About Nick: i am an economist based in malaysia. I write about development economics, while sneaking in a pop culture reference or two.

Elasticity, Complexity and The Wire

Published in The Edge Malaysia, 5 - 11 October 2015.

Over the weekend, I finished watching The Wire, a HBO drama series concluded in 2008, that revolved around the city of Baltimore, Maryland – the murder capital of the United States – and how its urban decay was reflected in a variety of ways including its political institutions, its school systems, its ports and shipping industry, its print media (the Baltimore Sun) and, of course, its streets and the drug trade. It is a tour-de-force of story-telling and is, in my mind, the best visualisation of how the tentacles of urban decay can infiltrate every single segment of an urban setting.

For instance, we see how a sole focus on achieving statistics (Key Performance Indicators) leads to short-term police work that addresses symptoms of the drug trade and not the causes; we see how a drive to achieve an upgrade in standardised test scores serves to decapitate learning in schools; we see how rough neighbourhoods and broken families lead characters to feel that they were more free in jail than they were at home; we see how a Senator defends public donations that went into his personal accounts were used, without documentation, to help his constituents (“…and excuse me if I didn’t ask that old arthritic woman for a receipt…”); and we see how the desire to chase awards such as the Pulitzer Prize can lead to a total disregard for journalistic integrity and oversight on important issues.

While this may come across as advertising for The Wire – indeed I think everyone should give it a watch for its realism, brilliant acting and smart writing – a moment in the series that particularly stuck with me, given my profession, is where one of the chief drug lords in West Baltimore, Stringer Bell played by Idris Elba, was taking a Macroeconomics class in the Baltimore Community College. Indeed, it was in that class where he learned the concept of ‘price elasticity of demand.’ I should probably point out that this was one of the mistakes of the show – elasticities are commonly taught in Microeconomic not Macroeconomics, but that is nitpicking.

Elasticity is the percentage change in quantity demanded for a product divided by the percentage change in price for that product. An elastic good is one where a price change results in a more than proportionate change in quantity demanded whereas an inelastic good is one where a price change results in a less than proportionate change in quantity demanded. Intuitively, if you were selling a product, you would prefer it to have inelastic demand as price changes (via margin increases) would still result in people buying that product. A product with elastic demand would simply see its quantity demanded fall disproportionately more than the increased price change.

Having learned the concept, Stringer Bell later applies it to his photocopy and printing side business where he tells his lackeys, “What you’re thinking is that we have an inelastic product here but what we have here is an elastic product.” If one has an elastic product, one must continuously reduce prices (even if it kills margins, and thus profits) to ensure the ongoing capture of market share. Therefore, attempts to increase margins are highly risky, if not self-destructing. This then implies that, as a seller of a given product, one would seek to reduce the elasticity of one’s product to the point that it becomes inelastic. In that way, increases in price would lead to reduced quantity demand, sure, but the change in quantity demanded would be less than proportionate to the change in price. Intuitively, people would not significantly reduce their demand for the product even if the price of the product shot up a lot. Examples of inelastic goods are typically everyday needs such as oil, rice, shelter or addictive goods such as cigarettes and alcohol.

Thinking at a more macro level, when we consider Malaysia’s production of goods and services, particularly its exports, we must therefore ask, are the goods and services we produce more elastic or inelastic in demand? If they were elastic, then any change in prices, internally or externally driven (changing exchange rates, oil prices and so on) would not bode well for our producers. They would see the quantity demanded of their products reduce disproportionately more than the change in price with the demand for those other products now moving to other countries that also produce those products, but at a cheaper cost. If they were inelastic, then producers would be relatively insulated from price volatilities. Therefore, it makes economic sense for our producers to move from producing elastic goods and services to inelastic goods and services.

This is not a call to say that we should prioritise the production of daily needs goods or addictive goods. Rather, in the exports sector, we should ask how we can make our exports more inelastic. One way of decreasing the elasticity of our exports is to increase the ‘complexity’ of our exports. Economic Complexity, a concept introduced by Professor Ricardo Hausmann of the Kennedy School, is measured along two indicators – ubiquity and diversity. Diversity is defined as the “number of products (that) that country is connected to.” The more products an economy is associated with, the more diverse it is. Ubiquity, on the other hand, is related to the number of countries that a product is connected to. The more ubiquitous a product, the more countries produce it.

Therefore, when measuring economic complexity, diversity, which represents the amount of embedded knowledge that a country has, is positively related with economic complexity while ubiquity is negatively related with economic complexity since “ubiquitous products are more likely to require few capabilities, and less ubiquitous products are more likely to require a large variety of capabilities.” Essentially, to reduce the elasticity of their goods and services, producers need to create goods that are more diverse and less ubiquitous; in essence, they need to move up the value chain and produce things that others do not produce. We should be agnostic about what those goods and services are (as long as they are ethical) but to capitalise on elasticity (or lack thereof), those goods and services need to be more complex.

From an economic growth standpoint, growth regressions done by Hausmann and his team show that a one standard deviation increase in the Economic Complexity Index would “accelerate growth by 2.3% per year in a country at the 10th percentile of income, by 1.6% in a country at the median income, and by 0.7% for countries in the 90th percentile.” Given that Malaysia sits somewhere between the median and the 90th percentile of incomes worldwide, a one standard deviation increase in the Economic Complexity Index is estimated to increase growth in Malaysia by between 0.9% and 1.6% per year. In a time when Malaysian growth seems to be paring downwards to a new normal, that extra approximately 1 to 1.5% growth per annum could be very useful indeed. Therefore, returning to The Wire, producers and exporters should take heed of Stringer Bell’s caution; we may actually have an elastic product when we believe we have an inelastic one. And if the product is indeed elastic, producers need to find a way to make it inelastic, perhaps by increasing its complexity.

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