Principles of Microeconomics: Scarcity and Social Provisioning

Principles of Microeconomics: Scarcity and Social Provisioning

Erik Dean

Justin Elardo

Mitch Green

Benjamin Wilson

Sebastian Berger

Open Oregon Educational Resources

Principles of Microeconomics: Scarcity and Social Provisioning

Icon for the Creative Commons Attribution 4.0 International License

Principles of Microeconomics: Scarcity and Social Provisioning by Erik Dean, Justin Elardo, Mitch Green, Benjamin Wilson, Sebastian Berger is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

This book is an adaptation of Principles of Economics by OpenStax, licensed under a Creative Commons Attribution 4.0 International License.

Preface

1

Principles of Economics is designed for a two-semester principles of economics sequence. It is traditional in coverage, including introductory economics content, microeconomics, macroeconomics and international economics. At the same time, the book includes a number of innovative and interactive features designed to enhance student learning. Instructors can also customize the book, adapting it to the approach that works best in their classroom.

Welcome to Principles of Economics, an OpenStax resource. This textbook has been created with several goals in mind: accessibility, customization, and student engagement—all while encouraging students toward high levels of academic scholarship. Instructors and students alike will find that this textbook offers a strong foundation in economics in an accessible format.

About OpenStax

OpenStax is a non-profit organization committed to improving student access to quality learning materials. Our free textbooks go through a rigorous editorial publishing process. Our texts are developed and peer-reviewed by educators to ensure they are readable, accurate, and meet the scope and sequence requirements of today’s college courses. Unlike traditional textbooks, OpenStax resources live online and are owned by the community of educators using them. Through our partnerships with companies and foundations committed to reducing costs for students, OpenStax is working to improve access to higher education for all. OpenStax is an initiative of Rice University and is made possible through the generous support of several philanthropic foundations.

About OpenStax’s Resources

OpenStax resources provide quality academic instruction. Three key features set our materials apart from others: they can be customized by instructors for each class, they are a “living” resource that grows online through contributions from science educators, and they are available free or for minimal cost.

Customization

OpenStax learning resources are designed to be customized for each course. Our textbooks provide a solid foundation on which instructors can build, and our resources are conceived and written with flexibility in mind. Instructors can select the sections most relevant to their curricula and create a textbook that speaks directly to the needs of their classes and student body. Teachers are encouraged to expand on existing examples by adding unique context via geographically localized applications and topical connections.

Principles of Economics can be easily customized using our online platform (http://cnx.org/content/col11613/). Simply select the content most relevant to your current semester and create a textbook that speaks directly to the needs of your class. Principles of Economics is organized as a collection of sections that can be rearranged, modified, and enhanced through localized examples or to incorporate a specific theme of your course. This customization feature will ensure that your textbook truly reflects the goals of your course. Principles of Economics is also available in two volumes, one covering microeconomics and one covering macroeconomics principles.

Curation

To broaden access and encourage community curation, Principles of Economics is “open source” licensed under a Creative Commons Attribution (CC-BY) license. The economics community is invited to submit examples, emerging research, and other feedback to enhance and strengthen the material and keep it current and relevant for today’s students. You can submit your suggestions to info@openstaxcollege.org.

Cost

Our textbooks are available for free online, and in low-cost print and e-book editions.

About Principles of Economics

Principles of Economics is designed for a two-semester principles of economics sequence. The text has been developed to meet the scope and sequence of most introductory courses. At the same time, the book includes a number of innovative features designed to enhance student learning. Instructors can also customize the book, adapting it to the approach that works best in their classroom.

Coverage and Scope

To develop Principles of Economics, we acquired the rights to Timothy Taylor’s second edition of Principles of Economics and solicited ideas from economics instructors at all levels of higher education, from community colleges to Ph.D.-granting universities. They told us about their courses, students, challenges, resources, and how a textbook can best meet the needs of both instructors and students.

The result is a book that covers the breadth of economics topics and also provides the necessary depth to ensure the course is manageable for instructors and students alike. And to make it more applied, we have incorporated many current topics. We hope students will be interested to know just how far-reaching the recent recession was (and still is), for example, and why there is so much controversy even among economists over the Affordable Care Act (Obamacare). The Keystone Pipeline, Occupy Wall Street, minimum wage debates, and the appointment of the United States’ first female Federal Reserve chair, Janet Yellen, are just a few of the other important topics covered.

The pedagogical choices, chapter arrangements, and learning objective fulfillment were developed and vetted with feedback from educators dedicated to the project. They thoroughly read the material and offered critical and detailed commentary. The outcome is a balanced approach to micro and macro economics, to both Keynesian and classical views, and to the theory and application of economics concepts. New 2015 data are incorporated for topics that range from average U.S. household consumption in Chapter 2 to the total value of all home equity in Chapter 17. Current events are treated in a politically-balanced way as well.

The book is organized into eight main parts:

  • What is Economics? The first two chapters introduce students to the study of economics with a focus on making choices in a world of scarce resources.
  • Supply and Demand, Chapters 3 and 4, introduces and explains the first analytical model in economics: supply, demand, and equilibrium, before showing applications in the markets for labor and finance.
  • The Fundamentals of Microeconomic Theory, Chapters 5 through 10, begins the microeconomics portion of the text, presenting the theories of consumer behavior, production and costs, and the different models of market structure, including some simple game theory.
  • Microeconomic Policy Issues, Chapters 11 through 18, cover the range of topics in applied micro, framed around the concepts of public goods and positive and negative externalities. Students explore competition and antitrust policies, environmental problems, poverty, income inequality, and other labor market issues. The text also covers information, risk and financial markets, as well as public economy.
  • The Macroeconomic Perspective and Goals, Chapters 19 through 23, introduces a number of key concepts in macro: economic growth, unemployment and inflation, and international trade and capital flows.
  • A Framework for Macroeconomic Analysis, Chapters 24 through 26, introduces the principal analytic model in macro, namely the Aggregate Demand/Aggregate Supply Model. The model is then applied to the Keynesian and Neoclassical perspectives. The Expenditure-Output model is fully explained in a stand-alone appendix.
  • Monetary and Fiscal Policy, Chapters 27 through 31, explains the role of money and the banking system, as well as monetary policy and financial regulation. Then the discussion switches to government deficits and fiscal policy.
  • International Economics, Chapters 32 through 34, the final part of the text, introduces the international dimensions of economics, including international trade and protectionism.

Chapter 1 Welcome to Economics!

Chapter 2 Choice in a World of Scarcity

Chapter 3 Demand and Supply

Chapter 4 Labor and Financial Markets

Chapter 5 Elasticity

Chapter 6 Consumer Choices

Chapter 7 Cost and Industry Structure

Chapter 8 Perfect Competition

Chapter 9 Monopoly

Chapter 10 Monopolistic Competition and Oligopoly

Chapter 11 Monopoly and Antitrust Policy

Chapter 12 Environmental Protection and Negative Externalities

Chapter 13 Positive Externalities and Public Goods

Chapter 14 Poverty and Economic Inequality

Chapter 15 Issues in Labor Markets: Unions, Discrimination, Immigration

Chapter 16 Information, Risk, and Insurance

Chapter 17 Financial Markets

Chapter 18 Public Economy

Chapter 19 The Macroeconomic Perspective

Chapter 20 Economic Growth

Chapter 21 Unemployment

Chapter 22 Inflation

Chapter 23 The International Trade and Capital Flows

Chapter 24 The Aggregate Demand/Aggregate Supply Model

Chapter 25 The Keynesian Perspective

Chapter 26 The Neoclassical Perspective

Chapter 27 Money and Banking

Chapter 28 Monetary Policy and Bank Regulation

Chapter 29 Exchange Rates and International Capital Flows

Chapter 30 Government Budgets and Fiscal Policy

Chapter 31 The Impacts of Government Borrowing

Chapter 32 Macroeconomic Policy Around the World

Chapter 33 International Trade

Chapter 34 Globalization and Protectionism

Appendix A The Use of Mathematics in Principles of Economics

Appendix B Indifference Curves

Appendix C Present Discounted Value

Appendix D The Expenditure-Output Model

Alternate Sequencing
Principles of Economics was conceived and written to fit a particular topical sequence, but it can be used flexibly to accommodate other course structures. One such potential structure, which will fit reasonably well with the textbook content, is provided. Please consider, however, that the chapters were not written to be completely independent, and that the proposed alternate sequence should be carefully considered for student preparation and textual consistency.

Chapter 1 Welcome to Economics!

Chapter 2 Choice in a World of Scarcity

Chapter 3 Demand and Supply

Chapter 4 Labor and Financial Markets

Chapter 5 Elasticity

Chapter 6 Consumer Choices

Chapter 33 International Trade

Chapter 7 Cost and Industry Structure

Chapter 12 Environmental Protection and Negative Externalities

Chapter 13 Positive Externalities and Public Goods

Chapter 8 Perfect Competition

Chapter 9 Monopoly

Chapter 10 Monopolistic Competition and Oligopoly

Chapter 11 Monopoly and Antitrust Policy

Chapter 14 Poverty and Economic Inequality

Chapter 15 Issues in Labor Markets: Unions, Discrimination, Immigration

Chapter 16 Information, Risk, and Insurance

Chapter 17 Financial Markets

Chapter 18 Public Economy

Chapter 19 The Macroeconomic Perspective

Chapter 20 Economic Growth

Chapter 21 Unemployment

Chapter 22 Inflation

Chapter 23 The International Trade and Capital Flows

Chapter 24 The Aggregate Demand/Aggregate Supply Model

Chapter 25 The Keynesian Perspective

Chapter 26 The Neoclassical Perspective

Chapter 27 Money and Banking

Chapter 28 Monetary Policy and Bank Regulation

Chapter 29 Exchange Rates and International Capital Flows

Chapter 30 Government Budgets and Fiscal Policy

Chapter 31 The Impacts of Government Borrowing

Chapter 32 Macroeconomic Policy Around the World

Chapter 34 Globalization and Protectionism

Appendix A The Use of Mathematics in Principles of Economics

Appendix B Indifference Curves

Appendix C Present Discounted Value

Appendix D The Expenditure-Output Model

Pedagogical Foundation

Throughout the OpenStax version of Principles of Economics, you will find new features that engage the students in economic inquiry by taking selected topics a step further. Our features include:

  • Bring It Home: This added feature is a brief case study, specific to each chapter, which connects the chapter’s main topic to the real word. It is broken up into two parts: the first at the beginning of the chapter (in the Intro module) and the second at chapter’s end, when students have learned what’s necessary to understand the case and “bring home” the chapter’s core concepts.
  • Work It Out: This added feature asks students to work through a generally analytical or computational problem, and guides them step-by-step to find out how its solution is derived.
  • Clear It Up: This boxed feature, which includes pre-existing features from Taylor’s text, addresses common student misconceptions about the content. Clear It Ups are usually deeper explanations of something in the main body of the text. Each CIU starts with a question. The rest of the feature explains the answer.
  • Link It Up: This added feature is a very brief introduction to a website that is pertinent to students’ understanding and enjoyment of the topic at hand.

Questions for Each Level of Learning

The OpenStax version of Principles of Economics further expands on Taylor’s original end of chapter materials by offering four types of end-of-module questions for students.

  • Self-Checks: Are analytical self-assessment questions that appear at the end of each module. They “click–to-reveal” an answer in the web view so students can check their understanding before moving on to the next module. Self-Check questions are not simple look-up questions. They push the student to think a bit beyond what is said in the text. Self-Check questions are designed for formative (rather than summative) assessment. The questions and answers are explained so that students feel like they are being walked through the problem.
  • Review Questions: Have been retained from Taylor’s version, and are simple recall questions from the chapter and are in open-response format (not multiple choice or true/false). The answers can be looked up in the text.
  • Critical Thinking Questions: Are new higher-level, conceptual questions that ask students to demonstrate their understanding by applying what they have learned in different contexts. They ask for outside-the-box thinking, for reasoning about the concepts. They push the student to places they wouldn’t have thought of going themselves.
  • Problems: Are exercises that give students additional practice working with the analytic and computational concepts in the module.

Updated Art

Principles of Economics includes an updated art program to better inform today’s student, providing the latest data on covered topics.

Sample chart detailing U.S. minimum wage and inflation rates from 1968-2018.
Figure 1. U.S. Minimum Wage and Inflation. After adjusting for inflation, the federal minimum wage dropped more than 30 percent from 1967 to 2010, even though the nominal figure climbed from $1.40 to $7.25 per hour. Increases in the minimum wage in 2007, 2008, and 2009 kept the decline from being worse—as it would have been if the wage had remained the same as it did from 1997 through 2006. (Sources: http://www.dol.gov/whd/minwage/chart.htm; http://data.bls.gov/cgi-bin/surveymost?cu)

About Our Team

Senior Contributing Author

Timothy Taylor, Macalester College

Timothy Taylor has been writing and teaching about economics for 30 years, and is the Managing Editor of the Journal of Economic Perspectives, a post he’s held since 1986. He has been a lecturer for The Teaching Company, the University of Minnesota, and the Hubert H. Humphrey Institute of Public Affairs, where students voted him Teacher of the Year in 1997. His writings include numerous pieces for journals such as the Milken Institute Review and The Public Interest, and he has been an editor on many projects, most notably for the Brookings Institution and the World Bank, where he was Chief Outside Editor for the World Development Report 1999/2000, Entering the 21st Century: The Changing Development Landscape. He also blogs four to five times per week at http://conversableeconomist.blogspot.com. Timothy Taylor lives near Minneapolis with his wife Kimberley and their three children.

Steven A. Greenlaw, University of Mary Washington

Steven Greenlaw has been teaching principles of economics for more than 30 years. In 1999, he received the Grellet C. Simpson Award for Excellence in Undergraduate Teaching at the University of Mary Washington. He is the author of Doing Economics: A Guide to Doing and Understanding Economic Research, as well as a variety of articles on economics pedagogy and instructional technology, published in the Journal of Economic Education, the International Review of Economic Education, and other outlets. He wrote the module on Quantitative Writing for Starting Point: Teaching and Learning Economics, the web portal on best practices in teaching economics. Steven Greenlaw lives in Alexandria, Virginia with his wife Kathy and their three children.

Contributing Authors

Eric Dodge Hanover College
Cynthia Gamez University of Texas at El Paso
Andres Jauregui Columbus State University
Diane Keenan Cerritos College
Dan MacDonald California State University San Bernardino
Amyaz Moledina The College of Wooster
Craig Richardson Winston-Salem State University
David Shapiro Pennsylvania State University
Ralph Sonenshine American University

Expert Reviewers

Bryan Aguiar Northwest Arkansas Community College
Basil Al Hashimi Mesa Community College
Emil Berendt Mount St. Mary’s University
Zena Buser Adams State University
Douglas Campbell The University of Memphis
Sanjukta Chaudhuri University of Wisconsin – Eau Claire
Xueyu Cheng Alabama State University
Robert Cunningham Alma College
Rosa Lea Danielson College of DuPage
Steven Deloach Elon University
Debbie Evercloud University of Colorado Denver
Sal Figueras Hudson County Community College
Reza Ghorashi Richard Stockton College of New Jersey
Robert Gillette University of Kentucky
Shaomin Huang Lewis-Clark State College
George Jones University of Wisconsin-Rock County
Charles Kroncke College of Mount St. Joseph
Teresa Laughlin Palomar Community College
Carlos Liard-Muriente Central Connecticut State University
Heather Luea Kansas State University
Steven Lugauer University of Notre Dame
William Mosher Nashua Community College
Michael Netta Hudson County Community College
Nick Noble Miami University
Joe Nowakowski Muskingum University
Shawn Osell University of Wisconsin, Superior
Mark Owens Middle Tennessee State University
Sonia Pereira Barnard College
Brian Peterson Central College
Jennifer Platania Elon University
Robert Rycroft University of Mary Washington
Adrienne Sachse Florida State College at Jacksonville
Hans Schumann Texas AM
Gina Shamshak Goucher College
Chris Warburton John Jay College of Criminal Justice, CUNY
Mark Witte Northwestern
Chiou-nan Yeh Alabama State University

Ancillaries

OpenStax projects offer an array of ancillaries for students and instructors. Please visit http://openstaxcollege.org and view the learning resources for this title.

Copyright

© May 18, 2016 OpenStax Economics. Textbook content produced by OpenStax Economics is licensed under a Creative Commons Attribution License 4.0 license.Under this license, any user of this textbook or the textbook contents herein must provide proper attribution as follows:The OpenStax College name, OpenStax College logo, OpenStax College book covers, OpenStax CNX name, and OpenStax CNX logo are not subject to the creative commons license and may not be reproduced without the prior and express written consent of Rice University. For questions regarding this license, please contact partners@openstaxcollege.org.If you use this textbook as a bibliographic reference, then you should cite it as follows:OpenStax Economics, Principles of Economics. OpenStax CNX. May 18, 2016 http://cnx.org/contents/69619d2b-68f0-44b0-b074-a9b2bf90b2c6@11.330.If you redistribute this textbook in a print format, then you must include on every physical page the following attribution:
“Download for free at http://cnx.org/contents/69619d2b-68f0-44b0-b074-a9b2bf90b2c6@11.330.”If you redistribute part of this textbook, then you must retain in every digital format page view (including but not limited to EPUB, PDF, and HTML) and on every physical printed page the following attribution:
“Download for free at http://cnx.org/contents/69619d2b-68f0-44b0-b074-a9b2bf90b2c6@11.330.”

Book Name:
Principles of Economics

Author:
OpenStax

Keywords/Tags:
Economics, Microeconomics, Macroeconomics, Introductory

Copyright:2016 by Rice University.

Creative Commons License
Principles of Economics by Rice University is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

This textbook is available for free at open.bccampus.ca

Chapter 1. Welcome to Economics!

I

Introduction

1

Photo of a smartphone with the Facebook application open
Figure 1. Do You Use Facebook? Economics is greatly impacted by how well information travels through society. Today, social media giants Twitter, Facebook, and Instagram are major forces on the information super highway. (Credit: Johan Larsson/Flickr)

Decisions … Decisions in the Social Media Age

To post or not to post? Every day we are faced with a myriad of decisions, from what to have for breakfast, to which route to take to class, to the more complex—“Should I double major and add possibly another semester of study to my education?” Our response to these choices depends on the information we have available at any given moment; information economists call “imperfect” because we rarely have all the data we need to make perfect decisions. Despite the lack of perfect information, we still make hundreds of decisions a day.

And now, we have another avenue in which to gather information—social media. Outlets like Facebook and Twitter are altering the process by which we make choices, how we spend our time, which movies we see, which products we buy, and more. How many of you chose a university without checking out its Facebook page or Twitter stream first for information and feedback?

As you will see in this course, what happens in economics is affected by how well and how fast information is disseminated through a society, such as how quickly information travels through Facebook. “Economists love nothing better than when deep and liquid markets operate under conditions of perfect information,” says Jessica Irvine, National Economics Editor for News Corp Australia.

This leads us to the topic of this chapter, an introduction to the world of making decisions, processing information, and understanding behavior in markets —the world of economics. Each chapter in this book will start with a discussion about current (or sometimes past) events and revisit it at chapter’s end—to “bring home” the concepts in play.

Chapter Objectives

Introduction

In this chapter, you will learn about:

  • What Is Economics, and Why Is It Important?
  • Microeconomics and Macroeconomics
  • How Economists Use Theories and Models to Understand Economic Issues
  • How Economies Can Be Organized: An Overview of Economic Systems

What is economics and why should you spend your time learning it? After all, there are other disciplines you could be studying, and other ways you could be spending your time. As the Bring it Home feature just mentioned, making choices is at the heart of what economists study, and your decision to take this course is as much as economic decision as anything else.

Economics is probably not what you think. It is not primarily about money or finance. It is not primarily about business. It is not mathematics. What is it then? It is both a subject area and a way of viewing the world.

1.1 What Is Economics, and Why Is It Important?

2

Learning Objectives

By the end of this section, you will be able to:

  • Discuss the importance of studying economics
  • Explain the relationship between production and division of labor
  • Evaluate the significance of scarcity

Economics is the study of how humans make decisions in the face of scarcity. These can be individual decisions, family decisions, business decisions or societal decisions. If you look around carefully, you will see that scarcity is a fact of life. Scarcity means that human wants for goods, services and resources exceed what is available. Resources, such as labor, tools, land, and raw materials are necessary to produce the goods and services we want but they exist in limited supply. Of course, the ultimate scarce resource is time- everyone, rich or poor, has just 24 hours in the day to try to acquire the goods they want. At any point in time, there is only a finite amount of resources available.

Think about it this way: In 2015 the labor force in the United States contained over 158.6 million workers, according to the U.S. Bureau of Labor Statistics. Similarly, the total area of the United States is 3,794,101 square miles. These are large numbers for such crucial resources, however, they are limited. Because these resources are limited, so are the numbers of goods and services we produce with them. Combine this with the fact that human wants seem to be virtually infinite, and you can see why scarcity is a problem.

The image is a photograph of two people who are homeless and sleeping on public city benches.
Figure 1. Scarcity of Resources. Homeless people are a stark reminder that scarcity of resources is real. (Credit: “daveynin”/Flickr Creative Commons)

If you still do not believe that scarcity is a problem, consider the following: Does everyone need food to eat? Does everyone need a decent place to live? Does everyone have access to healthcare? In every country in the world, there are people who are hungry, homeless (for example, those who call park benches their beds, as shown in Figure 1), and in need of healthcare, just to focus on a few critical goods and services. Why is this the case? It is because of scarcity. Let’s delve into the concept of scarcity a little deeper, because it is crucial to understanding economics.

The Problem of Scarcity

Think about all the things you consume: food, shelter, clothing, transportation, healthcare, and entertainment. How do you acquire those items? You do not produce them yourself. You buy them. How do you afford the things you buy? You work for pay. Or if you do not, someone else does on your behalf. Yet most of us never have enough to buy all the things we want. This is because of scarcity. So how do we solve it?

Visit this website to read about how the United States is dealing with scarcity in resources.


QR Code representing a URL

Every society, at every level, must make choices about how to use its resources. Families must decide whether to spend their money on a new car or a fancy vacation. Towns must choose whether to put more of the budget into police and fire protection or into the school system. Nations must decide whether to devote more funds to national defense or to protecting the environment. In most cases, there just isn’t enough money in the budget to do everything. So why do we not each just produce all of the things we consume? The simple answer is most of us do not know how, but that is not the main reason. (When you study economics, you will discover that the obvious choice is not always the right answer—or at least the complete answer. Studying economics teaches you to think in a different of way.) Think back to pioneer days, when individuals knew how to do so much more than we do today, from building their homes, to growing their crops, to hunting for food, to repairing their equipment. Most of us do not know how to do all—or any—of those things. It is not because we could not learn. Rather, we do not have to. The reason why is something called the division and specialization of labor, a production innovation first put forth by Adam Smith, Figure 2, in his book, The Wealth of Nations.

The image is a profile sketch of Adam Smith.
Figure 2. Adam Smith. Adam Smith introduced the idea of dividing labor into discrete tasks. (Credit: Wikimedia Commons)

The Division of and Specialization of Labor

The formal study of economics began when Adam Smith (1723–1790) published his famous book The Wealth of Nations in 1776. Many authors had written on economics in the centuries before Smith, but he was the first to address the subject in a comprehensive way. In the first chapter, Smith introduces the division of labor, which means that the way a good or service is produced is divided into a number of tasks that are performed by different workers, instead of all the tasks being done by the same person.

To illustrate the division of labor, Smith counted how many tasks went into making a pin: drawing out a piece of wire, cutting it to the right length, straightening it, putting a head on one end and a point on the other, and packaging pins for sale, to name just a few. Smith counted 18 distinct tasks that were often done by different people—all for a pin, believe it or not!

Modern businesses divide tasks as well. Even a relatively simple business like a restaurant divides up the task of serving meals into a range of jobs like top chef, sous chefs, less-skilled kitchen help, servers to wait on the tables, a greeter at the door, janitors to clean up, and a business manager to handle paychecks and bills—not to mention the economic connections a restaurant has with suppliers of food, furniture, kitchen equipment, and the building where it is located. A complex business like a large manufacturing factory, such as the shoe factory shown in Figure 3, or a hospital can have hundreds of job classifications.

The image is a photograph of factory workers for a shoe company working separately on individualized tasks.
Figure 3. Division of Labor. Workers on an assembly line are an example of the divisions of labor. (Credit: Nina Hale/Flickr Creative Commons)

Why the Division of Labor Increases Production

When the tasks involved with producing a good or service are divided and subdivided, workers and businesses can produce a greater quantity of output. In his observations of pin factories, Smith observed that one worker alone might make 20 pins in a day, but that a small business of 10 workers (some of whom would need to do two or three of the 18 tasks involved with pin-making), could make 48,000 pins in a day. How can a group of workers, each specializing in certain tasks, produce so much more than the same number of workers who try to produce the entire good or service by themselves? Smith offered three reasons.

First, specialization in a particular small job allows workers to focus on the parts of the production process where they have an advantage. (In later chapters, we will develop this idea by discussing comparative advantage.) People have different skills, talents, and interests, so they will be better at some jobs than at others. The particular advantages may be based on educational choices, which are in turn shaped by interests and talents. Only those with medical degrees qualify to become doctors, for instance. For some goods, specialization will be affected by geography—it is easier to be a wheat farmer in North Dakota than in Florida, but easier to run a tourist hotel in Florida than in North Dakota. If you live in or near a big city, it is easier to attract enough customers to operate a successful dry cleaning business or movie theater than if you live in a sparsely populated rural area. Whatever the reason, if people specialize in the production of what they do best, they will be more productive than if they produce a combination of things, some of which they are good at and some of which they are not.

Second, workers who specialize in certain tasks often learn to produce more quickly and with higher quality. This pattern holds true for many workers, including assembly line laborers who build cars, stylists who cut hair, and doctors who perform heart surgery. In fact, specialized workers often know their jobs well enough to suggest innovative ways to do their work faster and better.

A similar pattern often operates within businesses. In many cases, a business that focuses on one or a few products (sometimes called its “core competency”) is more successful than firms that try to make a wide range of products.

Third, specialization allows businesses to take advantage of economies of scale, which means that for many goods, as the level of production increases, the average cost of producing each individual unit declines. For example, if a factory produces only 100 cars per year, each car will be quite expensive to make on average. However, if a factory produces 50,000 cars each year, then it can set up an assembly line with huge machines and workers performing specialized tasks, and the average cost of production per car will be lower. The ultimate result of workers who can focus on their preferences and talents, learn to do their specialized jobs better, and work in larger organizations is that society as a whole can produce and consume far more than if each person tried to produce all of their own goods and services. The division and specialization of labor has been a force against the problem of scarcity.

Trade and Markets

Specialization only makes sense, though, if workers can use the pay they receive for doing their jobs to purchase the other goods and services that they need. In short, specialization requires trade.

You do not have to know anything about electronics or sound systems to play music—you just buy an iPod or MP3 player, download the music and listen. You do not have to know anything about artificial fibers or the construction of sewing machines if you need a jacket—you just buy the jacket and wear it. You do not need to know anything about internal combustion engines to operate a car—you just get in and drive. Instead of trying to acquire all the knowledge and skills involved in producing all of the goods and services that you wish to consume, the market allows you to learn a specialized set of skills and then use the pay you receive to buy the goods and services you need or want. This is how our modern society has evolved into a strong economy.

Why Study Economics?

Now that we have gotten an overview on what economics studies, let’s quickly discuss why you are right to study it. Economics is not primarily a collection of facts to be memorized, though there are plenty of important concepts to be learned. Instead, economics is better thought of as a collection of questions to be answered or puzzles to be worked out. Most important, economics provides the tools to work out those puzzles. If you have yet to be been bitten by the economics “bug,” there are other reasons why you should study economics.

  • Virtually every major problem facing the world today, from global warming, to world poverty, to the conflicts in Syria, Afghanistan, and Somalia, has an economic dimension. If you are going to be part of solving those problems, you need to be able to understand them. Economics is crucial.
  • It is hard to overstate the importance of economics to good citizenship. You need to be able to vote intelligently on budgets, regulations, and laws in general. When the U.S. government came close to a standstill at the end of 2012 due to the “fiscal cliff,” what were the issues involved? Did you know?
  • A basic understanding of economics makes you a well-rounded thinker. When you read articles about economic issues, you will understand and be able to evaluate the writer’s argument. When you hear classmates, co-workers, or political candidates talking about economics, you will be able to distinguish between common sense and nonsense. You will find new ways of thinking about current events and about personal and business decisions, as well as current events and politics.

The study of economics does not dictate the answers, but it can illuminate the different choices.

Key Concepts and Summary

Economics seeks to solve the problem of scarcity, which is when human wants for goods and services exceed the available supply. A modern economy displays a division of labor, in which people earn income by specializing in what they produce and then use that income to purchase the products they need or want. The division of labor allows individuals and firms to specialize and to produce more for several reasons: a) It allows the agents to focus on areas of advantage due to natural factors and skill levels; b) It encourages the agents to learn and invent; c) It allows agents to take advantage of economies of scale. Division and specialization of labor only work when individuals can purchase what they do not produce in markets. Learning about economics helps you understand the major problems facing the world today, prepares you to be a good citizen, and helps you become a well-rounded thinker.

Self-Check Questions

  1. What is scarcity? Can you think of two causes of scarcity?
  2. Residents of the town of Smithfield like to consume hams, but each ham requires 10 people to produce it and takes a month. If the town has a total of 100 people, what is the maximum amount of ham the residents can consume in a month?
  3. A consultant works for $200 per hour. She likes to eat vegetables, but is not very good at growing them. Why does it make more economic sense for her to spend her time at the consulting job and shop for her vegetables?
  4. A computer systems engineer could paint his house, but it makes more sense for him to hire a painter to do it. Explain why.

Review Questions

  1. Give the three reasons that explain why the division of labor increases an economy’s level of production.
  2. What are three reasons to study economics?

Critical Thinking Questions

  1. Suppose you have a team of two workers: one is a baker and one is a chef. Explain why the kitchen can produce more meals in a given period of time if each worker specializes in what they do best than if each worker tries to do everything from appetizer to dessert.
  2. Why would division of labor without trade not work?
  3. Can you think of any examples of free goods, that is, goods or services that are not scarce?

References

Bureau of Labor Statistics, U.S. Department of Labor. 2015. “The Employment Situation—February 2015.” Accessed March 27, 2015. http://www.bls.gov/news.release/pdf/empsit.pdf.

Williamson, Lisa. “US Labor Market in 2012.” Bureau of Labor Statistics. Accessed December 1, 2013. http://www.bls.gov/opub/mlr/2013/03/art1full.pdf.

Glossary

division of labor
the way in which the work required to produce a good or service is divided into tasks performed by different workers
economics
the study of how humans make choices under conditions of scarcity
economies of scale
when the average cost of producing each individual unit declines as total output increases
scarcity
when human wants for goods and services exceed the available supply
specialization
when workers or firms focus on particular tasks for which they are well-suited within the overall production process

Solutions

Answers for Self-Check Questions

  1. Scarcity means human wants for goods and services exceed the available supply. Supply is limited because resources are limited. Demand, however, is virtually unlimited. Whatever the supply, it seems human nature to want more.
  2. 100 people / 10 people per ham = a maximum of 10 hams per month if all residents produce ham. Since consumption is limited by production, the maximum number of hams residents could consume per month is 10.
  3. She is very productive at her consulting job, but not very productive growing vegetables. Time spent consulting would produce far more income than it what she could save growing her vegetables using the same amount of time. So on purely economic grounds, it makes more sense for her to maximize her income by applying her labor to what she does best (i.e. specialization of labor).
  4. The engineer is better at computer science than at painting. Thus, his time is better spent working for pay at his job and paying a painter to paint his house. Of course, this assumes he does not paint his house for fun!

1.2 Microeconomics and Macroeconomics

3

Learning Objectives

By the end of this section, you will be able to:

  • Describe microeconomics
  • Describe macroeconomics
  • Contrast monetary policy and fiscal policy

Economics is concerned with the well-being of all people, including those with jobs and those without jobs, as well as those with high incomes and those with low incomes. Economics acknowledges that production of useful goods and services can create problems of environmental pollution. It explores the question of how investing in education helps to develop workers’ skills. It probes questions like how to tell when big businesses or big labor unions are operating in a way that benefits society as a whole and when they are operating in a way that benefits their owners or members at the expense of others. It looks at how government spending, taxes, and regulations affect decisions about production and consumption.

It should be clear by now that economics covers a lot of ground. That ground can be divided into two parts: Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and businesses; Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels of exports and imports. Microeconomics and macroeconomics are not separate subjects, but rather complementary perspectives on the overall subject of the economy.

To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of studying a biological ecosystem like a lake. One person who sets out to study the lake might focus on specific topics: certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding the lake. Another person might take an overall view and instead consider the entire ecosystem of the lake from top to bottom; what eats what, how the system stays in a rough balance, and what environmental stresses affect this balance. Both approaches are useful, and both examine the same lake, but the viewpoints are different. In a similar way, both microeconomics and macroeconomics study the same economy, but each has a different viewpoint.

Whether you are looking at lakes or economics, the micro and the macro insights should blend with each other. In studying a lake, the micro insights about particular plants and animals help to understand the overall food chain, while the macro insights about the overall food chain help to explain the environment in which individual plants and animals live.

In economics, the micro decisions of individual businesses are influenced by whether the macroeconomy is healthy; for example, firms will be more likely to hire workers if the overall economy is growing. In turn, the performance of the macroeconomy ultimately depends on the microeconomic decisions made by individual households and businesses.

Microeconomics

What determines how households and individuals spend their budgets? What combination of goods and services will best fit their needs and wants, given the budget they have to spend? How do people decide whether to work, and if so, whether to work full time or part time? How do people decide how much to save for the future, or whether they should borrow to spend beyond their current means?

What determines the products, and how many of each, a firm will produce and sell? What determines what prices a firm will charge? What determines how a firm will produce its products? What determines how many workers it will hire? How will a firm finance its business? When will a firm decide to expand, downsize, or even close? In the microeconomic part of this book, we will learn about the theory of consumer behavior and the theory of the firm.

Macroeconomics

What determines the level of economic activity in a society? In other words, what determines how many goods and services a nation actually produces? What determines how many jobs are available in an economy? What determines a nation’s standard of living? What causes the economy to speed up or slow down? What causes firms to hire more workers or to lay workers off? Finally, what causes the economy to grow over the long term?

An economy’s macroeconomic health can be defined by a number of goals: growth in the standard of living, low unemployment, and low inflation, to name the most important. How can macroeconomic policy be used to pursue these goals? Monetary policy, which involves policies that affect bank lending, interest rates, and financial capital markets, is conducted by a nation’s central bank. For the United States, this is the Federal Reserve. Fiscal policy, which involves government spending and taxes, is determined by a nation’s legislative body. For the United States, this is the Congress and the executive branch, which originates the federal budget. These are the main tools the government has to work with. Americans tend to expect that government can fix whatever economic problems we encounter, but to what extent is that expectation realistic? These are just some of the issues that will be explored in the macroeconomic chapters of this book.

Key Concepts and Summary

Microeconomics and macroeconomics are two different perspectives on the economy. The microeconomic perspective focuses on parts of the economy: individuals, firms, and industries. The macroeconomic perspective looks at the economy as a whole, focusing on goals like growth in the standard of living, unemployment, and inflation. Macroeconomics has two types of policies for pursuing these goals: monetary policy and fiscal policy.

Self-Check Questions

What would be another example of a “system” in the real world that could serve as a metaphor for micro and macroeconomics?

Review Questions

  1. What is the difference between microeconomics and macroeconomics?
  2. What are examples of individual economic agents?
  3. What are the three main goals of macroeconomics?

Critical Thinking Questions

  1. A balanced federal budget and a balance of trade are considered secondary goals of macroeconomics, while growth in the standard of living (for example) is considered a primary goal. Why do you think that is so?
  2. Macroeconomics is an aggregate of what happens at the microeconomic level. Would it be possible for what happens at the macro level to differ from how economic agents would react to some stimulus at the micro level? Hint: Think about the behavior of crowds.

Glossary

fiscal policy
economic policies that involve government spending and taxes
macroeconomics
the branch of economics that focuses on broad issues such as growth, unemployment, inflation, and trade balance.
microeconomics
the branch of economics that focuses on actions of particular agents within the economy, like households, workers, and business firms
monetary policy
policy that involves altering the level of interest rates, the availability of credit in the economy, and the extent of borrowing

Solutions

Answers to Self-Check Questions

There are many physical systems that would work, for example, the study of planets (micro) in the solar system (macro), or solar systems (micro) in the galaxy (macro).

1.3 How Economists Use Theories and Models to Understand Economic Issues

4

Learning Objectives

By the end of this section, you will be able to:

  • Interpret a circular flow diagram
  • Explain the importance of economic theories and models
  • Describe goods and services markets and labor markets
The image is a photograph of John Maynard Keynes.
Figure 1. John Maynard Keynes. One of the most influential economists in modern times was John Maynard Keynes. (Credit: Wikimedia Commons)

John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes, shown in Figure 1, famously wrote in the introduction to a fellow economist’s book: “[Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions.” In other words, economics teaches you how to think, not what to think.

Watch this video about John Maynard Keynes and his influence on economics.


QR Code representing a URL

Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline. They analyze issues and problems with economic theories that are based on particular assumptions about human behavior, that are different than the assumptions an anthropologist or psychologist might use. A theory is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to be understood, while complex enough to capture the key features of the object or situation being studied.

Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more abstract representation, while a model is more applied or empirical representation. Models are used to test theories, but for this course we will use the terms interchangeably.

For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product will be, but can still demonstrate how the new product will work.

A good model to start with in economics is the circular flow diagram, which is shown in Figure 2. It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees.

The circular flow diagram’s outer arrows represent a goods and services market, and the inner arrows represent a labor market. As illustrated by the outer arrows, in a goods and services market, firms give goods and services to households and, in exchange, households give payment to firms. As illustrated by the inner arrows, in a labor market, households provide labor to firms and, in exchange, firms give wages, salaries, and benefits to households.
Figure 2. The Circular Flow Diagram. The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits.

Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. This is shown in the outer circle, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries and benefits. This is shown in the inner circle and represents the two sides of the labor market in which households supply and firms demand.

This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).

Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. In economics, theories are expressed as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. Both micro and macroeconomics are explained in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others.

Key Concepts and Summary

Economists analyze problems differently than do other disciplinary experts. The main tools economists use are economic theories or models. A theory is not an illustration of the answer to a problem. Rather, a theory is a tool for determining the answer.

Self-Check Questions

  1. Suppose we extend the circular flow model to add imports and exports. Copy the circular flow diagram onto a sheet of paper and then add a foreign country as a third agent. Draw a rough sketch of the flows of imports, exports, and the payments for each on your diagram.
  2. What is an example of a problem in the world today, not mentioned in the chapter, that has an economic dimension?

Review Questions

  1. How did John Maynard Keynes define economics?
  2. Are households primarily buyers or sellers in the goods and services market? In the labor market?
  3. Are firms primarily buyers or sellers in the goods and services market? In the labor market?

Critical Thinking Questions

  1. Why is it unfair or meaningless to criticize a theory as “unrealistic?”
  2. Suppose, as an economist, you are asked to analyze an issue unlike anything you have ever done before. Also, suppose you do not have a specific model for analyzing that issue. What should you do? Hint: What would a carpenter do in a similar situation?

Glossary

circular flow diagram
a diagram that views the economy as consisting of households and firms interacting in a goods and services market and a labor market
goods and services market
a market in which firms are sellers of what they produce and households are buyers
labor market
the market in which households sell their labor as workers to business firms or other employers
model
see theory
theory
a representation of an object or situation that is simplified while including enough of the key features to help us understand the object or situation

Solutions

Answers to Self-Check Questions

  1. Draw a box outside the original circular flow to represent the foreign country. Draw an arrow from the foreign country to firms, to represents imports. Draw an arrow in the reverse direction representing payments for imports. Draw an arrow from firms to the foreign country to represent exports. Draw an arrow in the reverse direction to represent payments for imports.
  2. There are many such problems. Consider the AIDS epidemic. Why are so few AIDS patients in Africa and Southeast Asia treated with the same drugs that are effective in the United States and Europe? It is because neither those patients nor the countries in which they live have the resources to purchase the same drugs.

1.4 How Economies Can Be Organized: An Overview of Economic Systems

5

Learning Objectives

By the end of this section, you will be able to:

  • Contrast traditional economies, command economies, and market economies
  • Explain gross domestic product (GDP)
  • Assess the importance and effects of globalization

Think about what a complex system a modern economy is. It includes all production of goods and services, all buying and selling, all employment. The economic life of every individual is interrelated, at least to a small extent, with the economic lives of thousands or even millions of other individuals. Who organizes and coordinates this system? Who insures that, for example, the number of televisions a society provides is the same as the amount it needs and wants? Who insures that the right number of employees work in the electronics industry? Who insures that televisions are produced in the best way possible? How does it all get done?

There are at least three ways societies have found to organize an economy. The first is the traditional economy, which is the oldest economic system and can be found in parts of Asia, Africa, and South America. Traditional economies organize their economic affairs the way they have always done (i.e., tradition). Occupations stay in the family. Most families are farmers who grow the crops they have always grown using traditional methods. What you produce is what you get to consume. Because things are driven by tradition, there is little economic progress or development.

