Economics

London Bridge over the ThamesIs economics a science or a theory?

If all the economists were laid end to end they would still not know the true Gross Domestic Product (GDP) of any country; no one really knows. GDP is essentially the measure of the total productive value of all the economic activity of a particular region (city, country, or continent – and, of course, someone has totalled up a global figure). It is pretty obvious that not all of economic activity is measured. There are the entrepreneurs starting a one-man (or woman) business, whose activity would only partly be recorded (if they filled in the right forms). More broadly, every country has an ‘informal sector’, which by definition is an area of economic activity where nothing is recorded. Then you have to add in the illicit businesses (there are millions of those) that by definition can’t record their business activity. There are plenty of people who use ‘creative accounting’ to limit their tax liabilities, and those that avoid paying tax altogether through fraud. There’s ‘ghost accounting’ where activity is recorded that never exists, to cover something else up; and, for example, over-invoicing to move currency around the globe to avoid exchange controls. Finally, on this point, let’s consider gambling. Is it an economic activity? It makes lots of profits. It also finds its way into GDP figures. But is it productive?

There are a whole host of other economic measures used to assess a country’s financial position and provide for its forecasting and budgeting. For example, the government will use forecasts to anticipate tax revenues and expenditures (fiscal policy). Statistics are gathered for things like unemployment, population demographics, and the value of goods and services supplied. Statistics are used to record price levels and therefore inflation, which in turn influences money supply and therefore the government’s monetary policy. Does it increase or lower interest rates? Does it impose limits on borrowing and the supply of money? This and many more decisions are based on what our economists record, measure, put into graphs, compare data, to come up with some predictions about where we are going and what we need to do about it.

Sadly, even governments manipulate figures and adjust budgets based largely on wishful thinking and garnering votes. Take the HS2, for example. This is the UK High-Speed rail service project between London and Birmingham (initially) then further north, budgeted in 2015 to cost £55.7 billion, up from the original budget of £33 billion. In 2019 the cost was estimated at £78 billion with a time frame to completion extended seven years. Will it end up costing over £100 billion? Probably.

The point here is that, even if your economists get all the figures right (they don’t), human intervention adds another layer of indeterminacy to ‘massage’ the argument in favour of, or against a given policy. In this case, £33 billion gets the project on the table and signed off, when the true figure might have had it shelved.

It is often said that economics is a science. In my view, its basis may be science (the raw process of data) but there are too many variables overlying the subject to allow it to wear a full lab coat. Rather it should be seen as ‘Economic theory’, which means that observations and projections (based on scientifically gathered data) often become a matter of opinion. Bring political and social dynamics into play and there is little hope left for clarity. So much for economic forecasting. So what of the weather?

When the weatherman says, ‘There is a fifty percent chance of rain,’ all you can say is, ‘Thanks very much. I could have told you that.’

Supply and demand

An important–and central—concept in economics is the ‘Theory of Supply and Demand.’ In view of what we have said, perhaps no surprise to see the word ‘theory’ pop up.’ Supply and demand theory basically tries to analyse and explain the forces at work when a person decides whether or not to buy something. It could be anything, a good or a service, and it could be influenced by the weather, a change of life, being fired, having a baby: indeed, all manner of human condition.

There is the inherent demand, that is, how strong a desire there is in that demand. And then the price the person will have to pay to satisfy that demand. Most often the price will be of monetary value involving the transfer of ownership of an asset: sweets, oil painting, or a property. The transactions are recorded, taxed, added to GDP, and so on.

But a transaction could also be in the form of a barter arrangement: as if to say, “I’ll do this for you, if you do that for me”. Here there is no record of the value exchanged. Indeed, whatever form bartering takes, it will not be recorded. There are also things people do for free, and again the value of such services is not recorded. This is another example to suggest that the estimate of gross domestic product can hardly be scientific.

Another factor in the supply and demand balance is whether a buyer will pay cash for his purchase or borrow to pay for what he wants. In turn the level of interest he will be charged for a loan will influence his decision.

