result: the concept of opportunity cost is one of the most difficult concepts for students. In my undergraduate intermediate micro class (thus, students who have passed introductory micro), only 5 out of 38 students got it right (2 of which with wrong reasons) – about 13 percent. Idem ditto in the graduate level.

What went wrong? Introductory courses are vital. Failure to explain and understand opportunity costs and other key concepts (marginal-approach, comparative advantage, zero profit, the role of incentive, the role of price, the role of expectation, and the difference between economic cost and accounting cost) is one of the reasons why we see so many fallacies in economic analysis and reasoning. Be it in academic papers or especially in newspapers and media.

I was told by wise people, when you talk, use your audience "language". That's why I use Peterpan and Radja in the quizz given to sophomores and juniors. (For graduate levels it’s way more complicated: “Who the he** is Radja?” Try the Beatles, but some youngsters in the back fall asleep).

So far, I find it easier not to use textbook examples to the students. Instead, I use examples they like, or at least are familiar with. (Did I tell you how I managed to make them understand the concept of marginal rate of substitution using somay and teh botol, with no math?). Whenever I find interesting article with economics innuendo in it, I keep it for illustration in class.

And I just found another one today in an article in the Jakarta Post (sorry, it's not a permanent link, just google up). It features an interview with a teenage star (I assume a college students magnet she is, no?). She is nineteen, energetic, ambitious, and most importantly, she gives examples of economics – rightly and wrongly. There’s a true application of opportunity cost (“I love studying. It’s just something weird of me. If my career weren’t this big, I’d probably study all the time”). Incorrect case of comparative advantage (“I have to do my best in everything I do. And hopefully the result is the best, too"). A good starter for understanding tradeoff and marginal rate of substitution (“I want everything to be at the first level, meanwhile, I know that my body can’t cope with that”) or interior versus corner solution (“We should not just listen to pop or dangdut but also listen to jazz, blues, pop-rock”). And, a kicker really: “I want to be at a point where my idealism and the market can walk the same path”.

She'd make a good econ major.