The image is a photograph of people riding camels in front of two pyramids in Egypt.
Figure 1. A Command Economy. Ancient Egypt was an example of a command economy. (Credit: Jay Bergesen/Flickr Creative Commons)

Command economies are very different. In a command economy, economic effort is devoted to goals passed down from a ruler or ruling class. Ancient Egypt was a good example: a large part of economic life was devoted to building pyramids, like those shown in Figure 1, for the pharaohs. Medieval manor life is another example: the lord provided the land for growing crops and protection in the event of war. In return, vassals provided labor and soldiers to do the lord’s bidding. In the last century, communism emphasized command economies.

In a command economy, the government decides what goods and services will be produced and what prices will be charged for them. The government decides what methods of production will be used and how much workers will be paid. Many necessities like healthcare and education are provided for free. Currently, Cuba and North Korea have command economies.

The image is a photograph of the New York Stock Exchange’s entrance
Figure 2. A Market Economy. Nothing says “market” more than The New York Stock Exchange. (Credit: Erik Drost/Flickr Creative Commons)

Although command economies have a very centralized structure for economic decisions, market economies have a very decentralized structure. A market is an institution that brings together buyers and sellers of goods or services, who may be either individuals or businesses. The New York Stock Exchange, shown in Figure 2, is a prime example of market in which buyers and sellers are brought together. In a market economy, decision-making is decentralized. Market economies are based on private enterprise: the means of production (resources and businesses) are owned and operated by private individuals or groups of private individuals. Businesses supply goods and services based on demand. (In a command economy, by contrast, resources and businesses are owned by the government.) What goods and services are supplied depends on what is demanded. A person’s income is based on his or her ability to convert resources (especially labor) into something that society values. The more society values the person’s output, the higher the income (think Lady Gaga or LeBron James). In this scenario, economic decisions are determined by market forces, not governments.

Most economies in the real world are mixed; they combine elements of command and market (and even traditional) systems. The U.S. economy is positioned toward the market-oriented end of the spectrum. Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than does the U.S. economy. China and Russia, while they are closer to having a market-oriented system now than several decades ago, remain closer to the command economy end of the spectrum. A rich resource of information about countries and their economies can be found on the Heritage Foundation’s website, as the following Clear It Up feature discusses.

What countries are considered economically free?

Who is in control of economic decisions? Are people free to do what they want and to work where they want? Are businesses free to produce when they want and what they choose, and to hire and fire as they wish? Are banks free to choose who will receive loans? Or does the government control these kinds of choices? Each year, researchers at the Heritage Foundation and the Wall Street Journal look at 50 different categories of economic freedom for countries around the world. They give each nation a score based on the extent of economic freedom in each category.

The 2015 Heritage Foundation’s Index of Economic Freedom report ranked 178 countries around the world: some examples of the most free and the least free countries are listed in Table 1. Several countries were not ranked because of extreme instability that made judgments about economic freedom impossible. These countries include Afghanistan, Iraq, Syria, and Somalia.

The assigned rankings are inevitably based on estimates, yet even these rough measures can be useful for discerning trends. In 2015, 101 of the 178 included countries shifted toward greater economic freedom, although 77 of the countries shifted toward less economic freedom. In recent decades, the overall trend has been a higher level of economic freedom around the world.

Most Economic Freedom Least Economic Freedom
1. Hong Kong 167. Timor-Leste
2. Singapore 168. Democratic Republic of Congo
3. New Zealand 169. Argentina
4. Australia 170. Republic of Congo
5. Switzerland 171. Iran
6. Canada 172. Turkmenistan
7. Chile 173. Equatorial Guinea
8. Estonia 174. Eritrea
9. Ireland 175. Zimbabwe
10. Mauritius 176. Venezuela
11. Denmark 177. Cuba
12. United States 178. North Korea
Table 1. Economic Freedoms, 2015 (Source: The Heritage Foundation, 2015 Index of Economic Freedom, Country Rankings, http://www.heritage.org/index/ranking)

Regulations: The Rules of the Game

Markets and government regulations are always entangled. There is no such thing as an absolutely free market. Regulations always define the “rules of the game” in the economy. Economies that are primarily market-oriented have fewer regulations—ideally just enough to maintain an even playing field for participants. At a minimum, these laws govern matters like safeguarding private property against theft, protecting people from violence, enforcing legal contracts, preventing fraud, and collecting taxes. Conversely, even the most command-oriented economies operate using markets. How else would buying and selling occur? But the decisions of what will be produced and what prices will be charged are heavily regulated. Heavily regulated economies often have underground economies, which are markets where the buyers and sellers make transactions without the government’s approval.

The question of how to organize economic institutions is typically not a black-or-white choice between all market or all government, but instead involves a balancing act over the appropriate combination of market freedom and government rules.

The image is a photograph of a cargo ship transporting goods.
Figure 3. Globalization. Cargo ships are one mode of transportation for shipping goods in the global economy. (Credit: Raul Valdez/Flickr Creative Commons)

The Rise of Globalization

Recent decades have seen a trend toward globalization, which is the expanding cultural, political, and economic connections between people around the world. One measure of this is the increased buying and selling of goods, services, and assets across national borders—in other words, international trade and financial capital flows.

Globalization has occurred for a number of reasons. Improvements in shipping, as illustrated by the container ship shown in Figure 3, and air cargo have driven down transportation costs. Innovations in computing and telecommunications have made it easier and cheaper to manage long-distance economic connections of production and sales. Many valuable products and services in the modern economy can take the form of information—for example: computer software; financial advice; travel planning; music, books and movies; and blueprints for designing a building. These products and many others can be transported over telephones and computer networks at ever-lower costs. Finally, international agreements and treaties between countries have encouraged greater trade.

Table 2 presents one measure of globalization. It shows the percentage of domestic economic production that was exported for a selection of countries from 2010 to 2013, according to an entity known as The World Bank. Exports are the goods and services that are produced domestically and sold abroad. Imports are the goods and services that are produced abroad and then sold domestically. The size of total production in an economy is measured by the gross domestic product (GDP). Thus, the ratio of exports divided by GDP measures what share of a country’s total economic production is sold in other countries.

Country 2010 2011 2012 2013
Higher Income Countries
United States 12.4 13.6 13.6 13.5
Belgium 76.2 81.4 82.2 82.8
Canada 29.1 30.7 30.0 30.1
France 26.0 27.8 28.1 28.3
Middle Income Countries
Brazil 10.9 11.9 12.6 12.6
Mexico 29.9 31.2 32.6 31.7
South Korea 49.4 55.7 56.3 53.9
Lower Income Countries
Chad 36.8 38.9 36.9 32.2
China 29.4 28.5 27.3 26.4
India 22.0 23.9 24.0 24.8
Nigeria 25.3 31.3 31.4 18.0
Table 2. The Extent of Globalization (exports/GDP) (Source: http://databank.worldbank.org/data/)

In recent decades, the export/GDP ratio has generally risen, both worldwide and for the U.S. economy. Interestingly, the share of U.S. exports in proportion to the U.S. economy is well below the global average, in part because large economies like the United States can contain more of the division of labor inside their national borders. However, smaller economies like Belgium, Korea, and Canada need to trade across their borders with other countries to take full advantage of division of labor, specialization, and economies of scale. In this sense, the enormous U.S. economy is less affected by globalization than most other countries.

Table 2 also shows that many medium and low income countries around the world, like Mexico and China, have also experienced a surge of globalization in recent decades. If an astronaut in orbit could put on special glasses that make all economic transactions visible as brightly colored lines and look down at Earth, the astronaut would see the planet covered with connections.

So, hopefully, you now have an idea of what economics is about. Before you move to any other chapter of study, be sure to read the very important appendix to this chapter called The Use of Mathematics in Principles of Economics. It is essential that you learn more about how to read and use models in economics.

Decisions … Decisions in the Social Media Age

The world we live in today provides nearly instant access to a wealth of information. Consider that as recently as the late 1970s, the Farmer’s Almanac, along with the Weather Bureau of the U.S. Department of Agriculture, were the primary sources American farmers used to determine when to plant and harvest their crops. Today, farmers are more likely to access, online, weather forecasts from the National Oceanic and Atmospheric Administration or watch the Weather Channel. After all, knowing the upcoming forecast could drive when to harvest crops. Consequently, knowing the upcoming weather could change the amount of crop harvested.

Some relatively new information forums, such as Facebook, are rapidly changing how information is distributed; hence, influencing decision making. In 2014, the Pew Research Center reported that 71% of online adults use Facebook. Facebook post topics range from the National Basketball Association, to celebrity singers and performers, to farmers.

Information helps us make decisions. Decisions as simple as what to wear today to how many reporters should be sent to cover a crash. Each of these decisions is an economic decision. After all, resources are scarce. If ten reporters are sent to cover an accident, they are not available to cover other stories or complete other tasks. Information provides the knowledge needed to make the best possible decisions on how to utilize scarce resources. Welcome to the world of economics!

Key Concepts and Summary

Societies can be organized as traditional, command, or market-oriented economies. Most societies are a mix. The last few decades have seen globalization evolve as a result of growth in commercial and financial networks that cross national borders, making businesses and workers from different economies increasingly interdependent.

Self-Check Questions

  1. The chapter defines private enterprise as a characteristic of market-oriented economies. What would public enterprise be? Hint: It is a characteristic of command economies.
  2. Why might Belgium, France, Italy, and Sweden have a higher export to GDP ratio than the United States?

Review Questions

  1. What are the three ways that societies can organize themselves economically?
  2. What is globalization? How do you think it might have affected the economy over the past decade?

Critical Thinking Questions

  1. Why do you think that most modern countries’ economies are a mix of command and market types?
  2. Can you think of ways that globalization has helped you economically? Can you think of ways that it has not?

References

The Heritage Foundation. 2015. “2015 Index of Economic Freedom.” Accessed March 11, 2015. http://www.heritage.org/index/ranking.

Garling, Caleb. “S.F. plane crash: Reporting, emotions on social media,” The San Francisco Chronicle. July 7, 2013. http://www.sfgate.com/news/article/S-F-plane-crash-Reporting-emotions-on-social-4651639.php.

Irvine, Jessica. “Social Networking Sites are Factories of Modern Ideas.” The Sydney Morning Herald. November 25, 2011.http://www.smh.com.au/federal-politics/society-and-culture/social-networking-sites-are-factories-of-modern-ideas-20111124-1nwy3.html#ixzz2YZhPYeME.

Pew Research Center. 2015. “Social Networking Fact Sheet.” Accessed March 11, 2015. http://www.pewinternet.org/fact-sheets/social-networking-fact-sheet/.

The World Bank Group. 2015. “World Data Bank.” Accessed March 30, 2014. http://databank.worldbank.org/data/.

Glossary

command economy
an economy where economic decisions are passed down from government authority and where resources are owned by the government
exports
products (goods and services) made domestically and sold abroad
globalization
the trend in which buying and selling in markets have increasingly crossed national borders
gross domestic product (GDP)
measure of the size of total production in an economy
imports
products (goods and services) made abroad and then sold domestically
market
interaction between potential buyers and sellers; a combination of demand and supply
market economy
an economy where economic decisions are decentralized, resources are owned by private individuals, and businesses supply goods and services based on demand
private enterprise
system where the means of production (resources and businesses) are owned and operated by private individuals or groups of private individuals
traditional economy
typically an agricultural economy where things are done the same as they have always been done
underground economy
a market where the buyers and sellers make transactions in violation of one or more government regulations

Solutions

Answers to Self-Check Questions

  1. Public enterprise means the factors of production (resources and businesses) are owned and operated by the government.
  2. The United States is a large country economically speaking, so it has less need to trade internationally than the other countries mentioned. (This is the same reason that France and Italy have lower ratios than Belgium or Sweden.) One additional reason is that each of the other countries is a member of the European Union, where trade between members occurs without barriers to trade, like tariffs and quotas.

Chapter 2. Choice in a World of Scarcity

II

Introduction to Choice in a World of Scarcity

6

This is a photograph of students at their high school graduation ceremony
Figure 1. Choices and Tradeoffs. In general, the higher the degree, the higher the salary. So why aren’t more people pursuing higher degrees? The short answer: choices and tradeoffs. (Credit: modification of work by “Jim, the Photographer”/Flickr Creative Commons)

Choices … To What Degree?

In 2015, the median income for workers who hold master’s degrees varies from males to females. The average of the two is $2,951 weekly. Multiply this average by 52 weeks, and you get an average salary of $153,452. Compare that to the median weekly earnings for a full-time worker over 25 with no higher than a bachelor’s degree: $1,224 weekly and $63,648 a year. What about those with no higher than a high school diploma in 2015? They earn just $664 weekly and $34,528 over 12 months. In other words, says the Bureau of Labor Statistics (BLS), earning a bachelor’s degree boosted salaries 54% over what you would have earned if you had stopped your education after high school. A master’s degree yields a salary almost double that of a high school diploma.

Given these statistics, we might expect a lot of people to choose to go to college and at least earn a bachelor’s degree. Assuming that people want to improve their material well-being, it seems like they would make those choices that give them the greatest opportunity to consume goods and services. As it turns out, the analysis is not nearly as simple as this. In fact, in 2014, the BLS reported that while almost 88% of the population in the United States had a high school diploma, only 33.6% of 25–65 year olds had bachelor’s degrees, and only 7.4% of 25–65 year olds in 2014 had earned a master’s.

This brings us to the subject of this chapter: why people make the choices they make and how economists go about explaining those choices.

Chapter Objectives

Introduction to Choice in a World of Scarcity

In this chapter, you will learn about:

  • How Individuals Make Choices Based on Their Budget Constraint
  • The Production Possibilities Frontier and Social Choices
  • Confronting Objections to the Economic Approach

You will learn quickly when you examine the relationship between economics and scarcity that choices involve tradeoffs. Every choice has a cost.

In 1968, the Rolling Stones recorded “You Can’t Always Get What You Want.” Economists chuckled, because they had been singing a similar tune for decades. English economist Lionel Robbins (1898–1984), in his Essay on the Nature and Significance of Economic Science in 1932, described not always getting what you want in this way:

The time at our disposal is limited. There are only twenty-four hours in the day. We have to choose between the different uses to which they may be put. … Everywhere we turn, if we choose one thing we must relinquish others which, in different circumstances, we would wish not to have relinquished. Scarcity of means to satisfy given ends is an almost ubiquitous condition of human nature.

Because people live in a world of scarcity, they cannot have all the time, money, possessions, and experiences they wish. Neither can society.

This chapter will continue our discussion of scarcity and the economic way of thinking by first introducing three critical concepts: opportunity cost, marginal decision making, and diminishing returns. Later, it will consider whether the economic way of thinking accurately describes either how choices are made or how they should be made.

2.1 How Individuals Make Choices Based on Their Budget Constraint

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Learning Objectives

By the end of this section, you will be able to:

  • Calculate and graph budgets constraints
  • Explain opportunity sets and opportunity costs
  • Evaluate the law of diminishing marginal utility
  • Explain how marginal analysis and utility influence choices

Consider the typical consumer’s budget problem. Consumers have a limited amount of income to spend on the things they need and want. Suppose Alphonso has $10 in spending money each week that he can allocate between bus tickets for getting to work and the burgers that he eats for lunch. Burgers cost $2 each, and bus tickets are 50 cents each. Figure 1 shows Alphonso’s budget constraint, that is, the outer boundary of his opportunity set. The opportunity set identifies all the opportunities for spending within his budget. The budget constraint indicates all the combinations of burgers and bus tickets Alphonso can afford when he exhausts his budget, given the prices of the two goods. (There are actually many different kinds of budget constraints. You will learn more about them in the chapter on Consumer Choices.)

The graph shows the budget line as a downward slope representing the opportunity set of burgers and bus tickets.
Figure 1. The Budget Constraint: Alphonso’s Consumption Choice Opportunity Frontier. Each point on the budget constraint represents a combination of burgers and bus tickets whose total cost adds up to Alphonso’s budget of $10. The slope of the budget constraint is determined by the relative price of burgers and bus tickets. All along the budget set, giving up one burger means gaining four bus tickets.

The vertical axis in the figure shows burger purchases and the horizontal axis shows bus ticket purchases. If Alphonso spends all his money on burgers, he can afford five per week. ($10 per week/$2 per burger = 5 burgers per week.) But if he does this, he will not be able to afford any bus tickets. This choice (zero bus tickets and five burgers) is shown by point A in the figure. Alternatively, if Alphonso spends all his money on bus tickets, he can afford 20 per week. ($10 per week/$0.50 per bus ticket = 20 bus tickets per week.) Then, however, he will not be able to afford any burgers. This alternative choice (20 bus tickets and zero burgers) is shown by point F.

If Alphonso is like most people, he will choose some combination that includes both bus tickets and burgers. That is, he will choose some combination on the budget constraint that connects points A and F. Every point on (or inside) the constraint shows a combination of burgers and bus tickets that Alphonso can afford. Any point outside the constraint is not affordable, because it would cost more money than Alphonso has in his budget.

The budget constraint clearly shows the tradeoff Alphonso faces in choosing between burgers and bus tickets. Suppose he is currently at point D, where he can afford 12 bus tickets and two burgers. What would it cost Alphonso for one more burger? It would be natural to answer $2, but that’s not the way economists think. Instead they ask, how many bus tickets would Alphonso have to give up to get one more burger, while staying within his budget? The answer is four bus tickets. That is the true cost to Alphonso of one more burger.

The Concept of Opportunity Cost

Economists use the term opportunity cost to indicate what must be given up to obtain something that is desired. The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else; in short, opportunity cost is the value of the next best alternative. For Alphonso, the opportunity cost of a burger is the four bus tickets he would have to give up. He would decide whether or not to choose the burger depending on whether the value of the burger exceeds the value of the forgone alternative—in this case, bus tickets. Since people must choose, they inevitably face tradeoffs in which they have to give up things they desire to get other things they desire more.

View this website for an example of opportunity cost—paying someone else to wait in line for you.


QR Code representing a URL

A fundamental principle of economics is that every choice has an opportunity cost. If you sleep through your economics class (not recommended, by the way), the opportunity cost is the learning you miss from not attending class. If you spend your income on video games, you cannot spend it on movies. If you choose to marry one person, you give up the opportunity to marry anyone else. In short, opportunity cost is all around us and part of human existence.

The following Work It Out feature shows a step-by-step analysis of a budget constraint calculation. Read through it to understand another important concept—slope—that is further explained in the appendix The Use of Mathematics in Principles of Economics.

Understanding Budget Constraints

Budget constraints are easy to understand if you apply a little math. The appendix The Use of Mathematics in Principles of Economics explains all the math you are likely to need in this book. So if math is not your strength, you might want to take a look at the appendix.

Step 1: The equation for any budget constraint is:

Budget = P_1 \times Q_1 + P_2 \times Q_2

where P and Q are the price and quantity of items purchased and Budget is the amount of income one has to spend.

Step 2. Apply the budget constraint equation to the scenario. In Alphonso’s case, this works out to be:

\begin{array}{r @{{}={}} l} Budget & P_1 \times Q_1 + P_2 \times Q_2 \\[1em] \$10\;budget & \$2\;per\;burger\;\times\;quantity\;of\;burgers\;+\;\$0.50\;per\;bus\;ticket\;\times\;quantity\;of\;bus\;tickets \\[1em] \$10 & \$2 \times Q_{burgers} + \$0.50 \times Q_{bus\;tickets} \end{array}

Step 3. Using a little algebra, we can turn this into the familiar equation of a line:

y = b + mx

For Alphonso, this is:

\$10 = \$2 \times Q_{burgers} + \$0.50 \times Q_{bus\;tickets}

Step 4. Simplify the equation. Begin by multiplying both sides of the equation by 2:

\begin{array}{r @{{}={}} l}2 \times 10 & 2 \times 2 \times Q_{burgers} + 2 \times 0.5 \times Q_{bus\;tickets} \\[1em] 20 & 4 \times Q_{burgers} + 1 \times Q_{bus\;tickets} \end{array}

Step 5. Subtract one bus ticket from both sides:

20 - Q_{bus\;tickets} = 4 \times Q_{burgers}

Divide each side by 4 to yield the answer:

\begin{array}{rcl}5 - 0.25 \times Q_{bus\;tickets} & = & Q_{burgers} \\ & or & \\ Q_{burgers} & = & 5 - 0.25 \times Q_{bus\;tickets} \end{array}

Step 6. Notice that this equation fits the budget constraint in Figure 1. The vertical intercept is 5 and the slope is –0.25, just as the equation says. If you plug 20 bus tickets into the equation, you get 0 burgers. If you plug other numbers of bus tickets into the equation, you get the results shown in Table 1, which are the points on Alphonso’s budget constraint.

Point Quantity of Burgers (at $2) Quantity of Bus Tickets (at 50 cents)
A 5 0
B 4 4
C 3 8
D 2 12
E 1 16
F 0 20
Table 1.

Step 7. Notice that the slope of a budget constraint always shows the opportunity cost of the good which is on the horizontal axis. For Alphonso, the slope is −0.25, indicating that for every four bus tickets he buys, Alphonso must give up 1 burger.

There are two important observations here. First, the algebraic sign of the slope is negative, which means that the only way to get more of one good is to give up some of the other. Second, the slope is defined as the price of bus tickets (whatever is on the horizontal axis in the graph) divided by the price of burgers (whatever is on the vertical axis), in this case $0.50/$2 = 0.25. So if you want to determine the opportunity cost quickly, just divide the two prices.

Identifying Opportunity Cost

In many cases, it is reasonable to refer to the opportunity cost as the price. If your cousin buys a new bicycle for $300, then $300 measures the amount of “other consumption” that he has given up. For practical purposes, there may be no special need to identify the specific alternative product or products that could have been bought with that $300, but sometimes the price as measured in dollars may not accurately capture the true opportunity cost. This problem can loom especially large when costs of time are involved.

For example, consider a boss who decides that all employees will attend a two-day retreat to “build team spirit.” The out-of-pocket monetary cost of the event may involve hiring an outside consulting firm to run the retreat, as well as room and board for all participants. But an opportunity cost exists as well: during the two days of the retreat, none of the employees are doing any other work.

Attending college is another case where the opportunity cost exceeds the monetary cost. The out-of-pocket costs of attending college include tuition, books, room and board, and other expenses. But in addition, during the hours that you are attending class and studying, it is impossible to work at a paying job. Thus, college imposes both an out-of-pocket cost and an opportunity cost of lost earnings.

What is the opportunity cost associated with increased airport security measures?

After the terrorist plane hijackings on September 11, 2001, many steps were proposed to improve air travel safety. For example, the federal government could provide armed “sky marshals” who would travel inconspicuously with the rest of the passengers. The cost of having a sky marshal on every flight would be roughly $3 billion per year. Retrofitting all U.S. planes with reinforced cockpit doors to make it harder for terrorists to take over the plane would have a price tag of $450 million. Buying more sophisticated security equipment for airports, like three-dimensional baggage scanners and cameras linked to face recognition software, could cost another $2 billion.

But the single biggest cost of greater airline security does not involve spending money. It is the opportunity cost of additional waiting time at the airport. According to the United States Department of Transportation (DOT), more than 800 million passengers took plane trips in the United States in 2012. Since the 9/11 hijackings, security screening has become more intensive, and consequently, the procedure takes longer than in the past. Say that, on average, each air passenger spends an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure. Because many air travelers are relatively high-paid business people, conservative estimates set the average price of time for air travelers at $20 per hour. By these back-of-the-envelope calculations, the opportunity cost of delays in airports could be as much as 800 million × 0.5 hours × $20/hour, or $8 billion per year. Clearly, the opportunity costs of waiting time can be just as important as costs that involve direct spending.

In some cases, realizing the opportunity cost can alter behavior. Imagine, for example, that you spend $8 on lunch every day at work. You may know perfectly well that bringing a lunch from home would cost only $3 a day, so the opportunity cost of buying lunch at the restaurant is $5 each day (that is, the $8 buying lunch costs minus the $3 your lunch from home would cost). $5 each day does not seem to be that much. However, if you project what that adds up to in a year—250 days a year × $5 per day equals $1,250, the cost, perhaps, of a decent vacation. If the opportunity cost is described as “a nice vacation” instead of “$5 a day,” you might make different choices.

Marginal Decision-Making and Diminishing Marginal Utility

The budget constraint framework helps to emphasize that most choices in the real world are not about getting all of one thing or all of another; that is, they are not about choosing either the point at one end of the budget constraint or else the point all the way at the other end. Instead, most choices involve marginal analysis, which means comparing the benefits and costs of choosing a little more or a little less of a good.

People desire goods and services for the satisfaction or utility those goods and services provide. Utility, as we will see in the chapter on Consumer Choices, is subjective but that does not make it less real. Economists typically assume that the more of some good one consumes (for example, slices of pizza), the more utility one obtains. At the same time, the utility a person receives from consuming the first unit of a good is typically more than the utility received from consuming the fifth or the tenth unit of that same good. When Alphonso chooses between burgers and bus tickets, for example, the first few bus rides that he chooses might provide him with a great deal of utility—perhaps they help him get to a job interview or a doctor’s appointment. But later bus rides might provide much less utility—they may only serve to kill time on a rainy day. Similarly, the first burger that Alphonso chooses to buy may be on a day when he missed breakfast and is ravenously hungry. However, if Alphonso has a burger every single day, the last few burgers may taste pretty boring. The general pattern that consumption of the first few units of any good tends to bring a higher level of utility to a person than consumption of later units is a common pattern. Economists refer to this pattern as the law of diminishing marginal utility, which means that as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines. In other words, the first slice of pizza brings more satisfaction than the sixth.

The law of diminishing marginal utility explains why people and societies rarely make all-or-nothing choices. You would not say, “My favorite food is ice cream, so I will eat nothing but ice cream from now on.” Instead, even if you get a very high level of utility from your favorite food, if you ate it exclusively, the additional or marginal utility from those last few servings would not be very high. Similarly, most workers do not say: “I enjoy leisure, so I’ll never work.” Instead, workers recognize that even though some leisure is very nice, a combination of all leisure and no income is not so attractive. The budget constraint framework suggests that when people make choices in a world of scarcity, they will use marginal analysis and think about whether they would prefer a little more or a little less.

Sunk Costs

In the budget constraint framework, all decisions involve what will happen next: that is, what quantities of goods will you consume, how many hours will you work, or how much will you save. These decisions do not look back to past choices. Thus, the budget constraint framework assumes that sunk costs, which are costs that were incurred in the past and cannot be recovered, should not affect the current decision.

Consider the case of Selena, who pays $8 to see a movie, but after watching the film for 30 minutes, she knows that it is truly terrible. Should she stay and watch the rest of the movie because she paid for the ticket, or should she leave? The money she spent is a sunk cost, and unless the theater manager is feeling kindly, Selena will not get a refund. But staying in the movie still means paying an opportunity cost in time. Her choice is whether to spend the next 90 minutes suffering through a cinematic disaster or to do something—anything—else. The lesson of sunk costs is to forget about the money and time that is irretrievably gone and instead to focus on the marginal costs and benefits of current and future options.

For people and firms alike, dealing with sunk costs can be frustrating. It often means admitting an earlier error in judgment. Many firms, for example, find it hard to give up on a new product that is doing poorly because they spent so much money in creating and launching the product. But the lesson of sunk costs is to ignore them and make decisions based on what will happen in the future.

From a Model with Two Goods to One of Many Goods

The budget constraint diagram containing just two goods, like most models used in this book, is not realistic. After all, in a modern economy people choose from thousands of goods. However, thinking about a model with many goods is a straightforward extension of what we discussed here. Instead of drawing just one budget constraint, showing the tradeoff between two goods, you can draw multiple budget constraints, showing the possible tradeoffs between many different pairs of goods. Or in more advanced classes in economics, you would use mathematical equations that include many possible goods and services that can be purchased, together with their quantities and prices, and show how the total spending on all goods and services is limited to the overall budget available. The graph with two goods that was presented here clearly illustrates that every choice has an opportunity cost, which is the point that does carry over to the real world.

Key Concepts and Summary

Economists see the real world as one of scarcity: that is, a world in which people’s desires exceed what is possible. As a result, economic behavior involves tradeoffs in which individuals, firms, and society must give up something that they desire to obtain things that they desire more. Individuals face the tradeoff of what quantities of goods and services to consume. The budget constraint, which is the frontier of the opportunity set, illustrates the range of choices available. The slope of the budget constraint is determined by the relative price of the choices. Choices beyond the budget constraint are not affordable.

Opportunity cost measures cost by what is given up in exchange. Sometimes opportunity cost can be measured in money, but it is often useful to consider time as well, or to measure it in terms of the actual resources that must be given up.

Most economic decisions and tradeoffs are not all-or-nothing. Instead, they involve marginal analysis, which means they are about decisions on the margin, involving a little more or a little less. The law of diminishing marginal utility points out that as a person receives more of something—whether it is a specific good or another resource—the additional marginal gains tend to become smaller. Because sunk costs occurred in the past and cannot be recovered, they should be disregarded in making current decisions.

Self-Check Questions

Suppose Alphonso’s town raised the price of bus tickets to $1 per trip (while the price of burgers stayed at $2 and his budget remained $10 per week.) Draw Alphonso’s new budget constraint. What happens to the opportunity cost of bus tickets?

Review Questions

  1. Explain why scarcity leads to tradeoffs.
  2. Explain why individuals make choices that are directly on the budget constraint, rather than inside the budget constraint or outside it.

Critical Thinking Questions

Suppose Alphonso’s town raises the price of bus tickets from $0.50 to $1 and the price of burgers rises from $2 to $4. Why is the opportunity cost of bus tickets unchanged? Suppose Alphonso’s weekly spending money increases from $10 to $20. How is his budget constraint affected from all three changes? Explain.

Problems

Use this information to answer the following 4 questions: Marie has a weekly budget of $24, which she likes to spend on magazines and pies.

  1. If the price of a magazine is $4 each, what is the maximum number of magazines she could buy in a week?
  2. If the price of a pie is $12, what is the maximum number of pies she could buy in a week?
  3. Draw Marie’s budget constraint with pies on the horizontal axis and magazines on the vertical axis. What is the slope of the budget constraint?
  4. What is Marie’s opportunity cost of purchasing a pie?

References

Bureau of Labor Statistics, U.S. Department of Labor. 2015. “Median Weekly Earnings by Educational Attainment in 2014.” Accessed March 27, 2015. http://www.bls.gov/opub/ted/2015/median-weekly-earnings-by-education-gender-race-and-ethnicity-in-2014.htm.

Robbins, Lionel. An Essay on the Nature and Significance of Economic Science. London: Macmillan. 1932.

United States Department of Transportation. “Total Passengers on U.S Airlines and Foreign Airlines U.S. Flights Increased 1.3% in 2012 from 2011.” Accessed October 2013. http://www.rita.dot.gov/bts/press_releases/bts016_13

Glossary

budget constraint
all possible consumption combinations of goods that someone can afford, given the prices of goods, when all income is spent; the boundary of the opportunity set
law of diminishing marginal utility
as we consume more of a good or service, the utility we get from additional units of the good or service tend to become smaller than what we received from earlier units
marginal analysis
examination of decisions on the margin, meaning a little more or a little less from the status quo
opportunity cost
measures cost by what is given up in exchange; opportunity cost measures the value of the forgone alternative
opportunity set
all possible combinations of consumption that someone can afford given the prices of goods and the individual’s income
sunk costs
costs that are made in the past and cannot be recovered
utility
satisfaction, usefulness, or value one obtains from consuming goods and services

Solutions

Answers to Self-Check Questions

The opportunity cost of bus tickets is the number of burgers that must be given up to obtain one more bus ticket. Originally, when the price of bus tickets was 50 cents per trip, this opportunity cost was 0.50/2 = .25 burgers. The reason for this is that at the original prices, one burger ($2) costs the same as four bus tickets ($0.50), so the opportunity cost of a burger is four bus tickets, and the opportunity cost of a bus ticket is .25 (the inverse of the opportunity cost of a burger). With the new, higher price of bus tickets, the opportunity cost rises to $1/$2 or 0.50. You can see this graphically since the slope of the new budget constraint is flatter than the original one. If Alphonso spends all of his budget on burgers, the higher price of bus tickets has no impact so the horizontal intercept of the budget constraint is the same. If he spends all of his budget on bus tickets, he can now afford only half as many, so the vertical intercept is half as much. In short, the budget constraint rotates clockwise around the horizontal intercept, flattening as it goes and the opportunity cost of bus tickets increases.

The graph shows how opportunity cost is affected by the purchase of either burgers or bus tickets. The opportunity cost of bus tickets is the number of burgers that must be given up to obtain one more bus ticket.
Figure 2.

2.2 The Production Possibilities Frontier and Social Choices

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Learning Objectives

By the end of this section, you will be able to:

  • Interpret production possibilities frontier graphs
  • Contrast a budget constraint and a production possibilities frontier
  • Explain the relationship between a production possibilities frontier and the law of diminishing returns
  • Contrast productive efficiency and allocative efficiency
  • Define comparative advantage

Just as individuals cannot have everything they want and must instead make choices, society as a whole cannot have everything it might want, either. This section of the chapter will explain the constraints faced by society, using a model called the production possibilities frontier (PPF). There are more similarities than differences between individual choice and social choice. As you read this section, focus on the similarities.

Because society has limited resources (e.g., labor, land, capital, raw materials) at any point in time, there is a limit to the quantities of goods and services it can produce. Suppose a society desires two products, healthcare and education. This situation is illustrated by the production possibilities frontier in Figure 1.

The graph shows that a society has limited resources and often must prioritize where to invest. On this graph, the y-axis is ʺHealthcare,ʺ and the x-axis is ʺEducation.ʺ
Figure 1. A Healthcare vs. Education Production Possibilities Frontier. This production possibilities frontier shows a tradeoff between devoting social resources to healthcare and devoting them to education. At A all resources go to healthcare and at B, most go to healthcare. At D most resources go to education, and at F, all go to education.

In Figure 1, healthcare is shown on the vertical axis and education is shown on the horizontal axis. If the society were to allocate all of its resources to healthcare, it could produce at point A. But it would not have any resources to produce education. If it were to allocate all of its resources to education, it could produce at point F. Alternatively, the society could choose to produce any combination of healthcare and education shown on the production possibilities frontier. In effect, the production possibilities frontier plays the same role for society as the budget constraint plays for Alphonso. Society can choose any combination of the two goods on or inside the PPF. But it does not have enough resources to produce outside the PPF.

Most important, the production possibilities frontier clearly shows the tradeoff between healthcare and education. Suppose society has chosen to operate at point B, and it is considering producing more education. Because the PPF is downward sloping from left to right, the only way society can obtain more education is by giving up some healthcare. That is the tradeoff society faces. Suppose it considers moving from point B to point C. What would the opportunity cost be for the additional education? The opportunity cost would be the healthcare society has to give up. Just as with Alphonso’s budget constraint, the opportunity cost is shown by the slope of the production possibilities frontier. By now you might be saying, “Hey, this PPF is sounding like the budget constraint.” If so, read the following Clear It Up feature.

What’s the difference between a budget constraint and a PPF?

There are two major differences between a budget constraint and a production possibilities frontier. The first is the fact that the budget constraint is a straight line. This is because its slope is given by the relative prices of the two goods. In contrast, the PPF has a curved shape because of the law of the diminishing returns. The second is the absence of specific numbers on the axes of the PPF. There are no specific numbers because we do not know the exact amount of resources this imaginary economy has, nor do we know how many resources it takes to produce healthcare and how many resources it takes to produce education. If this were a real world example, that data would be available. An additional reason for the lack of numbers is that there is no single way to measure levels of education and healthcare. However, when you think of improvements in education, you can think of accomplishments like more years of school completed, fewer high-school dropouts, and higher scores on standardized tests. When you think of improvements in healthcare, you can think of longer life expectancies, lower levels of infant mortality, and fewer outbreaks of disease.

Whether or not we have specific numbers, conceptually we can measure the opportunity cost of additional education as society moves from point B to point C on the PPF. The additional education is measured by the horizontal distance between B and C. The foregone healthcare is given by the vertical distance between B and C. The slope of the PPF between B and C is (approximately) the vertical distance (the “rise”) over the horizontal distance (the “run”). This is the opportunity cost of the additional education.

The Shape of the PPF and the Law of Diminishing Returns

The budget constraints presented earlier in this chapter, showing individual choices about what quantities of goods to consume, were all straight lines. The reason for these straight lines was that the slope of the budget constraint was determined by relative prices of the two goods in the consumption budget constraint. However, the production possibilities frontier for healthcare and education was drawn as a curved line. Why does the PPF have a different shape?

To understand why the PPF is curved, start by considering point A at the top left-hand side of the PPF. At point A, all available resources are devoted to healthcare and none are left for education. This situation would be extreme and even ridiculous. For example, children are seeing a doctor every day, whether they are sick or not, but not attending school. People are having cosmetic surgery on every part of their bodies, but no high school or college education exists. Now imagine that some of these resources are diverted from healthcare to education, so that the economy is at point B instead of point A. Diverting some resources away from A to B causes relatively little reduction in health because the last few marginal dollars going into healthcare services are not producing much additional gain in health. However, putting those marginal dollars into education, which is completely without resources at point A, can produce relatively large gains. For this reason, the shape of the PPF from A to B is relatively flat, representing a relatively small drop-off in health and a relatively large gain in education.

Now consider the other end, at the lower right, of the production possibilities frontier. Imagine that society starts at choice D, which is devoting nearly all resources to education and very few to healthcare, and moves to point F, which is devoting all spending to education and none to healthcare. For the sake of concreteness, you can imagine that in the movement from D to F, the last few doctors must become high school science teachers, the last few nurses must become school librarians rather than dispensers of vaccinations, and the last few emergency rooms are turned into kindergartens. The gains to education from adding these last few resources to education are very small. However, the opportunity cost lost to health will be fairly large, and thus the slope of the PPF between D and F is steep, showing a large drop in health for only a small gain in education.

The lesson is not that society is likely to make an extreme choice like devoting no resources to education at point A or no resources to health at point F. Instead, the lesson is that the gains from committing additional marginal resources to education depend on how much is already being spent. If on the one hand, very few resources are currently committed to education, then an increase in resources used can bring relatively large gains. On the other hand, if a large number of resources are already committed to education, then committing additional resources will bring relatively smaller gains.

This pattern is common enough that it has been given a name: the law of diminishing returns, which holds that as additional increments of resources are added to a certain purpose, the marginal benefit from those additional increments will decline. When government spends a certain amount more on reducing crime, for example, the original gains in reducing crime could be relatively large. But additional increases typically cause relatively smaller reductions in crime, and paying for enough police and security to reduce crime to nothing at all would be tremendously expensive.

The curvature of the production possibilities frontier shows that as additional resources are added to education, moving from left to right along the horizontal axis, the original gains are fairly large, but gradually diminish. Similarly, as additional resources are added to healthcare, moving from bottom to top on the vertical axis, the original gains are fairly large, but again gradually diminish. In this way, the law of diminishing returns produces the outward-bending shape of the production possibilities frontier.

Productive Efficiency and Allocative Efficiency

The study of economics does not presume to tell a society what choice it should make along its production possibilities frontier. In a market-oriented economy with a democratic government, the choice will involve a mixture of decisions by individuals, firms, and government. However, economics can point out that some choices are unambiguously better than others. This observation is based on the concept of efficiency. In everyday usage, efficiency refers to lack of waste. An inefficient machine operates at high cost, while an efficient machine operates at lower cost, because it is not wasting energy or materials. An inefficient organization operates with long delays and high costs, while an efficient organization meets schedules, is focused, and performs within budget.

The production possibilities frontier can illustrate two kinds of efficiency: productive efficiency and allocative efficiency. Figure 2 illustrates these ideas using a production possibilities frontier between healthcare and education.

The graph shows that when a greater quantity of one good increases, the quantity of other goods will decrease. Point R on the graph represents the good that drops in quantity as a result of greater efficiency in producing other goods.
Figure 2. Productive and Allocative Efficiency. Productive efficiency means it is impossible to produce more of one good without decreasing the quantity that is produced of another good. Thus, all choices along a given PPF like B, C, and D display productive efficiency, but R does not. Allocative efficiency means that the particular mix of goods being produced—that is, the specific choice along the production possibilities frontier—represents the allocation that society most desires.

Productive efficiency means that, given the available inputs and technology, it is impossible to produce more of one good without decreasing the quantity that is produced of another good. All choices on the PPF in Figure 2, including A, B, C, D, and F, display productive efficiency. As a firm moves from any one of these choices to any other, either healthcare increases and education decreases or vice versa. However, any choice inside the production possibilities frontier is productively inefficient and wasteful because it is possible to produce more of one good, the other good, or some combination of both goods.

For example, point R is productively inefficient because it is possible at choice C to have more of both goods: education on the horizontal axis is higher at point C than point R (E2 is greater than E1), and healthcare on the vertical axis is also higher at point C than point R (H2 is great than H1).

The particular mix of goods and services being produced—that is, the specific combination of healthcare and education chosen along the production possibilities frontier—can be shown as a ray (line) from the origin to a specific point on the PPF. Output mixes that had more healthcare (and less education) would have a steeper ray, while those with more education (and less healthcare) would have a flatter ray.