Yet another factor concerns the feelings and emotions involved. Advertisers often focus on this area. They just love ‘the impulse purchase’. “Keeping up with the Joneses” is enough to encourage someone to buy something they may not really want. There’s the related aspect of the ‘status purchase’; or, whether something is now ‘fashionable’. By the same token, we are all familiar with ‘end of line’ sales, where prices are reduced to clear unwanted stock, and make space for the next season. In all these cases, do we really need want we propose to buy?

Other emotional forces include: the whingeing kid—buy it to keep him quiet; the suspicious wife—buy her an expensive gift to fake commitment; the reluctant negotiator—buy him a gift to ‘sweeten the deal’; or simply buying something expensive to show off.

Finally, on the demand side, consider the individual where “money is no object”. A very rich person with lots of assets and an inexhaustible bank account will buy what they want, regardless of price, regardless of availability (the rarer the better) and without any real decision factor based on need.

All these above factors demonstrate how difficult it is to include human behaviour in economic calculations, estimates and projections.

On the other side of the scale is the ‘supply side’. Again there are many forces at work. There is the cost of the raw materials to make the product. This will be affected by availability, transport costs, for instance, and even the weather. A strike by workers in a supplier country, an accident, hostilities, the number of producers of a given component each competing on price and quality, all these can affect the cost to manufacture – the supply side. Cross-border trade will affect supply too in terms of exchange rates, the ability and preparedness of a country to import at certain landed prices in local currency terms, and so on.

The supply side influences the end price and availability of a product. The more you make on a production line, the faster you can make it, the lower the unit price will be. Against this will be the demand factor for a given product. The price will rise if production cannot meet demand; the price will fall if there is an oversupply. This brings us on to ‘the elasticity of demand.’

Elasticity of demand

‘Elasticity’ refers to the degree to which something will respond. For example: to a price shift; a change in quality; or, a change in supply, and so on. You could say that a given item was ‘inelastic’ if no matter what happened the demand would not vary. For example, staple foods such as bread and potatoes have a fairly inelastic demand profile: demand will vary little if the price goes up because the food is a basic necessity.

At the other end of the scale, where a slight increase in price bears a huge influence, then demand is said to ‘elastic’: put up the price and you sell less. Luxury goods, air travel, say, or seasonal vegetables have a fairly elastic demand profile. Out of season vegetables cost more; air travel to exotic destinations cost more (perhaps because of low passenger volumes).

Of course, this, once again, is where economics proves itself more a theory than a science. This is because unquantifiable forces can also determine whether the demand for something is relatively inelastic or elastic. Sentiment and emotion can interfere with the simple balance. “Keeping up with the Joneses”, as we mentioned above, for example, may cause a neighbour to buy a status symbol, even if the price goes up. Emotion can be a reaction to, say, a bomb scare. The word ‘scare’ is important here because it refers, not to an actual occurrence but to a belief that such occurrence may happen. Fear of a sugar shortage, even if the price goes up, will still encourage people to stockpile. In turn the price will increase further because of demand. People will decide not to buy, say, an air ticket to a war zone, no matter how cheap. A belief system can interfere with demand. No matter how cheap the bacon devout Jews will not buy it. Health conscious individuals will not buy full-cream milk even if it were the cheapest form of milk on the shelf.

None of these events, or forces can be entered in scientific economic calculations. Panic buying is simply not quantifiable; lifestyle choices are not quantifiable.

But, putting all the emotional forces aside, let’s talk of elasticity of demand on a scientific basis. Suppose oranges cost 25 pence each. There are 1 000 in the fruiterers, supplied every two days. Shoppers collectively buy 1 000 oranges every two days, and everything is in balance: supply side works efficiently, meets demand and the shopkeeper is a happy chap. Mid-season for oranges arrives and the supply increases to 1 200, but the fruiterer does not change his price: he is left with, say, 100 unsold oranges. Something is out of balance. Of course, the product is perishable, and he can’t leave it on the shelves for too long. Something has to give. Next day more fresh oranges arrive (another 1 200), and the shopkeeper sensibly reduces his price, let’s say, to 20 pence each. That day, again he sells all his oranges and he is a happy trader. You could say then that the elasticity of demand for oranges is fairly even in this case: demand does not change with an increase in supply; demand increases if you reduce the price.

