An Estimation of the New Economy’s Contribution to China’s Economic Growth

(Yicai Global) Mar 27 — When we look at the so-called New Economy, it can be concluded that a significant change has occurred to the current [Chinese] economy, and this change is very likely to lead us into a new phase of development. What will this change bring to our economy? Can we describe the consequences now? These are the questions that this speech intends to address.

I have been following this trend over the past few years, though without researching it with great depth. I would like to share my views on the New Economy at this seminar, and evaluate its contribution to our economic growth. I am open to suggestions and criticism, with the hope that further studies in this area will bring forth fruitful results.

The New Economy is a rather broad concept that incorporates many aspects. Besides, definitions of the New Economy vary greatly. To approach it properly, I would like to narrow the definition down to online retail, that is web-based retail, excluding Business-to-Business (B2B) and wholesale. This explicitly means the final products that are sold by retail online.

Firstly, allow me to talk about how we should study the New Economy, and examine the potential of online retail. I have been following institutional economics methodology over the years, which is a very simple way of handling such studies. It entails the analytical method of utilizing transaction cost. As we know, the great institutional economist Douglas North once said that one of the features of modern industrial revolution is mass production, and the premise of mass production is mass sale. However, the premise of mass sale is the expansion of the market, where technical and institutional innovations down bring the transaction cost.

Professor Steven N. S. Cheung further argues that “transaction cost is the dissipation of rent.” This is a very important theorem. To put it in a metaphor, it bears the weight of Einstein’s energy-mass conversion. When the transaction cost is high, the same amount of rent is dissipated, causing economic loss. On the other hand, when the transaction cost is lowered, economic efficiency is raised as rent dissipation is lowered.

I discussed this in a footnote to an article I wrote in 1992. When we talk about transaction costs, we normally say certain measures will save us the transaction cost. However, the saved transaction cost not only leads to saved costs, but also enables transactions of goods and services that had previously not been possible to transact.

In that footnote, I wrote, “for example, through transaction, certain resources can be used for purpose B instead of purpose A, and thus obtaining CNY10 profit. If the transaction cost of this change of purpose is lowered from CNY10 to CNY5, it will make all those transactions with a transaction cost above CNY5 possible and profitable. Consequently, the whole resource allocation of society is improved.” Besides, the CNY5 saved transaction cost, more transactions with a profit margin of CNY5 can be undertaken now. How much then? We’ll discuss this later in this seminar.

There are two concepts, namely retail price, and transaction cost. In fact, when we purchase something, we are not only reacting to the price, but reacting to the price and the transaction cost. This is important.

The upper line is the price plus transaction cost. This transaction cost normally falls into two categories. One is the transaction cost included in the price, usually borne by commercial and industrial enterprises. The other is the transaction cost beyond the price, which is the transaction cost borne by us consumers. We’ll get to that in a minute.

Now the price plus transaction cost determines the transaction amount Qc (see Fig. 1), as the transaction costs decreases, the two lines converge more likely in the area Qw where there are more transactions undertaken. The rectangular area is the surplus transaction amount. Many are now talking about this issue, the so-called “long tail theory”. Well, this is the long tail here, as transaction cost lowers more, the tail runs longer. This is a very generalized explanation.

However, I don’t think the “long tail theory” has explained it all. In fact, what we have in mind is not a long tail. The /picture/ we saw was a two-dimensional one, but what we need is a three-dimensional one.

Like a mountain (see Fig. 2), this represents the transaction amount and price; these two multiplied are the transaction volume, all in one mountain. Now imagine the transaction cost as the water around this mountain. What we suppose here is that the transaction cost is above this line between the blue and green, that is the light blue part is not submerged in the water. What can be transacted is the part above the water. Now that the transaction cost is down, as we imagine, the water is down here between the deep blue and light blue. Apparently, what we thought worth buying, originally the green and red area got extended including now the light blue part. What we need is the three-dimensional model, and I’ll do the evaluation with this model.

Therefore, when we talk about the “long tail”, we should also imagine it in the three-dimensional space, instead of the two-dimensional space. Now we see, as the transaction cost is reduced, more transactions can be done, much larger than we thought.

We need to evaluate the transaction cost though., heading for more technical details that are of importance. We’ve got some figures. First, the transaction cost of industries which can be obtained from the accounting materials and statistics of those enterprises. The figure is around 1% of the retail price. Another figure is the transaction cost of a commercial product, close to the commercial added value, which we also have. Here’s a nationwide input-output table of 2010, where the commercial added value is about 59%, which is 59% of the retail price.

Second, we need to consider the consumer’s transaction cost. As I just mentioned, both the industrial and commercial transaction costs are included in the price of products, in the form of currency. As we buy those products, we pay for the transaction costs with money. However, the transaction cost of consumers does not take the form of currency, or entirely of currency. It is in the form of the time consumers expend on their way to the store, and some other difficulties that they have to deal with, which can only be estimated per our experiences. Of course, what I offer today is my own judgement. As products vary, the transaction cost of consumers varies. I’d like to take books as an example, since it’s a standardized product that I purchase a lot. I bet many of us do, too. As I estimate, the transaction cost of a book is its retail price, that is 100%. As we must evaluate the transaction cost of other products too, I’ll tone it down to 50%. When we add up the three types of transaction cost, it accounts to 110% of the retail price of the product, which is high.