Allocative efficiency means that the particular mix of goods a society produces represents the combination that society most desires. How to determine what a society desires can be a controversial question, and is usually discussed in political science, sociology, and philosophy classes as well as in economics. At its most basic, allocative efficiency means producers supply the quantity of each product that consumers demand. Only one of the productively efficient choices will be the allocatively efficient choice for society as a whole.

Why Society Must Choose

Every economy faces two situations in which it may be able to expand consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently, in which case by improving efficiency and producing on the production possibilities frontier, it can have more of all goods (or at least more of some and less of none). In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford more of all goods.

But improvements in productive efficiency take time to discover and implement, and economic growth happens only gradually. So, a society must choose between tradeoffs in the present. For government, this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm. At the individual and firm level, the market economy coordinates a process in which firms seek to produce goods and services in the quantity, quality, and price that people want. But for both the government and the market economy in the short term, increases in production of one good typically mean offsetting decreases somewhere else in the economy.

The PPF and Comparative Advantage

While every society must choose how much of each good it should produce, it does not need to produce every single good it consumes. Often how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country. As we saw earlier, the curvature of a country’s PPF gives us information about the tradeoff between devoting resources to producing one good versus another. In particular, its slope gives the opportunity cost of producing one more unit of the good in the x-axis in terms of the other good (in the y-axis). Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology or skills.

Suppose two countries, the US and Brazil, need to decide how much they will produce of two crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce a lot of sugar cane per acre but not much wheat. Conversely, the U.S. can produce a lot of wheat per acre, but not much sugar cane. Clearly, Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true; the U.S. has a lower opportunity cost of producing wheat than Brazil. This can be illustrated by the PPFs of the two countries in Figure 3.

This graph shows two images. Both images have y-axes labeled “Sugar Cane” and x-axes labeled “Wheat.” In image (a), Brazil’s Sugar Cane production is nearly double the production of its wheat. In image (b), the U.S.’s Sugar Cane production is nearly half the production of its wheat.
Figure 3. Production Possibility Frontier for the U.S. and Brazil. The U.S. PPF is flatter than the Brazil PPF implying that the opportunity cost of wheat in term of sugar cane is lower in the U.S. than in Brazil. Conversely, the opportunity cost of sugar cane is lower in Brazil. The U.S. has comparative advantage in wheat and Brazil has comparative advantage in sugar cane.

When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. In our example, Brazil has a comparative advantage in sugar cane and the U.S. has a comparative advantage in wheat. One can easily see this with a simple observation of the extreme production points in the PPFs of the two countries. If Brazil devoted all of its resources to producing wheat, it would be producing at point A. If however it had devoted all of its resources to producing sugar cane instead, it would be producing a much larger amount, at point B. By moving from point A to point B Brazil would give up a relatively small quantity in wheat production to obtain a large production in sugar cane. The opposite is true for the U.S. If the U.S. moved from point A to B and produced only sugar cane, this would result in a large opportunity cost in terms of foregone wheat production.

The slope of the PPF gives the opportunity cost of producing an additional unit of wheat. While the slope is not constant throughout the PPFs, it is quite apparent that the PPF in Brazil is much steeper than in the U.S., and therefore the opportunity cost of wheat generally higher in Brazil. In the chapter on International Trade you will learn that countries’ differences in comparative advantage determine which goods they will choose to produce and trade. When countries engage in trade, they specialize in the production of the goods that they have comparative advantage in, and trade part of that production for goods they do not have comparative advantage in. With trade, goods are produced where the opportunity cost is lowest, so total production increases, benefiting both trading parties.

Key Concepts and Summary

A production possibilities frontier defines the set of choices society faces for the combinations of goods and services it can produce given the resources available. The shape of the PPF is typically curved outward, rather than straight. Choices outside the PPF are unattainable and choices inside the PPF are wasteful. Over time, a growing economy will tend to shift the PPF outwards.

The law of diminishing returns holds that as increments of additional resources are devoted to producing something, the marginal increase in output will become smaller and smaller. All choices along a production possibilities frontier display productive efficiency; that is, it is impossible to use society’s resources to produce more of one good without decreasing production of the other good. The specific choice along a production possibilities frontier that reflects the mix of goods society prefers is the choice with allocative efficiency. The curvature of the PPF is likely to differ by country, which results in different countries having comparative advantage in different goods. Total production can increase if countries specialize in the goods they have comparative advantage in and trade some of their production for the remaining goods.

Self-Check Questions

  1. Return to the example in Figure 2. Suppose there is an improvement in medical technology that enables more healthcare to be provided with the same amount of resources. How would this affect the production possibilities curve and, in particular, how would it affect the opportunity cost of education?
  2. Could a nation be producing in a way that is allocatively efficient, but productively inefficient?
  3. What are the similarities between a consumer’s budget constraint and society’s production possibilities frontier, not just graphically but analytically?

Review Questions

  1. What is comparative advantage?
  2. What does a production possibilities frontier illustrate?
  3. Why is a production possibilities frontier typically drawn as a curve, rather than a straight line?
  4. Explain why societies cannot make a choice above their production possibilities frontier and should not make a choice below it.
  5. What are diminishing marginal returns?
  6. What is productive efficiency? Allocative efficiency?

Critical Thinking Questions

  1. During the Second World War, Germany’s factories were decimated. It also suffered many human casualties, both soldiers and civilians. How did the war affect Germany’s production possibilities curve?
  2. It is clear that productive inefficiency is a waste since resources are being used in a way that produces less goods and services than a nation is capable of. Why is allocative inefficiency also wasteful?

Glossary

allocative efficiency
when the mix of goods being produced represents the mix that society most desires
comparative advantage
when a country can produce a good at a lower cost in terms of other goods; or, when a country has a lower opportunity cost of production
law of diminishing returns
as additional increments of resources are added to producing a good or service, the marginal benefit from those additional increments will decline
production possibilities frontier (PPF)
a diagram that shows the productively efficient combinations of two products that an economy can produce given the resources it has available.
productive efficiency
when it is impossible to produce more of one good (or service) without decreasing the quantity produced of another good (or service)

Solutions

Answers to Self-Check Questions

  1. Because of the improvement in technology, the vertical intercept of the PPF would be at a higher level of healthcare. In other words, the PPF would rotate clockwise around the horizontal intercept. This would make the PPF steeper, corresponding to an increase in the opportunity cost of education, since resources devoted to education would now mean forgoing a greater quantity of healthcare.
  2. No. Allocative efficiency requires productive efficiency, because it pertains to choices along the production possibilities frontier.
  3. Both the budget constraint and the PPF show the constraint that each operates under. Both show a tradeoff between having more of one good but less of the other. Both show the opportunity cost graphically as the slope of the constraint (budget or PPF).

2.3 Confronting Objections to the Economic Approach

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Learning Objectives

By the end of this section, you will be able to:
  • Analyze arguments against economic approaches to decision-making
  • Interpret a tradeoff diagram
  • Contrast normative statements and positive statements

It is one thing to understand the economic approach to decision-making and another thing to feel comfortable applying it. The sources of discomfort typically fall into two categories: that people do not act in the way that fits the economic way of thinking, and that even if people did act that way, they should try not to. Let’s consider these arguments in turn.

First Objection: People, Firms, and Society Do Not Act Like This

The economic approach to decision-making seems to require more information than most individuals possess and more careful decision-making than most individuals actually display. After all, do you or any of your friends draw a budget constraint and mutter to yourself about maximizing utility before you head to the shopping mall? Do members of the U.S. Congress contemplate production possibilities frontiers before they vote on the annual budget? The messy ways in which people and societies operate somehow doesn’t look much like neat budget constraints or smoothly curving production possibilities frontiers.

However, the economics approach can be a useful way to analyze and understand the tradeoffs of economic decisions even so. To appreciate this point, imagine for a moment that you are playing basketball, dribbling to the right, and throwing a bounce-pass to the left to a teammate who is running toward the basket. A physicist or engineer could work out the correct speed and trajectory for the pass, given the different movements involved and the weight and bounciness of the ball. But when you are playing basketball, you do not perform any of these calculations. You just pass the ball, and if you are a good player, you will do so with high accuracy.

Someone might argue: “The scientist’s formula of the bounce-pass requires a far greater knowledge of physics and far more specific information about speeds of movement and weights than the basketball player actually has, so it must be an unrealistic description of how basketball passes are actually made.” This reaction would be wrongheaded. The fact that a good player can throw the ball accurately because of practice and skill, without making a physics calculation, does not mean that the physics calculation is wrong.

Similarly, from an economic point of view, someone who goes shopping for groceries every week has a great deal of practice with how to purchase the combination of goods that will provide that person with utility, even if the shopper does not phrase decisions in terms of a budget constraint. Government institutions may work imperfectly and slowly, but in general, a democratic form of government feels pressure from voters and social institutions to make the choices that are most widely preferred by people in that society. So, when thinking about the economic actions of groups of people, firms, and society, it is reasonable, as a first approximation, to analyze them with the tools of economic analysis. For more on this, read about behavioral economics in the chapter on Consumer Choices.

Second Objection: People, Firms, and Society Should Not Act This Way

The economics approach portrays people as self-interested. For some critics of this approach, even if self-interest is an accurate description of how people behave, these behaviors are not moral. Instead, the critics argue that people should be taught to care more deeply about others. Economists offer several answers to these concerns.

First, economics is not a form of moral instruction. Rather, it seeks to describe economic behavior as it actually exists. Philosophers draw a distinction between positive statements, which describe the world as it is, and normative statements, which describe how the world should be. For example, an economist could analyze a proposed subway system in a certain city. If the expected benefits exceed the costs, he concludes that the project is worth doing—an example of positive analysis. Another economist argues for extended unemployment compensation during the Great Depression because a rich country like the United States should take care of its less fortunate citizens—an example of normative analysis.

Even if the line between positive and normative statements is not always crystal clear, economic analysis does try to remain rooted in the study of the actual people who inhabit the actual economy. Fortunately however, the assumption that individuals are purely self-interested is a simplification about human nature. In fact, we need to look no further than to Adam Smith, the very father of modern economics to find evidence of this. The opening sentence of his book, The Theory of Moral Sentiments, puts it very clearly: “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.” Clearly, individuals are both self-interested and altruistic.

Second, self-interested behavior and profit-seeking can be labeled with other names, such as personal choice and freedom. The ability to make personal choices about buying, working, and saving is an important personal freedom. Some people may choose high-pressure, high-paying jobs so that they can earn and spend a lot of money on themselves. Others may earn a lot of money and give it to charity or spend it on their friends and family. Others may devote themselves to a career that can require a great deal of time, energy, and expertise but does not offer high financial rewards, like being an elementary school teacher or a social worker. Still others may choose a job that does not take lots of their time or provide a high level of income, but still leaves time for family, friends, and contemplation. Some people may prefer to work for a large company; others might want to start their own business. People’s freedom to make their own economic choices has a moral value worth respecting.

Is a diagram by any other name the same?

When you study economics, you may feel buried under an avalanche of diagrams: diagrams in the text, diagrams in the lectures, diagrams in the problems, and diagrams on exams. Your goal should be to recognize the common underlying logic and pattern of the diagrams, not to memorize each of the individual diagrams.

This chapter uses only one basic diagram, although it is presented with different sets of labels. The consumption budget constraint and the production possibilities frontier for society, as a whole, are the same basic diagram. Figure 1 shows an individual budget constraint and a production possibilities frontier for two goods, Good 1 and Good 2. The tradeoff diagram always illustrates three basic themes: scarcity, tradeoffs, and economic efficiency.

The first theme is scarcity. It is not feasible to have unlimited amounts of both goods. But even if the budget constraint or a PPF shifts, scarcity remains—just at a different level. The second theme is tradeoffs. As depicted in the budget constraint or the production possibilities frontier, it is necessary to give up some of one good to gain more of the other good. The details of this tradeoff vary. In a budget constraint, the tradeoff is determined by the relative prices of the goods: that is, the relative price of two goods in the consumption choice budget constraint. These tradeoffs appear as a straight line. However, the tradeoffs in many production possibilities frontiers are represented by a curved line because the law of diminishing returns holds that as resources are added to an area, the marginal gains tend to diminish. Regardless of the specific shape, tradeoffs remain.

The third theme is economic efficiency, or getting the most benefit from scarce resources. All choices on the production possibilities frontier show productive efficiency because in such cases, there is no way to increase the quantity of one good without decreasing the quantity of the other. Similarly, when an individual makes a choice along a budget constraint, there is no way to increase the quantity of one good without decreasing the quantity of the other. The choice on a production possibilities set that is socially preferred, or the choice on an individual’s budget constraint that is personally preferred, will display allocative efficiency.

The basic budget constraint/production possibilities frontier diagram will recur throughout this book. Some examples include using these tradeoff diagrams to analyze trade, labor supply versus leisure, saving versus consumption, environmental protection and economic output, equality of incomes and economic output, and the macroeconomic tradeoff between consumption and investment. Do not be confused by the different labels. The budget constraint/production possibilities frontier diagram is always just a tool for thinking carefully about scarcity, tradeoffs, and efficiency in a particular situation.

Two graphs will occur frequently throughout the text. They represent the possible outcomes of constraints/production of goods. The graph on the left has “Good 2” along the y-axis and “Good 1” along the x-axis. The graph on the right has “Good 1” along the y-axis and “Good 2” along the x-axis.
Figure 1. The Tradeoff Diagram. Both the individual opportunity set (or budget constraint) and the social production possibilities frontier show the constraints under which individual consumers and society as a whole operate. Both diagrams show the tradeoff in choosing more of one good at the cost of less of the other.

Third, self-interested behavior can lead to positive social results. For example, when people work hard to make a living, they create economic output. Consumers who are looking for the best deals will encourage businesses to offer goods and services that meet their needs. Adam Smith, writing in The Wealth of Nations, christened this property the invisible hand. In describing how consumers and producers interact in a market economy, Smith wrote:

Every individual…generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain. And he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention…By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.

The metaphor of the invisible hand suggests the remarkable possibility that broader social good can emerge from selfish individual actions.

Fourth, even people who focus on their own self-interest in the economic part of their life often set aside their own narrow self-interest in other parts of life. For example, you might focus on your own self-interest when asking your employer for a raise or negotiating to buy a car. But then you might turn around and focus on other people when you volunteer to read stories at the local library, help a friend move to a new apartment, or donate money to a charity. Self-interest is a reasonable starting point for analyzing many economic decisions, without needing to imply that people never do anything that is not in their own immediate self-interest.

Choices … To What Degree?

What have we learned? We know that scarcity impacts all the choices we make. So, an economist might argue that people do not go on to get bachelor’s degrees or master’s degrees because they do not have the resources to make those choices or because their incomes are too low and/or the price of these degrees is too high. A bachelor’s degree or a master’s degree may not be available in their opportunity set.

The price of these degrees may be too high not only because the actual price, college tuition (and perhaps room and board), is too high. An economist might also say that for many people, the full opportunity cost of a bachelor’s degree or a master’s degree is too high. For these people, they are unwilling or unable to make the tradeoff of giving up years of working, and earning an income, to earn a degree.

Finally, the statistics introduced at the start of the chapter reveal information about intertemporal choices. An economist might say that people choose not to get a college degree because they may have to borrow money to go to college, and the interest they have to pay on that loan in the future will affect their decisions today. Also, it could be that some people have a preference for current consumption over future consumption, so they choose to work now at a lower salary and consume now, rather than putting that consumption off until after they graduate college.

Key Concepts and Summary

The economic way of thinking provides a useful approach to understanding human behavior. Economists make the careful distinction between positive statements, which describe the world as it is, and normative statements, which describe how the world should be. Even when economics analyzes the gains and losses from various events or policies, and thus draws normative conclusions about how the world should be, the analysis of economics is rooted in a positive analysis of how people, firms, and governments actually behave, not how they should behave.

Self-Check Questions

  1. Individuals may not act in the rational, calculating way described by the economic model of decision making, measuring utility and costs at the margin, but can you make a case that they behave approximately that way?
  2. Would an op-ed piece in a newspaper urging the adoption of a particular economic policy be considered a positive or normative statement?
  3. Would a research study on the effects of soft drink consumption on children’s cognitive development be considered a positive or normative statement?

Review Questions

  1. What is the difference between a positive and a normative statement?
  2. Is the economic model of decision-making intended as a literal description of how individuals, firms, and the governments actually make decisions?
  3. What are four responses to the claim that people should not behave in the way described in this chapter?

Critical Thinking Questions

  1. What assumptions about the economy must be true for the invisible hand to work? To what extent are those assumptions valid in the real world?
  2. Do economists have any particular expertise at making normative arguments? In other words, they have expertise at making positive statements (i.e., what will happen) about some economic policy, for example, but do they have special expertise to judge whether or not the policy should be undertaken?

References

Smith, Adam. “Of Restraints upon the Importation from Foreign Countries.” In The Wealth of Nations. London: Methuen & Co., 1904, first pub 1776), I.V. 2.9.

Smith, Adam. “Of the Propriety of Action.” In The Theory of Moral Sentiments. London: A. Millar, 1759, 1.

Glossary

invisible hand
idea that self-interested behavior by individuals can lead to positive social outcomes
normative statement
statement which describes how the world should be
positive statement
statement which describes the world as it is

Solutions

Answers to Self-Check Questions

  1. When individuals compare cost per unit in the grocery store, or characteristics of one product versus another, they are behaving approximately like the model describes.
  2. Since an op-ed makes a case for what should be, it is considered normative.
  3. Assuming that the study is not taking an explicit position about whether soft drink consumption is good or bad, but just reporting the science, it would be considered positive.

Chapter 3: Defining Economics: A Pluralistic Approach

III

Defining Economics: A Pluralistic Approach

Defining Economics: A Pluralistic Approach

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Chapter Objectives

In this chapter, you will learn about:

  • Multiple Definitions of Economics
  • Diversity of Paradigms in Economics
  • A Critical Examination of the Orthodox (Neoclassical) Definition of Economics
  • The Presentation of an Alternative Definition

 

3.1 The Importance of Definitions

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Learning Objectives

By the end of this section, you will be able to:

  • Discuss how definitions provide theoretical direction.

 

The presentation of an alternative definition may appear generic, even unimportant.  A definition often washes over a reader, leaving the reader influenced, but without any obvious new insight as to the intended meaning or implications of a word.   Worse, without proper guidance, a reader may interpret a definition differently than what is intended by the author, or in the case of economics, different from how the discipline is actually employing the definition.  Definitions are, however, important, potentially very important.  A definition has the potential to provide clarity.  At their best, definitions act like a compass, providing a lost reader with several potential directions from which to proceed.

3.2 Multiple Perspectives Require Multiple Definitions

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Learning Objectives

By the end of this section, you will be able to:

  • Define the term paradigm.

The importance of clarity and directionality becomes heightened when a discipline has more than one potential definition.  The discipline of economics, similar to the other social sciences, does not ascribe to only one definition.  The definition of economics that is utilized by an economist will often depend on the paradigmatic perspective of the economist.

Paradigm – A school of thought.  It represents the boundary of a discipline, framing the types of questions and phenomena that will be analyzed, and the approach or method of study a theorist will employ.

The discipline of economics has more than one paradigm.  Not surprisingly, the discipline of economics also has more than one definition.

3.3 A Brief Synopsis of Different Economic Perspectives

13

Learning Objectives

By the end of this section, you will be able to:

  • Define the term ideology.
  • Describe the relationship between ideology and paradigms
  • Identify some of the differences between competing economic paradigms.

Multiple theoretical perspectives tend to create multiple ideas as to what economic questions, phenomena, and methods are most appropriate.  With paradigmatic differences come ideological differences.

Ideology – The ideas, beliefs, subjective values, and prevailing world views that a person holds.  One’s ideology influences the way in which a person perceives what they believe is correct or incorrect about their social circumstance or the larger world in which they live.

Broadly speaking, the discipline of economics is occupied by theorists who tend to fall within one of three categories.

  1. Conservative economists
  2. Progressive economists
  3. Radical economists

In terms of beliefs, while there is some crossover, the differences between each of the ideological perspectives tends to be overwhelming.

Conservative Economists Believe…

 Progressive Economists Believe…

 Radical Economists Believe…

 

Competing Paradigmatic Views

 How might different economists address Different Microeconomic Issues?

  1. Consider the issue of Negative Externalities – When a third party suffers a loss from the actions of othersFor example, consider the massive social costs associated with carbon emissions and climate change.
  • Conservative Economists: Argue that the solution to market failure associated with externalities is to assign property rights. If the party causing or impacted by the externality has property rights, then markets and accurate prices emerge.
  • Progressive Economists: Argue that the government is needed to assist in correcting for externalities. Taxes and/or regulations can be instituted that require producers of externalities to account for the social costs they have generated.
  • Radical Economists: Argue that externalities are pervasive in market economies.   Assigning property rights encourages producers of externalities to produce more negative externalities in an effort to extort payments from those afflicted.  Also it is impossible to tax and/or regulate all externalities.  An alternative to the market, as an allocative institution, is needed.

 

How might different economists address structural issues in economics?

  1. Consider the issue of Preferred Economic Institutional Structure(s),
  • Conservative Economists: Argue that the free market is the ideal institution for allocating resources to their best (socially optimal) outcomes. Advocate that government should be limited to institutions useful toward the defense of private property and the enforcement of economic contracts.
  • Progressive Economists: Argue that as a result of market failure such as environmental pollution and significant unemployment, institutions, typically government institutions, are necessary in order to correct market failure and return markets to a more efficient allocation of resources.
  • Radical Economists: Argue that government institutions are an incomplete and ineffective mechanism for addressing market failure. Advocate for the creation of alternative institutions, such as worker cooperatives, that are designed to challenge and potentially supplant institutions favorable to the current operation of the economic system.

 

How might different economists address economic development issues?

  1. Consider the issue of Income Inequality,
  • Conservative Economists: Argue that income inequality arises from productivity differences that emerge between and among individuals.  Efforts to reduce inequality should be avoided as they distort incentives and market allocation.
  • Progressive Economists: Argue that income inequality results from social circumstances.  Children born into higher income (higher wealth) families have more opportunities available to garner both the resources and skills necessary for higher incomes.  Hence, these economists favor government programs that promote equality of opportunity.
  • Radical Economists: Argue that income inequality is a byproduct of a class-based economic system.  Also inequality is exacerbated by social circumstances.  Generally, they would support government programs that promote equality of opportunity, however, also argue that those programs cannot eliminate inequality in a system built upon inequality.

 

How might different economists address world economic issues?

  1. Consider the issue of Global Poverty,
  • Conservative Economists: Argue that free trade between nations will drive specialization and the expansion of material production, thus gradually reducing global poverty.
  • Progressive Economists: Argue for a degree of government intervention in international trade. Suggest trade via such policies as infant industry, fair labor standards, and environmental protections. Trade is an economic development tool.
  • Radical Economists: Argue that international trade worsens class tensions. Low wages in developing countries cause wages to decline in developed countries.  Poverty is a part of capitalism, free trade and/or managed trade cannot end global poverty.

 

3.4 Deconstructing the Orthodox Definition of Economics

14

Learning Objectives

By the end of this section, you will be able to:

  • Discuss the orthodox definition of economics.
  • Understand the organization of the orthodox definition of economics.
  • Describe the paradigmatic direction of orthodox economics.

Sometimes, in order to better understand how something works it is useful to break apart, or deconstruct (de-engineer), the object of examination.  During periods of war, oppositional armies are known to commandeer their opponent’s weaponry in order to de-engineer, or deconstruct, the equipment.   The United States Army Air Forces Operation LUSTY (Luftwaffe Secret Technology) sought to capture German technology both during and after World War Two. By taking apart a piece of equipment piece by piece the examiner gains insight into both how the equipment operates as well as its weaknesses.  In times of war, stealing good ideas and developing better ways to destroy an opponent’s weapons can be invaluable.  The object of deconstruction does not have to be physical or mechanical for the process to be useful; deconstructing an idea is also a valuable process for enriching understanding.  Regarding the orthodox definition of economics, as it is the object of both examination and critique, this same type of deconstruction will also be useful.

In the first chapter of this text an example of the orthodox definition of economics was provided to the reader.  The definition provided, similar to variations on the orthodox definition of economics in most textbooks, owes its origins to a famous early 20th century economist, Lionel Robbins.  Robbins famously defined economics as, “the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.”  Contemporary orthodox economic textbooks tend to utilize a generic variation on Robbins’ definition, often stipulating something akin to “Economics is the study of the allocation of limited resources over unlimited wants.”  In order to examine the appropriateness, or lack thereof, of the orthodox definition of economics, a closer examination of the definition is necessary.

One approach toward deconstructing the orthodox definition of economics is to define, specifically within the context of the orthodox economic meaning of the words, the other terms within the definition.  Given the organization of the orthodox definition, with wants being conditioned by the availability of resources, one possible starting point for deconstruction is the orthodox definition of the term resources.

As should be noted from chapter two of this text, the orthodox economic definition of resources emphasizes that resources are those things that are needed for production.  While other resources may be relevant, orthodox economics nearly exclusively focuses on Land,Labor, andCapital as the essential resources necessary for production.  When more resources are present, more production is possible and when fewer resources are present, less production is possible.  Obviously, if resources are unlimited, then production would be unlimited and all wants, and presumably needs, could be met.  Of course, as noted by the definition, resources are assumed to be limited, otherwise referred to as scarce.

The terms “limited” or “scarce” are fairly self-explanatory.  By definition, if something is scarce or limited, then there is only so much of the thing in question.  In this case, orthodox economists are assuming that Land, Labor, and Capital are in some way constrained.  In many ways this is a sensible assumption as the planet we reside upon has only so much available land, human population, albeit significant, is limited to 7.4 billion people, and capital, consisting of tools and equipment, are limited because only so many machines are available at any one time. Given limited or scarce resources, the ability for wants to be met must be limited.

Limits to wants are an important consideration.  Given the orthodox definition of economics, the term wants could, presumably, represent any and all things people could want.  However, because wants are deemed to be conditioned by resources and what resources are capable of producing, it stands to reason that what orthodox economics means by its use of the term “wants” are those things that are produced by resources.  Since resources are factors of production, land, labor, and capital, then “wants” must be those things that are produced by land, labor, and capital—essentially products (goods and services).

But why do people want products?  According to orthodox economics people want products because people garner satisfaction or utility (happiness) from their consumption of products.  Given that wants are considered to be unlimited, which is to say endless or infinite, then, by logical continuation, people must have an endless desire for utility or happiness.  Importantly, considering that wants must be the byproduct of the products produced by resources, orthodox economics is arguing that people have an endless desire for happiness and that happiness is derived, apparently exclusively, from the products that people acquire.  Additionally, consistent with the circular logic of orthodox economics, if human beings have unlimited wants, then resources must be scarce.  All wants can never be met, rendering resources on a finite planet scarce, if wants are endless.

In summary, given the above set of definitions the following if-then statement provides a summary of the belief of orthodox economists. If wants are unlimited and resources are used to produce the things that people want, those things being products for consumption, then economists assume people have an insatiable desire to acquire products (aka. inherently greedy).  Additionally, if, presumably, products bring happiness and people have an endless desire for products, then it must be that people have an endless desire to be happy.

3.5 A Critical Examination of the Orthodox Definition of Economics and its Resultant Impacts

15

Learning Objectives

By the end of this section, you will be able to:

  • Discuss critiques of the orthodox definition of economics.
  • Understand the differences between facts and beliefs.
  • Describe the differences between needs and wants.
  • Understand the interconnection between facts and values.
  • Compare the differences between scarcity and surplus.
  • Compare the differences between and individual and social approach to economics.
  • Identify the relationship between unlimited wants and environmental degradation.

Chapter one presented the orthodox case for utilizing the limited resource, unlimited want definition.  For economists outside of the orthodox paradigm, however, the orthodox story contains troubling elements.  While potentially insightful in certain instances, the orthodox definition is also potentially misleading in terms of clarifying what it is that is actually happening in the economy.  What follows are, from a heterodox (alternative) economic perspective, four critiques of the orthodox definition of economics and its implications.

Are Unlimited Wants (and therefore Scarce Resources) a Fact of Life or a Belief?

A fact is something immutable, it just is, whereas a belief is something that a person or people think, whether there is evidence to support their contention or not.  An atheist or a theist cannot prove their beliefs, God may or may not exist, but there is no way to empirically prove either view.  Atheism and theism are beliefs, not facts.  In terms of belief-based versus fact-based analyses in the realm of economics, noted 20th century political economist Karl Polanyi criticized the orthodox (neoclassical) scarcity story as scarcity assumed within the mind of the orthodox economist. In other words, scarcity is a belief of the orthodox economist, not a fact.

Outside of orthodox economics, such as within heterodox (alternative) economic circles as well as the other social science disciplines, the issue of scarcity as induced by unlimited wants has been extensively evaluated and re-evaluated.  For many theorists, the concept of unlimited/endless want of material items is simply not an immutable fact present in all times and places among all human beings.  Among anthropologists, for example, there is a rich history of ethnographic studies documenting ways in which small-scale, non-market oriented economies appear to behave differently than orthodox economists predict.  One such anthropologist, Marshall Sahlins, explicitly notes that people residing in hunter-gatherer societies, while viewed as deeply impoverished by the standards of people residing in advanced industrial economies, are actually quite affluent because “all the people’s wants are easily satisfied.”  For Sahlins and other anthropologists, the hunter-gatherer’s affluence is not one of vast material abundance, but rather a happiness shaped by being contented with having basic needs and wants met.  By having little and demanding little, a successful hunt can yield great want satisfaction.

Borrowing from psychology, there is also a sub-discipline of economics known as Happiness Economics.  Utilizing survey data, theorists pursuing the study of happiness have repeatedly found that people that focus on the goals of monetary gain and material benefits tend to be less happy than people who are less focused or not focused on those goals.  It seems that for every endless maximizer of products, there are many more people that are apt to be content and satisfied with far fewer material items, particularly if fewer material items mean a greater level of interpersonal satisfaction like love, the respect of peers, affection, family fulfillment, and relationship fulfillment.  Apparently, these and other equally non-material but important psychological factors are more important to the pursuit of happiness than is monetary wealth.

Can Facts and Values Really be Separated?

Utilizing beliefs, ideas, or subjective values is not, however, an unacceptable practice for most social scientists.  Orthodox economics insists that facts and values are to remain separate, otherwise known as positive economics.  The orthodox fact/value dichotomy is, however, misleading.  Nearly all theorists apply some sort of pre-analytical value to their analysis.  The very use of assumptions implies that some kind of value-based decision making process was utilized by the theorist.  The irony in this instance is that orthodox economics insists that it is a fact-based science when, in fact, it utilizes value based (normative) propositions.

Within their very definition, orthodox economists employ subjective values, such as the desire to maximize acquisition (an assumption, or belief, not a fact), to frame their vision of the discipline of economics.  Once again, the use of subjective values on their own is not the problem or even a problem (contrary to the orthodox perspective that economics should be a positive science), but it becomes a problem when a definition states something as “is” as opposed to “believed.”  Compare the following phrases, “the study of economics is” and “one belief is that economics studies.”  The first phrase leads the reader to believe that economists deal in absolute facts while the second phrase implies that some economists may have settled on an accepted set of ideas, but those ideas remain up for debate.  An honest presentation of the orthodox definition of economics would note its subjective, normative, non-positive nature.

Scarcity or Surplus?

There is another fundamental question that Polanyi’s critique alludes to: does scarcity as perceived by the mind actually mean that there is a scarcity of resources?  For Polanyi, the orthodox definition of economics is circular, it has neither a beginning nor an end, just continuous scarcity because of limitless want.  After all, if human beings have unlimited wants, then resources have to be scarce, there is simply no way for all wants to be met if wants are endless.  Close inspection of the orthodox definition of economics makes it clear that the picture of the homeless man on the bench presented in chapter one is not actually a result of scarcity, at least not as scarcity is defined within the orthodox tradition.

Again, recall that the orthodox definition of economics describes scarcity as resulting from endless “want.”  Endless want does not mean that there are not enough resources available to fulfill all of humanities basic needs.  Nor does endless “want” mean that many wants cannot be met given available resources.  Obviously the man on the park bench may have some very legitimate wants (certainly needs, like adequate shelter), but is he on the bench because there are not enough resources available to make sure his basic needs, such as a home, or other wants, are met?  At least in terms of available housing, the answer to this question is an overwhelming no.   According to the U.S. Department of Housing and Urban Development on any given night in January of 2015, 564,708 people were homeless.  At the same time, the number of vacant residential properties in the United States numbered approximately 1.4 million.

The homeless man’s lack of housing is not the byproduct of scarcity, at least not by the definition of scarcity that many people are accustomed.  Rather, the homeless man on the bench is the byproduct of either misallocated resources or a maldistribution of production.

Homelessness (or house-less-ness) is not the only instance in which the orthodox economic scarcity story breaks down.  There are other well documented instances.  One particularly disturbing instance relates to malnourishment and general starvation.  According to the World Hunger Education Service (WHES) around the world there is enough food produced on an annualized basis to ensure that every person is adequately nourished.  In fact, the sheer amount of calories per person generated by global food production has risen since the early 1960s through the mid-2000s, with the amount of per capita calories produced being enough to adequately feed an adult in both developed and developing economies.  At the same time, “The United Nations Food and Agriculture Organization estimates that about 795 million people of the 7.3 billion people in the world, or one in nine, were suffering from chronic undernourishment in 2014-2016.”

http://www.fao.org/3/a-i4674e.pdf

Again, this instance of basic needs not being met may be perceived as a situation of scarcity.  However, as reported by the WHES, poverty is the overwhelming driver of global malnourishment.  While poverty implies a scarcity of income, possibly due to a scarcity of employment possibilities, the actual product that resolves malnourishment, food is produced in enough abundance to adequately feed everyone.  Once again, basic human needs are going unmet and this has nothing at all to do with the scarcity of resources.

An interesting outcome of reorienting the definition of economics away from the scarcity story, when evaluated on what is actually available, is not that resources are endless or that all wants can necessarily be met, but that it is apparent that there are often more than enough resources to meet all of humanity’s material needs as well as many, many, many of humanities wants.  Reoriented this way the story of economics becomes a story of surplus and abundance, rather than shortfall and hardship.  A much less dismal, and likely more realistic, science indeed!

 Needs versus Wants

A distinction must be made between needs and wants, as they are decidedly not the same.

Need – Reflects something that is necessary for a human being to sustain basic physical and psychological health. 

One fairly well known measure defining needs is Maslow’s hierarchy of needs.  In Maslow’s hierarchy basic physiological needs, like food, water, air, shelter, safety, must be met first, followed by psychological needs, such as love and affection, with self-actualizing needs being met last.  Importantly, while Maslow’s hierarchy provides a framework, it must also be understood that the concept of need evolves depending on the social circumstances and technological make up of a given economy.  In the absence of basic physiological needs being met, a person’s life will suffer to the degree that in many instances their life may be shortened.  For example, homeless people have shorter life spans, 42 to 52 years, than non-homeless people, 78 years.

A want is different from a need.

Want – is something that is desired, but also not necessary for an individual to live and function in a society.

For example, while basic shelter with appropriate utilities such as gas, electric, water, sanitation, and basic cooking, cleaning, and food storage appliances will generally fulfill basic needs, additional products such as dishwashers, large screen televisions, hot tubs, and many, many other products are wants.

To further distinguish between needs and wants, consider the following example.  In some communities the existing transportation infrastructure is nearly completely and exclusively automobile dependent.  In order for a person to have a reasonable expectation of functioning, physically, socially, and economically in this socioeconomic environment, a person will need access to an automobile.  In this case, a functional automobile is, in fact, a need, but a high end SUV is not a need, it is a want.

Based on the orthodox definition of economics it is clear that the orthodoxy is interested in wants rather than needs.  The absence of needs from the orthodox definition is a curiosity.  There are several possible reasons why needs are not explicitly referenced in the orthodox definition.  Two possible reasons will be addressed here.  First, it is possible that orthodox economists do not differentiate between needs and wants, thus all needs really are just wants.  Second, orthodox economists may be assuming that needs are already being met.  If basic needs are met, then it is not only possible but reasonable to study what people want.

In critique, the orthodox merger of needs and wants seems to produce potentially misleading insights.  While one can certainly make the argument that all people want their needs to be met, such that a need is nothing more than a type of want, basic needs must be met or the study of additional wants becomes useless as there can be no other wants.  Additionally, even if it is assumed that needs are being met, this does not actually mean that needs are being met in the world where people really live.  If needs are not being met, can orthodox economics be trusted to study the situation and then prescribe a solution that might ease human suffering?  The answer to this question is unclear as the orthodox definition of economics does not provide direction toward the study of needs.

 

INDIVIDUAL PERSPECTIVE OR SOCIAL PERSPECTIVE?

As a discipline, economics is categorized as a social science.  The social sciences, in general, seek to develop understandings about human interactions on a social level.  For example, an anthropologist may be interested in understanding the role of culture as it influences human behavior.  Culture can be represented as social norms, rituals, and/or customs that different groups of people, mostly collectively, participate in performing.  Another example of a social science is political science.  A political scientist may be interested in examining political institutions and legal structures.  In order to better understand why individuals or larger social groups of people exhibit certain behaviors, an understanding of how a society structures its laws, the rewards or penalties people encounter as a result of socially derived rules, is essential.

For the orthodox economist, however, the social element of economics is secondary to that of the individual.  Again, the orthodox definition of economics gives the orthodox economist direction.  Recall, the focus of the orthodox economist is on want fulfillment with wants being satisfied by goods and services produced by resources.  The reason products are wanted is because products, presumably, provide the recipient with happiness, or utility.  Since people are presumed to have endless wants, people are also presumed to have an endless desire for utility.  In many ways orthodox economics is really just the study of the maximization of utility.  But how is utility measured?  Well, it’s not.  Utility is subjective, it is in the eye of the beholder.  As such, the study of utility maximization is the study of individual choices.  After all, the only way to know what makes a person happy, or bringing the most utility is to evaluate the consumption choices that people make.  As such, the focus of orthodox economics is that of individual choice making.

For some in the orthodox economic community, the focus on the individual is a conscious choice, purposeful and known, and often times affectionately referred to as “methodological individualism.”  A methodology is an approach for addressing concerns that a discipline believes are essential.  Methodological individualism is a method anchored to examining the individual, placing front and center the issue most essential to that of the orthodox economist: individual decision-making.  But if the individual is of utmost importance, then the role of social is much less clear within orthodox economics.  This is not to say that the larger society is ignored by orthodox economists.  For orthodox economics the social does emerge but, consistent with their dedication to studying individual choice, it is as a byproduct of individual maximizing behavior.  Once individuals pursue their own self-interest, the orthodox economist is tasked with simply summing or aggregating the individual behavior and the result is the larger social outcome.

For those outside of the orthodox economic tradition, many important considerations are seemingly lost by the direction of orthodox economic analysis.  Take for example the question of how broader societal norms as a function of social institutions may have influenced the behavior of individuals.  By assuming away the social and focusing exclusively on the individual, the orthodox economist will be apt to ignore such issues as how social institutions may have influenced individual behavior such that it is now not prone to maximizing individual acquisition.  In other words, let’s say people really don’t just look out for themselves all of the time, seeking to acquire as many products for themselves as they can, but instead, people behave such that they are concerned for the well-being of others, maybe because the norms of their society encourage a less than self-centered set of behaviors.  Non-acquisitive, non-self-interested individual behavior tends to be outside of the scope of orthodox economics, but it is not outside the scope of actual human economic interactions.  For many non-orthodox economists, the absence of a clear social perspective limits the understandings available to the practitioner of methodological individualism.

 

  1. UTILITY AS EVERYTHING, UTILITY AS NOTHING

Some orthodox economists have objected to the idea that they are assuming that people are greedy, only wanting products or those things that can get products, namely resources or money as money is what is used to perform purchases.  One orthodox economic argument that has emerged claims that the orthodox economic model can be extended to include the story of “enlightened self-interest.”  Enlightened self-interest is the idea that it can be in one’s self-interest to act to benefit others.  In some regards enlightened self-interest can be interpreted as someone serving society such that through their service society is better-off and, subsequently, as a member of society, the individual then benefits.

A common example of enlightened self-interest is charitable giving.  Charitable giving is the opposite of individual acquisition as the person giving to charity is presumably giving away something of personal value for themselves so that someone else can benefit.  Orthodox economists argue that the reason a person engages in charity, or another type of enlightened self-interest, is because they gain utility from knowing that they have done something that is perceived as “good” for society.

There are two problems that become evident when the orthodox enlightened self-interest argument is compared to the orthodox definition of economics.  First, enlightened self-interest is inconsistent with the basic premise described by the orthodox definition of economics.  To once again reiterate, the orthodox definition of economics is stipulating that people’s unlimited wants are fulfilled by resources and resources are utilized to produce products, thus want fulfillment is synonymous with product acquisition.  Returning to the charitable giving example, it is clear that charitable giving is not product acquisition but rather product dissipation.  Thus orthodox economics cannot, without contradicting itself, apply its definition of economics to a story of enlightened self-interest.  Another definition of economics would be necessary to account for human behavioral actions associated with what is perceived as enlightened self-interest, or really any human action that is not associated with the acquisition of products.