But there is another thing with elasticity of demand. The further up the scale towards complete elasticity, the more sensitive the item is to supply and demand forces. In other words, as the price of something goes up its elasticity can also increase. Say, we come to the end of the season and consumers have got used to having a few oranges in the fruit bowl ready to eat. The fruiter can only get 700 oranges a day now, yet he knows he usually sells 1 000. Someone is going to be disappointed late afternoon when the shelves run dry. The tendency will be for the price of oranges to go up, say, to 30 pence each. The fruiterer may sell all 700 oranges at this price. If he has a few left-over the end of the week, he might have to reduce his price for a ‘Friday Special’.

Supposing a month or so later he can only get 300 oranges a day. The price is now 50 pence each. Fewer people buy, but the stock is eventually sold at the end of the day. Again, the demand for this fruit is fairly elastic. If the price is too high, the demand for oranges falls. Retailers that fail to watch their stock turnover and adjust prices accordingly end up with deteriorating stock they cannot sell, and they will make a loss.

One more factor concerns tax, surely the great disrupter in the order of things. Changes to tax can materially affect demand and, indeed, are used by governments to control supply, limit imports and reduce demand (such as for alcohol and cigarettes). Incidentally, alcohol is a good example of a relatively inelastic product. Its habit forming and drug dependency nature mean marginal price increases have little effect on demand.

Suppose the government were to impose a 30% surcharge on all imported television sets‡ (allegedly to control pressure on foreign exchange markets*) – whereas before the rate was only 15%. This has a knock-on effect. The retailer adds his mark up as a percentage of his wholesale price. Note that his mark-up is on the 30% surcharge too, so a further boost to prices. Then there is VAT, so the government earns 20% on the retail value (including 20% of the 30% import surcharge it imposed). It is clear a large increase in import duty on televisions would have a marked effect on demand.  So the demand for luxury goods like this is relatively elastic.

‡This is for illustrative purposes only. I don’t think there is import duty on TVs from the Eurozone. Otherwise I think it is about 32%.

*Imports into the UK are initially priced in the foreign currency, say, euros or dollars. If imports rise substantially this might affect the exchange rate by increasing the demand for euros at the cost of sterling: the euro will rise; the pound will fall. Controlling imports is thus an aspect of managing the value of your domestic currency.

What is the right price?

Whatever the price, in some retail situations the prospective buyer may ask for a discount or ‘if he can make an offer.’

Sometimes you see “ono” next to a sale item, meaning ‘or near offer’. A perhaps more clearer invitation to haggle would be “negotiable” on the price tag. Either way, immediately the price is out to auction it is not just a matter of negotiation, but a battle of wills and emotion. The bidder will think, ‘How low can I go without losing the deal?’ The seller will be thinking, ‘How serious is this buyer, and how far can I pressure him to pay the price?’ It’s a sort of duplicity, the one trying to outwit the other. People’s ability to haggle and negotiate is just another factor that is hard to scientifically quantify.

A final comment

People have tended to think of economics as a science, probably because it has a lot of figures, graphs and calculations in it. But the fact is, there is very little science in it at all; else why would two economists get a Nobel Prize for each saying exactly the opposite thing? This happened in 2013.

Economist Robert Shiller warned in 2005 about the dangers of the rapid rise in house prices in the US, calling it a bubble. He was right. Five years later the bubble burst and house prices plunged.

Eugene Fama, an equally prominent and well-respected economist, said he did not know what a “bubble” meant and insisted that asset prices perfectly reflect all available information.

Yet these two men with diametrically opposing views were both given the Nobel Memorial Prize in Economic Science in 2013!. Er… economic science? [They shared the prize with Lars Peter Hansen in an oft-repeated strategy in the Nobel drama of hedging one’s bets]. For what it’s worth, I agree with Shiller who holds that investors, being human, can be swayed by psychology. I disagree with Fama who contends that markets are always efficient, with people incorporating all available information into prices. This is simply not true. There isn’t perfect knowledge in the markets. Otherwise we would not have consumerism!

But what a bizarre outcome that in economics it is possible to share a Nobel Prize for saying the opposite thing. It would be impossible, say, in chemistry or physics. But then they really are sciences.
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By Nigel Benetton, science fiction author of Red Moon and The Sands of Rotar.

Last updated: Thursday, 23rd January 2020