Now that we have online bookstores and booming e-commerce, what happens to the transaction cost then? Let’s say that not much has changed to the industrial transaction cost, which is just 1%. What’s more important are the other two transaction costs, one of which is the commercial transaction cost. We could see it as a change to the commercial added value rate. As I just mentioned, we’ll take a book as a standardized product for the simplicity of the analysis. In the past, I went to bookstores to buy books according to the price tags. I’d pay CNY20 for a book as that was the price. Now, I purchase books from Dangdang, an online bookstore. Normally there is a discount of 25% off, but of course Dangdang gets those books at an approximately stable discount rate from the publishing houses. A 25% discount is 25% off the commercial added value. Therefore, the commercial transaction cost is down by 25% from 59%, making 34%. That is by how much the commercial transaction cost is lowered.

As for the transaction cost of consumers, it is rather difficult to estimate. I’ll estimate by my own experience, and I encourage you to make your own estimation. In the past, I usually went to Wansheng Book Market. As I liked to browse through the book market, it took another two hours, plus there were traffic expenses. So, the transaction cost for me was high. Now that I have my iPad and I can buy books online, the transaction cost is one tenth of the previous cost. These are estimated figures. If the previous transaction cost was 50% of the retail price, now it’s only 5%.

As I estimate, if we adopt the two-dimensional model, an increase of market volume could reach 80% thanks to online shopping, which is 80% of sales volume. However, if we use the three-dimensional model, the mountain model as above, this increased sales volume equals two previous markets. That’s just a rough estimation, but you get the gist. The sales revenue could increase by as much as one and a half markets.

If there’s sales revenue of CNY30 trillion, with online shopping at an enterprises’ disposal, it could reach CNY75 trillion.

How did this change take place? As I see it, people begin to seek for alternatives in the beginning, such as new ways to buy books. Apparently buying books online is more convenient than going to a real bookstore. There are many other products that I don’t bother buying in a real shop now. In the past, I’d rather skip it if it was too much trouble to go to the shops. For instance, if I want to buy a drone and don’t know where to buy it, all I need to do is just click the mouse and buy it online. This accounts for the new increased demand.

This process can also be roughly estimated in this chart (see Fig. 3) : the blue area is the alternative demand, and the orange area is the new increased demand. These are the real figures over the period of 2008 to 2015. As we can see, the new increased area is getting bigger and more important, whereas the alternative area is getting smaller. This is a structural change.

What’s our estimation of the online retail then? We estimate that it has increased by an average about 72% on a yearly basis from 2005 to 2015. But it slowed down a little to 38% in 2015. Therefore, I wouldn’t be too optimistic for the future. There is not likely to be rapid growth in online retail in the future, and it’s growing slowly.

So, a cautious estimation is that online retail will keep growing at 25% annually from now on. The straight line in the chart is the estimated figure, and the figures before were all historic data, the highest was a growth rate of 120% in 2008 (see Fig. 4)

Online retail revenue is growing fast and weighing more in the total retail revenue. In this chart, the purple area is the non-online retail revenue, that is conventional retail revenue; and the blue area here is the online retail revenue. As we can see, the blue area has been increasing over the years. This is my estimation for 2025, when online retail is likely to constitute 40% of total retail revenue.

By 2025, online retail revenue is likely to be 1.5 times that of 2014, and the new online retail volume is likely to amount to 1.5 times of the total market volume.

Be advised, this doesn’t mean that we’ll be there in a blink of an eye. It is a process that takes time. As we all know, online users and consumers are growing in number. It’s not that the case that just because we have Taobao, an online shopping platform, everyone will start instantly using it.

Lastly, I’d like to provide you with a rough estimate. Do not take it as a fact, but rather as a general picture of how the landscape will change. In this chart, the orange line here is the boost to GDP from the increase of online retail. Thanks to the increase of online retail, our GDP growth increases by a few percentage points.

Just to clarify, there are two aspects involved, one is the commercial added value as I mentioned, and it is mainly the online shopping commercial added value. However, it differs from the 59% of added value rate increase earlier. The reason is the reduced transaction cost. As the retail price is also decreased, the 59% and 34% added value rate do not apply because the new price is not taken into account. My estimation is about 46%, that is the added value rate.

Another aspect is the industrial added value of industrial products that needs to be taken into consideration.

This is just a static estimation. It’s difficult to give a dynamic estimation, because online shopping has brought about tremendous change to the way of production, division of labor, and technological innovation. In the static estimation, the New Economy contributed at least 1% to China’s GDP growth in 2015.

I think this figure could increase to 3.3% by 2025 (see Fig. 5)

As we saw in the charts earlier, the GDP growth rate was pretty high in the past few years, and the turning point was 2015. After that, it goes up again thanks to the New Economy that features mainly the growth of online retail. This is the general picture.

(This article presents remarks made by Professor Sheng Hong at the Seminar on “An Estimation of the New Economy’s Contribution to Economic Growth” held in Beijing, China on Sept. 27th, 2016.)