Some thoughtful orthodox economists have recognized the contradiction between their definition of economics and the idea of enlightened self-interest.  As a result, some orthodox economists have re-cast their position arguing that utility can be derived from anything, not just material products.  In other words, for the orthodox economist all human actions and behaviors are driven around utility maximization and thus the study of economics is really the study of utility maximization.  When re-cast in this light, however, the second problem appears.  If all actions provide a person with utility, and all people are utility maximizers, then any action can be said to be utility maximizing, otherwise the person would not engage in the action.  Based on this construction, the orthodox economist would be reduced to observing what people do and then proclaiming that it must be in their best interest.  As a critical thinking exercise an important question now emerges: when exactly does orthodox economics become a social science?  Saying that people do as they do because otherwise they wouldn’t do it does not represent science, it has very little empirical function. It is also not focused on the social as it does not account for any social factors that may influence or disrupt individual behavior. And it provides almost no predictive possibilities other than identifying what might happen in the future based on what has happened in the past.  Once again, confronted with such limitations many economists suggest that another definition of economics may be more substantive and useful.

 

Breakout Box – What About Behavioral Economics?

Because people frequently engage in behaviors that are not considered rational, that is to say individually acquisitive, orthodox economics has been targeted for criticism that their models do not accurately depict the real world.  In response a sub-field of orthodox economics, behavioral economics, has developed that seeks to utilize experiments and psychology to better understand actual human behavior.  Behavioral economics tends to start from the position that otherwise-rational, optimizing people will deviate from standard orthodox economic actions because people can be influenced by non-economic factors, such as religious beliefs or cultural norms

 

A common approach to identifying the factors that condition individual choice-making is to run experiments that test human response to incentives.  A controlled experiment provides researchers with empirical, data-driven evidence as to how and why people may not respond to opportunities for individual gain in the ways that orthodox economics predicts.

 

For many outside of orthodox economics, the development of behavioral economics is a step in right direction for the larger science of economics.  Having evidence and being able to explain a wider range of phenomena rather than simply stipulating that people do as they do otherwise they wouldn’t do it, appears to move the discipline of economics toward more realistic insights.  At the same time, critiques of orthodox economics are also apt to note that behavioral economics still does not go far enough with its approach.  Behavioral economics emphasizes an analysis that begins with the standard orthodox isolated maximizing individual and then searches for deviations from this behavior.  By the very nature of their focus, behavioral economics under-emphasizes social considerations.  As such, data may be derived that draws out the idea that an individual is making choices that are influenced by social institutions, but absent the study of those social institutions, the theorist is possibly still in the dark as to why the social institutions elicit the response that they do on the part of the individual.  The result is that behavioral economics broadens the scope of economic inquiry but, for those outside of orthodox economics, it is still too narrow of an approach.

 

LIMITLESS VERSUS LIMITS: THE IMPLICATIONS FOR THE HEALTH OF THE PLANETARY ENVIRONMENT

 The final critique presented here may be the most important in terms of its implications for the future of humanity.  The Earth is a finite biosphere.  There is simply only so much atmosphere, land, water, minerals, ores, and other natural resources within the bounds of the planet.  In this way, the Earth really is representative of a circumstance of scarcity.  Certainly improved efficiency is capable of extending the productive capability of the available natural resources, but this does not change the fact that there is a limit to how much is actually available.

Regardless, for many orthodox economists, the principle of endless growth is unquestionably desirable and it is downright sacrilegious to doubt the merits of endless economic growth.  Consider the orthodox definition of economics and its emphasis on the desirability of endless happiness and that happiness being derived from the endless consumption of products.  Given the premise of unlimited wants, the need for endless production is obvious and, by continuation, endless production is a synonym for endless, exponential, economic growth.  In the simplest sense, more products produced means that the material well-being of society is improved.  For orthodox economists, the improved material well-being of society cannot be understated.  For example, it is not uncommon for orthodox economists to argue that given enough growth, social maladies such as poverty can be alleviated and, in time, eliminated.  Of course, the orthodox economic perspective leaves aside incredibly important considerations such as whether or not new material products are equitably distributed.  But, as orthodox economists would note, an unequal distribution of products is a separate problem from inadequate production and overt want, so the existence of inequality does not undermine the importance of economic growth.

The issue of endless growth in a finite biosphere presents orthodox economics with interesting conundrums.  If resources are finite, how is endless growth possible?  Again, orthodox economics does provide an answer in form of the advancement of knowledge and technology that allow for improvements in productivity and efficiencies creating opportunities for endless growth.  But what if endless growth then yields waste that pollutes the natural environment making human life on the planet ever more difficult to sustain?  The answer to this question is more difficult and the failure to answer is more perilous.  Even if knowledge and technological advancement can improve productive efficiencies, absent the elimination of waste, exponential economic growth will add waste to the land, sea, and air.  Just as lily pads can overrun a pond, with exponential economic growth and its associated waste, the effluent byproducts of industrial production can inundate and overwhelm a finite biosphere.

The mass annihilation of the Plain’s Bison in the 19th century is a grave depiction of the ability of humanity to inflict harm upon the natural environment.

Photograph from the mid-1870s of a pile of American bison skulls waiting to be ground for fertilizer
Figure 1. A large pile of bison skulls c. 1870s. (Wikimedia, Public Domain)

 

A photo of a section of forest in Sourther Mexico that has been cleared for agriculture.
Figure 2. Endless economic growth necessitates endless production. At the expense of rich, biodiverse, rainforest human beings burn and clear cut the forest in order expand agricultural capacity. (Credit: Jami Dwyer, Wikimedia, Public Domain)

 

It is clear that human economic activity nearly inevitably leads to the creation of waste byproducts, pollution.  Not only is the Earth’s biosphere limited in terms of what it can provide in the way of natural resources toward productive output, it is also limited in terms of how much waste it is capable of absorbing on land, in the sea, and in the air.  For example, the Stockholm Resilience Centre has identified nine planetary boundaries (environmental thresholds) that must not be eclipsed if human life is to safely exist.  The nine planetary boundaries are stratospheric ozone depletion, biodiversity loss, chemical pollution, climate change, ocean acidification, freshwater consumption, land system change, nitrogen and phosphorous flows to the biosphere and oceans, and atmospheric aerosol loading.  Of these nine boundaries, three in particular, climate change, ocean acidification, and stratospheric ozone depletion, are of such consequence that if the threshold is surpassed, then the planet’s basic ecology will likely be fundamentally destabilized.  In the case of climate change and ocean acidification, the two issues are caused by human economic activity and are inherently interrelated.  Climate change is caused by carbon dioxide emissions and ocean acidification is triggered when the oceans absorb and process carbon dioxide.  Strikingly, at least in the case of climate change, the proposed boundary for atmospheric carbon dioxide has been surpassed as 350 parts per million (ppm) is the boundary while actual carbon dioxide levels now exceed 400 ppm.  Clearly, human economic activity, and the associated environmental destruction of the Earth’s biosphere as a result of economic growth, does present a powerful challenge to the importance of economic growth.

Given the above-stated considerations, going forward humanity must consider the possibility of orienting its economic activity within the context of limits.  The direction of orthodox economics, as guided by its definition, is not, however, oriented toward accepting limits.  In the face of the abundance of scientific evidence pointing toward human factors as the cause of a de-stabilizing natural environment, the orthodox definition of economics appears to point economic analysis in a direction counter-productive to health and well-being of life on this planet.  As a result, it stands to reason that another definition of economics, one less rigid and one-dimensional, may be of use.

Environmental Resource Economics

Orthodox economics is not entirely oblivious to environmental concerns.  Nearly a century ago orthodox economic thinkers such as A. C. Pigou recognized the potential for a concept known as externalities.  Discussed in chapter 18: Environmental Protection and Negative Externalities, negative externalities represent the idea that sometimes economic activities create unaccounted for costs that impact third parties, or those people who are not directly involved in the economic activity.    Any failure to properly account for a negative externality means that the market system has failed to efficiently allocate resources.  For Pigou and orthodox economics, the solution to negative externalities is the development of institutional mechanisms that assign penalties to those that create negative externalities.

A common orthodox example of an institutional mechanism designed to address negative externalities is the government being granted the regulatory task of environmental protection.  From the standpoint of orthodox economics, pollution and environmental degradation represent a negative externality, an unaccounted for cost on the larger society.  As a regulator, the government can utilize any number of regulatory tools to try and mitigate pollution.  For example, one choice preferred by many, but not all, orthodox economists, is the use of taxation as a way to increase costs to polluters.  Overall, orthodox environmental resource economics places the environment as sub-ordinate to the economy, and argues that marginal analysis should be utilized to measure the economic costs and benefits of environmental changes.

As will be later illustrated in chapter 18: Environmental Protection and Negative Externalities, by invoking a tax on polluters in a market economy, costs to producers rise.  As costs rise the producer will produce less of the product the production of which is creating pollution.  Additionally, with less production of the product, the supply of the product will decline generating an increase in price of the product.  The outcome is three-fold.  First, with less production comes less pollution.  Second, with less production the product now sells at a higher price, with the price capturing more of the negative externality and reflecting something closer to the true cost of the product.  Third, the tax revenue generated from the tax has the potential to be used to compensate the victims of the negative externality.  On the face of it, it appears as though the taxation solution to an externality is providing a final outcome that is close to ideal.

Critics of the orthodox economic externality resolution argument have their doubts about the efficacy of the orthodox approach.  The following questions represent a small sample of possible concerns.  For starters, it is possible to conceive of an economy with a seemingly endless variety of negative externalities, does this mean that all externalities will be taxed?  Failure to properly tax negative externalities means that the economy is rife with inefficiencies.  Additionally, how large of a government bureaucratic structure would be needed to adequately address all externalities?  Might the solution be worse than the cure?  Also, even if all products to be taxed could be identified, how can a regulator be certain to precisely calculate the size of the tax in order to correct for the costs of the negative externality.

Of course, even if all of the questions above could be sorted out and resolved, there are still basic fundamental issues and contradictions, associated with the orthodox definition of economics, which the orthodox argument fails to address.  For example, all efforts to address negative environmental externalities call for the reduction of waste and some kind of constraint on economic activity and growth.  Any check on growth clearly and obviously runs afoul of the basic tenet of orthodox economics, as is clear in their definition, of endless want of products and the associated desirability to try and meet those wants.  Also, any reduction in production will also act to reduce consumption, presumably limiting consumers’ abilities to increase their utility by acquiring products.  The primary conclusion being that orthodox economics’ own solution for externalities runs counter to the foundations of their definition of economics.

Some critics of the standard orthodox environmental resource economics arguments, through their application and advocacy for ecological economics, have sought to re-orient the relationship between the economy and the environment.  Whereas orthodox economics views the natural environment as an external factor that may be impacted by economic activity, ecological economists place the economy in a sub-ordinate role to the natural environment.  Ecological economics generally tends to support the notion that the natural environment must be nurtured and protected, as, without it, an economy and human life cannot function.  As such ecological economics has a more cautious perspective regarding economic activity and how it impacts the natural environment.  As a result, standard orthodox economic concepts such as endless economic growth and want fulfillment are of secondary importance to long term sustained living made possible through the protection of the natural environment.  As such, ecological economics operates outside of the orthodox definition of economics.

Glossary

need

something that is necessary for a human being to sustain basic physical and psychological health

want

something that is desired, but also not necessary for an individual to live and function in a society

negative externalities

situations in which economic activities create unaccounted for costs that impact third parties, or those people who are not directly involved in the economic activity

ecological economics

a heterodox school of economic thought that situates the economy as a subordinate structure within the natural environment

3.6 An Alternative Approach to Defining Economics

16

Learning Objectives

By the end of this section, you will be able to:

  • Describe an alternative definition of economics.
  • Understand the basis for framing an alternative definition of economics.

The preceding presentation centered on deconstructing and then challenging the orthodox definition of economics.  Of central concern throughout is the way in which the orthodox definition of economics potentially handcuffs the economist into viewing economic activity through a very narrow and specific lens.  Given the problems associated with the orthodox definition of economics, a concerned student may be apt to ask, what does an alternative definition of economics look like?  The answer to this question is that there are many possible alternative definitional variations.

The structure of an alternative definition of economics can take many forms, although the overall essence of alternative definitions is frequently similar.  With regard to structure, some alternative definitions are apt to simplify economic activity to its most basic form.  For example, economics can be the study of how human beings must work together, and with nature, to produce those things that fulfill the material needs and wants of society.  In other instances alternative definitions of economics seek to reduce the definition to the essential characteristics of an economy.  For example, economics can be defined as the study of how human beings organize production, distribution, and consumption.  Still in other instances alternative definitions of economics focus on interdisciplinary facets of the structure of economic decision making.  For instance, economics can be defined as the study of how cultural norms, social institutions, political structures, and general decision making processes influence human behavior toward economic ends.

Importantly, each of the possible definitional structures stipulated above appear to avoid the pitfalls that plague the orthodox definition of economics.  First, none of the above alternative definitional possibilities assumes scarcity. Rather, each definition is open to the possibility of differing forms of economic organization and a diversity of ways to meet societal needs and wants.  Second, none of the above alternative definitional structures make unprovable assumptions about individual human behavior and motivation. Rather, the social elements of the organization of economic activity are emphasized, opening the door to analyzing how individuals respond to social conditions.  Third, none of the above alternative definitional structures predicates endless want and the need and desirability for endless economic growth. Rather, each is open to the possibility of alternative economic structures that can be coordinated to operate within the limits of the natural biosphere.

Going forward, within the context of the alternative perspectives developed within this textbook, and in addition to the above definitional structures, the following definition of economics is suggested.

Economics – Is the study of social provisioning, in which an understanding of the development of political economies is rooted in social, political, natural, and cultural processes.

 

Chapter 4. Demand and Supply

IV

Introduction to Demand and Supply

17

This is a photograph of various organic vegetables in baskets at a farmer's market.
Figure 1. Farmer’s Market. Organic vegetables and fruits that are grown and sold within a specific geographical region should, in theory, cost less than conventional produce because the transportation costs are less. That is not, however, usually the case. (Credit: modification of work by Natalie Maynor/Flickr Creative Commons)

Why Can We Not Get Enough of Organic?

Organic food is increasingly popular, not just in the United States, but worldwide. At one time, consumers had to go to specialty stores or farmer’s markets to find organic produce. Now it is available in most grocery stores. In short, organic is part of the mainstream.

Ever wonder why organic food costs more than conventional food? Why, say, does an organic Fuji apple cost $1.99 a pound, while its conventional counterpart costs $1.49 a pound? The same price relationship is true for just about every organic product on the market. If many organic foods are locally grown, would they not take less time to get to market and therefore be cheaper? What are the forces that keep those prices from coming down? Turns out those forces have a lot to do with this chapter’s topic: demand and supply.

Chapter Objectives

Introduction to Demand and Supply

In this chapter, you will learn about:

  • Demand, Supply, and Equilibrium in Markets for Goods and Services
  • Shifts in Demand and Supply for Goods and Services
  • Changes in Equilibrium Price and Quantity: The Four-Step Process
  • Price Ceilings and Price Floors

An auction bidder pays thousands of dollars for a dress Whitney Houston wore. A collector spends a small fortune for a few drawings by John Lennon. People usually react to purchases like these in two ways: their jaw drops because they think these are high prices to pay for such goods or they think these are rare, desirable items and the amount paid seems right.

Visit this website to read a list of bizarre items that have been purchased for their ties to celebrities. These examples represent an interesting facet of demand and supply.


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When economists talk about prices, they are less interested in making judgments than in gaining a practical understanding of what determines prices and why prices change. Consider a price most of us contend with weekly: that of a gallon of gas. Why was the average price of gasoline in the United States $3.71 per gallon in June 2014? Why did the price for gasoline fall sharply to $2.07 per gallon by January 2015? To explain these price movements, economists focus on the determinants of what gasoline buyers are willing to pay and what gasoline sellers are willing to accept.

As it turns out, the price of gasoline in June of any given year is nearly always higher than the price in January of that same year; over recent decades, gasoline prices in midsummer have averaged about 10 cents per gallon more than their midwinter low. The likely reason is that people drive more in the summer, and are also willing to pay more for gas, but that does not explain how steeply gas prices fell. Other factors were at work during those six months, such as increases in supply and decreases in the demand for crude oil.

This chapter introduces the economic model of demand and supply—one of the most powerful models in all of economics. The discussion here begins by examining how demand and supply determine the price and the quantity sold in markets for goods and services, and how changes in demand and supply lead to changes in prices and quantities.

4.1 Demand, Supply, and Equilibrium in Markets for Goods and Services

18

Learning Objectives

By the end of this section, you will be able to:

  • Explain demand, quantity demanded, and the law of demand
  • Identify a demand curve and a supply curve
  • Explain supply, quantity supply, and the law of supply
  • Explain equilibrium, equilibrium price, and equilibrium quantity

First let’s first focus on what economists mean by demand, what they mean by supply, and then how demand and supply interact in a market.

Demand for Goods and Services

Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is based on needs and wants—a consumer may be able to differentiate between a need and a want, but from an economist’s perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand.

What a buyer pays for a unit of the specific good or service is called price. The total number of units purchased at that price is called the quantity demanded. A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline goes up, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that affect demand (to be explained in the next module) are held constant.

An example from the market for gasoline can be shown in the form of a table or a graph. A table that shows the quantity demanded at each price, such as Table 1, is called a demand schedule. Price in this case is measured in dollars per gallon of gasoline. The quantity demanded is measured in millions of gallons over some time period (for example, per day or per year) and over some geographic area (like a state or a country). A demand curve shows the relationship between price and quantity demanded on a graph like Figure 1, with quantity on the horizontal axis and the price per gallon on the vertical axis. (Note that this is an exception to the normal rule in mathematics that the independent variable (x) goes on the horizontal axis and the dependent variable (y) goes on the vertical. Economics is not math.)

The demand schedule shown by Table 1 and the demand curve shown by the graph in Figure 1 are two ways of describing the same relationship between price and quantity demanded.

The graph shows a downward-sloping demand curve that represents the law of demand.
Figure 1. A Demand Curve for Gasoline. The demand schedule shows that as price rises, quantity demanded decreases, and vice versa. These points are then graphed, and the line connecting them is the demand curve (D). The downward slope of the demand curve again illustrates the law of demand—the inverse relationship between prices and quantity demanded.
Price (per gallon) Quantity Demanded (millions of gallons)
$1.00 800
$1.20 700
$1.40 600
$1.60 550
$1.80 500
$2.00 460
$2.20 420
Table 1. Price and Quantity Demanded of Gasoline

Demand curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. So demand curves embody the law of demand: As the price increases, the quantity demanded decreases, and conversely, as the price decreases, the quantity demanded increases.

Confused about these different types of demand? Read the next Clear It Up feature.

Is demand the same as quantity demanded?

In economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or a demand schedule. When economists talk about quantity demanded, they mean only a certain point on the demand curve, or one quantity on the demand schedule. In short, demand refers to the curve and quantity demanded refers to the (specific) point on the curve.

Supply of Goods and Services

When economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service. A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants where it can be refined into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply. The law of supply assumes that all other variables that affect supply (to be explained in the next module) are held constant.

Still unsure about the different types of supply? See the following Clear It Up feature.

Is supply the same as quantity supplied?

In economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices, a relationship that can be illustrated with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve and quantity supplied refers to the (specific) point on the curve.

Figure 2 illustrates the law of supply, again using the market for gasoline as an example. Like demand, supply can be illustrated using a table or a graph. A supply schedule is a table, like Table 2, that shows the quantity supplied at a range of different prices. Again, price is measured in dollars per gallon of gasoline and quantity supplied is measured in millions of gallons. A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. The supply schedule and the supply curve are just two different ways of showing the same information. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.

The graph shows an upward-sloping supply curve that represents the law of supply.
Figure 2. A Supply Curve for Gasoline. The supply schedule is the table that shows quantity supplied of gasoline at each price. As price rises, quantity supplied also increases, and vice versa. The supply curve (S) is created by graphing the points from the supply schedule and then connecting them. The upward slope of the supply curve illustrates the law of supply—that a higher price leads to a higher quantity supplied, and vice versa.
Price (per gallon) Quantity Supplied (millions of gallons)
$1.00 500
$1.20 550
$1.40 600
$1.60 640
$1.80 680
$2.00 700
$2.20 720
Table 2. Price and Supply of Gasoline

The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: they slope up from left to right and illustrate the law of supply: as the price rises, say, from $1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.

Equilibrium—Where Demand and Supply Intersect

Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market.

Figure 3 illustrates the interaction of demand and supply in the market for gasoline. The demand curve (D) is identical to Figure 1. The supply curve (S) is identical to Figure 2. Table 3 contains the same information in tabular form.

The graph shows the demand and supply for gasoline where the two curves intersect at the point of equilibrium.
Figure 3. Demand and Supply for Gasoline. The demand curve (D) and the supply curve (S) intersect at the equilibrium point E, with a price of $1.40 and a quantity of 600. The equilibrium is the only price where quantity demanded is equal to quantity supplied. At a price above equilibrium like $1.80, quantity supplied exceeds the quantity demanded, so there is excess supply. At a price below equilibrium such as $1.20, quantity demanded exceeds quantity supplied, so there is excess demand.
Price (per gallon) Quantity demanded (millions of gallons) Quantity supplied (millions of gallons)
$1.00 800 500
$1.20 700 550
$1.40 600 600
$1.60 550 640
$1.80 500 680
$2.00 460 700
$2.20 420 720
Table 3. Price, Quantity Demanded, and Quantity Supplied

Remember this: When two lines on a diagram cross, this intersection usually means something. The point where the supply curve (S) and the demand curve (D) cross, designated by point E in Figure 3, is called the equilibrium. The equilibrium price is the only price where the plans of consumers and the plans of producers agree—that is, where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). This common quantity is called the equilibrium quantity. At any other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium at that price.

In Figure 3, the equilibrium price is $1.40 per gallon of gasoline and the equilibrium quantity is 600 million gallons. If you had only the demand and supply schedules, and not the graph, you could find the equilibrium by looking for the price level on the tables where the quantity demanded and the quantity supplied are equal.

The word “equilibrium” means “balance.” If a market is at its equilibrium price and quantity, then it has no reason to move away from that point. However, if a market is not at equilibrium, then economic pressures arise to move the market toward the equilibrium price and the equilibrium quantity.

Imagine, for example, that the price of a gallon of gasoline was above the equilibrium price—that is, instead of $1.40 per gallon, the price is $1.80 per gallon. This above-equilibrium price is illustrated by the dashed horizontal line at the price of $1.80 in Figure 3. At this higher price, the quantity demanded drops from 600 to 500. This decline in quantity reflects how consumers react to the higher price by finding ways to use less gasoline.

Moreover, at this higher price of $1.80, the quantity of gasoline supplied rises from the 600 to 680, as the higher price makes it more profitable for gasoline producers to expand their output. Now, consider how quantity demanded and quantity supplied are related at this above-equilibrium price. Quantity demanded has fallen to 500 gallons, while quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price, the quantity supplied exceeds the quantity demanded. We call this an excess supply or a surplus.

With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are not receiving enough cash to pay their workers and to cover their expenses. In this situation, some producers and sellers will want to cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices, others will follow to avoid losing sales. These price reductions in turn will stimulate a higher quantity demanded. So, if the price is above the equilibrium level, incentives built into the structure of demand and supply will create pressures for the price to fall toward the equilibrium.

Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the dashed horizontal line at this price in Figure 3 shows. At this lower price, the quantity demanded increases from 600 to 700 as drivers take longer trips, spend more minutes warming up the car in the driveway in wintertime, stop sharing rides to work, and buy larger cars that get fewer miles to the gallon. However, the below-equilibrium price reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity supplied falls from 600 to 550.

When the price is below equilibrium, there is excess demand, or a shortage—that is, at the given price the quantity demanded, which has been stimulated by the lower price, now exceeds the quantity supplied, which had been depressed by the lower price. In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher price. As a result, the price rises toward the equilibrium level. Read Demand, Supply, and Efficiency for more discussion on the importance of the demand and supply model.

Key Concepts and Summary

A demand schedule is a table that shows the quantity demanded at different prices in the market. A demand curve shows the relationship between quantity demanded and price in a given market on a graph. The law of demand states that a higher price typically leads to a lower quantity demanded.

A supply schedule is a table that shows the quantity supplied at different prices in the market. A supply curve shows the relationship between quantity supplied and price on a graph. The law of supply says that a higher price typically leads to a higher quantity supplied.

The equilibrium price and equilibrium quantity occur where the supply and demand curves cross. The equilibrium occurs where the quantity demanded is equal to the quantity supplied. If the price is below the equilibrium level, then the quantity demanded will exceed the quantity supplied. Excess demand or a shortage will exist. If the price is above the equilibrium level, then the quantity supplied will exceed the quantity demanded. Excess supply or a surplus will exist. In either case, economic pressures will push the price toward the equilibrium level.

Self-Check Questions

Review Figure 3. Suppose the price of gasoline is $1.60 per gallon. Is the quantity demanded higher or lower than at the equilibrium price of $1.40 per gallon? And what about the quantity supplied? Is there a shortage or a surplus in the market? If so, of how much?

Review Questions

  1. What determines the level of prices in a market?
  2. What does a downward-sloping demand curve mean about how buyers in a market will react to a higher price?
  3. Will demand curves have the same exact shape in all markets? If not, how will they differ?
  4. Will supply curves have the same shape in all markets? If not, how will they differ?
  5. What is the relationship between quantity demanded and quantity supplied at equilibrium? What is the relationship when there is a shortage? What is the relationship when there is a surplus?
  6. How can you locate the equilibrium point on a demand and supply graph?
  7. If the price is above the equilibrium level, would you predict a surplus or a shortage? If the price is below the equilibrium level, would you predict a surplus or a shortage? Why?
  8. When the price is above the equilibrium, explain how market forces move the market price to equilibrium. Do the same when the price is below the equilibrium.
  9. What is the difference between the demand and the quantity demanded of a product, say milk? Explain in words and show the difference on a graph with a demand curve for milk.
  10. What is the difference between the supply and the quantity supplied of a product, say milk? Explain in words and show the difference on a graph with the supply curve for milk.

Critical Thinking Questions

  1. Review Figure 3. Suppose the government decided that, since gasoline is a necessity, its price should be legally capped at $1.30 per gallon. What do you anticipate would be the outcome in the gasoline market?
  2. Explain why the following statement is false: “In the goods market, no buyer would be willing to pay more than the equilibrium price.”
  3. Explain why the following statement is false: “In the goods market, no seller would be willing to sell for less than the equilibrium price.”

Problems

Review Figure 3 again. Suppose the price of gasoline is $1.00. Will the quantity demanded be lower or higher than at the equilibrium price of $1.40 per gallon? Will the quantity supplied be lower or higher? Is there a shortage or a surplus in the market? If so, of how much?

References

Costanza, Robert, and Lisa Wainger. “No Accounting For Nature: How Conventional Economics Distorts the Value of Things.” The Washington Post. September 2, 1990.

European Commission: Agriculture and Rural Development. 2013. “Overview of the CAP Reform: 2014-2024.” Accessed April 13, 205. http://ec.europa.eu/agriculture/cap-post-2013/.

Radford, R. A. “The Economic Organisation of a P.O.W. Camp.” Economica. no. 48 (1945): 189-201. http://www.jstor.org/stable/2550133.

Glossary

demand curve
a graphic representation of the relationship between price and quantity demanded of a certain good or service, with quantity on the horizontal axis and the price on the vertical axis
demand schedule
a table that shows a range of prices for a certain good or service and the quantity demanded at each price
demand
the relationship between price and the quantity demanded of a certain good or service
equilibrium price
the price where quantity demanded is equal to quantity supplied
equilibrium quantity
the quantity at which quantity demanded and quantity supplied are equal for a certain price level
equilibrium
the situation where quantity demanded is equal to the quantity supplied; the combination of price and quantity where there is no economic pressure from surpluses or shortages that would cause price or quantity to change
excess demand
at the existing price, the quantity demanded exceeds the quantity supplied; also called a shortage
excess supply
at the existing price, quantity supplied exceeds the quantity demanded; also called a surplus
law of demand
the common relationship that a higher price leads to a lower quantity demanded of a certain good or service and a lower price leads to a higher quantity demanded, while all other variables are held constant
law of supply
the common relationship that a higher price leads to a greater quantity supplied and a lower price leads to a lower quantity supplied, while all other variables are held constant
price
what a buyer pays for a unit of the specific good or service
quantity demanded
the total number of units of a good or service consumers are willing to purchase at a given price
quantity supplied
the total number of units of a good or service producers are willing to sell at a given price
shortage
at the existing price, the quantity demanded exceeds the quantity supplied; also called excess demand
supply curve
a line that shows the relationship between price and quantity supplied on a graph, with quantity supplied on the horizontal axis and price on the vertical axis
supply schedule
a table that shows a range of prices for a good or service and the quantity supplied at each price
supply
the relationship between price and the quantity supplied of a certain good or service
surplus
at the existing price, quantity supplied exceeds the quantity demanded; also called excess supply

Solutions

Answers to Self-Check Questions

Since $1.60 per gallon is above the equilibrium price, the quantity demanded would be lower at 550 gallons and the quantity supplied would be higher at 640 gallons. (These results are due to the laws of demand and supply, respectively.) The outcome of lower Qd and higher Qs would be a surplus in the gasoline market of 640 – 550 = 90 gallons.

4.2 Shifts in Demand and Supply for Goods and Services

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Learning Objectives

By the end of this section, you will be able to:

  • Identify factors that affect demand
  • Graph demand curves and demand shifts
  • Identify factors that affect supply
  • Graph supply curves and supply shifts

The previous module explored how price affects the quantity demanded and the quantity supplied. The result was the demand curve and the supply curve. Price, however, is not the only thing that influences demand. Nor is it the only thing that influences supply. For example, how is demand for vegetarian food affected if, say, health concerns cause more consumers to avoid eating meat? Or how is the supply of diamonds affected if diamond producers discover several new diamond mines? What are the major factors, in addition to the price, that influence demand or supply?

Visit this website to read a brief note on how marketing strategies can influence supply and demand of products.


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What Factors Affect Demand?

We defined demand as the amount of some product a consumer is willing and able to purchase at each price. That suggests at least two factors in addition to price that affect demand. Willingness to purchase suggests a desire, based on what economists call tastes and preferences. If you neither need nor want something, you will not buy it. Ability to purchase suggests that income is important. Professors are usually able to afford better housing and transportation than students, because they have more income. Prices of related goods can affect demand also. If you need a new car, the price of a Honda may affect your demand for a Ford. Finally, the size or composition of the population can affect demand. The more children a family has, the greater their demand for clothing. The more driving-age children a family has, the greater their demand for car insurance, and the less for diapers and baby formula.

These factors matter both for demand by an individual and demand by the market as a whole. Exactly how do these various factors affect demand, and how do we show the effects graphically? To answer those questions, we need the ceteris paribus assumption.

The Ceteris Paribus Assumption

A demand curve or a supply curve is a relationship between two, and only two, variables: quantity on the horizontal axis and price on the vertical axis. The assumption behind a demand curve or a supply curve is that no relevant economic factors, other than the product’s price, are changing. Economists call this assumption ceteris paribus, a Latin phrase meaning “other things being equal.” Any given demand or supply curve is based on the ceteris paribus assumption that all else is held equal. A demand curve or a supply curve is a relationship between two, and only two, variables when all other variables are kept constant. If all else is not held equal, then the laws of supply and demand will not necessarily hold, as the following Clear It Up feature shows.

When does ceteris paribus apply?

Ceteris paribus is typically applied when we look at how changes in price affect demand or supply, but ceteris paribus can be applied more generally. In the real world, demand and supply depend on more factors than just price. For example, a consumer’s demand depends on income and a producer’s supply depends on the cost of producing the product. How can we analyze the effect on demand or supply if multiple factors are changing at the same time—say price rises and income falls? The answer is that we examine the changes one at a time, assuming the other factors are held constant.

For example, we can say that an increase in the price reduces the amount consumers will buy (assuming income, and anything else that affects demand, is unchanged). Additionally, a decrease in income reduces the amount consumers can afford to buy (assuming price, and anything else that affects demand, is unchanged). This is what the ceteris paribus assumption really means. In this particular case, after we analyze each factor separately, we can combine the results. The amount consumers buy falls for two reasons: first because of the higher price and second because of the lower income.

How Does Income Affect Demand?

Let’s use income as an example of how factors other than price affect demand. Figure 1 shows the initial demand for automobiles as D0. At point Q, for example, if the price is $20,000 per car, the quantity of cars demanded is 18 million. D0 also shows how the quantity of cars demanded would change as a result of a higher or lower price. For example, if the price of a car rose to $22,000, the quantity demanded would decrease to 17 million, at point R.

The original demand curve D0, like every demand curve, is based on the ceteris paribus assumption that no other economically relevant factors change. Now imagine that the economy expands in a way that raises the incomes of many people, making cars more affordable. How will this affect demand? How can we show this graphically?

Return to Figure 1. The price of cars is still $20,000, but with higher incomes, the quantity demanded has now increased to 20 million cars, shown at point S. As a result of the higher income levels, the demand curve shifts to the right to the new demand curve D1, indicating an increase in demand. Table 4 shows clearly that this increased demand would occur at every price, not just the original one.

The graph shows demand curve D sub 0 as the original demand curve. Demand curve D sub 1 represents a shift based on increased income. Demand curve D sub 2 represents a shift based on decreased income.
Figure 1. Shifts in Demand: A Car Example. Increased demand means that at every given price, the quantity demanded is higher, so that the demand curve shifts to the right from D0 to D1. Decreased demand means that at every given price, the quantity demanded is lower, so that the demand curve shifts to the left from D0 to D2.
Price Decrease to D2 Original Quantity Demanded D0 Increase to D1
$16,000 17.6 million 22.0 million 24.0 million
$18,000 16.0 million 20.0 million 22.0 million
$20,000 14.4 million 18.0 million 20.0 million
$22,000 13.6 million 17.0 million 19.0 million
$24,000 13.2 million 16.5 million 18.5 million
$26,000 12.8 million 16.0 million 18.0 million
Table 4. Price and Demand Shifts: A Car Example

Now, imagine that the economy slows down so that many people lose their jobs or work fewer hours, reducing their incomes. In this case, the decrease in income would lead to a lower quantity of cars demanded at every given price, and the original demand curve D0 would shift left to D2. The shift from D0 to D2 represents such a decrease in demand: At any given price level, the quantity demanded is now lower. In this example, a price of $20,000 means 18 million cars sold along the original demand curve, but only 14.4 million sold after demand fell.

When a demand curve shifts, it does not mean that the quantity demanded by every individual buyer changes by the same amount. In this example, not everyone would have higher or lower income and not everyone would buy or not buy an additional car. Instead, a shift in a demand curve captures an pattern for the market as a whole.

In the previous section, we argued that higher income causes greater demand at every price. This is true for most goods and services. For some—luxury cars, vacations in Europe, and fine jewelry—the effect of a rise in income can be especially pronounced. A product whose demand rises when income rises, and vice versa, is called a normal good. A few exceptions to this pattern do exist. As incomes rise, many people will buy fewer generic brand groceries and more name brand groceries. They are less likely to buy used cars and more likely to buy new cars. They will be less likely to rent an apartment and more likely to own a home, and so on. A product whose demand falls when income rises, and vice versa, is called an inferior good. In other words, when income increases, the demand curve shifts to the left.

Other Factors That Shift Demand Curves

Income is not the only factor that causes a shift in demand. Other things that change demand include tastes and preferences, the composition or size of the population, the prices of related goods, and even expectations. A change in any one of the underlying factors that determine what quantity people are willing to buy at a given price will cause a shift in demand. Graphically, the new demand curve lies either to the right (an increase) or to the left (a decrease) of the original demand curve. Let’s look at these factors.

Changing Tastes or Preferences

From 1980 to 2014, the per-person consumption of chicken by Americans rose from 48 pounds per year to 85 pounds per year, and consumption of beef fell from 77 pounds per year to 54 pounds per year, according to the U.S. Department of Agriculture (USDA). Changes like these are largely due to movements in taste, which change the quantity of a good demanded at every price: that is, they shift the demand curve for that good, rightward for chicken and leftward for beef.

Changes in the Composition of the Population

The proportion of elderly citizens in the United States population is rising. It rose from 9.8% in 1970 to 12.6% in 2000, and will be a projected (by the U.S. Census Bureau) 20% of the population by 2030. A society with relatively more children, like the United States in the 1960s, will have greater demand for goods and services like tricycles and day care facilities. A society with relatively more elderly persons, as the United States is projected to have by 2030, has a higher demand for nursing homes and hearing aids. Similarly, changes in the size of the population can affect the demand for housing and many other goods. Each of these changes in demand will be shown as a shift in the demand curve.

The demand for a product can also be affected by changes in the prices of related goods such as substitutes or complements. A substitute is a good or service that can be used in place of another good or service. As electronic books, like this one, become more available, you would expect to see a decrease in demand for traditional printed books. A lower price for a substitute decreases demand for the other product. For example, in recent years as the price of tablet computers has fallen, the quantity demanded has increased (because of the law of demand). Since people are purchasing tablets, there has been a decrease in demand for laptops, which can be shown graphically as a leftward shift in the demand curve for laptops. A higher price for a substitute good has the reverse effect.

Other goods are complements for each other, meaning that the goods are often used together, because consumption of one good tends to enhance consumption of the other. Examples include breakfast cereal and milk; notebooks and pens or pencils, golf balls and golf clubs; gasoline and sport utility vehicles; and the five-way combination of bacon, lettuce, tomato, mayonnaise, and bread. If the price of golf clubs rises, since the quantity demanded of golf clubs falls (because of the law of demand), demand for a complement good like golf balls decreases, too. Similarly, a higher price for skis would shift the demand curve for a complement good like ski resort trips to the left, while a lower price for a complement has the reverse effect.

Changes in Expectations about Future Prices or Other Factors that Affect Demand

While it is clear that the price of a good affects the quantity demanded, it is also true that expectations about the future price (or expectations about tastes and preferences, income, and so on) can affect demand. For example, if people hear that a hurricane is coming, they may rush to the store to buy flashlight batteries and bottled water. If people learn that the price of a good like coffee is likely to rise in the future, they may head for the store to stock up on coffee now. These changes in demand are shown as shifts in the curve. Therefore, a shift in demand happens when a change in some economic factor (other than price) causes a different quantity to be demanded at every price. The following Work It Out feature shows how this happens.

Shift in Demand

A shift in demand means that at any price (and at every price), the quantity demanded will be different than it was before. Following is an example of a shift in demand due to an income increase.

Step 1. Draw the graph of a demand curve for a normal good like pizza. Pick a price (like P0). Identify the corresponding Q0. An example is shown in Figure 2.

The graph represents the directions for step 1.A demand curve shows how much consumers would be willing to buy at any given price.
Figure 2. Demand Curve. The demand curve can be used to identify how much consumers would buy at any given price.

Step 2. Suppose income increases. As a result of the change, are consumers going to buy more or less pizza? The answer is more. Draw a dotted horizontal line from the chosen price, through the original quantity demanded, to the new point with the new Q1. Draw a dotted vertical line down to the horizontal axis and label the new Q1. An example is provided in Figure 3.

The graph represents the directions for step 2. With an increased income, consumers will wish to buy a higher quantity (Q sub 1) than they bought with a lower income.
Figure 3. Demand Curve with Income Increase. With an increase in income, consumers will purchase larger quantities, pushing demand to the right.

Step 3. Now, shift the curve through the new point. You will see that an increase in income causes an upward (or rightward) shift in the demand curve, so that at any price the quantities demanded will be higher, as shown in Figure 4.

The graph represents the directions for step 3. An increased income results in an increase in demand, which is shown by a rightward shift in the demand curve.
Figure 4. Demand Curve Shifted Right. With an increase in income, consumers will purchase larger quantities, pushing demand to the right, and causing the demand curve to shift right.

Summing Up Factors That Change Demand

Six factors that can shift demand curves are summarized in Figure 5. The direction of the arrows indicates whether the demand curve shifts represent an increase in demand or a decrease in demand. Notice that a change in the price of the good or service itself is not listed among the factors that can shift a demand curve. A change in the price of a good or service causes a movement along a specific demand curve, and it typically leads to some change in the quantity demanded, but it does not shift the demand curve.

The graph on the left lists events that could lead to increased demand. The graph on the right lists events that could lead to decreased demand.
Figure 5. Factors That Shift Demand Curves. (a) A list of factors that can cause an increase in demand from D0 to D1. (b) The same factors, if their direction is reversed, can cause a decrease in demand from D0 to D1.

When a demand curve shifts, it will then intersect with a given supply curve at a different equilibrium price and quantity. We are, however, getting ahead of our story. Before discussing how changes in demand can affect equilibrium price and quantity, we first need to discuss shifts in supply curves.

How Production Costs Affect Supply

A supply curve shows how quantity supplied will change as the price rises and falls, assuming ceteris paribus so that no other economically relevant factors are changing. If other factors relevant to supply do change, then the entire supply curve will shift. Just as a shift in demand is represented by a change in the quantity demanded at every price, a shift in supply means a change in the quantity supplied at every price.

In thinking about the factors that affect supply, remember what motivates firms: profits, which are the difference between revenues and costs. Goods and services are produced using combinations of labor, materials, and machinery, or what we call inputs or factors of production. If a firm faces lower costs of production, while the prices for the good or service the firm produces remain unchanged, a firm’s profits go up. When a firm’s profits increase, it is more motivated to produce output, since the more it produces the more profit it will earn. So, when costs of production fall, a firm will tend to supply a larger quantity at any given price for its output. This can be shown by the supply curve shifting to the right.

Take, for example, a messenger company that delivers packages around a city. The company may find that buying gasoline is one of its main costs. If the price of gasoline falls, then the company will find it can deliver messages more cheaply than before. Since lower costs correspond to higher profits, the messenger company may now supply more of its services at any given price. For example, given the lower gasoline prices, the company can now serve a greater area, and increase its supply.

Conversely, if a firm faces higher costs of production, then it will earn lower profits at any given selling price for its products. As a result, a higher cost of production typically causes a firm to supply a smaller quantity at any given price. In this case, the supply curve shifts to the left.

Consider the supply for cars, shown by curve S0 in Figure 6. Point J indicates that if the price is $20,000, the quantity supplied will be 18 million cars. If the price rises to $22,000 per car, ceteris paribus, the quantity supplied will rise to 20 million cars, as point K on the S0 curve shows. The same information can be shown in table form, as in Table 5.

The graph shows supply curve S sub 0 as the original supply curve. Supply curve S sub 1 represents a shift based on decreased supply. Supply curve S sub 2 represents a shift based on increased supply.
Figure 6. Shifts in Supply: A Car Example. Decreased supply means that at every given price, the quantity supplied is lower, so that the supply curve shifts to the left, from S0 to S1. Increased supply means that at every given price, the quantity supplied is higher, so that the supply curve shifts to the right, from S0 to S2.
Price Decrease to S1 Original Quantity Supplied S0 Increase to S2
$16,000 10.5 million 12.0 million 13.2 million
$18,000 13.5 million 15.0 million 16.5 million
$20,000 16.5 million 18.0 million 19.8 million
$22,000 18.5 million 20.0 million 22.0 million
$24,000 19.5 million 21.0 million 23.1 million
$26,000 20.5 million 22.0 million 24.2 million
Table 5. Price and Shifts in Supply: A Car Example

Now, imagine that the price of steel, an important ingredient in manufacturing cars, rises, so that producing a car has become more expensive. At any given price for selling cars, car manufacturers will react by supplying a lower quantity. This can be shown graphically as a leftward shift of supply, from S0 to S1, which indicates that at any given price, the quantity supplied decreases. In this example, at a price of $20,000, the quantity supplied decreases from 18 million on the original supply curve (S0) to 16.5 million on the supply curve S1, which is labeled as point L.

Conversely, if the price of steel decreases, producing a car becomes less expensive. At any given price for selling cars, car manufacturers can now expect to earn higher profits, so they will supply a higher quantity. The shift of supply to the right, from S0 to S2, means that at all prices, the quantity supplied has increased. In this example, at a price of $20,000, the quantity supplied increases from 18 million on the original supply curve (S0) to 19.8 million on the supply curve S2, which is labeled M.

Other Factors That Affect Supply

In the example above, we saw that changes in the prices of inputs in the production process will affect the cost of production and thus the supply. Several other things affect the cost of production, too, such as changes in weather or other natural conditions, new technologies for production, and some government policies.

The cost of production for many agricultural products will be affected by changes in natural conditions. For example, in 2014 the Manchurian Plain in Northeastern China, which produces most of the country’s wheat, corn, and soybeans, experienced its most severe drought in 50 years. A drought decreases the supply of agricultural products, which means that at any given price, a lower quantity will be supplied; conversely, especially good weather would shift the supply curve to the right.

When a firm discovers a new technology that allows the firm to produce at a lower cost, the supply curve will shift to the right, as well. For instance, in the 1960s a major scientific effort nicknamed the Green Revolution focused on breeding improved seeds for basic crops like wheat and rice. By the early 1990s, more than two-thirds of the wheat and rice in low-income countries around the world was grown with these Green Revolution seeds—and the harvest was twice as high per acre. A technological improvement that reduces costs of production will shift supply to the right, so that a greater quantity will be produced at any given price.

Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on alcoholic beverages that collects about $8 billion per year from producers. Taxes are treated as costs by businesses. Higher costs decrease supply for the reasons discussed above. Other examples of policy that can affect cost are the wide array of government regulations that require firms to spend money to provide a cleaner environment or a safer workplace; complying with regulations increases costs.

A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs when the government pays a firm directly or reduces the firm’s taxes if the firm carries out certain actions. From the firm’s perspective, taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price. Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right. The following Work It Out feature shows how this shift happens.

Shift in Supply

We know that a supply curve shows the minimum price a firm will accept to produce a given quantity of output. What happens to the supply curve when the cost of production goes up? Following is an example of a shift in supply due to a production cost increase.

Step 1. Draw a graph of a supply curve for pizza. Pick a quantity (like Q0). If you draw a vertical line up from Q0 to the supply curve, you will see the price the firm chooses. An example is shown in Figure 7.

The graph represents the directions for step 1. A supply curve shows the minimum price a firm will accept (P sub 0) to supply a given quantity of output (Q sub 0).
Figure 7. Supply Curve. The supply curve can be used to show the minimum price a firm will accept to produce a given quantity of output.

Step 2. Why did the firm choose that price and not some other? One way to think about this is that the price is composed of two parts. The first part is the average cost of production, in this case, the cost of the pizza ingredients (dough, sauce, cheese, pepperoni, and so on), the cost of the pizza oven, the rent on the shop, and the wages of the workers. The second part is the firm’s desired profit, which is determined, among other factors, by the profit margins in that particular business. If you add these two parts together, you get the price the firm wishes to charge. The quantity Q0 and associated price P0 give you one point on the firm’s supply curve, as shown in Figure 8.

The graph represents the directions for step 2. For a given quantity of output (Q sub 0), the firm wishes to charge a price (P sub 0) equal to the cost of production plus the desired profit margin.
Figure 8. Setting Prices. The cost of production and the desired profit equal the price a firm will set for a product.

Step 3. Now, suppose that the cost of production goes up. Perhaps cheese has become more expensive by $0.75 per pizza. If that is true, the firm will want to raise its price by the amount of the increase in cost ($0.75). Draw this point on the supply curve directly above the initial point on the curve, but $0.75 higher, as shown in Figure 9.

The graph represents the directions for step 3. An increase in production cost will raise the price a firm wishes to charge (to P sub 1) for a given quantity of output (Q sub 0).
Figure 9. Increasing Costs Leads to Increasing Price. Because the cost of production and the desired profit equal the price a firm will set for a product, if the cost of production increases, the price for the product will also need to increase.

Step 4. Shift the supply curve through this point. You will see that an increase in cost causes an upward (or a leftward) shift of the supply curve so that at any price, the quantities supplied will be smaller, as shown in Figure 10.

The graph represents the directions for step 4. An increase in the cost of production will shift the supply curve vertically by the amount of the cost increase.
Figure 10. Supply Curve Shifts. When the cost of production increases, the supply curve shifts upwardly to a new price level.

Summing Up Factors That Change Supply

Changes in the cost of inputs, natural disasters, new technologies, and the impact of government decisions all affect the cost of production. In turn, these factors affect how much firms are willing to supply at any given price.

Figure 11 summarizes factors that change the supply of goods and services. Notice that a change in the price of the product itself is not among the factors that shift the supply curve. Although a change in price of a good or service typically causes a change in quantity supplied or a movement along the supply curve for that specific good or service, it does not cause the supply curve itself to shift.

The graph on the left lists events that could lead to increased supply. The graph on the right lists events that could lead to decreased supply.
Figure 11. Factors That Shift Supply Curves. (a) A list of factors that can cause an increase in supply from S0 to S1. (b) The same factors, if their direction is reversed, can cause a decrease in supply from S0 to S1.

Because demand and supply curves appear on a two-dimensional diagram with only price and quantity on the axes, an unwary visitor to the land of economics might be fooled into believing that economics is about only four topics: demand, supply, price, and quantity. However, demand and supply are really “umbrella” concepts: demand covers all the factors that affect demand, and supply covers all the factors that affect supply. Factors other than price that affect demand and supply are included by using shifts in the demand or the supply curve. In this way, the two-dimensional demand and supply model becomes a powerful tool for analyzing a wide range of economic circumstances.

Key Concepts and Summary

Economists often use the ceteris paribus or “other things being equal” assumption: while examining the economic impact of one event, all other factors remain unchanged for the purpose of the analysis. Factors that can shift the demand curve for goods and services, causing a different quantity to be demanded at any given price, include changes in tastes, population, income, prices of substitute or complement goods, and expectations about future conditions and prices. Factors that can shift the supply curve for goods and services, causing a different quantity to be supplied at any given price, include input prices, natural conditions, changes in technology, and government taxes, regulations, or subsidies.

Self-Check Questions

  1. Why do economists use the ceteris paribus assumption?
  2. In an analysis of the market for paint, an economist discovers the facts listed below. State whether each of these changes will affect supply or demand, and in what direction.
    1. There have recently been some important cost-saving inventions in the technology for making paint.
    2. Paint is lasting longer, so that property owners need not repaint as often.
    3. Because of severe hailstorms, many people need to repaint now.
    4. The hailstorms damaged several factories that make paint, forcing them to close down for several months.
  3. Many changes are affecting the market for oil. Predict how each of the following events will affect the equilibrium price and quantity in the market for oil. In each case, state how the event will affect the supply and demand diagram. Create a sketch of the diagram if necessary.
    1. Cars are becoming more fuel efficient, and therefore get more miles to the gallon.
    2. The winter is exceptionally cold.
    3. A major discovery of new oil is made off the coast of Norway.
    4. The economies of some major oil-using nations, like Japan, slow down.
    5. A war in the Middle East disrupts oil-pumping schedules.
    6. Landlords install additional insulation in buildings.
    7. The price of solar energy falls dramatically.
    8. Chemical companies invent a new, popular kind of plastic made from oil.

Review Questions

  1. When analyzing a market, how do economists deal with the problem that many factors that affect the market are changing at the same time?
  2. Name some factors that can cause a shift in the demand curve in markets for goods and services.
  3. Name some factors that can cause a shift in the supply curve in markets for goods and services.

Critical Thinking Questions

  1. Consider the demand for hamburgers. If the price of a substitute good (for example, hot dogs) increases and the price of a complement good (for example, hamburger buns) increases, can you tell for sure what will happen to the demand for hamburgers? Why or why not? Illustrate your answer with a graph.
  2. How do you suppose the demographics of an aging population of “Baby Boomers” in the United States will affect the demand for milk? Justify your answer.
  3. We know that a change in the price of a product causes a movement along the demand curve. Suppose consumers believe that prices will be rising in the future. How will that affect demand for the product in the present? Can you show this graphically?
  4. Suppose there is soda tax to curb obesity. What should a reduction in the soda tax do to the supply of sodas and to the equilibrium price and quantity? Can you show this graphically? Hint: assume that the soda tax is collected from the sellers

Problems

  1. Table 6 shows information on the demand and supply for bicycles, where the quantities of bicycles are measured in thousands.
    Price Qd Qs
    $120 50 36
    $150 40 40
    $180 32 48
    $210 28 56
    $240 24 70
    Table 6. Demand and Supply for Bicycles
    1. What is the quantity demanded and the quantity supplied at a price of $210?
    2. At what price is the quantity supplied equal to 48,000?
    3. Graph the demand and supply curve for bicycles. How can you determine the equilibrium price and quantity from the graph? How can you determine the equilibrium price and quantity from the table? What are the equilibrium price and equilibrium quantity?
    4. If the price was $120, what would the quantities demanded and supplied be? Would a shortage or surplus exist? If so, how large would the shortage or surplus be?
  2. The computer market in recent years has seen many more computers sell at much lower prices. What shift in demand or supply is most likely to explain this outcome? Sketch a demand and supply diagram and explain your reasoning for each.
    1. A rise in demand
    2. A fall in demand
    3. A rise in supply
    4. A fall in supply

References

Landsburg, Steven E. The Armchair Economist: Economics and Everyday Life. New York: The Free Press. 2012. specifically Section IV: How Markets Work.

National Chicken Council. 2015. “Per Capita Consumption of Poultry and Livestock, 1965 to Estimated 2015, in Pounds.” Accessed April 13, 2015. http://www.nationalchickencouncil.org/about-the-industry/statistics/per-capita-consumption-of-poultry-and-livestock-1965-to-estimated-2012-in-pounds/.

Wessel, David. “Saudi Arabia Fears $40-a-Barrel Oil, Too.” The Wall Street Journal. May 27, 2004, p. 42. http://online.wsj.com/news/articles/SB108561000087822300.

Glossary

ceteris paribus
other things being equal
complements
goods that are often used together so that consumption of one good tends to enhance consumption of the other
factors of production
the combination of labor, materials, and machinery that is used to produce goods and services; also called inputs
inferior good
a good in which the quantity demanded falls as income rises, and in which quantity demanded rises and income falls
inputs
the combination of labor, materials, and machinery that is used to produce goods and services; also called factors of production
normal good
a good in which the quantity demanded rises as income rises, and in which quantity demanded falls as income falls
shift in demand
when a change in some economic factor (other than price) causes a different quantity to be demanded at every price
shift in supply
when a change in some economic factor (other than price) causes a different quantity to be supplied at every price
substitute
a good that can replace another to some extent, so that greater consumption of one good can mean less of the other

Solutions

Answers to Self-Check Questions

  1. To make it easier to analyze complex problems. Ceteris paribus allows you to look at the effect of one factor at a time on what it is you are trying to analyze. When you have analyzed all the factors individually, you add the results together to get the final answer.
    1. An improvement in technology that reduces the cost of production will cause an increase in supply. Alternatively, you can think of this as a reduction in price necessary for firms to supply any quantity. Either way, this can be shown as a rightward (or downward) shift in the supply curve.
    2. An improvement in product quality is treated as an increase in tastes or preferences, meaning consumers demand more paint at any price level, so demand increases or shifts to the right. If this seems counterintuitive, note that demand in the future for the longer-lasting paint will fall, since consumers are essentially shifting demand from the future to the present.
    3. An increase in need causes an increase in demand or a rightward shift in the demand curve.
    4. Factory damage means that firms are unable to supply as much in the present. Technically, this is an increase in the cost of production. Either way you look at it, the supply curve shifts to the left.
    1. More fuel-efficient cars means there is less need for gasoline. This causes a leftward shift in the demand for gasoline and thus oil. Since the demand curve is shifting down the supply curve, the equilibrium price and quantity both fall.
    2. Cold weather increases the need for heating oil. This causes a rightward shift in the demand for heating oil and thus oil. Since the demand curve is shifting up the supply curve, the equilibrium price and quantity both rise.
    3. A discovery of new oil will make oil more abundant. This can be shown as a rightward shift in the supply curve, which will cause a decrease in the equilibrium price along with an increase in the equilibrium quantity. (The supply curve shifts down the demand curve so price and quantity follow the law of demand. If price goes down, then the quantity goes up.)
    4. When an economy slows down, it produces less output and demands less input, including energy, which is used in the production of virtually everything. A decrease in demand for energy will be reflected as a decrease in the demand for oil, or a leftward shift in demand for oil. Since the demand curve is shifting down the supply curve, both the equilibrium price and quantity of oil will fall.
    5. Disruption of oil pumping will reduce the supply of oil. This leftward shift in the supply curve will show a movement up the demand curve, resulting in an increase in the equilibrium price of oil and a decrease in the equilibrium quantity.
    6. Increased insulation will decrease the demand for heating. This leftward shift in the demand for oil causes a movement down the supply curve, resulting in a decrease in the equilibrium price and quantity of oil.
    7. Solar energy is a substitute for oil-based energy. So if solar energy becomes cheaper, the demand for oil will decrease as consumers switch from oil to solar. The decrease in demand for oil will be shown as a leftward shift in the demand curve. As the demand curve shifts down the supply curve, both equilibrium price and quantity for oil will fall.
    8. A new, popular kind of plastic will increase the demand for oil. The increase in demand will be shown as a rightward shift in demand, raising the equilibrium price and quantity of oil.

4.3 Changes in Equilibrium Price and Quantity: The Four-Step Process

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Learning Objectives

By the end of this section, you will be able to:

  • Identify equilibrium price and quantity through the four-step process
  • Graph equilibrium price and quantity
  • Contrast shifts of demand or supply and movements along a demand or supply curve
  • Graph demand and supply curves, including equilibrium price and quantity, based on real-world examples

Let’s begin this discussion with a single economic event. It might be an event that affects demand, like a change in income, population, tastes, prices of substitutes or complements, or expectations about future prices. It might be an event that affects supply, like a change in natural conditions, input prices, or technology, or government policies that affect production. How does this economic event affect equilibrium price and quantity? We will analyze this question using a four-step process.

Step 1. Draw a demand and supply model before the economic change took place. To establish the model requires four standard pieces of information: The law of demand, which tells us the slope of the demand curve; the law of supply, which gives us the slope of the supply curve; the shift variables for demand; and the shift variables for supply. From this model, find the initial equilibrium values for price and quantity.

Step 2. Decide whether the economic change being analyzed affects demand or supply. In other words, does the event refer to something in the list of demand factors or supply factors?

Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram. In other words, does the event increase or decrease the amount consumers want to buy or producers want to sell?

Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.

Let’s consider one example that involves a shift in supply and one that involves a shift in demand. Then we will consider an example where both supply and demand shift.

Good Weather for Salmon Fishing

In the summer of 2000, weather conditions were excellent for commercial salmon fishing off the California coast. Heavy rains meant higher than normal levels of water in the rivers, which helps the salmon to breed. Slightly cooler ocean temperatures stimulated the growth of plankton, the microscopic organisms at the bottom of the ocean food chain, providing everything in the ocean with a hearty food supply. The ocean stayed calm during fishing season, so commercial fishing operations did not lose many days to bad weather. How did these climate conditions affect the quantity and price of salmon? Figure 1 illustrates the four-step approach, which is explained below, to work through this problem. Table 7 provides the information to work the problem as well.

The graph represents the four-step approach to determining shifts in the new equilibrium price and quantity in response to good weather for salmon fishing.
Figure 1. Good Weather for Salmon Fishing: The Four-Step Process. Unusually good weather leads to changes in the price and quantity of salmon.
Price per Pound Quantity Supplied in 1999 Quantity Supplied in 2000 Quantity Demanded
$2.00 80 400 840
$2.25 120 480 680
$2.50 160 550 550
$2.75 200 600 450
$3.00 230 640 350
$3.25 250 670 250
$3.50 270 700 200
Table 7. Salmon Fishing

Step 1. Draw a demand and supply model to illustrate the market for salmon in the year before the good weather conditions began. The demand curve D0 and the supply curve S0 show that the original equilibrium price is $3.25 per pound and the original equilibrium quantity is 250,000 fish. (This price per pound is what commercial buyers pay at the fishing docks; what consumers pay at the grocery is higher.)

Step 2. Did the economic event affect supply or demand? Good weather is an example of a natural condition that affects supply.

Step 3. Was the effect on supply an increase or a decrease? Good weather is a change in natural conditions that increases the quantity supplied at any given price. The supply curve shifts to the right, moving from the original supply curve S0 to the new supply curve S1, which is shown in both the table and the figure.

Step 4. Compare the new equilibrium price and quantity to the original equilibrium. At the new equilibrium E1, the equilibrium price falls from $3.25 to $2.50, but the equilibrium quantity increases from 250,000 to 550,000 salmon. Notice that the equilibrium quantity demanded increased, even though the demand curve did not move.

In short, good weather conditions increased supply of the California commercial salmon. The result was a higher equilibrium quantity of salmon bought and sold in the market at a lower price.

Newspapers and the Internet

According to the Pew Research Center for People and the Press, more and more people, especially younger people, are getting their news from online and digital sources. The majority of U.S. adults now own smartphones or tablets, and most of those Americans say they use them in part to get the news. From 2004 to 2012, the share of Americans who reported getting their news from digital sources increased from 24% to 39%. How has this affected consumption of print news media, and radio and television news? Figure 2 and the text below illustrates using the four-step analysis to answer this question.

The graph represents the four-step approach to determining changes in equilibrium price and quantity of print news.
Figure 2. The Print News Market: A Four-Step Analysis. A change in tastes from print news sources to digital sources results in a leftward shift in demand for the former. The result is a decrease in both equilibrium price and quantity.

Step 1. Develop a demand and supply model to think about what the market looked like before the event. The demand curve D0 and the supply curve S0 show the original relationships. In this case, the analysis is performed without specific numbers on the price and quantity axis.

Step 2. Did the change described affect supply or demand? A change in tastes, from traditional news sources (print, radio, and television) to digital sources, caused a change in demand for the former.

Step 3. Was the effect on demand positive or negative? A shift to digital news sources will tend to mean a lower quantity demanded of traditional news sources at every given price, causing the demand curve for print and other traditional news sources to shift to the left, from D0 to D1.

Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E1) occurs at a lower quantity and a lower price than the original equilibrium (E0).

The decline in print news reading predates 2004. Print newspaper circulation peaked in 1973 and has declined since then due to competition from television and radio news. In 1991, 55% of Americans indicated they got their news from print sources, while only 29% did so in 2012. Radio news has followed a similar path in recent decades, with the share of Americans getting their news from radio declining from 54% in 1991 to 33% in 2012. Television news has held its own over the last 15 years, with a market share staying in the mid to upper fifties. What does this suggest for the future, given that two-thirds of Americans under 30 years old say they do not get their news from television at all?

The Interconnections and Speed of Adjustment in Real Markets

In the real world, many factors that affect demand and supply can change all at once. For example, the demand for cars might increase because of rising incomes and population, and it might decrease because of rising gasoline prices (a complementary good). Likewise, the supply of cars might increase because of innovative new technologies that reduce the cost of car production, and it might decrease as a result of new government regulations requiring the installation of costly pollution-control technology.

Moreover, rising incomes and population or changes in gasoline prices will affect many markets, not just cars. How can an economist sort out all these interconnected events? The answer lies in the ceteris paribus assumption. Look at how each economic event affects each market, one event at a time, holding all else constant. Then combine the analyses to see the net effect.

A Combined Example

The U.S. Postal Service is facing difficult challenges. Compensation for postal workers tends to increase most years due to cost-of-living increases. At the same time, more and more people are using email, text, and other digital message forms such as Facebook and Twitter to communicate with friends and others. What does this suggest about the continued viability of the Postal Service? Figure 3 and the text below illustrates using the four-step analysis to answer this question.

This image has two panels. The one on the left shows the four step analysis of higher compensation for postal workers. The one on the right shows the four-step analysis of a change in tastes away from Postal Services.
Figure 3. Higher Compensation for Postal Workers: A Four-Step Analysis. (a) Higher labor compensation causes a leftward shift in the supply curve, a decrease in the equilibrium quantity, and an increase in the equilibrium price. (b) A change in tastes away from Postal Services causes a leftward shift in the demand curve, a decrease in the equilibrium quantity, and a decrease in the equilibrium price.

Since this problem involves two disturbances, we need two four-step analyses, the first to analyze the effects of higher compensation for postal workers, the second to analyze the effects of many people switching from “snailmail” to email and other digital messages.

Figure 3 (a) shows the shift in supply discussed in the following steps.

Step 1. Draw a demand and supply model to illustrate what the market for the U.S. Postal Service looked like before this scenario starts. The demand curve D0 and the supply curve S0 show the original relationships.

Step 2. Did the change described affect supply or demand? Labor compensation is a cost of production. A change in production costs caused a change in supply for the Postal Service.

Step 3. Was the effect on supply positive or negative? Higher labor compensation leads to a lower quantity supplied of postal services at every given price, causing the supply curve for postal services to shift to the left, from S0 to S1.

Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E1) occurs at a lower quantity and a higher price than the original equilibrium (E0).

Figure 3 (b) shows the shift in demand discussed in the following steps.

Step 1. Draw a demand and supply model to illustrate what the market for U.S. Postal Services looked like before this scenario starts. The demand curve D0 and the supply curve S0 show the original relationships. Note that this diagram is independent from the diagram in panel (a).

Step 2. Did the change described affect supply or demand? A change in tastes away from snailmail toward digital messages will cause a change in demand for the Postal Service.

Step 3. Was the effect on supply positive or negative? Higher labor compensation leads to a lower quantity supplied of postal services at every given price, causing the supply curve for postal services to shift to the left, from D0 to D1.

Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E2) occurs at a lower quantity and a lower price than the original equilibrium (E0).

The final step in a scenario where both supply and demand shift is to combine the two individual analyses to determine what happens to the equilibrium quantity and price. Graphically, we superimpose the previous two diagrams one on top of the other, as in Figure 4.

The graph shows a leftward supply shift as well as a leftward demand shift.
Figure 4. Combined Effect of Decreased Demand and Decreased Supply. Supply and demand shifts cause changes in equilibrium price and quantity.

Following are the results:

Effect on Quantity: The effect of higher labor compensation on Postal Services because it raises the cost of production is to decrease the equilibrium quantity. The effect of a change in tastes away from snailmail is to decrease the equilibrium quantity. Since both shifts are to the left, the overall impact is a decrease in the equilibrium quantity of Postal Services (Q3). This is easy to see graphically, since Q3 is to the left of Q0.

Effect on Price: The overall effect on price is more complicated. The effect of higher labor compensation on Postal Services, because it raises the cost of production, is to increase the equilibrium price. The effect of a change in tastes away from snailmail is to decrease the equilibrium price. Since the two effects are in opposite directions, unless we know the magnitudes of the two effects, the overall effect is unclear. This is not unusual. When both curves shift, typically we can determine the overall effect on price or on quantity, but not on both. In this case, we determined the overall effect on the equilibrium quantity, but not on the equilibrium price. In other cases, it might be the opposite.

The next Clear It Up feature focuses on the difference between shifts of supply or demand and movements along a curve.

What is the difference between shifts of demand or supply versus movements along a demand or supply curve?

One common mistake in applying the demand and supply framework is to confuse the shift of a demand or a supply curve with movement along a demand or supply curve. As an example, consider a problem that asks whether a drought will increase or decrease the equilibrium quantity and equilibrium price of wheat. Lee, a student in an introductory economics class, might reason:

“Well, it is clear that a drought reduces supply, so I will shift back the supply curve, as in the shift from the original supply curve S0 to S1 shown on the diagram (called Shift 1). So the equilibrium moves from E0 to E1, the equilibrium quantity is lower and the equilibrium price is higher. Then, a higher price makes farmers more likely to supply the good, so the supply curve shifts right, as shown by the shift from S1 to S2, on the diagram (shown as Shift 2), so that the equilibrium now moves from E1 to E2. The higher price, however, also reduces demand and so causes demand to shift back, like the shift from the original demand curve, D0 to D1 on the diagram (labeled Shift 3), and the equilibrium moves from E2 to E3.”

The graph shows the difference between shifts of demand and supply, and movement of demand and supply.
Figure 5. Shifts of Demand or Supply versus Movements along a Demand or Supply Curve. A shift in one curve never causes a shift in the other curve. Rather, a shift in one curve causes a movement along the second curve.

At about this point, Lee suspects that this answer is headed down the wrong path. Think about what might be wrong with Lee’s logic, and then read the answer that follows.

Answer: Lee’s first step is correct: that is, a drought shifts back the supply curve of wheat and leads to a prediction of a lower equilibrium quantity and a higher equilibrium price. This corresponds to a movement along the original demand curve (D0), from E0 to E1. The rest of Lee’s argument is wrong, because it mixes up shifts in supply with quantity supplied, and shifts in demand with quantity demanded. A higher or lower price never shifts the supply curve, as suggested by the shift in supply from S1 to S2. Instead, a price change leads to a movement along a given supply curve. Similarly, a higher or lower price never shifts a demand curve, as suggested in the shift from D0 to D1. Instead, a price change leads to a movement along a given demand curve. Remember, a change in the price of a good never causes the demand or supply curve for that good to shift.

Think carefully about the timeline of events: What happens first, what happens next? What is cause, what is effect? If you keep the order right, you are more likely to get the analysis correct.

In the four-step analysis of how economic events affect equilibrium price and quantity, the movement from the old to the new equilibrium seems immediate. As a practical matter, however, prices and quantities often do not zoom straight to equilibrium. More realistically, when an economic event causes demand or supply to shift, prices and quantities set off in the general direction of equilibrium. Indeed, even as they are moving toward one new equilibrium, prices are often then pushed by another change in demand or supply toward another equilibrium.

Key Concepts and Summary

When using the supply and demand framework to think about how an event will affect the equilibrium price and quantity, proceed through four steps: (1) sketch a supply and demand diagram to think about what the market looked like before the event; (2) decide whether the event will affect supply or demand; (3) decide whether the effect on supply or demand is negative or positive, and draw the appropriate shifted supply or demand curve; (4) compare the new equilibrium price and quantity to the original ones.

Self-Check Questions

  1. Let’s think about the market for air travel. From August 2014 to January 2015, the price of jet fuel decreased roughly 47%. Using the four-step analysis, how do you think this fuel price decrease affected the equilibrium price and quantity of air travel?
  2. A tariff is a tax on imported goods. Suppose the U.S. government cuts the tariff on imported flat screen televisions. Using the four-step analysis, how do you think the tariff reduction will affect the equilibrium price and quantity of flat screen TVs?

Review Questions

  1. How does one analyze a market where both demand and supply shift?
  2. What causes a movement along the demand curve? What causes a movement along the supply curve?

Critical Thinking Questions

  1. Use the four-step process to analyze the impact of the advent of the iPod (or other portable digital music players) on the equilibrium price and quantity of the Sony Walkman (or other portable audio cassette players).
  2. Use the four-step process to analyze the impact of a reduction in tariffs on imports of iPods on the equilibrium price and quantity of Sony Walkman-type products.
  3. Suppose both of these events took place at the same time. Combine your analyses of the impacts of the iPod and the tariff reduction to determine the likely impact on the equilibrium price and quantity of Sony Walkman-type products. Show your answer graphically.

Problems

  1. Demand and supply in the market for cheddar cheese is illustrated in Table 8. Graph the data and find the equilibrium. Next, create a table showing the change in quantity demanded or quantity supplied, and a graph of the new equilibrium, in each of the following situations:
    1. The price of milk, a key input for cheese production, rises, so that the supply decreases by 80 pounds at every price.
    2. A new study says that eating cheese is good for your health, so that demand increases by 20% at every price.
    Price per Pound Qd Qs
    $3.00 750 540
    $3.20 700 600
    $3.40 650 650
    $3.60 620 700
    $3.80 600 720
    $4.00 590 730
    Table 8. Demand and supply in the market for cheddar cheese
  2. Supply and demand for movie tickets in a city are shown in Table 9. Graph demand and supply and identify the equilibrium. Then calculate in a table and graph the effect of the following two changes.
    1. Three new nightclubs open. They offer decent bands and have no cover charge, but make their money by selling food and drink. As a result, demand for movie tickets falls by six units at every price.
    2. The city eliminates a tax that it had been placing on all local entertainment businesses. The result is that the quantity supplied of movies at any given price increases by 10%.
    Price per Pound Qd Qs
    $5.00 26 16
    $6.00 24 18
    $7.00 22 20
    $8.00 21 21
    $9.00 20 22
    Table 9. Demand and supply for movie tickets

References

Pew Research Center. “Pew Research: Center for the People & the Press.” http://www.people-press.org/.

Solutions

Answers to Self-Check Questions

  1. Step 1. Draw the graph with the initial supply and demand curves. Label the initial equilibrium price and quantity.

    Step 2. Did the economic event affect supply or demand? Jet fuel is a cost of producing air travel, so an increase in jet fuel price affects supply.

    Step 3. An increase in the price of jet fuel caused a decrease in the cost of air travel. We show this as a downward or rightward shift in supply.

    Step 4. A rightward shift in supply causes a movement down the demand curve, lowering the equilibrium price of air travel and increasing the equilibrium quantity.

  2. Step 1. Draw the graph with the initial supply and demand curves. Label the initial equilibrium price and quantity.

    Step 2. Did the economic event affect supply or demand? A tariff is treated like a cost of production, so this affects supply.

    Step 3. A tariff reduction is equivalent to a decrease in the cost of production, which we can show as a rightward (or downward) shift in supply.

    Step 4. A rightward shift in supply causes a movement down the demand curve, lowering the equilibrium price and raising the equilibrium quantity.

4.4 Price Ceilings and Price Floors

21

Learning Objectives

By the end of this section, you will be able to:

  • Explain price controls, price ceilings, and price floors
  • Analyze demand and supply as a social adjustment mechanism

Controversy sometimes surrounds the prices and quantities established by demand and supply, especially for products that are considered necessities. In some cases, discontent over prices turns into public pressure on politicians, who may then pass legislation to prevent a certain price from climbing “too high” or falling “too low.”

The demand and supply model shows how people and firms will react to the incentives provided by these laws to control prices, in ways that will often lead to undesirable consequences. Alternative policy tools can often achieve the desired goals of price control laws, while avoiding at least some of their costs and tradeoffs.

Price Ceilings

Laws that government enacts to regulate prices are called Price controls. Price controls come in two flavors. A price ceiling keeps a price from rising above a certain level (the “ceiling”), while a price floor keeps a price from falling below a certain level (the “floor”). This section uses the demand and supply framework to analyze price ceilings. The next section discusses price floors.

In many markets for goods and services, demanders outnumber suppliers. Consumers, who are also potential voters, sometimes unite behind a political proposal to hold down a certain price. In some cities, such as Albany, renters have pressed political leaders to pass rent control laws, a price ceiling that usually works by stating that rents can be raised by only a certain maximum percentage each year.

Rent control becomes a politically hot topic when rents begin to rise rapidly. Everyone needs an affordable place to live. Perhaps a change in tastes makes a certain suburb or town a more popular place to live. Perhaps locally-based businesses expand, bringing higher incomes and more people into the area. Changes of this sort can cause a change in the demand for rental housing, as Figure 1 illustrates. The original equilibrium (E0) lies at the intersection of supply curve S0 and demand curve D0, corresponding to an equilibrium price of $500 and an equilibrium quantity of 15,000 units of rental housing. The effect of greater income or a change in tastes is to shift the demand curve for rental housing to the right, as shown by the data in Table 10 and the shift from D0 to D1 on the graph. In this market, at the new equilibrium E1, the price of a rental unit would rise to $600 and the equilibrium quantity would increase to 17,000 units.

The graph shows a shift in demand with a price ceiling.
Figure 1. A Price Ceiling Example—Rent Control. The original intersection of demand and supply occurs at E0. If demand shifts from D0 to D1, the new equilibrium would be at E1—unless a price ceiling prevents the price from rising. If the price is not permitted to rise, the quantity supplied remains at 15,000. However, after the change in demand, the quantity demanded rises to 19,000, resulting in a shortage.
Price Original Quantity Supplied Original Quantity Demanded New Quantity Demanded
$400 12,000 18,000 23,000
$500 15,000 15,000 19,000
$600 17,000 13,000 17,000
$700 19,000 11,000 15,000
$800 20,000 10,000 14,000
Table 10. Rent Control

Suppose that a rent control law is passed to keep the price at the original equilibrium of $500 for a typical apartment. In Figure 1, the horizontal line at the price of $500 shows the legally fixed maximum price set by the rent control law. However, the underlying forces that shifted the demand curve to the right are still there. At that price ($500), the quantity supplied remains at the same 15,000 rental units, but the quantity demanded is 19,000 rental units. In other words, the quantity demanded exceeds the quantity supplied, so there is a shortage of rental housing. One of the ironies of price ceilings is that while the price ceiling was intended to help renters, there are actually fewer apartments rented out under the price ceiling (15,000 rental units) than would be the case at the market rent of $600 (17,000 rental units).

Price ceilings do not simply benefit renters at the expense of landlords. Rather, some renters (or potential renters) lose their housing as landlords convert apartments to co-ops and condos. Even when the housing remains in the rental market, landlords tend to spend less on maintenance and on essentials like heating, cooling, hot water, and lighting. The first rule of economics is you do not get something for nothing—everything has an opportunity cost. So if renters get “cheaper” housing than the market requires, they tend to also end up with lower quality housing.

Price ceilings have been proposed for other products. For example, price ceilings to limit what producers can charge have been proposed in recent years for prescription drugs, doctor and hospital fees, the charges made by some automatic teller bank machines, and auto insurance rates. Price ceilings are enacted in an attempt to keep prices low for those who demand the product. But when the market price is not allowed to rise to the equilibrium level, quantity demanded exceeds quantity supplied, and thus a shortage occurs. Those who manage to purchase the product at the lower price given by the price ceiling will benefit, but sellers of the product will suffer, along with those who are not able to purchase the product at all. Quality is also likely to deteriorate.

Price Floors

A price floor is the lowest legal price that can be paid in markets for goods and services, labor, or financial capital. Perhaps the best-known example of a price floor is the minimum wage, which is based on the normative view that someone working full time ought to be able to afford a basic standard of living. The federal minimum wage at the end of 2014 was $7.25 per hour, which yields an income for a single person slightly higher than the poverty line. As the cost of living rises over time, the Congress periodically raises the federal minimum wage.

Price floors are sometimes called “price supports,” because they support a price by preventing it from falling below a certain level. Around the world, many countries have passed laws to create agricultural price supports. Farm prices and thus farm incomes fluctuate, sometimes widely. So even if, on average, farm incomes are adequate, some years they can be quite low. The purpose of price supports is to prevent these swings.

The most common way price supports work is that the government enters the market and buys up the product, adding to demand to keep prices higher than they otherwise would be. According to the Common Agricultural Policy reform passed in 2013, the European Union (EU) will spend about 60 billion euros per year, or 67 billion dollars per year, or roughly 38% of the EU budget, on price supports for Europe’s farmers from 2014 to 2020.

Figure 2 illustrates the effects of a government program that assures a price above the equilibrium by focusing on the market for wheat in Europe. In the absence of government intervention, the price would adjust so that the quantity supplied would equal the quantity demanded at the equilibrium point E0, with price P0 and quantity Q0. However, policies to keep prices high for farmers keeps the price above what would have been the market equilibrium level—the price Pf shown by the dashed horizontal line in the diagram. The result is a quantity supplied in excess of the quantity demanded (Qd). When quantity supplied exceeds quantity demanded, a surplus exists.

The high-income areas of the world, including the United States, Europe, and Japan, are estimated to spend roughly $1 billion per day in supporting their farmers. If the government is willing to purchase the excess supply (or to provide payments for others to purchase it), then farmers will benefit from the price floor, but taxpayers and consumers of food will pay the costs. Numerous proposals have been offered for reducing farm subsidies. In many countries, however, political support for subsidies for farmers remains strong. Either because this is viewed by the population as supporting the traditional rural way of life or because of the lobbying power of the agro-business industry.

For more detail on the effects price ceilings and floors have on demand and supply, see the following Clear It Up feature.

The graph shows an example of a price floor which results in a surplus.
Figure 2. European Wheat Prices: A Price Floor Example. The intersection of demand (D) and supply (S) would be at the equilibrium point E0. However, a price floor set at Pf holds the price above E0 and prevents it from falling. The result of the price floor is that the quantity supplied Qs exceeds the quantity demanded Qd. There is excess supply, also called a surplus.

Do price ceilings and floors change demand or supply?

Neither price ceilings nor price floors cause demand or supply to change. They simply set a price that limits what can be legally charged in the market. Remember, changes in price do not cause demand or supply to change. Price ceilings and price floors can cause a different choice of quantity demanded along a demand curve, but they do not move the demand curve. Price controls can cause a different choice of quantity supplied along a supply curve, but they do not shift the supply curve.

Key Concepts and Summary

Price ceilings prevent a price from rising above a certain level. When a price ceiling is set below the equilibrium price, quantity demanded will exceed quantity supplied, and excess demand or shortages will result. Price floors prevent a price from falling below a certain level. When a price floor is set above the equilibrium price, quantity supplied will exceed quantity demanded, and excess supply or surpluses will result. Price floors and price ceilings often lead to unintended consequences.

Self-Check Questions

  1. What is the effect of a price ceiling on the quantity demanded of the product? What is the effect of a price ceiling on the quantity supplied? Why exactly does a price ceiling cause a shortage?
  2. Does a price ceiling change the equilibrium price?
  3. What would be the impact of imposing a price floor below the equilibrium price?

Review Questions

  1. Does a price ceiling attempt to make a price higher or lower?
  2. How does a price ceiling set below the equilibrium level affect quantity demanded and quantity supplied?
  3. Does a price floor attempt to make a price higher or lower?
  4. How does a price floor set above the equilibrium level affect quantity demanded and quantity supplied?

Critical Thinking Questions

  1. Most government policy decisions have winners and losers. What are the effects of raising the minimum wage? It is more complex than simply producers lose and workers gain. Who are the winners and who are the losers, and what exactly do they win and lose? To what extent does the policy change achieve its goals?
  2. Agricultural price supports result in governments holding large inventories of agricultural products. Why do you think the government cannot simply give the products away to poor people?
  3. Can you propose a policy that would induce the market to supply more rental housing units?

Problems

A low-income country decides to set a price ceiling on bread so it can make sure that bread is affordable to the poor. The conditions of demand and supply are given in Table 11. What are the equilibrium price and equilibrium quantity before the price ceiling? What will the excess demand or the shortage (that is, quantity demanded minus quantity supplied) be if the price ceiling is set at $2.40? At $2.00? At $3.60?

Price Qd Qs
$1.60 9,000 5,000
$2.00 8,500 5,500
$2.40 8,000 6,400
$2.80 7,500 7,500
$3.20 7,000 9,000
$3.60 6,500 11,000
$4.00 6,000 15,000
Table 11. Demand and Supply of Bread in Low-Income Country

Glossary

price ceiling
a legal maximum price
price control
government laws to regulate prices instead of letting market forces determine prices
price floor
a legal minimum price
total surplus
see social surplus

Solutions

Answers to Self-Check Questions

  1. A price ceiling (which is below the equilibrium price) will cause the quantity demanded to rise and the quantity supplied to fall. This is why a price ceiling creates a shortage.
  2. A price ceiling is just a legal restriction. Equilibrium is an economic condition. People may or may not obey the price ceiling, so the actual price may be at or above the price ceiling, but the price ceiling does not change the equilibrium price.
  3. A price ceiling is a legal maximum price, but a price floor is a legal minimum price and, consequently, it would leave room for the price to rise to its equilibrium level. In other words, a price floor below equilibrium will not be binding and will have no effect.

4.5 Demand, Supply, and Efficiency

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Learning Objectives

By the end of this section, you will be able to:
  • Contrast consumer surplus, producer surplus, and social surplus
  • Explain why price floors and price ceilings can be inefficient
  • Analyze demand and supply as a social adjustment mechanism

The familiar demand and supply diagram holds within it the concept of economic efficiency. One typical way that economists define efficiency is when it is impossible to improve the situation of one party without imposing a cost on another. Conversely, if a situation is inefficient, it becomes possible to benefit at least one party without imposing costs on others.

Efficiency in the demand and supply model has the same basic meaning: The economy is getting as much benefit as possible from its scarce resources and all the possible gains from trade have been achieved. In other words, the optimal amount of each good and service is being produced and consumed.

Consumer Surplus, Producer Surplus, Social Surplus

Consider a market for tablet computers, as shown in Figure 1. The equilibrium price is $80 and the equilibrium quantity is 28 million. To see the benefits to consumers, look at the segment of the demand curve above the equilibrium point and to the left. This portion of the demand curve shows that at least some demanders would have been willing to pay more than $80 for a tablet.

For example, point J shows that if the price was $90, 20 million tablets would be sold. Those consumers who would have been willing to pay $90 for a tablet based on the utility they expect to receive from it, but who were able to pay the equilibrium price of $80, clearly received a benefit beyond what they had to pay for. Remember, the demand curve traces consumers’ willingness to pay for different quantities. The amount that individuals would have been willing to pay, minus the amount that they actually paid, is called consumer surplus. Consumer surplus is the area labeled F—that is, the area above the market price and below the demand curve.

The graph shows consumer surplus above the equilibrium and producer surplus beneath the equilibrium.
Figure 1. Consumer and Producer Surplus. The somewhat triangular area labeled by F shows the area of consumer surplus, which shows that the equilibrium price in the market was less than what many of the consumers were willing to pay. Point J on the demand curve shows that, even at the price of $90, consumers would have been willing to purchase a quantity of 20 million. The somewhat triangular area labeled by G shows the area of producer surplus, which shows that the equilibrium price received in the market was more than what many of the producers were willing to accept for their products. For example, point K on the supply curve shows that at a price of $45, firms would have been willing to supply a quantity of 14 million.

The supply curve shows the quantity that firms are willing to supply at each price. For example, point K in Figure 1 illustrates that, at $45, firms would still have been willing to supply a quantity of 14 million. Those producers who would have been willing to supply the tablets at $45, but who were instead able to charge the equilibrium price of $80, clearly received an extra benefit beyond what they required to supply the product. The amount that a seller is paid for a good minus the seller’s actual cost is called producer surplus. In Figure 1, producer surplus is the area labeled G—that is, the area between the market price and the segment of the supply curve below the equilibrium.

The sum of consumer surplus and producer surplus is social surplus, also referred to as economic surplus or total surplus. In Figure 1, social surplus would be shown as the area F + G. Social surplus is larger at equilibrium quantity and price than it would be at any other quantity. This demonstrates the economic efficiency of the market equilibrium. In addition, at the efficient level of output, it is impossible to produce greater consumer surplus without reducing producer surplus, and it is impossible to produce greater producer surplus without reducing consumer surplus.

Inefficiency of Price Floors and Price Ceilings

The imposition of a price floor or a price ceiling will prevent a market from adjusting to its equilibrium price and quantity, and thus will create an inefficient outcome. But there is an additional twist here. Along with creating inefficiency, price floors and ceilings will also transfer some consumer surplus to producers, or some producer surplus to consumers.

Imagine that several firms develop a promising but expensive new drug for treating back pain. If this therapy is left to the market, the equilibrium price will be $600 per month and 20,000 people will use the drug, as shown in Figure 2 (a). The original level of consumer surplus is T + U and producer surplus is V + W + X. However, the government decides to impose a price ceiling of $400 to make the drug more affordable. At this price ceiling, firms in the market now produce only 15,000.

As a result, two changes occur. First, an inefficient outcome occurs and the total surplus of society is reduced. The loss in social surplus that occurs when the economy produces at an inefficient quantity is called deadweight loss. In a very real sense, it is like money thrown away that benefits no one. In Figure 2 (a), the deadweight loss is the area U + W. When deadweight loss exists, it is possible for both consumer and producer surplus to be higher, in this case because the price control is blocking some suppliers and demanders from transactions they would both be willing to make.

A second change from the price ceiling is that some of the producer surplus is transferred to consumers. After the price ceiling is imposed, the new consumer surplus is T + V, while the new producer surplus is X. In other words, the price ceiling transfers the area of surplus (V) from producers to consumers. Note that the gain to consumers is less than the loss to producers, which is just another way of seeing the deadweight loss.

The two graphs show how equilibrium is affected by price floors and price ceilings.
Figure 2. (a) Efficiency and Price Floors and Ceilings. The original equilibrium price is $600 with a quantity of 20,000. Consumer surplus is T + U, and producer surplus is V + W + X. A price ceiling is imposed at $400, so firms in the market now produce only a quantity of 15,000. As a result, the new consumer surplus is T + V, while the new producer surplus is X. (b) The original equilibrium is $8 at a quantity of 1,800. Consumer surplus is G + H + J, and producer surplus is I + K. A price floor is imposed at $12, which means that quantity demanded falls to 1,400. As a result, the new consumer surplus is G, and the new producer surplus is H + I.

Figure 2 (b) shows a price floor example using a string of struggling movie theaters, all in the same city. The current equilibrium is $8 per movie ticket, with 1,800 people attending movies. The original consumer surplus is G + H + J, and producer surplus is I + K. The city government is worried that movie theaters will go out of business, reducing the entertainment options available to citizens, so it decides to impose a price floor of $12 per ticket. As a result, the quantity demanded of movie tickets falls to 1,400. The new consumer surplus is G, and the new producer surplus is H + I. In effect, the price floor causes the area H to be transferred from consumer to producer surplus, but also causes a deadweight loss of J + K.

This analysis shows that a price ceiling, like a law establishing rent controls, will transfer some producer surplus to consumers—which helps to explain why consumers often favor them. Conversely, a price floor like a guarantee that farmers will receive a certain price for their crops will transfer some consumer surplus to producers, which explains why producers often favor them. However, both price floors and price ceilings block some transactions that buyers and sellers would have been willing to make, and creates deadweight loss. Removing such barriers, so that prices and quantities can adjust to their equilibrium level, will increase the economy’s social surplus.

Demand and Supply as a Social Adjustment Mechanism

The demand and supply model emphasizes that prices are not set only by demand or only by supply, but by the interaction between the two. In 1890, the famous economist Alfred Marshall wrote that asking whether supply or demand determined a price was like arguing “whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper.” The answer is that both blades of the demand and supply scissors are always involved.

The adjustments of equilibrium price and quantity in a market-oriented economy often occur without much government direction or oversight. If the coffee crop in Brazil suffers a terrible frost, then the supply curve of coffee shifts to the left and the price of coffee rises. Some people—call them the coffee addicts—continue to drink coffee and pay the higher price. Others switch to tea or soft drinks. No government commission is needed to figure out how to adjust coffee prices, which companies will be allowed to process the remaining supply, which supermarkets in which cities will get how much coffee to sell, or which consumers will ultimately be allowed to drink the brew. Such adjustments in response to price changes happen all the time in a market economy, often so smoothly and rapidly that we barely notice them.

Think for a moment of all the seasonal foods that are available and inexpensive at certain times of the year, like fresh corn in midsummer, but more expensive at other times of the year. People alter their diets and restaurants alter their menus in response to these fluctuations in prices without fuss or fanfare. For both the U.S. economy and the world economy as a whole, markets—that is, demand and supply—are the primary social mechanism for answering the basic questions about what is produced, how it is produced, and for whom it is produced.

Why Can We Not Get Enough of Organic?

Organic food is grown without synthetic pesticides, chemical fertilizers or genetically modified seeds. In recent decades, the demand for organic products has increased dramatically. The Organic Trade Association reported sales increased from $1 billion in 1990 to $35.1 billion in 2013, more than 90% of which were sales of food products.

Why, then, are organic foods more expensive than their conventional counterparts? The answer is a clear application of the theories of supply and demand. As people have learned more about the harmful effects of chemical fertilizers, growth hormones, pesticides and the like from large-scale factory farming, our tastes and preferences for safer, organic foods have increased. This change in tastes has been reinforced by increases in income, which allow people to purchase pricier products, and has made organic foods more mainstream. This has led to an increased demand for organic foods. Graphically, the demand curve has shifted right, and we have moved up the supply curve as producers have responded to the higher prices by supplying a greater quantity.

In addition to the movement along the supply curve, we have also had an increase in the number of farmers converting to organic farming over time. This is represented by a shift to the right of the supply curve. Since both demand and supply have shifted to the right, the resulting equilibrium quantity of organic foods is definitely higher, but the price will only fall when the increase in supply is larger than the increase in demand. We may need more time before we see lower prices in organic foods. Since the production costs of these foods may remain higher than conventional farming, because organic fertilizers and pest management techniques are more expensive, they may never fully catch up with the lower prices of non-organic foods.

As a final, specific example: The Environmental Working Group’s “Dirty Dozen” list of fruits and vegetables, which test high for pesticide residue even after washing, was released in April 2013. The inclusion of strawberries on the list has led to an increase in demand for organic strawberries, resulting in both a higher equilibrium price and quantity of sales.

Key Concepts and Summary

Consumer surplus is the gap between the price that consumers are willing to pay, based on their preferences, and the market equilibrium price. Producer surplus is the gap between the price for which producers are willing to sell a product, based on their costs, and the market equilibrium price. Social surplus is the sum of consumer surplus and producer surplus. Total surplus is larger at the equilibrium quantity and price than it will be at any other quantity and price. Deadweight loss is loss in total surplus that occurs when the economy produces at an inefficient quantity.

Self-Check Questions

  1. Does a price ceiling increase or decrease the number of transactions in a market? Why? What about a price floor?
  2. If a price floor benefits producers, why does a price floor reduce social surplus?

Review Questions

  1. What is consumer surplus? How is it illustrated on a demand and supply diagram?
  2. What is producer surplus? How is it illustrated on a demand and supply diagram?
  3. What is total surplus? How is it illustrated on a demand and supply diagram?
  4. What is the relationship between total surplus and economic efficiency?
  5. What is deadweight loss?

Critical Thinking Questions

  1. What term would an economist use to describe what happens when a shopper gets a “good deal” on a product?
  2. Explain why voluntary transactions improve social welfare.
  3. Why would a free market never operate at a quantity greater than the equilibrium quantity? Hint: What would be required for a transaction to occur at that quantity?

Glossary

consumer surplus
the extra benefit consumers receive from buying a good or service, measured by what the individuals would have been willing to pay minus the amount that they actually paid
deadweight loss
the loss in social surplus that occurs when a market produces an inefficient quantity
economic surplus
see social surplus
producer surplus
the extra benefit producers receive from selling a good or service, measured by the price the producer actually received minus the price the producer would have been willing to accept
social surplus
the sum of consumer surplus and producer surplus

Solutions

Answers to Self-Check Questions

  1. Assuming that people obey the price ceiling, the market price will be below equilibrium, which means that Qd will be more than Qs. Buyers can only buy what is offered for sale, so the number of transactions will fall to Qs. This is easy to see graphically. By analogous reasoning, with a price floor the market price will be above the equilibrium price, so Qd will be less than Qs. Since the limit on transactions here is demand, the number of transactions will fall to Qd. Note that because both price floors and price ceilings reduce the number of transactions, social surplus is less.
  2. Because the losses to consumers are greater than the benefits to producers, so the net effect is negative. Since the lost consumer surplus is greater than the additional producer surplus, social surplus falls.

Chapter 5. Labor and Financial Markets

V

Introduction to Labor and Financial Markets

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The photograph shows a nurse administering a vaccine to a patient.
Figure 1. People often think of demand and supply in relation to goods, but labor markets, such as the nursing profession, can also apply to this analysis. (Credit: modification of work by “Fotos GOVBA”/Flickr Creative Commons)

Baby Boomers Come of Age

The Census Bureau reports that as of 2013, 20% of the U.S. population was over 60 years old, which means that almost 63 million people are reaching an age when they will need increased medical care.

The baby boomer population, the group born between 1946 and 1964, is comprised of approximately 74 million people who have just reached retirement age. As this population grows older, they will be faced with common healthcare issues such as heart conditions, arthritis, and Alzheimer’s that may require hospitalization, long-term, or at-home nursing care. Aging baby boomers and advances in life-saving and life-extending technologies will increase the demand for healthcare and nursing. Additionally, the Affordable Care Act, which expands access to healthcare for millions of Americans, will further increase the demand.

According to the Bureau of Labor Statistics, registered nursing jobs are expected to increase by 19% between 2012 and 2022. The median annual wage of $67,930 (in 2012) is also expected to increase. The BLS forecasts that 526,000 new nurses will be needed by 2022. One concern is the low rate of enrollment in nursing programs to help meet the growing demand. According to the American Association of Colleges of Nursing (AACN), enrollment in 2011 increased by only 5.1% due to a shortage of nursing educators and teaching facilities.

These data tell us, as economists, that the market for healthcare professionals, and nurses in particular, will face several challenges. Our study of supply and demand will help us to analyze what might happen in the labor market for nursing and other healthcare professionals, as discussed in the second half of this case at the end of the chapter.

Chapter Objectives

Introduction to Labor and Financial Markets

In this chapter, you will learn about:

  • Demand and Supply at Work in Labor Markets
  • Demand and Supply in Financial Markets
  • The Market System as an Efficient Mechanism for Information

The theories of supply and demand do not apply just to markets for goods. They apply to any market, even markets for labor and financial services. Labor markets are markets for employees or jobs. Financial services markets are markets for saving or borrowing.

When we think about demand and supply curves in goods and services markets, it is easy to picture who the demanders and suppliers are: businesses produce the products and households buy them. Who are the demanders and suppliers in labor and financial service markets? In labor markets job seekers (individuals) are the suppliers of labor, while firms and other employers who hire labor are the demanders for labor. In financial markets, any individual or firm who saves contributes to the supply of money, and any who borrows (person, firm, or government) contributes to the demand for money.

As a college student, you most likely participate in both labor and financial markets. Employment is a fact of life for most college students: In 2011, says the BLS, 52% of undergraduates worked part time and another 20% worked full time. Most college students are also heavily involved in financial markets, primarily as borrowers. Among full-time students, about half take out a loan to help finance their education each year, and those loans average about $6,000 per year. Many students also borrow for other expenses, like purchasing a car. As this chapter will illustrate, we can analyze labor markets and financial markets with the same tools we use to analyze demand and supply in the goods markets.

5.1 Demand and Supply at Work in Labor Markets

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Learning Objectives

By the end of this section, you will be able to:

  • Predict shifts in the demand and supply curves of the labor market
  • Explain the impact of new technology on the demand and supply curves of the labor market
  • Explain price floors in the labor market such as minimum wage or a living wage

Markets for labor have demand and supply curves, just like markets for goods. The law of demand applies in labor markets this way: A higher salary or wage—that is, a higher price in the labor market—leads to a decrease in the quantity of labor demanded by employers, while a lower salary or wage leads to an increase in the quantity of labor demanded. The law of supply functions in labor markets, too: A higher price for labor leads to a higher quantity of labor supplied; a lower price leads to a lower quantity supplied.

Equilibrium in the Labor Market

In 2013, about 34,000 registered nurses worked in the Minneapolis-St. Paul-Bloomington, Minnesota-Wisconsin metropolitan area, according to the BLS. They worked for a variety of employers: hospitals, doctors’ offices, schools, health clinics, and nursing homes. Figure 1 illustrates how demand and supply determine equilibrium in this labor market. The demand and supply schedules in Table 1 list the quantity supplied and quantity demanded of nurses at different salaries.

This graph shows how equilibrium is affected by demand and supply. The downward- sloping demand curve and the upward-sloping supply curve intersect at equilibrium salary.
Figure 1. Labor Market Example: Demand and Supply for Nurses in Minneapolis-St. Paul-Bloomington. The demand curve (D) of those employers who want to hire nurses intersects with the supply curve (S) of those who are qualified and willing to work as nurses at the equilibrium point (E). The equilibrium salary is $70,000 and the equilibrium quantity is 34,000 nurses. At an above-equilibrium salary of $75,000, quantity supplied increases to 38,000, but the quantity of nurses demanded at the higher pay declines to 33,000. At this above-equilibrium salary, an excess supply or surplus of nurses would exist. At a below-equilibrium salary of $60,000, quantity supplied declines to 27,000, while the quantity demanded at the lower wage increases to 40,000 nurses. At this below-equilibrium salary, excess demand or a surplus exists.
Annual Salary Quantity Demanded Quantity Supplied
$55,000 45,000 20,000
$60,000 40,000 27,000
$65,000 37,000 31,000
$70,000 34,000 34,000
$75,000 33,000 38,000
$80,000 32,000 41,000
Table 1. Demand and Supply of Nurses in Minneapolis-St. Paul-Bloomington

The horizontal axis shows the quantity of nurses hired. In this example, labor is measured by number of workers, but another common way to measure the quantity of labor is by the number of hours worked. The vertical axis shows the price for nurses’ labor—that is, how much they are paid. In the real world, this “price” would be total labor compensation: salary plus benefits. It is not obvious, but benefits are a significant part (as high as 30 percent) of labor compensation. In this example, the price of labor is measured by salary on an annual basis, although in other cases the price of labor could be measured by monthly or weekly pay, or even the wage paid per hour. As the salary for nurses rises, the quantity demanded will fall. Some hospitals and nursing homes may cut back on the number of nurses they hire, or they may lay off some of their existing nurses, rather than pay them higher salaries. Employers who face higher nurses’ salaries may also try to replace some nursing functions by investing in physical equipment, like computer monitoring and diagnostic systems to monitor patients, or by using lower-paid health care aides to reduce the number of nurses they need.

As the salary for nurses rises, the quantity supplied will rise. If nurses’ salaries in Minneapolis-St. Paul-Bloomington are higher than in other cities, more nurses will move to Minneapolis-St. Paul-Bloomington to find jobs, more people will be willing to train as nurses, and those currently trained as nurses will be more likely to pursue nursing as a full-time job. In other words, there will be more nurses looking for jobs in the area.

At equilibrium, the quantity supplied and the quantity demanded are equal. Thus, every employer who wants to hire a nurse at this equilibrium wage can find a willing worker, and every nurse who wants to work at this equilibrium salary can find a job. In Figure 1, the supply curve (S) and demand curve (D) intersect at the equilibrium point (E). The equilibrium quantity of nurses in the Minneapolis-St. Paul-Bloomington area is 34,000, and the equilibrium salary is $70,000 per year. This example simplifies the nursing market by focusing on the “average” nurse. In reality, of course, the market for nurses is actually made up of many smaller markets, like markets for nurses with varying degrees of experience and credentials. Many markets contain closely related products that differ in quality; for instance, even a simple product like gasoline comes in regular, premium, and super-premium, each with a different price. Even in such cases, discussing the average price of gasoline, like the average salary for nurses, can still be useful because it reflects what is happening in most of the submarkets.

When the price of labor is not at the equilibrium, economic incentives tend to move salaries toward the equilibrium. For example, if salaries for nurses in Minneapolis-St. Paul-Bloomington were above the equilibrium at $75,000 per year, then 38,000 people want to work as nurses, but employers want to hire only 33,000 nurses. At that above-equilibrium salary, excess supply or a surplus results. In a situation of excess supply in the labor market, with many applicants for every job opening, employers will have an incentive to offer lower wages than they otherwise would have. Nurses’ salary will move down toward equilibrium.

In contrast, if the salary is below the equilibrium at, say, $60,000 per year, then a situation of excess demand or a shortage arises. In this case, employers encouraged by the relatively lower wage want to hire 40,000 nurses, but only 27,000 individuals want to work as nurses at that salary in Minneapolis-St. Paul-Bloomington. In response to the shortage, some employers will offer higher pay to attract the nurses. Other employers will have to match the higher pay to keep their own employees. The higher salaries will encourage more nurses to train or work in Minneapolis-St. Paul-Bloomington. Again, price and quantity in the labor market will move toward equilibrium.

Shifts in Labor Demand

The demand curve for labor shows the quantity of labor employers wish to hire at any given salary or wage rate, under the ceteris paribus assumption. A change in the wage or salary will result in a change in the quantity demanded of labor. If the wage rate increases, employers will want to hire fewer employees. The quantity of labor demanded will decrease, and there will be a movement upward along the demand curve. If the wages and salaries decrease, employers are more likely to hire a greater number of workers. The quantity of labor demanded will increase, resulting in a downward movement along the demand curve.

Shifts in the demand curve for labor occur for many reasons. One key reason is that the demand for labor is based on the demand for the good or service that is being produced. For example, the more new automobiles consumers demand, the greater the number of workers automakers will need to hire. Therefore the demand for labor is called a “derived demand.” Here are some examples of derived demand for labor:

  • The demand for chefs is dependent on the demand for restaurant meals.
  • The demand for pharmacists is dependent on the demand for prescription drugs.
  • The demand for attorneys is dependent on the demand for legal services.

As the demand for the goods and services increases, the demand for labor will increase, or shift to the right, to meet employers’ production requirements. As the demand for the goods and services decreases, the demand for labor will decrease, or shift to the left. Table 2 shows that in addition to the derived demand for labor, demand can also increase or decrease (shift) in response to several factors.

Factors Results
Demand for Output When the demand for the good produced (output) increases, both the output price and profitability increase. As a result, producers demand more labor to ramp up production.
Education and Training A well-trained and educated workforce causes an increase in the demand for that labor by employers. Increased levels of productivity within the workforce will cause the demand for labor to shift to the right. If the workforce is not well-trained or educated, employers will not hire from within that labor pool, since they will need to spend a significant amount of time and money training that workforce. Demand for such will shift to the left.
Technology Technology changes can act as either substitutes for or complements to labor. When technology acts as a substitute, it replaces the need for the number of workers an employer needs to hire. For example, word processing decreased the number of typists needed in the workplace. This shifted the demand curve for typists left. An increase in the availability of certain technologies may increase the demand for labor. Technology that acts as a complement to labor will increase the demand for certain types of labor, resulting in a rightward shift of the demand curve. For example, the increased use of word processing and other software has increased the demand for information technology professionals who can resolve software and hardware issues related to a firm’s network. More and better technology will increase demand for skilled workers who know how to use technology to enhance workplace productivity. Those workers who do not adapt to changes in technology will experience a decrease in demand.
Number of Companies An increase in the number of companies producing a given product will increase the demand for labor resulting in a shift to the right. A decrease in the number of companies producing a given product will decrease the demand for labor resulting in a shift to the left.
Government Regulations Complying with government regulations can increase or decrease the demand for labor at any given wage. In the healthcare industry, government rules may require that nurses be hired to carry out certain medical procedures. This will increase the demand for nurses. Less-trained healthcare workers would be prohibited from carrying out these procedures, and the demand for these workers will shift to the left.
Price and Availability of Other Inputs Labor is not the only input into the production process. For example, a salesperson at a call center needs a telephone and a computer terminal to enter data and record sales. The demand for salespersons at the call center will increase if the number of telephones and computer terminals available increases. This will cause a rightward shift of the demand curve. As the amount of inputs increases, the demand for labor will increase. If the terminal or the telephones malfunction, then the demand for that labor force will decrease. As the quantity of other inputs decreases, the demand for labor will decrease. Similarly, if prices of other inputs fall, production will become more profitable and suppliers will demand more labor to increase production. The opposite is also true. Higher input prices lower demand for labor
Table 2. Factors That Can Shift Demand

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Shifts in Labor Supply

The supply of labor is upward-sloping and adheres to the law of supply: The higher the price, the greater the quantity supplied and the lower the price, the less quantity supplied. The supply curve models the tradeoff between supplying labor into the market or using time in leisure activities at every given price level. The higher the wage, the more labor is willing to work and forego leisure activities. Table 3 lists some of the factors that will cause the supply to increase or decrease.

Factors Results
Number of Workers An increased number of workers will cause the supply curve to shift to the right. An increased number of workers can be due to several factors, such as immigration, increasing population, an aging population, and changing demographics. Policies that encourage immigration will increase the supply of labor, and vice versa. Population grows when birth rates exceed death rates; this eventually increases supply of labor when the former reach working age. An aging and therefore retiring population will decrease the supply of labor. Another example of changing demographics is more women working outside of the home, which increases the supply of labor.
Required Education The more required education, the lower the supply. There is a lower supply of PhD mathematicians than of high school mathematics teachers; there is a lower supply of cardiologists than of primary care physicians; and there is a lower supply of physicians than of nurses.
Government Policies Government policies can also affect the supply of labor for jobs. On the one hand, the government may support rules that set high qualifications for certain jobs: academic training, certificates or licenses, or experience. When these qualifications are made tougher, the number of qualified workers will decrease at any given wage. On the other hand, the government may also subsidize training or even reduce the required level of qualifications. For example, government might offer subsidies for nursing schools or nursing students. Such provisions would shift the supply curve of nurses to the right. In addition, government policies that change the relative desirability of working versus not working also affect the labor supply. These include unemployment benefits, maternity leave, child care benefits and welfare policy. For example, child care benefits may increase the labor supply of working mothers. Long term unemployment benefits may discourage job searching for unemployed workers. All these policies must therefore be carefully designed to minimize any negative labor supply effects.
Table 3. Factors that Can Shift Supply

A change in salary will lead to a movement along labor demand or labor supply curves, but it will not shift those curves. However, other events like those outlined here will cause either the demand or the supply of labor to shift, and thus will move the labor market to a new equilibrium salary and quantity.

Technology and Wage Inequality: The Four-Step Process

Economic events can change the equilibrium salary (or wage) and quantity of labor. Consider how the wave of new information technologies, like computer and telecommunications networks, has affected low-skill and high-skill workers in the U.S. economy. From the perspective of employers who demand labor, these new technologies are often a substitute for low-skill laborers like file clerks who used to keep file cabinets full of paper records of transactions. However, the same new technologies are a complement to high-skill workers like managers, who benefit from the technological advances by being able to monitor more information, communicate more easily, and juggle a wider array of responsibilities. So, how will the new technologies affect the wages of high-skill and low-skill workers? For this question, the four-step process of analyzing how shifts in supply or demand affect a market (introduced in Demand and Supply) works in this way:

Step 1. What did the markets for low-skill labor and high-skill labor look like before the arrival of the new technologies? In Figure 2 (a) and Figure 2 (b), S0 is the original supply curve for labor and D0 is the original demand curve for labor in each market. In each graph, the original point of equilibrium, E0, occurs at the price W0 and the quantity Q0.

The two graphs show how new technology influences supply and demand. The graph on the left represents low-skill labor, and the graph on the right represents high-skill labor.
Figure 2. Technology and Wages: Applying Demand and Supply (a) The demand for low-skill labor shifts to the left when technology can do the job previously done by these workers. (b) New technologies can also increase the demand for high-skill labor in fields such as information technology and network administration.

Step 2. Does the new technology affect the supply of labor from households or the demand for labor from firms? The technology change described here affects demand for labor by firms that hire workers.

Step 3. Will the new technology increase or decrease demand? Based on the description earlier, as the substitute for low-skill labor becomes available, demand for low-skill labor will shift to the left, from D0 to D1. As the technology complement for high-skill labor becomes cheaper, demand for high-skill labor will shift to the right, from D0 to D1.

Step 4. The new equilibrium for low-skill labor, shown as point E1 with price W1 and quantity Q1, has a lower wage and quantity hired than the original equilibrium, E0. The new equilibrium for high-skill labor, shown as point E1 with price W1 and quantity Q1, has a higher wage and quantity hired than the original equilibrium (E0).

So, the demand and supply model predicts that the new computer and communications technologies will raise the pay of high-skill workers but reduce the pay of low-skill workers. Indeed, from the 1970s to the mid-2000s, the wage gap widened between high-skill and low-skill labor. According to the National Center for Education Statistics, in 1980, for example, a college graduate earned about 30% more than a high school graduate with comparable job experience, but by 2012, a college graduate earned about 60% more than an otherwise comparable high school graduate. Many economists believe that the trend toward greater wage inequality across the U.S. economy was primarily caused by the new technologies.

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Price Floors in the Labor Market: Living Wages and Minimum Wages

In contrast to goods and services markets, price ceilings are rare in labor markets, because rules that prevent people from earning income are not politically popular. There is one exception: sometimes limits are proposed on the high incomes of top business executives.

The labor market, however, presents some prominent examples of price floors, which are often used as an attempt to increase the wages of low-paid workers. The U.S. government sets a minimum wage, a price floor that makes it illegal for an employer to pay employees less than a certain hourly rate. In mid-2009, the U.S. minimum wage was raised to $7.25 per hour. Local political movements in a number of U.S. cities have pushed for a higher minimum wage, which they call a living wage. Promoters of living wage laws maintain that the minimum wage is too low to ensure a reasonable standard of living. They base this conclusion on the calculation that, if you work 40 hours a week at a minimum wage of $7.25 per hour for 50 weeks a year, your annual income is $14,500, which is less than the official U.S. government definition of what it means for a family to be in poverty. (A family with two adults earning minimum wage and two young children will find it more cost efficient for one parent to provide childcare while the other works for income. So the family income would be $14,500, which is significantly lower than the federal poverty line for a family of four, which was $23,850 in 2014.)

Supporters of the living wage argue that full-time workers should be assured a high enough wage so that they can afford the essentials of life: food, clothing, shelter, and healthcare. Since Baltimore passed the first living wage law in 1994, several dozen cities enacted similar laws in the late 1990s and the 2000s. The living wage ordinances do not apply to all employers, but they have specified that all employees of the city or employees of firms that are hired by the city be paid at least a certain wage that is usually a few dollars per hour above the U.S. minimum wage.

Figure 3 illustrates the situation of a city considering a living wage law. For simplicity, we assume that there is no federal minimum wage. The wage appears on the vertical axis, because the wage is the price in the labor market. Before the passage of the living wage law, the equilibrium wage is $10 per hour and the city hires 1,200 workers at this wage. However, a group of concerned citizens persuades the city council to enact a living wage law requiring employers to pay no less than $12 per hour. In response to the higher wage, 1,600 workers look for jobs with the city. At this higher wage, the city, as an employer, is willing to hire only 700 workers. At the price floor, the quantity supplied exceeds the quantity demanded, and a surplus of labor exists in this market. For workers who continue to have a job at a higher salary, life has improved. For those who were willing to work at the old wage rate but lost their jobs with the wage increase, life has not improved. Table 4 shows the differences in supply and demand at different wages.

The graph shows how a price floor results from an excess supply of labor.
Figure 3. A Living Wage: Example of a Price Floor The original equilibrium in this labor market is a wage of $10/hour and a quantity of 1,200 workers, shown at point E. Imposing a wage floor at $12/hour leads to an excess supply of labor. At that wage, the quantity of labor supplied is 1,600 and the quantity of labor demanded is only 700.
Wage Quantity Labor Demanded Quantity Labor Supplied
$8/hr 1,900 500
$9/hr 1,500 900
$10/hr 1,200 1,200
$11/hr 900 1,400
$12/hr 700 1,600
$13/hr 500 1,800
$14/hr 400 1,900
Table 4. Living Wage: Example of a Price Floor

The Minimum Wage as an Example of a Price Floor

The U.S. minimum wage is a price floor that is set either very close to the equilibrium wage or even slightly below it. About 1% of American workers are actually paid the minimum wage. In other words, the vast majority of the U.S. labor force has its wages determined in the labor market, not as a result of the government price floor. But for workers with low skills and little experience, like those without a high school diploma or teenagers, the minimum wage is quite important. In many cities, the federal minimum wage is apparently below the market price for unskilled labor, because employers offer more than the minimum wage to checkout clerks and other low-skill workers without any government prodding.

Economists have attempted to estimate how much the minimum wage reduces the quantity demanded of low-skill labor. A typical result of such studies is that a 10% increase in the minimum wage would decrease the hiring of unskilled workers by 1 to 2%, which seems a relatively small reduction. In fact, some studies have even found no effect of a higher minimum wage on employment at certain times and places—although these studies are controversial.

Let’s suppose that the minimum wage lies just slightly below the equilibrium wage level. Wages could fluctuate according to market forces above this price floor, but they would not be allowed to move beneath the floor. In this situation, the price floor minimum wage is said to be nonbinding —that is, the price floor is not determining the market outcome. Even if the minimum wage moves just a little higher, it will still have no effect on the quantity of employment in the economy, as long as it remains below the equilibrium wage. Even if the minimum wage is increased by enough so that it rises slightly above the equilibrium wage and becomes binding, there will be only a small excess supply gap between the quantity demanded and quantity supplied.

These insights help to explain why U.S. minimum wage laws have historically had only a small impact on employment. Since the minimum wage has typically been set close to the equilibrium wage for low-skill labor and sometimes even below it, it has not had a large effect in creating an excess supply of labor. However, if the minimum wage were increased dramatically—say, if it were doubled to match the living wages that some U.S. cities have considered—then its impact on reducing the quantity demanded of employment would be far greater. The following Clear It Up feature describes in greater detail some of the arguments for and against changes to minimum wage.

What’s the harm in raising the minimum wage?

Because of the law of demand, a higher required wage will reduce the amount of low-skill employment either in terms of employees or in terms of work hours. Although there is controversy over the numbers, let’s say for the sake of the argument that a 10% rise in the minimum wage will reduce the employment of low-skill workers by 2%. Does this outcome mean that raising the minimum wage by 10% is bad public policy? Not necessarily.

If 98% of those receiving the minimum wage have a pay increase of 10%, but 2% of those receiving the minimum wage lose their jobs, are the gains for society as a whole greater than the losses? The answer is not clear, because job losses, even for a small group, may cause more pain than modest income gains for others. For one thing, we need to consider which minimum wage workers are losing their jobs. If the 2% of minimum wage workers who lose their jobs are struggling to support families, that is one thing. If those who lose their job are high school students picking up spending money over summer vacation, that is something else.

Another complexity is that many minimum wage workers do not work full-time for an entire year. Imagine a minimum wage worker who holds different part-time jobs for a few months at a time, with bouts of unemployment in between. The worker in this situation receives the 10% raise in the minimum wage when working, but also ends up working 2% fewer hours during the year because the higher minimum wage reduces how much employers want people to work. Overall, this worker’s income would rise because the 10% pay raise would more than offset the 2% fewer hours worked.

Of course, these arguments do not prove that raising the minimum wage is necessarily a good idea either. There may well be other, better public policy options for helping low-wage workers. (The Poverty and Economic Inequality chapter discusses some possibilities.) The lesson from this maze of minimum wage arguments is that complex social problems rarely have simple answers. Even those who agree on how a proposed economic policy affects quantity demanded and quantity supplied may still disagree on whether the policy is a good idea.

Key Concepts and Summary

In the labor market, households are on the supply side of the market and firms are on the demand side. In the market for financial capital, households and firms can be on either side of the market: they are suppliers of financial capital when they save or make financial investments, and demanders of financial capital when they borrow or receive financial investments.

In the demand and supply analysis of labor markets, the price can be measured by the annual salary or hourly wage received. The quantity of labor can be measured in various ways, like number of workers or the number of hours worked.

Factors that can shift the demand curve for labor include: a change in the quantity demanded of the product that the labor produces; a change in the production process that uses more or less labor; and a change in government policy that affects the quantity of labor that firms wish to hire at a given wage. Demand can also increase or decrease (shift) in response to: workers’ level of education and training, technology, the number of companies, and availability and price of other inputs.

The main factors that can shift the supply curve for labor are: how desirable a job appears to workers relative to the alternatives, government policy that either restricts or encourages the quantity of workers trained for the job, the number of workers in the economy, and required education.

Self-Check Questions

  1. In the labor market, what causes a movement along the demand curve? What causes a shift in the demand curve?
  2. In the labor market, what causes a movement along the supply curve? What causes a shift in the supply curve?
  3. Why is a living wage considered a price floor? Does imposing a living wage have the same outcome as a minimum wage?

Review Questions

  1. What is the “price” commonly called in the labor market?
  2. Are households demanders or suppliers in the goods market? Are firms demanders or suppliers in the goods market? What about the labor market and the financial market?
  3. Name some factors that can cause a shift in the demand curve in labor markets.
  4. Name some factors that can cause a shift in the supply curve in labor markets.

Critical Thinking Questions

  1. Other than the demand for labor, what would be another example of a “derived demand?”
  2. Suppose that a 5% increase in the minimum wage causes a 5% reduction in employment. How would this affect employers and how would it affect workers? In your opinion, would this be a good policy?
  3. What assumption is made for a minimum wage to be a nonbinding price floor? What assumption is made for a living wage price floor to be binding?

Problems

  1. Identify each of the following as involving either demand or supply. Draw a circular flow diagram and label the flows A through F. (Some choices can be on both sides of the goods market.)
    1. Households in the labor market
    2. Firms in the goods market
    3. Firms in the financial market
    4. Households in the goods market
    5. Firms in the labor market
    6. Households in the financial market
  2. Predict how each of the following events will raise or lower the equilibrium wage and quantity of coal miners in West Virginia. In each case, sketch a demand and supply diagram to illustrate your answer.
    1. The price of oil rises.
    2. New coal-mining equipment is invented that is cheap and requires few workers to run.
    3. Several major companies that do not mine coal open factories in West Virginia, offering a lot of well-paid jobs.
    4. Government imposes costly new regulations to make coal-mining a safer job.

References

American Community Survey. 2012. “School Enrollment and Work Status: 2011.” Accessed April 13, 2015. http://www.census.gov/prod/2013pubs/acsbr11-14.pdf.

National Center for Educational Statistics. “Digest of Education Statistics.” (2008 and 2010). Accessed December 11, 2013. nces.ed.gov.

Glossary

minimum wage
a price floor that makes it illegal for an employer to pay employees less than a certain hourly rate

Solutions

Answers to Self-Check Questions

  1. Changes in the wage rate (the price of labor) cause a movement along the demand curve. A change in anything else that affects demand for labor (e.g., changes in output, changes in the production process that use more or less labor, government regulation) causes a shift in the demand curve.
  2. Changes in the wage rate (the price of labor) cause a movement along the supply curve. A change in anything else that affects supply of labor (e.g., changes in how desirable the job is perceived to be, government policy to promote training in the field) causes a shift in the supply curve.
  3. Since a living wage is a suggested minimum wage, it acts like a price floor (assuming, of course, that it is followed). If the living wage is binding, it will cause an excess supply of labor at that wage rate.

5.2 Demand and Supply in Financial Markets

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Learning Objectives

By the end of this section, you will be able to:

  • Identify the demanders and suppliers in a financial market.
  • Explain how interest rates can affect supply and demand
  • Analyze the economic effects of U.S. debt in terms of domestic financial markets
  • Explain the role of price ceilings and usury laws in the U.S.

United States’ households, institutions, and domestic businesses saved almost $1.9 trillion in 2013. Where did that savings go and what was it used for? Some of the savings ended up in banks, which in turn loaned the money to individuals or businesses that wanted to borrow money. Some was invested in private companies or loaned to government agencies that wanted to borrow money to raise funds for purposes like building roads or mass transit. Some firms reinvested their savings in their own businesses.

In this section, we will determine how the demand and supply model links those who wish to supply financial capital (i.e., savings) with those who demand financial capital (i.e., borrowing). Those who save money (or make financial investments, which is the same thing), whether individuals or businesses, are on the supply side of the financial market. Those who borrow money are on the demand side of the financial market. For a more detailed treatment of the different kinds of financial investments like bank accounts, stocks and bonds, see the Financial Markets chapter.

Who Demands and Who Supplies in Financial Markets?

In any market, the price is what suppliers receive and what demanders pay. In financial markets, those who supply financial capital through saving expect to receive a rate of return, while those who demand financial capital by receiving funds expect to pay a rate of return. This rate of return can come in a variety of forms, depending on the type of investment.

The simplest example of a rate of return is the interest rate. For example, when you supply money into a savings account at a bank, you receive interest on your deposit. The interest paid to you as a percent of your deposits is the interest rate. Similarly, if you demand a loan to buy a car or a computer, you will need to pay interest on the money you borrow.

Let’s consider the market for borrowing money with credit cards. In 2014, almost 200 million Americans were cardholders. Credit cards allow you to borrow money from the card’s issuer, and pay back the borrowed amount plus interest, though most allow you a period of time in which you can repay the loan without paying interest. A typical credit card interest rate ranges from 12% to 18% per year. In 2014, Americans had about $793 billion outstanding in credit card debts. About half of U.S. families with credit cards report that they almost always pay the full balance on time, but one-quarter of U.S. families with credit cards say that they “hardly ever” pay off the card in full. In fact, in 2014, 56% of consumers carried an unpaid balance in the last 12 months. Let’s say that, on average, the annual interest rate for credit card borrowing is 15% per year. So, Americans pay tens of billions of dollars every year in interest on their credit cards—plus basic fees for the credit card or fees for late payments.

Figure 1 illustrates demand and supply in the financial market for credit cards. The horizontal axis of the financial market shows the quantity of money that is loaned or borrowed in this market. The vertical or price axis shows the rate of return, which in the case of credit card borrowing can be measured with an interest rate. Table 5 shows the quantity of financial capital that consumers demand at various interest rates and the quantity that credit card firms (often banks) are willing to supply.

The graph shows how a price set below equilibrium causes a shortage of credit and how one set above the equilibrium creates a surplus of credit
Figure 1. Demand and Supply for Borrowing Money with Credit Cards. In this market for credit card borrowing, the demand curve (D) for borrowing financial capital intersects the supply curve (S) for lending financial capital at equilibrium €. At the equilibrium, the interest rate (the “price” in this market) is 15% and the quantity of financial capital being loaned and borrowed is $600 billion. The equilibrium price is where the quantity demanded and the quantity supplied are equal. At an above-equilibrium interest rate like 21%, the quantity of financial capital supplied would increase to $750 billion, but the quantity demanded would decrease to $480 billion. At a below-equilibrium interest rate like 13%, the quantity of financial capital demanded would increase to $700 billion, but the quantity of financial capital supplied would decrease to $510 billion.
Interest Rate (%) Quantity of Financial Capital Demanded (Borrowing) ($ billions) Quantity of Financial Capital Supplied (Lending) ($ billions)
11 $800 $420
13 $700 $510
15 $600 $600
17 $550 $660
19 $500 $720
21 $480 $750
Table 5. Demand and Supply for Borrowing Money with Credit Cards

The laws of demand and supply continue to apply in the financial markets. According to the law of demand, a higher rate of return (that is, a higher price) will decrease the quantity demanded. As the interest rate rises, consumers will reduce the quantity that they borrow. According to the law of supply, a higher price increases the quantity supplied. Consequently, as the interest rate paid on credit card borrowing rises, more firms will be eager to issue credit cards and to encourage customers to use them. Conversely, if the interest rate on credit cards falls, the quantity of financial capital supplied in the credit card market will decrease and the quantity demanded will fall.

Equilibrium in Financial Markets

In the financial market for credit cards shown in Figure 1, the supply curve (S) and the demand curve (D) cross at the equilibrium point (E). The equilibrium occurs at an interest rate of 15%, where the quantity of funds demanded and the quantity supplied are equal at an equilibrium quantity of $600 billion.

If the interest rate (remember, this measures the “price” in the financial market) is above the equilibrium level, then an excess supply, or a surplus, of financial capital will arise in this market. For example, at an interest rate of 21%, the quantity of funds supplied increases to $750 billion, while the quantity demanded decreases to $480 billion. At this above-equilibrium interest rate, firms are eager to supply loans to credit card borrowers, but relatively few people or businesses wish to borrow. As a result, some credit card firms will lower the interest rates (or other fees) they charge to attract more business. This strategy will push the interest rate down toward the equilibrium level.

If the interest rate is below the equilibrium, then excess demand or a shortage of funds occurs in this market. At an interest rate of 13%, the quantity of funds credit card borrowers demand increases to $700 billion; but the quantity credit card firms are willing to supply is only $510 billion. In this situation, credit card firms will perceive that they are overloaded with eager borrowers and conclude that they have an opportunity to raise interest rates or fees. The interest rate will face economic pressures to creep up toward the equilibrium level.

Shifts in Demand and Supply in Financial Markets

Those who supply financial capital face two broad decisions: how much to save, and how to divide up their savings among different forms of financial investments. We will discuss each of these in turn.

Participants in financial markets must decide when they prefer to consume goods: now or in the future. Economists call this intertemporal decision making because it involves decisions across time. Unlike a decision about what to buy from the grocery store, decisions about investment or saving are made across a period of time, sometimes a long period.

Most workers save for retirement because their income in the present is greater than their needs, while the opposite will be true once they retire. So they save today and supply financial markets. If their income increases, they save more. If their perceived situation in the future changes, they change the amount of their saving. For example, there is some evidence that Social Security, the program that workers pay into in order to qualify for government checks after retirement, has tended to reduce the quantity of financial capital that workers save. If this is true, Social Security has shifted the supply of financial capital at any interest rate to the left.

By contrast, many college students need money today when their income is low (or nonexistent) to pay their college expenses. As a result, they borrow today and demand from financial markets. Once they graduate and become employed, they will pay back the loans. Individuals borrow money to purchase homes or cars. A business seeks financial investment so that it has the funds to build a factory or invest in a research and development project that will not pay off for five years, ten years, or even more. So when consumers and businesses have greater confidence that they will be able to repay in the future, the quantity demanded of financial capital at any given interest rate will shift to the right.

For example, in the technology boom of the late 1990s, many businesses became extremely confident that investments in new technology would have a high rate of return, and their demand for financial capital shifted to the right. Conversely, during the Great Recession of 2008 and 2009, their demand for financial capital at any given interest rate shifted to the left.

To this point, we have been looking at saving in total. Now let us consider what affects saving in different types of financial investments. In deciding between different forms of financial investments, suppliers of financial capital will have to consider the rates of return and the risks involved. Rate of return is a positive attribute of investments, but risk is a negative. If Investment A becomes more risky, or the return diminishes, then savers will shift their funds to Investment B—and the supply curve of financial capital for Investment A will shift back to the left while the supply curve of capital for Investment B shifts to the right.

The United States as a Global Borrower

In the global economy, trillions of dollars of financial investment cross national borders every year. In the early 2000s, financial investors from foreign countries were investing several hundred billion dollars per year more in the U.S. economy than U.S. financial investors were investing abroad. The following Work It Out deals with one of the macroeconomic concerns for the U.S. economy in recent years.

The Effect of Growing U.S. Debt

Imagine that the U.S. economy became viewed as a less desirable place for foreign investors to put their money because of fears about the growth of the U.S. public debt. Using the four-step process for analyzing how changes in supply and demand affect equilibrium outcomes, how would increased U.S. public debt affect the equilibrium price and quantity for capital in U.S. financial markets?

Step 1. Draw a diagram showing demand and supply for financial capital that represents the original scenario in which foreign investors are pouring money into the U.S. economy. Figure 2 shows a demand curve, D, and a supply curve, S, where the supply of capital includes the funds arriving from foreign investors. The original equilibrium E0 occurs at interest rate R0 and quantity of financial investment Q0.

The graph shows the supply and demand for financial capital that includes the foreign sector.
Figure 2. The United States as a Global Borrower Before U.S. Debt Uncertainty. The graph shows the demand for financial capital from and supply of financial capital into the U.S. financial markets by the foreign sector before the increase in uncertainty regarding U.S. public debt. The original equilibrium (E0) occurs at an equilibrium rate of return (R0) and the equilibrium quantity is at Q0.

Step 2. Will the diminished confidence in the U.S. economy as a place to invest affect demand or supply of financial capital? Yes, it will affect supply. Many foreign investors look to the U.S. financial markets to store their money in safe financial vehicles with low risk and stable returns. As the U.S. debt increases, debt servicing will increase—that is, more current income will be used to pay the interest rate on past debt. Increasing U.S. debt also means that businesses may have to pay higher interest rates to borrow money, because business is now competing with the government for financial resources.

Step 3. Will supply increase or decrease? When the enthusiasm of foreign investors’ for investing their money in the U.S. economy diminishes, the supply of financial capital shifts to the left. Figure 3 shows the supply curve shift from S0 to S1.

The graph shows the supply and demand for financial capital that includes the foreign sector.
Figure 3. The United States as a Global Borrower Before and After U.S. Debt Uncertainty. The graph shows the demand for financial capital and supply of financial capital into the U.S. financial markets by the foreign sector before and after the increase in uncertainty regarding U.S. public debt. The original equilibrium (E0) occurs at an equilibrium rate of return (R0) and the equilibrium quantity is at Q0.

Step 4. Thus, foreign investors’ diminished enthusiasm leads to a new equilibrium, E1, which occurs at the higher interest rate, R1, and the lower quantity of financial investment, Q1.

The economy has experienced an enormous inflow of foreign capital. According to the U.S. Bureau of Economic Analysis, by the third quarter of 2014, U.S. investors had accumulated $24.6 trillion of foreign assets, but foreign investors owned a total of $30.8 trillion of U.S. assets. If foreign investors were to pull their money out of the U.S. economy and invest elsewhere in the world, the result could be a significantly lower quantity of financial investment in the United States, available only at a higher interest rate. This reduced inflow of foreign financial investment could impose hardship on U.S. consumers and firms interested in borrowing.

In a modern, developed economy, financial capital often moves invisibly through electronic transfers between one bank account and another. Yet these flows of funds can be analyzed with the same tools of demand and supply as markets for goods or labor.

Price Ceilings in Financial Markets: Usury Laws

As we noted earlier, about 200 million Americans own credit cards, and their interest payments and fees total tens of billions of dollars each year. It is little wonder that political pressures sometimes arise for setting limits on the interest rates or fees that credit card companies charge. The firms that issue credit cards, including banks, oil companies, phone companies, and retail stores, respond that the higher interest rates are necessary to cover the losses created by those who borrow on their credit cards and who do not repay on time or at all. These companies also point out that cardholders can avoid paying interest if they pay their bills on time.

Consider the credit card market as illustrated in Figure 4. In this financial market, the vertical axis shows the interest rate (which is the price in the financial market). Demanders in the credit card market are households and businesses; suppliers are the companies that issue credit cards. This figure does not use specific numbers, which would be hypothetical in any case, but instead focuses on the underlying economic relationships. Imagine a law imposes a price ceiling that holds the interest rate charged on credit cards at the rate Rc, which lies below the interest rate R0 that would otherwise have prevailed in the market. The price ceiling is shown by the horizontal dashed line in Figure 4. The demand and supply model predicts that at the lower price ceiling interest rate, the quantity demanded of credit card debt will increase from its original level of Q0 to Qd; however, the quantity supplied of credit card debt will decrease from the original Q0 to Qs. At the price ceiling (Rc), quantity demanded will exceed quantity supplied. Consequently, a number of people who want to have credit cards and are willing to pay the prevailing interest rate will find that companies are unwilling to issue cards to them. The result will be a credit shortage.

The graph shows the results of an interest rate that is set at the price ceiling, both beneath the equilibrium interest rate
Figure 4. Credit Card Interest Rates: Another Price Ceiling Example. The original intersection of demand D and supply S occurs at equilibrium E0. However, a price ceiling is set at the interest rate Rc, below the equilibrium interest rate R0, and so the interest rate cannot adjust upward to the equilibrium. At the price ceiling, the quantity demanded, Qd, exceeds the quantity supplied, Qs. There is excess demand, also called a shortage.

Many states do have usury laws, which impose an upper limit on the interest rate that lenders can charge. However, in many cases these upper limits are well above the market interest rate. For example, if the interest rate is not allowed to rise above 30% per year, it can still fluctuate below that level according to market forces. A price ceiling that is set at a relatively high level is nonbinding, and it will have no practical effect unless the equilibrium price soars high enough to exceed the price ceiling.

Key Concepts and Summary

In the demand and supply analysis of financial markets, the “price” is the rate of return or the interest rate received. The quantity is measured by the money that flows from those who supply financial capital to those who demand it.

Two factors can shift the supply of financial capital to a certain investment: if people want to alter their existing levels of consumption, and if the riskiness or return on one investment changes relative to other investments. Factors that can shift demand for capital include business confidence and consumer confidence in the future—since financial investments received in the present are typically repaid in the future.

Self-Check Questions

  1. In the financial market, what causes a movement along the demand curve? What causes a shift in the demand curve?
  2. In the financial market, what causes a movement along the supply curve? What causes a shift in the supply curve?
  3. If a usury law limits interest rates to no more than 35%, what would the likely impact be on the amount of loans made and interest rates paid?
  4. Which of the following changes in the financial market will lead to a decline in interest rates:
    1. a rise in demand
    2. a fall in demand
    3. a rise in supply
    4. a fall in supply
  5. Which of the following changes in the financial market will lead to an increase in the quantity of loans made and received:
    1. a rise in demand
    2. a fall in demand
    3. a rise in supply
    4. a fall in supply

Review Questions

  1. How is equilibrium defined in financial markets?
  2. What would be a sign of a shortage in financial markets?
  3. Would usury laws help or hinder resolution of a shortage in financial markets?

Critical Thinking Questions

  1. Suppose the U.S. economy began to grow more rapidly than other countries in the world. What would be the likely impact on U.S. financial markets as part of the global economy?
  2. If the government imposed a federal interest rate ceiling of 20% on all loans, who would gain and who would lose?

Problems

  1. Predict how each of the following economic changes will affect the equilibrium price and quantity in the financial market for home loans. Sketch a demand and supply diagram to support your answers.
    1. The number of people at the most common ages for home-buying increases.
    2. People gain confidence that the economy is growing and that their jobs are secure.
    3. Banks that have made home loans find that a larger number of people than they expected are not repaying those loans.
    4. Because of a threat of a war, people become uncertain about their economic future.
    5. The overall level of saving in the economy diminishes.
    6. The federal government changes its bank regulations in a way that makes it cheaper and easier for banks to make home loans.
  2. Table 6 shows the amount of savings and borrowing in a market for loans to purchase homes, measured in millions of dollars, at various interest rates. What is the equilibrium interest rate and quantity in the capital financial market? How can you tell? Now, imagine that because of a shift in the perceptions of foreign investors, the supply curve shifts so that there will be $10 million less supplied at every interest rate. Calculate the new equilibrium interest rate and quantity, and explain why the direction of the interest rate shift makes intuitive sense.
    Interest Rate Qs Qd
    5% 130 170
    6% 135 150
    7% 140 140
    8% 145 135
    9% 150 125
    10% 155 110
    Table 6. Loans to Purchase Homes at Various Interest Rates

References

CreditCards.com. 2013. http://www.creditcards.com/credit-card-news/credit-card-industry-facts-personal-debt-statistics-1276.php.

Glossary

interest rate
the “price” of borrowing in the financial market; a rate of return on an investment
usury laws
laws that impose an upper limit on the interest rate that lenders can charge

Solutions

Answers to Self-Check Questions

  1. Changes in the interest rate (i.e., the price of financial capital) cause a movement along the demand curve. A change in anything else (non-price variable) that affects demand for financial capital (e.g., changes in confidence about the future, changes in needs for borrowing) would shift the demand curve.
  2. Changes in the interest rate (i.e., the price of financial capital) cause a movement along the supply curve. A change in anything else that affects the supply of financial capital (a non-price variable) such as income or future needs would shift the supply curve.
  3. If market interest rates stay in their normal range, an interest rate limit of 35% would not be binding. If the equilibrium interest rate rose above 35%, the interest rate would be capped at that rate, and the quantity of loans would be lower than the equilibrium quantity, causing a shortage of loans.
  4. b and c will lead to a fall in interest rates. At a lower demand, lenders will not be able to charge as much, and with more available lenders, competition for borrowers will drive rates down.
  5. a and c will increase the quantity of loans. More people who want to borrow will result in more loans being given, as will more people who want to lend.

5.3 The Market System as an Efficient Mechanism for Information

26

Learning Objectives

By the end of this section, you will be able to:
  • Apply demand and supply models to analyze prices and quantities
  • Explain the effects of price controls on the equilibrium of prices and quantities

Prices exist in markets for goods and services, for labor, and for financial capital. In all of these markets, prices serve as a remarkable social mechanism for collecting, combining, and transmitting information that is relevant to the market—namely, the relationship between demand and supply—and then serving as messengers to convey that information to buyers and sellers. In a market-oriented economy, no government agency or guiding intelligence oversees the set of responses and interconnections that result from a change in price. Instead, each consumer reacts according to that person’s preferences and budget set, and each profit-seeking producer reacts to the impact on its expected profits. The following Clear It Up feature examines the demand and supply models.

Why are demand and supply curves important?

The demand and supply model is the second fundamental diagram for this course. (The opportunity set model introduced in the Choice in a World of Scarcity chapter was the first.) Just as it would be foolish to try to learn the arithmetic of long division by memorizing every possible combination of numbers that can be divided by each other, it would be foolish to try to memorize every specific example of demand and supply in this chapter, this textbook, or this course. Demand and supply is not primarily a list of examples; it is a model to analyze prices and quantities. Even though demand and supply diagrams have many labels, they are fundamentally the same in their logic. Your goal should be to understand the underlying model so you can use it to analyze any market.

Figure 1 displays a generic demand and supply curve. The horizontal axis shows the different measures of quantity: a quantity of a good or service, or a quantity of labor for a given job, or a quantity of financial capital. The vertical axis shows a measure of price: the price of a good or service, the wage in the labor market, or the rate of return (like the interest rate) in the financial market.

The demand and supply model can explain the existing levels of prices, wages, and rates of return. To carry out such an analysis, think about the quantity that will be demanded at each price and the quantity that will be supplied at each price—that is, think about the shape of the demand and supply curves—and how these forces will combine to produce equilibrium.

Demand and supply can also be used to explain how economic events will cause changes in prices, wages, and rates of return. There are only four possibilities: the change in any single event may cause the demand curve to shift right or to shift left; or it may cause the supply curve to shift right or to shift left. The key to analyzing the effect of an economic event on equilibrium prices and quantities is to determine which of these four possibilities occurred. The way to do this correctly is to think back to the list of factors that shift the demand and supply curves. Note that if more than one variable is changing at the same time, the overall impact will depend on the degree of the shifts; when there are multiple variables, economists isolate each change and analyze it independently.

The graph shows a straightforward example of standard supply and demand curves that intersect at equilibrium.
Figure 1. Demand and Supply Curves. The figure displays a generic demand and supply curve. The horizontal axis shows the different measures of quantity: a quantity of a good or service, a quantity of labor for a given job, or a quantity of financial capital. The vertical axis shows a measure of price: the price of a good or service, the wage in the labor market, or the rate of return (like the interest rate) in the financial market. The demand and supply curves can be used to explain how economic events will cause changes in prices, wages, and rates of return.

An increase in the price of some product signals consumers that there is a shortage and the product should perhaps be economized on. For example, if you are thinking about taking a plane trip to Hawaii, but the ticket turns out to be expensive during the week you intend to go, you might consider other weeks when the ticket might be cheaper. The price could be high because you were planning to travel during a holiday when demand for traveling is high. Or, maybe the cost of an input like jet fuel increased or the airline has raised the price temporarily to see how many people are willing to pay it. Perhaps all of these factors are present at the same time. You do not need to analyze the market and break down the price change into its underlying factors. You just have to look at the price of a ticket and decide whether and when to fly.

In the same way, price changes provide useful information to producers. Imagine the situation of a farmer who grows oats and learns that the price of oats has risen. The higher price could be due to an increase in demand caused by a new scientific study proclaiming that eating oats is especially healthful. Or perhaps the price of a substitute grain, like corn, has risen, and people have responded by buying more oats. But the oat farmer does not need to know the details. The farmer only needs to know that the price of oats has risen and that it will be profitable to expand production as a result.

The actions of individual consumers and producers as they react to prices overlap and interlock in markets for goods, labor, and financial capital. A change in any single market is transmitted through these multiple interconnections to other markets. The vision of the role of flexible prices helping markets to reach equilibrium and linking different markets together helps to explain why price controls can be so counterproductive. Price controls are government laws that serve to regulate prices rather than allow the various markets to determine prices. There is an old proverb: “Don’t kill the messenger.” In ancient times, messengers carried information between distant cities and kingdoms. When they brought bad news, there was an emotional impulse to kill the messenger. But killing the messenger did not kill the bad news. Moreover, killing the messenger had an undesirable side effect: Other messengers would refuse to bring news to that city or kingdom, depriving its citizens of vital information.

Those who seek price controls are trying to kill the messenger—or at least to stifle an unwelcome message that prices are bringing about the equilibrium level of price and quantity. But price controls do nothing to affect the underlying forces of demand and supply, and this can have serious repercussions. During China’s “Great Leap Forward” in the late 1950s, food prices were kept artificially low, with the result that 30 to 40 million people died of starvation because the low prices depressed farm production. Changes in demand and supply will continue to reveal themselves through consumers’ and producers’ behavior. Immobilizing the price messenger through price controls will deprive everyone in the economy of critical information. Without this information, it becomes difficult for everyone—buyers and sellers alike—to react in a flexible and appropriate manner as changes occur throughout the economy.

Baby Boomers Come of Age

The theory of supply and demand can explain what happens in the labor markets and suggests that the demand for nurses will increase as healthcare needs of baby boomers increase, as Figure 2 shows. The impact of that increase will result in an average salary higher than the $67,930 earned in 2012 referenced in the first part of this case. The new equilibrium (E1) will be at the new equilibrium price (Pe1).Equilibrium quantity will also increase from Qe0 to Qe1.

The graph shows an increase in the demand for and nurses from D0 to D1.
Figure 2. Impact of Increasing Demand for Nurses 2012-2022. In 2012, the median salary for nurses was $67,930. As demand for services increases, the demand curve shifts to the right (from D0 to D1) and the equilibrium quantity of nurses increases from Qe0 to Qe1. The equilibrium salary increases from Pe0 to Pe1.

Suppose that as the demand for nurses increases, the supply shrinks due to an increasing number of nurses entering retirement and increases in the tuition of nursing degrees. The impact of a decreasing supply of nurses is captured by the leftward shift of the supply curve in Figure 3 The shifts in the two curves result in higher salaries for nurses, but the overall impact in the quantity of nurses is uncertain, as it depends on the relative shifts of supply and demand.

The graph shows increases in both the supply and demand for nurses and its effect on equilibrium price and quantity
Figure 3. Impact of Decreasing Supply of Nurses between 2012 and 2022. Initially, salaries increase as demand for nursing increases to Pe1. When demand increases, so too does the equilibrium quantity, from Qe0 to Qe1. The decrease in the supply of nurses due to nurses retiring from the workforce and fewer nursing graduates (ceterus paribus), causes a leftward shift of the supply curve resulting in even higher salaries for nurses, at Pe2, but an uncertain outcome for the equilibrium quantity of nurses, which in this representation is less than Qe1, but more than the initial Qe0.

While we do not know if the number of nurses will increase or decrease relative to their initial employment, we know they will have higher salaries. The situation of the labor market for nurses described in the beginning of the chapter is different from this example, because instead of a shrinking supply, we had the supply growing at a lower rate than the growth in demand. Since both curves were shifting to the right, we would have an unequivocal increase in the quantity of nurses. And because the shift in the demand curve was larger than the one in the supply, we would expect higher wages as a result.

Key Concepts and Summary

The market price system provides a highly efficient mechanism for disseminating information about relative scarcities of goods, services, labor, and financial capital. Market participants do not need to know why prices have changed, only that the changes require them to revisit previous decisions they made about supply and demand. Price controls hide information about the true scarcity of products and thereby cause misallocation of resources.

Self-Check Questions

  1. Identify the most accurate statement. A price floor will have the largest effect if it is set:
    1. substantially above the equilibrium price
    2. slightly above the equilibrium price
    3. slightly below the equilibrium price
    4. substantially below the equilibrium price

    Sketch all four of these possibilities on a demand and supply diagram to illustrate your answer.

  2. A price ceiling will have the largest effect:
    1. substantially below the equilibrium price
    2. slightly below the equilibrium price
    3. substantially above the equilibrium price
    4. slightly above the equilibrium price

    Sketch all four of these possibilities on a demand and supply diagram to illustrate your answer.

  3. Select the correct answer. A price floor will usually shift:
    1. demand
    2. supply
    3. both
    4. neither

    Illustrate your answer with a diagram.

  4. Select the correct answer. A price ceiling will usually shift:
    1. demand
    2. supply
    3. both
    4. neither

Review Questions

Whether the product market or the labor market, what happens to the equilibrium price and quantity for each of the four possibilities: increase in demand, decrease in demand, increase in supply, and decrease in supply.

Critical Thinking Questions

  1. Why are the factors that shift the demand for a product different from the factors that shift the demand for labor? Why are the factors that shift the supply of a product different from those that shift the supply of labor?
  2. During a discussion several years ago on building a pipeline to Alaska to carry natural gas, the U.S. Senate passed a bill stipulating that there should be a guaranteed minimum price for the natural gas that would be carried through the pipeline. The thinking behind the bill was that if private firms had a guaranteed price for their natural gas, they would be more willing to drill for gas and to pay to build the pipeline.
    1. Using the demand and supply framework, predict the effects of this price floor on the price, quantity demanded, and quantity supplied.
    2. With the enactment of this price floor for natural gas, what are some of the likely unintended consequences in the market?
    3. Suggest some policies other than the price floor that the government can pursue if it wishes to encourage drilling for natural gas and for a new pipeline in Alaska.

Problems

  1. Imagine that to preserve the traditional way of life in small fishing villages, a government decides to impose a price floor that will guarantee all fishermen a certain price for their catch.
    1. Using the demand and supply framework, predict the effects on the price, quantity demanded, and quantity supplied.
    2. With the enactment of this price floor for fish, what are some of the likely unintended consequences in the market?
    3. Suggest some policies other than the price floor to make it possible for small fishing villages to continue.
  2. What happens to the price and the quantity bought and sold in the cocoa market if countries producing cocoa experience a drought and a new study is released demonstrating the health benefits of cocoa? Illustrate your answer with a demand and supply graph.

Solutions

Answers to Self-Check Questions

  1. A price floor prevents a price from falling below a certain level, but has no effect on prices above that level. It will have its biggest effect in creating excess supply (as measured by the entire area inside the dotted lines on the graph, from D to S) if it is substantially above the equilibrium price. This is illustrated in the following figure.
    The graph shows a dashed price floor line substanitally above the equilibrium price with excess supply beneath the equilibrium.
    Figure 4.

    It will have a lesser effect if it is slightly above the equilibrium price. This is illustrated in the next figure.

    The graph shows a dashed price floor line that is just slightly above equilibrium.
    Figure 5.

    It will have no effect if it is set either slightly or substantially below the equilibrium price, since an equilibrium price above a price floor will not be affected by that price floor. The following figure illustrates these situations.

    The left image shows a dashed price floor line that is just slightly below equilibrium. The right image shows a dashed price floor line that is substantially below equilibrium.
    Figure 6.
  2. A price ceiling prevents a price from rising above a certain level, but has no effect on prices below that level. It will have its biggest effect in creating excess demand if it is substantially below the equilibrium price. The following figure illustrates these situations.
    The left image shows a dashed price ceiling line that is substantially below equilibrium. The right image shows a dashed price floor line that is just slightly below equilibrium.
    Figure 7.

    When the price ceiling is set substantially or slightly above the equilibrium price, it will have no effect on creating excess demand. The following figure illustrates these situations.

    The left image shows a dashed price ceiling line that is substantially above equilibrium. The right image shows a dashed price ceiling line that is just slightly above equilibrium.
    Figure 8.
  3. Neither. A shift in demand or supply means that at every price, either a greater or a lower quantity is demanded or supplied. A price floor does not shift a demand curve or a supply curve. However, if the price floor is set above the equilibrium, it will cause the quantity supplied on the supply curve to be greater than the quantity demanded on the demand curve, leading to excess supply.
  4. Neither. A shift in demand or supply means that at every price, either a greater or a lower quantity is demanded or supplied. A price ceiling does not shift a demand curve or a supply curve. However, if the price ceiling is set below the equilibrium, it will cause the quantity demanded on the demand curve to be greater than the quantity supplied on the supply curve, leading to excess demand.

Chapter 6. Elasticity

VI

Introduction to Elasticity

27

Photo of the Netflix Watch Instantly tab to watch movies and TV episodes instantly via streaming media
Figure 1. Netflix On-Demand Media. Netflix, Inc. is an American provider of on-demand Internet streaming media to many countries around the world, including the United States, and of flat rate DVD-by-mail in the United States. (Credit: modification of work by Traci Lawson/Flickr Creative Commons)

That Will Be How Much?

Imagine going to your favorite coffee shop and having the waiter inform you the pricing has changed. Instead of $3 for a cup of coffee, you will now be charged $2 for coffee, $1 for creamer, and $1 for your choice of sweetener. If you pay your usual $3 for a cup of coffee, you must choose between creamer and sweetener. If you want both, you now face an extra charge of $1. Sound absurd? Well, that is the situation Netflix customers found themselves in—a 60% price hike to retain the same service in 2011.

In early 2011, Netflix consumers paid about $10 a month for a package consisting of streaming video and DVD rentals. In July 2011, the company announced a packaging change. Customers wishing to retain both streaming video and DVD rental would be charged $15.98 per month, a price increase of about 60%. In 2014, Netflix also raised its streaming video subscription price from $7.99 to $8.99 per month for new U.S. customers. The company also changed its policy of 4K streaming content from $9.00 to $12.00 per month that year.

How would customers of the 18-year-old firm react? Would they abandon Netflix? Would the ease of access to other venues make a difference in how consumers responded to the Netflix price change? The answers to those questions will be explored in this chapter: the change in quantity with respect to a change in price, a concept economists call elasticity.

Chapter Objectives

Introduction to Elasticity

In this chapter, you will learn about:

  • Price Elasticity of Demand and Price Elasticity of Supply
  • Polar Cases of Elasticity and Constant Elasticity
  • Elasticity and Pricing
  • Elasticity in Areas Other Than Price

Anyone who has studied economics knows the law of demand: a higher price will lead to a lower quantity demanded. What you may not know is how much lower the quantity demanded will be. Similarly, the law of supply shows that a higher price will lead to a higher quantity supplied. The question is: How much higher? This chapter will explain how to answer these questions and why they are critically important in the real world.

To find answers to these questions, we need to understand the concept of elasticity. Elasticity is an economics concept that measures responsiveness of one variable to changes in another variable. Suppose you drop two items from a second-floor balcony. The first item is a tennis ball. The second item is a brick. Which will bounce higher? Obviously, the tennis ball. We would say that the tennis ball has greater elasticity.

Consider an economic example. Cigarette taxes are an example of a “sin tax,” a tax on something that is bad for you, like alcohol. Cigarettes are taxed at the state and national levels. State taxes range from a low of 17 cents per pack in Missouri to $4.35 per pack in New York. The average state cigarette tax is $1.51 per pack. The 2014 federal tax rate on cigarettes was $1.01 per pack, but in 2015 the Obama Administration proposed raising the federal tax nearly a dollar to $1.95 per pack. The key question is: How much would cigarette purchases decline?

Taxes on cigarettes serve two purposes: to raise tax revenue for government and to discourage consumption of cigarettes. However, if a higher cigarette tax discourages consumption by quite a lot, meaning a greatly reduced quantity of cigarettes is sold, then the cigarette tax on each pack will not raise much revenue for the government. Alternatively, a higher cigarette tax that does not discourage consumption by much will actually raise more tax revenue for the government. Thus, when a government agency tries to calculate the effects of altering its cigarette tax, it must analyze how much the tax affects the quantity of cigarettes consumed. This issue reaches beyond governments and taxes; every firm faces a similar issue. Every time a firm considers raising the price that it charges, it must consider how much a price increase will reduce the quantity demanded of what it sells. Conversely, when a firm puts its products on sale, it must expect (or hope) that the lower price will lead to a significantly higher quantity demanded.

6.1 Price Elasticity of Demand and Price Elasticity of Supply

28

Learning Objectives

By the end of this section, you will be able to:
  • Calculate the price elasticity of demand
  • Calculate the price elasticity of supply

Both the demand and supply curve show the relationship between price and the number of units demanded or supplied. Price elasticity is the ratio between the percentage change in the quantity demanded (Qd) or supplied (Qs) and the corresponding percent change in price. The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.

Elasticities can be usefully divided into three broad categories: elastic, inelastic, and unitary. An elastic demand or elastic supply is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price. Elasticities that are less than one indicate low responsiveness to price changes and correspond to inelastic demand or inelastic supply. Unitary elasticities indicate proportional responsiveness of either demand or supply, as summarized in Table 1.

If: Then: And It Is Called:
image \%\;change\;in\;price" title="\%\;change\;in\;quantity > \%\;change\;in\;price" class="latex mathjax"> image 1" title="\frac{\%\;change\;in\;quantity}{\%\;change\;in\;price)} > 1" class="latex mathjax"> Elastic
\%\;change\;in\;quantity = \%\;change\;in\;price \frac{\%\;change\;in\;quantity}{\%\;change\;in\;price)} = 1 Unitary
\%\;change\;in\;quantity < \%\;change\;in\;price \frac{\%\;change\;in\;quantity}{\%\;change\;in\;price)} < 1 Inelastic
Table 1. Elastic, Inelastic, and Unitary: Three Cases of Elasticity

Before we get into the nitty gritty of elasticity, enjoy this article on elasticity and ticket prices at the Super Bowl.


QR Code representing a URL

To calculate elasticity, instead of using simple percentage changes in quantity and price, economists use the average percent change in both quantity and price. This is called the Midpoint Method for Elasticity, and is represented in the following equations:

\begin{array}{r @{{}={}} l}\%\;change\;in\;quantity & \frac { { Q }_{ 2 }-{ Q }_{ 1 } }{ ({ Q }_{ 2 }+{ Q }_{ 1 })/2 } \times 100 \\[1em] \%\;change\;in\;price & \frac { { P }_{ 2 }-{ P }_{ 1 } }{ ({ P }_{ 2 }+{ P }_{ 1 })/2 } \times 100 \end{array}

The advantage of the is Midpoint Method is that one obtains the same elasticity between two price points whether there is a price increase or decrease. This is because the formula uses the same base for both cases.

Calculating Price Elasticity of Demand

Let’s calculate the elasticity between points A and B and between points G and H shown in Figure 1.

The graph shows a downward sloping line that represents the price elasticity of demand.
Figure 1. Calculating the Price Elasticity of Demand. The price elasticity of demand is calculated as the percentage change in quantity divided by the percentage change in price.

First, apply the formula to calculate the elasticity as price decreases from $70 at point B to $60 at point A:

\begin{array}{r @{{}={}} l}\%\;change\;in\;quantity & \frac { { 3,000 }-{ 2,800 } }{ ({ 3,000 }+{ 2,800 })/2 } \times 100 \\[1em] & \frac { 200 }{ 2,900 } \times 100 \\[1em] & = 6.9 \\[1em] \%\;change\;in\;price & \frac { { 60 }-{ 70 } }{ ({ 60 }+{ 70 })/2 } \times 100 \\[1em] & \frac { -10 }{ 65 } \times 100 \\[1em] & -15.4 \\[1em] Price\;Elasticity\;of\;Demand & \frac { 6.9\% }{ -15.4\% } \\[1em] & 0.45 \end{array}

Therefore, the elasticity of demand between these two points is \frac { 6.9\% }{ -15.4\% } which is 0.45, an amount smaller than one, showing that the demand is inelastic in this interval. Price elasticities of demand are always negative since price and quantity demanded always move in opposite directions (on the demand curve). By convention, we always talk about elasticities as positive numbers. So mathematically, we take the absolute value of the result. We will ignore this detail from now on, while remembering to interpret elasticities as positive numbers.

This means that, along the demand curve between point B and A, if the price changes by 1%, the quantity demanded will change by 0.45%. A change in the price will result in a smaller percentage change in the quantity demanded. For example, a 10% increase in the price will result in only a 4.5% decrease in quantity demanded. A 10% decrease in the price will result in only a 4.5% increase in the quantity demanded. Price elasticities of demand are negative numbers indicating that the demand curve is downward sloping, but are read as absolute values. The following Work It Out feature will walk you through calculating the price elasticity of demand.

Finding the Price Elasticity of Demand

Calculate the price elasticity of demand using the data in Figure 1 for an increase in price from G to H. Has the elasticity increased or decreased?

Step 1. We know that:

Price\;Elasticity\;of\;Demand = \frac { \%\;change\;in\;quantity }{ \%\;change\;in\;price }

Step 2. From the Midpoint Formula we know that:

\begin{array}{r @{{}={}} l}\%\;change\;in\;quantity & \frac { { Q }_{ 2 }-{ Q }_{ 1 } }{ ({ Q }_{ 2 }+{ Q }_{ 1 })/2 } \times 100 \\[1em] \%\;change\;in\;price & \frac { { P }_{ 2 }-{ P }_{ 1 } }{ ({ P }_{ 2 }+{ P }_{ 1 })/2 } \times 100 \end{array}

Step 3. So we can use the values provided in the figure in each equation:

\begin{array}{r @{{}={}} l}\%\;change\;in\;quantity & \frac { { 1,600 }-{ 1,800 } }{ ({ 1,600 }+{ 1,800 })/2 } \times 100 \\[1em] & \frac { -200 }{ 1,700 } \times 100 \\[1em] & -11.76 \\[1em] \%\;change\;in\;price & \frac { { 130 }-{ 120 } }{ ({ 130 }+{ 120 })/2 } \times 100 \\[1em] & \frac { 10 }{ 125 } \times 100 \\[1em] & 8.0 \end{array}

Step 4. Then, those values can be used to determine the price elasticity of demand:

\begin{array}{r @{{}={}} l}Price\;Elasticity\;of\;Demand & \frac { \%\;change\;in\;quantity }{ \%\;change\;in\;price } \\[1em] & \frac { -11.76 }{ 8 } \\[1em] & 1.47 \end{array}

Therefore, the elasticity of demand from G to H 1.47. The magnitude of the elasticity has increased (in absolute value) as we moved up along the demand curve from points A to B. Recall that the elasticity between these two points was 0.45. Demand was inelastic between points A and B and elastic between points G and H. This shows us that price elasticity of demand changes at different points along a straight-line demand curve.

Calculating the Price Elasticity of Supply

Assume that an apartment rents for $650 per month and at that price 10,000 units are rented as shown in Figure 2. When the price increases to $700 per month, 13,000 units are supplied into the market. By what percentage does apartment supply increase? What is the price sensitivity?

The graph shows an upward sloping line that represents the supply of apartment rentals.
Figure 2. Price Elasticity of Supply. The price elasticity of supply is calculated as the percentage change in quantity divided by the percentage change in price.

Using the Midpoint Method,

\begin{array}{r @{{}={}} l}\%\;change\;in\;quantity & \frac { { 13,000 }-{ 10,000 } }{ ({ 13,000 }+{ 10,000 })/2 } \times 100 \\[1em] & \frac { 3,000 }{ 11,500 } \times 100 \\[1em] & 26.1 \\[1em] \%\;change\;in\;price & \frac { { \$700 }-{ \$650 } }{ ({ \$700 }+{ \$650 })/2 } \times 100 \\[1em] & \frac { 50 }{ 675 } \times 100 \\[1em] & 7.4 \\[1em] Price\;Elasticity\;of\;Demand & \frac { 26.1\% }{ 7.4\% } \\[1em] & 3.53 \end{array}

Again, as with the elasticity of demand, the elasticity of supply is not followed by any units. Elasticity is a ratio of one percentage change to another percentage change—nothing more—and is read as an absolute value. In this case, a 1% rise in price causes an increase in quantity supplied of 3.5%. The greater than one elasticity of supply means that the percentage change in quantity supplied will be greater than a one percent price change. If you’re starting to wonder if the concept of slope fits into this calculation, read the following Clear It Up box.

Is the elasticity the slope?

It is a common mistake to confuse the slope of either the supply or demand curve with its elasticity. The slope is the rate of change in units along the curve, or the rise/run (change in y over the change in x). For example, in Figure 1, each point shown on the demand curve, price drops by $10 and the number of units demanded increases by 200. So the slope is –10/200 along the entire demand curve and does not change. The price elasticity, however, changes along the curve. Elasticity between points A and B was 0.45 and increased to 1.47 between points G and H. Elasticity is the percentage change, which is a different calculation from the slope and has a different meaning.

When we are at the upper end of a demand curve, where price is high and the quantity demanded is low, a small change in the quantity demanded, even in, say, one unit, is pretty big in percentage terms. A change in price of, say, a dollar, is going to be much less important in percentage terms than it would have been at the bottom of the demand curve. Likewise, at the bottom of the demand curve, that one unit change when the quantity demanded is high will be small as a percentage.

So, at one end of the demand curve, where we have a large percentage change in quantity demanded over a small percentage change in price, the elasticity value would be high, or demand would be relatively elastic. Even with the same change in the price and the same change in the quantity demanded, at the other end of the demand curve the quantity is much higher, and the price is much lower, so the percentage change in quantity demanded is smaller and the percentage change in price is much higher. That means at the bottom of the curve we’d have a small numerator over a large denominator, so the elasticity measure would be much lower, or inelastic.

As we move along the demand curve, the values for quantity and price go up or down, depending on which way we are moving, so the percentages for, say, a $1 difference in price or a one unit difference in quantity, will change as well, which means the ratios of those percentages will change.

Key Concepts and Summary

Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It is computed as the percentage change in quantity demanded (or supplied) divided by the percentage change in price. Elasticity can be described as elastic (or very responsive), unit elastic, or inelastic (not very responsive). Elastic demand or supply curves indicate that quantity demanded or supplied respond to price changes in a greater than proportional manner. An inelastic demand or supply curve is one where a given percentage change in price will cause a smaller percentage change in quantity demanded or supplied. A unitary elasticity means that a given percentage change in price leads to an equal percentage change in quantity demanded or supplied.

Self-Check Questions

  1. From the data shown in Table 2 about demand for smart phones, calculate the price elasticity of demand from: point B to point C, point D to point E, and point G to point H. Classify the elasticity at each point as elastic, inelastic, or unit elastic.
    Points P Q
    A 60 3,000
    B 70 2,800
    C 80 2,600
    D 90 2,400
    E 100 2,200
    F 110 2,000
    G 120 1,800
    H 130 1,600
    Table 2.
  2. From the data shown in Table 3 about supply of alarm clocks, calculate the price elasticity of supply from: point J to point K, point L to point M, and point N to point P. Classify the elasticity at each point as elastic, inelastic, or unit elastic.
    Point Price Quantity Supplied
    J $8 50
    K $9 70
    L $10 80
    M $11 88
    N $12 95
    P $13 100
    Table 3.

Review Questions

  1. What is the formula for calculating elasticity?
  2. What is the price elasticity of demand? Can you explain it in your own words?
  3. What is the price elasticity of supply? Can you explain it in your own words?

Critical Thinking Questions

  1. Transatlantic air travel in business class has an estimated elasticity of demand of 0.40 less than transatlantic air travel in economy class, with an estimated price elasticity of 0.62. Why do you think this is the case?
  2. What is the relationship between price elasticity and position on the demand curve? For example, as you move up the demand curve to higher prices and lower quantities, what happens to the measured elasticity? How would you explain that?

Problems

  1. The equation for a demand curve is P = 48 – 3Q. What is the elasticity in moving from a quantity of 5 to a quantity of 6?
  2. The equation for a demand curve is P = 2/Q. What is the elasticity of demand as price falls from 5 to 4? What is the elasticity of demand as the price falls from 9 to 8? Would you expect these answers to be the same?
  3. The equation for a supply curve is 4P = Q. What is the elasticity of supply as price rises from 3 to 4? What is the elasticity of supply as the price rises from 7 to 8? Would you expect these answers to be the same?
  4. The equation for a supply curve is P = 3Q – 8. What is the elasticity in moving from a price of 4 to a price of 7?

Glossary

elastic demand
when the elasticity of demand is greater than one, indicating a high responsiveness of quantity demanded or supplied to changes in price
elastic supply
when the elasticity of either supply is greater than one, indicating a high responsiveness of quantity demanded or supplied to changes in price
elasticity
an economics concept that measures responsiveness of one variable to changes in another variable
inelastic demand
when the elasticity of demand is less than one, indicating that a 1 percent increase in price paid by the consumer leads to less than a 1 percent change in purchases (and vice versa); this indicates a low responsiveness by consumers to price changes
inelastic supply
when the elasticity of supply is less than one, indicating that a 1 percent increase in price paid to the firm will result in a less than 1 percent increase in production by the firm; this indicates a low responsiveness of the firm to price increases (and vice versa if prices drop)
price elasticity
the relationship between the percent change in price resulting in a corresponding percentage change in the quantity demanded or supplied
price elasticity of demand
percentage change in the quantity demanded of a good or service divided the percentage change in price
price elasticity of supply
percentage change in the quantity supplied divided by the percentage change in price
unitary elasticity
when the calculated elasticity is equal to one indicating that a change in the price of the good or service results in a proportional change in the quantity demanded or supplied

Solutions

Answers to Self-Check Questions

  1. From point B to point C, price rises from $70 to $80, and Qd decreases from 2,800 to 2,600. So:
    \begin{array}{r @{{}={}} l}\%\;change\;in\;quantity & \frac { { 2,600 }-{ 2,800 } }{ ({ 2,600 }+{ 2,800 })/2 } \times 100 \\[1em] & \frac { -200 }{ 2,700 } \times 100 \\[1em] & -7.41 \\[1em] \%\;change\;in\;price & \frac { { 80 }-{ 70 } }{ ({ 80 }+{ 70 })/2 } \times 100 \\[1em] & \frac { 10 }{ 75 } \times 100 \\[1em] & 13.33 \\[1em] Elasticity\;of\;Demand & \frac { -7.41\% }{ 13.33\% } \\[1em] & 0.56 \end{array}

    The demand curve is inelastic in this area; that is, its elasticity value is less than one.

    Answer from Point D to point E:

    \begin{array}{r @{{}={}} l}\%\;change\;in\;quantity & \frac { { 2,200 }-{ 2,400 } }{ ({ 2,200 }+{ 2,400 })/2 } \times 100 \\[1em] & \frac { -200 }{ 2,300 } \times 100 \\[1em] & -8.7 \\[1em] \%\;change\;in\;price & \frac { { 100 }-{ 90 } }{ ({ 100 }+{ 90 })/2 } \times 100 \\[1em] & \frac { 10 }{ 95 } \times 100 \\[1em] & 10.53 \\[1em] Elasticity\;of\;Demand & \frac { -8.7\% }{ 10.53\% } \\[1em] & 0.83 \end{array}

    The demand curve is inelastic in this area; that is, its elasticity value is less than one.

    Answer from Point G to point H:

    \ \begin{array}{r @{{}={}} l}\%\;change\;in\;quantity & \frac { { 1,600 }-{ 1,800 } }{ ({ 1,600 }+{ 1,800 })/2 } \times 100 \\[1em] & \frac { -200 }{ 1,700 } \times 100 \\[1em] & -11.76 \\[1em] \%\;change\;in\;price & \frac { { 130 }-{ 120 } }{ ({ 130 }+{ 120 })/2 } \times 100 \\[1em] & \frac { 10 }{ 125 } \times 100 \\[1em] & 7.81 \\[1em] Elasticity\;of\;Demand & \frac { -11.76\% }{ 7.81\% } \\[1em] & -1.51 \end{array}

    The demand curve is elastic in this interval.

  2. From point J to point K, price rises from $8 to $9, and quantity rises from 50 to 70. So:
    \begin{array}{r @{{}={}} l}\%\;change\;in\;quantity & \frac { { 70 }-{ 50 } }{ ({ 70 }+{ 50 })/2 } \times 100 \\[1em] & \frac { 20 }{ 60 } \times 100 \\[1em] & 33.33 \\[1em] \%\;change\;in\;price & \frac { { \$9 }-{ \$8 } }{ ({ \$9 }+{ \$8 })/2 } \times 100 \\[1em] & \frac { 1 }{ 8.5 } \times 100 \\[1em] & 11.76 \\[1em] Elasticity\;of\;Supply & \frac { 33.33\% }{ 11.76\% } \\[1em] & 2.83 \end{array}

    The supply curve is elastic in this area; that is, its elasticity value is greater than one.

    From point L to point M, the price rises from $10 to $11, while the Qs rises from 80 to 88:

    \begin{array}{r @{{}={}} l}\%\;change\;in\;quantity & \frac { { 88 }-{ 80 } }{ ({ 88 }+{ 80 })/2 } \times 100 \\[1em] & \frac { 8 }{ 84 } \times 100 \\[1em] & 9.52 \\[1em] \%\;change\;in\;price & \frac { { \$11 }-{ \$10 } }{ ({ \$11 }+{ \$10 })/2 } \times 100 \\[1em] & \frac { 1 }{ 10.5 } \times 100 \\[1em] & 9.52 \\[1em] Elasticity\;of\;Demand & \frac { 9.52\% }{ 9.52\% } \\[1em] & 1.0 \end{array}

    The supply curve has unitary elasticity in this area.

    From point N to point P, the price rises from $12 to $13, and Qs rises from 95 to 100:

    \ \begin{array}{r @{{}={}} l}\%\;change\;in\;quantity & \frac { { 100 }-{ 95 } }{ ({ 100 }+{ 95 })/2 } \times 100 \\[1em] & \frac { 5 }{ 97.5 } \times 100 \\[1em] & 5.13 \\[1em] \%\;change\;in\;price & \frac { { \$13 }-{ \$12 } }{ ({ \$13 }+{ \$12 })/2 } \times 100 \\[1em] & \frac { 1 }{ 12.5 } \times 100 \\[1em] & 8.0 \\[1em] Elasticity\;of\;Supply & \frac { 5.13\% }{ 8.0\% } \\[1em] & 0.64 \end{array}

    The supply curve is inelastic in this region of the supply curve.

6.2 Polar Cases of Elasticity and Constant Elasticity

29

Learning Objectives

By the end of this section, you will be able to:
  • Differentiate between infinite and zero elasticity
  • Analyze graphs in order to classify elasticity as constant unitary, infinite, or zero

There are two extreme cases of elasticity: when elasticity equals zero and when it is infinite. A third case is that of constant unitary elasticity. We will describe each case.

Infinite elasticity or perfect elasticity refers to the extreme case where either the quantity demanded (Qd) or supplied (Qs) changes by an infinite amount in response to any change in price at all. In both cases, the supply and the demand curve are horizontal as shown in Figure 1. While perfectly elastic supply curves are unrealistic, goods with readily available inputs and whose production can be easily expanded will feature highly elastic supply curves. Examples include pizza, bread, books and pencils. Similarly, perfectly elastic demand is an extreme example. But luxury goods, goods that take a large share of individuals’ income, and goods with many substitutes are likely to have highly elastic demand curves. Examples of such goods are Caribbean cruises and sports vehicles.

Two graphs, side by side, show that perfectly elastic demand and perfectly elastic supply are both straight, horizontal lines.
Figure 1. Infinite Elasticity. The horizontal lines show that an infinite quantity will be demanded or supplied at a specific price. This illustrates the cases of a perfectly (or infinitely) elastic demand curve and supply curve. The quantity supplied or demanded is extremely responsive to price changes, moving from zero for prices close to P to infinite when price reach P.

Zero elasticity or perfect inelasticity, as depicted in Figure 2 refers to the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. While a perfectly inelastic supply is an extreme example, goods with limited supply of inputs are likely to feature highly inelastic supply curves. Examples include diamond rings or housing in prime locations such as apartments facing Central Park in New York City. Similarly, while perfectly inelastic demand is an extreme case, necessities with no close substitutes are likely to have highly inelastic demand curves. This is the case of life-saving drugs and gasoline.

The two graphs show that zero elasticity of supply and zero elasticity of demand are straight, vertical lines.
Figure 2. Zero Elasticity. The vertical supply curve and vertical demand curve show that there will be zero percentage change in quantity (a) demanded or (b) supplied, regardless of the price.

Constant unitary elasticity, in either a supply or demand curve, occurs when a price change of one percent results in a quantity change of one percent. Figure 3 shows a demand curve with constant unit elasticity. As we move down the demand curve from A to B, the price falls by 33% and quantity demanded rises by 33%; as you move from B to C, the price falls by 25% and the quantity demanded rises by 25%; as you move from C to D, the price falls by 16% and the quantity rises by 16%. Notice that in absolute value, the declines in price, as you step down the demand curve, are not identical. Instead, the price falls by $3 from A to B, by a smaller amount of $1.50 from B to C, and by a still smaller amount of $0.75 from C to D. As a result, a demand curve with constant unitary elasticity moves from a steeper slope on the left and a flatter slope on the right—and a curved shape overall.

This graph shows how a demand curve with unitary elasticity at all points will always be a curved line.
Figure 3. A Constant Unitary Elasticity Demand Curve. A demand curve with constant unitary elasticity will be a curved line. Notice how price and quantity demanded change by an identical amount in each step down the demand curve.

Unlike the demand curve with unitary elasticity, the supply curve with unitary elasticity is represented by a straight line. In moving up the supply curve from left to right, each increase in quantity of 30, from 90 to 120 to 150 to 180, is equal in absolute value. However, in percentage value, the steps are decreasing, from 33.3% to 25% to 16.7%, because the original quantity points in each percentage calculation are getting larger and larger, which expands the denominator in the elasticity calculation.

Consider the price changes moving up the supply curve in Figure 4. From points D to E to F and to G on the supply curve, each step of $1.50 is the same in absolute value. However, if the price changes are measured in percentage change terms, they are also decreasing, from 33.3% to 25% to 16.7%, because the original price points in each percentage calculation are getting larger and larger in value. Along the constant unitary elasticity supply curve, the percentage quantity increases on the horizontal axis exactly match the percentage price increases on the vertical axis—so this supply curve has a constant unitary elasticity at all points.

This graph shows that a supply curve with unitary elasticity at all points will always be a straight line.
Figure 4. A Constant Unitary Elasticity Supply Curve. A constant unitary elasticity supply curve is a straight line reaching up from the origin. Between each point, the percentage increase in quantity supplied is the same as the percentage increase in price.

Key Concepts and Summary

Infinite or perfect elasticity refers to the extreme case where either the quantity demanded or supplied changes by an infinite amount in response to any change in price at all. Zero elasticity refers to the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. Constant unitary elasticity in either a supply or demand curve refers to a situation where a price change of one percent results in a quantity change of one percent.

Self-Check Questions

  1. Why is the demand curve with constant unitary elasticity concave?
  2. Why is the supply curve with constant unitary elasticity a straight line?

Review Questions

  1. Describe the general appearance of a demand or a supply curve with zero elasticity.
  2. Describe the general appearance of a demand or a supply curve with infinite elasticity.

Critical Thinking Questions

Can you think of an industry (or product) with near infinite elasticity of supply in the short term? That is, what is an industry that could increase Qs almost without limit in response to an increase in the price?

Problems

  1. The supply of paintings by Leonardo Da Vinci, who painted the Mona Lisa and The Last Supper and died in 1519, is highly inelastic. Sketch a supply and demand diagram, paying attention to the appropriate elasticities, to illustrate that demand for these paintings will determine the price.
  2. Say that a certain stadium for professional football has 70,000 seats. What is the shape of the supply curve for tickets to football games at that stadium? Explain.
  3. When someone’s kidneys fail, the person needs to have medical treatment with a dialysis machine (unless or until they receive a kidney transplant) or they will die. Sketch a supply and demand diagram, paying attention to the appropriate elasticities, to illustrate that the supply of such dialysis machines will primarily determine the price.

Glossary

constant unitary elasticity
when a given percent price change in price leads to an equal percentage change in quantity demanded or supplied
infinite elasticity
the extremely elastic situation of demand or supply where quantity changes by an infinite amount in response to any change in price; horizontal in appearance
perfect elasticity
see infinite elasticity
zero inelasticity
the highly inelastic case of demand or supply in which a percentage change in price, no matter how large, results in zero change in the quantity; vertical in appearance
perfect inelasticity
see zero elasticity

Solutions

Answers to Self-Check Questions

  1. The demand curve with constant unitary elasticity is concave because at high prices, a one percent decrease in price results in more than a one percent increase in quantity. As we move down the demand curve, price drops and the one percent decrease in price causes less than a one percent increase in quantity.
  2. The constant unitary elasticity is a straight line because the curve slopes upward and both price and quantity are increasing proportionally.

6.3 Elasticity and Pricing

30

Learning Objectives

By the end of this section, you will be able to:
  • Analyze how price elasticities impact revenue
  • Evaluate how elasticity can cause shifts in demand and supply
  • Predict how the long-run and short-run impacts of elasticity affect equilibrium
  • Explain how the elasticity of demand and supply determine the incidence of a tax on buyers and sellers

Studying elasticities is useful for a number of reasons, pricing being most important. Let’s explore how elasticity relates to revenue and pricing, both in the long run and short run. But first, let’s look at the elasticities of some common goods and services.

Table 4 shows a selection of demand elasticities for different goods and services drawn from a variety of different studies by economists, listed in order of increasing elasticity.

Goods and Services Elasticity of Price
Housing 0.12
Transatlantic air travel (economy class) 0.12
Rail transit (rush hour) 0.15
Electricity 0.20
Taxi cabs 0.22
Gasoline 0.35
Transatlantic air travel (first class) 0.40
Wine 0.55
Beef 0.59
Transatlantic air travel (business class) 0.62
Kitchen and household appliances 0.63
Cable TV (basic rural) 0.69
Chicken 0.64
Soft drinks 0.70
Beer 0.80
New vehicle 0.87
Rail transit (off-peak) 1.00
Computer 1.44
Cable TV (basic urban) 1.51
Cable TV (premium) 1.77
Restaurant meals 2.27
Table 4. Some Selected Elasticities of Demand

Note that necessities such as housing and electricity are inelastic, while items that are not necessities such as restaurant meals are more price-sensitive. If the price of the restaurant meal increases by 10%, the quantity demanded will decrease by 22.7%. A 10% increase in the price of housing will cause a slight decrease of 1.2% in the quantity of housing demanded.

Read this article for an example of price elasticity that may have affected you.


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Does Raising Price Bring in More Revenue?

Imagine that a band on tour is playing in an indoor arena with 15,000 seats. To keep this example simple, assume that the band keeps all the money from ticket sales. Assume further that the band pays the costs for its appearance, but that these costs, like travel, setting up the stage, and so on, are the same regardless of how many people are in the audience. Finally, assume that all the tickets have the same price. (The same insights apply if ticket prices are more expensive for some seats than for others, but the calculations become more complicated.) The band knows that it faces a downward-sloping demand curve; that is, if the band raises the price of tickets, it will sell fewer tickets. How should the band set the price for tickets to bring in the most total revenue, which in this example, because costs are fixed, will also mean the highest profits for the band? Should the band sell more tickets at a lower price or fewer tickets at a higher price?

The key concept in thinking about collecting the most revenue is the price elasticity of demand. Total revenue is price times the quantity of tickets sold. Imagine that the band starts off thinking about a certain price, which will result in the sale of a certain quantity of tickets. The three possibilities are laid out in Table 5. If demand is elastic at that price level, then the band should cut the price, because the percentage drop in price will result in an even larger percentage increase in the quantity sold—thus raising total revenue. However, if demand is inelastic at that original quantity level, then the band should raise the price of tickets, because a certain percentage increase in price will result in a smaller percentage decrease in the quantity sold—and total revenue will rise. If demand has a unitary elasticity at that quantity, then a moderate percentage change in the price will be offset by an equal percentage change in quantity—so the band will earn the same revenue whether it (moderately) increases or decreases the price of tickets.

If Demand Is . . . Then . . . Therefore . . .
Elastic % change in Qd > % change in P A given % rise in P will be more than offset by a larger % fall in Q so that total revenue (P × Q) falls.
Unitary % change in Qd = % change in P A given % rise in P will be exactly offset by an equal % fall in Q so that total revenue (P × Q) is unchanged.
Inelastic % change in Qd < % change in P A given % rise in P will cause a smaller % fall in Q so that total revenue (P × Q) rises.
Table 5. Will the Band Earn More Revenue by Changing Ticket Prices?

What if the band keeps cutting price, because demand is elastic, until it reaches a level where all 15,000 seats in the available arena are sold? If demand remains elastic at that quantity, the band might try to move to a bigger arena, so that it could cut ticket prices further and see a larger percentage increase in the quantity of tickets sold. Of course, if the 15,000-seat arena is all that is available or if a larger arena would add substantially to costs, then this option may not work.

Conversely, a few bands are so famous, or have such fanatical followings, that demand for tickets may be inelastic right up to the point where the arena is full. These bands can, if they wish, keep raising the price of tickets. Ironically, some of the most popular bands could make more revenue by setting prices so high that the arena is not filled—but those who buy the tickets would have to pay very high prices. However, bands sometimes choose to sell tickets for less than the absolute maximum they might be able to charge, often in the hope that fans will feel happier and spend more on recordings, T-shirts, and other paraphernalia.

Can Costs Be Passed on to Consumers?

Most businesses face a day-to-day struggle to figure out ways to produce at a lower cost, as one pathway to their goal of earning higher profits. However, in some cases, the price of a key input over which the firm has no control may rise. For example, many chemical companies use petroleum as a key input, but they have no control over the world market price for crude oil. Coffee shops use coffee as a key input, but they have no control over the world market price of coffee. If the cost of a key input rises, can the firm pass those higher costs along to consumers in the form of higher prices? Conversely, if new and less expensive ways of producing are invented, can the firm keep the benefits in the form of higher profits, or will the market pressure them to pass the gains along to consumers in the form of lower prices? The price elasticity of demand plays a key role in answering these questions.

Imagine that as a consumer of legal pharmaceutical products, you read a newspaper story that a technological breakthrough in the production of aspirin has occurred, so that every aspirin factory can now make aspirin more cheaply than it did before. What does this discovery mean to you? Figure 1 illustrates two possibilities. In Figure 1 (a), the demand curve is drawn as highly inelastic. In this case, a technological breakthrough that shifts supply to the right, from S0 to S1, so that the equilibrium shifts from E0 to E1, creates a substantially lower price for the product with relatively little impact on the quantity sold. In Figure 1 (b), the demand curve is drawn as highly elastic. In this case, the technological breakthrough leads to a much greater quantity being sold in the market at very close to the original price. Consumers benefit more, in general, when the demand curve is more inelastic because the shift in the supply results in a much lower price for consumers.

The two graphs show a highly elastic demand curve (on the left) and highly inelastic demand curve (on the right).
Figure 1. Passing along Cost Savings to Consumers. Cost-saving gains cause supply to shift out to the right from S0 to S1; that is, at any given price, firms will be willing to supply a greater quantity. If demand is inelastic, as in (a), the result of this cost-saving technological improvement will be substantially lower prices. If demand is elastic, as in (b), the result will be only slightly lower prices. Consumers benefit in either case, from a greater quantity at a lower price, but the benefit is greater when demand is inelastic, as in (a).

Producers of aspirin may find themselves in a nasty bind here. The situation shown in Figure 1, with extremely inelastic demand, means that a new invention may cause the price to drop dramatically while quantity changes little. As a result, the new production technology can lead to a drop in the revenue that firms earn from sales of aspirin. However, if strong competition exists between producers of aspirin, each producer may have little choice but to search for and implement any breakthrough that allows it to reduce production costs. After all, if one firm decides not to implement such a cost-saving technology, it can be driven out of business by other firms that do.

Since demand for food is generally inelastic, farmers may often face the situation in Figure 1 (a). That is, a surge in production leads to a severe drop in price that can actually decrease the total revenue received by farmers. Conversely, poor weather or other conditions that cause a terrible year for farm production can sharply raise prices so that the total revenue received increases. The Clear It Up box discusses how these issues relate to coffee.

How do coffee prices fluctuate?

Coffee is an international crop. The top five coffee-exporting nations are Brazil, Vietnam, Colombia, Indonesia, and Ethiopia. In these nations and others, 20 million families depend on selling coffee beans as their main source of income. These families are exposed to enormous risk, because the world price of coffee bounces up and down. For example, in 1993, the world price of coffee was about 50 cents per pound; in 1995 it was four times as high, at $2 per pound. By 1997 it had fallen by half to $1.00 per pound. In 1998 it leaped back up to $2 per pound. By 2001 it had fallen back to 46 cents a pound; by early 2011 it went back up to about $2.31 per pound. By the end of 2012, the price had fallen back to about $1.31 per pound.

The reason for these price bounces lies in a combination of inelastic demand and shifts in supply. The elasticity of coffee demand is only about 0.3; that is, a 10% rise in the price of coffee leads to a decline of about 3% in the quantity of coffee consumed. When a major frost hit the Brazilian coffee crop in 1994, coffee supply shifted to the left with an inelastic demand curve, leading to much higher prices. Conversely, when Vietnam entered the world coffee market as a major producer in the late 1990s, the supply curve shifted out to the right. With a highly inelastic demand curve, coffee prices fell dramatically. This situation is shown in Figure 1 (a).

Elasticity also reveals whether firms can pass higher costs that they incur on to consumers. Addictive substances tend to fall into this category. For example, the demand for cigarettes is relatively inelastic among regular smokers who are somewhat addicted; economic research suggests that increasing the price of cigarettes by 10% leads to about a 3% reduction in the quantity of cigarettes smoked by adults, so the elasticity of demand for cigarettes is 0.3. If society increases taxes on companies that make cigarettes, the result will be, as in Figure 2 (a), that the supply curve shifts from S0 to S1. However, as the equilibrium moves from E0 to E1, these taxes are mainly passed along to consumers in the form of higher prices. These higher taxes on cigarettes will raise tax revenue for the government, but they will not much affect the quantity of smoking.

If the goal is to reduce the quantity of cigarettes demanded, it must be achieved by shifting this inelastic demand back to the left, perhaps with public programs to discourage the use of cigarettes or to help people to quit. For example, anti-smoking advertising campaigns have shown some ability to reduce smoking. However, if demand for cigarettes was more elastic, as in Figure 2 (b), then an increase in taxes that shifts supply from S0 to S1 and equilibrium from E0 to E1 would reduce the quantity of cigarettes smoked substantially. Youth smoking seems to be more elastic than adult smoking—that is, the quantity of youth smoking will fall by a greater percentage than the quantity of adult smoking in response to a given percentage increase in price.

These two graphs show how a supply shift affects price and quantity. Figure (a) shows how supply shifts when demand is inelastic and figure (b) shows how supply shifts when demand is elastic.
Figure 2. Passing along Higher Costs to Consumers. Higher costs, like a higher tax on cigarette companies for the example given in the text, lead supply to shift to the left. This shift is identical in (a) and (b). However, in (a), where demand is inelastic, the cost increase can largely be passed along to consumers in the form of higher prices, without much of a decline in equilibrium quantity. In (b), demand is elastic, so the shift in supply results primarily in a lower equilibrium quantity. Consumers suffer in either case, but in (a), they suffer from paying a higher price for the same quantity, while in (b), they suffer from buying a lower quantity (and presumably needing to shift their consumption elsewhere).

Elasticity and Tax Incidence

The example of cigarette taxes showed that because demand is inelastic, taxes are not effective at reducing the equilibrium quantity of smoking, and they are mainly passed along to consumers in the form of higher prices. The analysis, or manner, of how the burden of a tax is divided between consumers and producers is called tax incidence. Typically, the incidence, or burden, of a tax falls both on the consumers and producers of the taxed good. But if one wants to predict which group will bear most of the burden, all one needs to do is examine the elasticity of demand and supply. In the tobacco example, the tax burden falls on the most inelastic side of the market.

If demand is more inelastic than supply, consumers bear most of the tax burden, and if supply is more inelastic than demand, sellers bear most of the tax burden.

The intuition for this is simple. When the demand is inelastic, consumers are not very responsive to price changes, and the quantity demanded remains relatively constant when the tax is introduced. In the case of smoking, the demand is inelastic because consumers are addicted to the product. The government can then pass the tax burden along to consumers in the form of higher prices, without much of a decline in the equilibrium quantity.

Similarly, when a tax is introduced in a market with an inelastic supply, such as, for example, beachfront hotels, and sellers have no alternative than to accept lower prices for their business, taxes do not greatly affect the equilibrium quantity. The tax burden is now passed on to the sellers. If the supply was elastic and sellers had the possibility of reorganizing their businesses to avoid supplying the taxed good, the tax burden on the sellers would be much smaller. The tax would result in a much lower quantity sold instead of lower prices received. Figure 3 illustrates this relationship between the tax incidence and elasticity of demand and supply.

This graph shows two images that represent the relationship between elasticity and tax incidence. Image (a) shows the situation that occurs when demand is elastic and supply is inelastic: tax incidence is lower on consumers. Image (b) shows the situation that occurs when demand is inelastic and supply is elastic: tax incidence is lower on producers.
Figure 3. Elasticity and Tax Incidence. An excise tax introduces a wedge between the price paid by consumers (Pc) and the price received by producers (Pp). (a) When the demand is more elastic than supply, the tax incidence on consumers Pc – Pe is lower than the tax incidence on producers Pe – Pp. (b) When the supply is more elastic than demand, the tax incidence on consumers Pc – Pe is larger than the tax incidence on producers Pe – Pp. The more elastic the demand and supply curves are, the lower the tax revenue.

In Figure 3 (a), the supply is inelastic and the demand is elastic, such as in the example of beachfront hotels. While consumers may have other vacation choices, sellers can’t easily move their businesses. By introducing a tax, the government essentially creates a wedge between the price paid by consumers Pc and the price received by producers Pp. In other words, of the total price paid by consumers, part is retained by the sellers and part is paid to the government in the form of a tax. The distance between Pc and Pp is the tax rate. The new market price is Pc, but sellers receive only Pp per unit sold, as they pay Pc-Pp to the government. Since a tax can be viewed as raising the costs of production, this could also be represented by a leftward shift of the supply curve, where the new supply curve would intercept the demand at the new quantity Qt. For simplicity, Figure 3 omits the shift in the supply curve.

The tax revenue is given by the shaded area, which is obtained by multiplying the tax per unit by the total quantity sold Qt. The tax incidence on the consumers is given by the difference between the price paid Pc and the initial equilibrium price Pe. The tax incidence on the sellers is given by the difference between the initial equilibrium price Pe and the price they receive after the tax is introduced Pp. In Figure 3 (a), the tax burden falls disproportionately on the sellers, and a larger proportion of the tax revenue (the shaded area) is due to the resulting lower price received by the sellers than by the resulting higher prices paid by the buyers. The example of the tobacco excise tax could be described by Figure 3 (b) where the supply is more elastic than demand. The tax incidence now falls disproportionately on consumers, as shown by the large difference between the price they pay, Pc, and the initial equilibrium price, Pe. Sellers receive a lower price than before the tax, but this difference is much smaller than the change in consumers’ price. From this analysis one can also predict whether a tax is likely to create a large revenue or not. The more elastic the demand curve, the easier it is for consumers to reduce quantity instead of paying higher prices. The more elastic the supply curve, the easier it is for sellers to reduce the quantity sold, instead of taking lower prices. In a market where both the demand and supply are very elastic, the imposition of an excise tax generates low revenue.

Excise taxes tend to be thought to hurt mainly the specific industries they target. For example, the medical device excise tax, in effect since 2013, has been controversial for it can delay industry profitability and therefore hamper start-ups and medical innovation. But ultimately, whether the tax burden falls mostly on the medical device industry or on the patients depends simply on the elasticity of demand and supply.

Long-Run vs. Short-Run Impact

Elasticities are often lower in the short run than in the long run. On the demand side of the market, it can sometimes be difficult to change Qd in the short run, but easier in the long run. Consumption of energy is a clear example. In the short run, it is not easy for a person to make substantial changes in the energy consumption. Maybe you can carpool to work sometimes or adjust your home thermostat by a few degrees if the cost of energy rises, but that is about all. However, in the long-run you can purchase a car that gets more miles to the gallon, choose a job that is closer to where you live, buy more energy-efficient home appliances, or install more insulation in your home. As a result, the elasticity of demand for energy is somewhat inelastic in the short run, but much more elastic in the long run.

Figure 4 is an example, based roughly on historical experience, for the responsiveness of Qd to price changes. In 1973, the price of crude oil was $12 per barrel and total consumption in the U.S. economy was 17 million barrels per day. That year, the nations who were members of the Organization of Petroleum Exporting Countries (OPEC) cut off oil exports to the United States for six months because the Arab members of OPEC disagreed with the U.S. support for Israel. OPEC did not bring exports back to their earlier levels until 1975—a policy that can be interpreted as a shift of the supply curve to the left in the U.S. petroleum market. Figure 4 (a) and Figure 4 (b) show the same original equilibrium point and the same identical shift of a supply curve to the left from S0 to S1.

Two graphs that show an inelastic demand curve means that a shift in supply will mainly affect price and that an elastic demand curve means that a shift in supply will mainly affect quantity.
Figure 4. How a Shift in Supply Can Affect Price or Quantity. The intersection (E0) between demand curve D and supply curve S0 is the same in both (a) and (b). The shift of supply to the left from S0 to S1 is identical in both (a) and (b). The new equilibrium (E1) has a higher price and a lower quantity than the original equilibrium (E0) in both (a) and (b). However, the shape of the demand curve D is different in (a) and (b). As a result, the shift in supply can result either in a new equilibrium with a much higher price and an only slightly smaller quantity, as in (a), or in a new equilibrium with only a small increase in price and a relatively larger reduction in quantity, as in (b).

Figure 4 (a) shows inelastic demand for oil in the short run similar to that which existed for the United States in 1973. In Figure 4 (a), the new equilibrium (E1) occurs at a price of $25 per barrel, roughly double the price before the OPEC shock, and an equilibrium quantity of 16 million barrels per day. Figure 4 (b) shows what the outcome would have been if the U.S. demand for oil had been more elastic, a result more likely over the long term. This alternative equilibrium (E1) would have resulted in a smaller price increase to $14 per barrel and larger reduction in equilibrium quantity to 13 million barrels per day. In 1983, for example, U.S. petroleum consumption was 15.3 million barrels a day, which was lower than in 1973 or 1975. U.S. petroleum consumption was down even though the U.S. economy was about one-fourth larger in 1983 than it had been in 1973. The primary reason for the lower quantity was that higher energy prices spurred conservation efforts, and after a decade of home insulation, more fuel-efficient cars, more efficient appliances and machinery, and other fuel-conserving choices, the demand curve for energy had become more elastic.

On the supply side of markets, producers of goods and services typically find it easier to expand production in the long term of several years rather than in the short run of a few months. After all, in the short run it can be costly or difficult to build a new factory, hire many new workers, or open new stores. But over a few years, all of these are possible.

Indeed, in most markets for goods and services, prices bounce up and down more than quantities in the short run, but quantities often move more than prices in the long run. The underlying reason for this pattern is that supply and demand are often inelastic in the short run, so that shifts in either demand or supply can cause a relatively greater change in prices. But since supply and demand are more elastic in the long run, the long-run movements in prices are more muted, while quantity adjusts more easily in the long run.

Key Concepts and Summary

In the market for goods and services, quantity supplied and quantity demanded are often relatively slow to react to changes in price in the short run, but react more substantially in the long run. As a result, demand and supply often (but not always) tend to be relatively inelastic in the short run and relatively elastic in the long run. The tax incidence depends on the relative price elasticity of supply and demand. When supply is more elastic than demand, buyers bear most of the tax burden, and when demand is more elastic than supply, producers bear most of the cost of the tax. Tax revenue is larger the more inelastic the demand and supply are.

Self-Check Questions

  1. The federal government decides to require that automobile manufacturers install new anti-pollution equipment that costs $2,000 per car. Under what conditions can carmakers pass almost all of this cost along to car buyers? Under what conditions can carmakers pass very little of this cost along to car buyers?
  2. Suppose you are in charge of sales at a pharmaceutical company, and your firm has a new drug that causes bald men to grow hair. Assume that the company wants to earn as much revenue as possible from this drug. If the elasticity of demand for your company’s product at the current price is 1.4, would you advise the company to raise the price, lower the price, or to keep the price the same? What if the elasticity were 0.6? What if it were 1? Explain your answer.

Review Questions

  1. If demand is elastic, will shifts in supply have a larger effect on equilibrium quantity or on price?
  2. If demand is inelastic, will shifts in supply have a larger effect on equilibrium price or on quantity?
  3. If supply is elastic, will shifts in demand have a larger effect on equilibrium quantity or on price?
  4. If supply is inelastic, will shifts in demand have a larger effect on equilibrium price or on quantity?
  5. Would you usually expect elasticity of demand or supply to be higher in the short run or in the long run? Why?
  6. Under which circumstances does the tax burden fall entirely on consumers?

Critical Thinking Questions

  1. Would you expect supply to play a more significant role in determining the price of a basic necessity like food or a luxury like perfume? Explain. Hint: Think about how the price elasticity of demand will differ between necessities and luxuries.
  2. A city has built a bridge over a river and it decides to charge a toll to everyone who crosses. For one year, the city charges a variety of different tolls and records information on how many drivers cross the bridge. The city thus gathers information about elasticity of demand. If the city wishes to raise as much revenue as possible from the tolls, where will the city decide to charge a toll: in the inelastic portion of the demand curve, the elastic portion of the demand curve, or the unit elastic portion? Explain.
  3. In a market where the supply curve is perfectly inelastic, how does an excise tax affect the price paid by consumers and the quantity bought and sold?

Problems

Assume that the supply of low-skilled workers is fairly elastic, but the employers’ demand for such workers is fairly inelastic. If the policy goal is to expand employment for low-skilled workers, is it better to focus on policy tools to shift the supply of unskilled labor or on tools to shift the demand for unskilled labor? What if the policy goal is to raise wages for this group? Explain your answers with supply and demand diagrams.

Glossary

tax incidence
manner in which the tax burden is divided between buyers and sellers

Solutions

Answers to Self-Check Questions

  1. Carmakers can pass this cost along to consumers if the demand for these cars is inelastic. If the demand for these cars is elastic, then the manufacturer must pay for the equipment.
  2. If the elasticity is 1.4 at current prices, you would advise the company to lower its price on the product, since a decrease in price will be offset by the increase in the amount of the drug sold. If the elasticity were 0.6, then you would advise the company to increase its price. Increases in price will offset the decrease in number of units sold, but increase your total revenue. If elasticity is 1, the total revenue is already maximized, and you would advise that the company maintain its current price level.

6.4 Elasticity in Areas Other Than Price

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Learning Objectives

By the end of this section, you will be able to:

  • Calculate the income elasticity of demand and the cross-price elasticity of demand
  • Calculate the elasticity in labor and financial capital markets through an understanding of the elasticity of labor supply and the elasticity of savings
  • Apply concepts of price elasticity to real-world situations

The basic idea of elasticity—how a percentage change in one variable causes a percentage change in another variable—does not just apply to the responsiveness of supply and demand to changes in the price of a product. Recall that quantity demanded (Qd) depends on income, tastes and preferences, the prices of related goods, and so on, as well as price. Similarly, quantity supplied (Qs) depends on the cost of production, and so on, as well as price. Elasticity can be measured for any determinant of supply and demand, not just the price.

Income Elasticity of Demand

The income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income.

Income\;elasticity\;of\;demand = \frac{ \%\;change\;in\;quantity\;demanded }{ \%\;change\;in\;income }

For most products, most of the time, the income elasticity of demand is positive: that is, a rise in income will cause an increase in the quantity demanded. This pattern is common enough that these goods are referred to as normal goods. However, for a few goods, an increase in income means that one might purchase less of the good; for example, those with a higher income might buy fewer hamburgers, because they are buying more steak instead, or those with a higher income might buy less cheap wine and more imported beer. When the income elasticity of demand is negative, the good is called an inferior good.

The concepts of normal and inferior goods were introduced in Demand and Supply. A higher level of income for a normal good causes a demand curve to shift to the right for a normal good, which means that the income elasticity of demand is positive. How far the demand shifts depends on the income elasticity of demand. A higher income elasticity means a larger shift. However, for an inferior good, that is, when the income elasticity of demand is negative, a higher level of income would cause the demand curve for that good to shift to the left. Again, how much it shifts depends on how large the (negative) income elasticity is.

Cross-Price Elasticity of Demand

A change in the price of one good can shift the quantity demanded for another good. If the two goods are complements, like bread and peanut butter, then a drop in the price of one good will lead to an increase in the quantity demanded of the other good. However, if the two goods are substitutes, like plane tickets and train tickets, then a drop in the price of one good will cause people to substitute toward that good, and to reduce consumption of the other good. Cheaper plane tickets lead to fewer train tickets, and vice versa.

The cross-price elasticity of demand puts some meat on the bones of these ideas. The term “cross-price” refers to the idea that the price of one good is affecting the quantity demanded of a different good. Specifically, the cross-price elasticity of demand is the percentage change in the quantity of good A that is demanded as a result of a percentage change in the price of good B.

Cross-price\;elasticity\;of\;demand = \frac{ \%\;change\;in\;Qd\;of\;good\;A }{ \%\;change\;in\;price\;of\;good\;B }

Substitute goods have positive cross-price elasticities of demand: if good A is a substitute for good B, like coffee and tea, then a higher price for B will mean a greater quantity consumed of A. Complement goods have negative cross-price elasticities: if good A is a complement for good B, like coffee and sugar, then a higher price for B will mean a lower quantity consumed of A.

Elasticity in Labor and Financial Capital Markets

The concept of elasticity applies to any market, not just markets for goods and services. In the labor market, for example, the wage elasticity of labor supply—that is, the percentage change in hours worked divided by the percentage change in wages—will determine the shape of the labor supply curve. Specifically:

Elasticity\;of\;labor\;supply = \frac{ \%\;change\;in\;quantity\;of\;labor\;supplied }{ \%\;change\;in\;wage }

The wage elasticity of labor supply for teenage workers is generally thought to be fairly elastic: that is, a certain percentage change in wages will lead to a larger percentage change in the quantity of hours worked. Conversely, the wage elasticity of labor supply for adult workers in their thirties and forties is thought to be fairly inelastic. When wages move up or down by a certain percentage amount, the quantity of hours that adults in their prime earning years are willing to supply changes but by a lesser percentage amount.

In markets for financial capital, the elasticity of savings—that is, the percentage change in the quantity of savings divided by the percentage change in interest rates—will describe the shape of the supply curve for financial capital. That is:

Elasticity\;of\;savings = \frac{ \%\;change\;in\;quantity\;of\;financial\;savings }{ \%\;change\;in\;interest\;rate }

Sometimes laws are proposed that seek to increase the quantity of savings by offering tax breaks so that the return on savings is higher. Such a policy will increase the quantity if the supply curve for financial capital is elastic, because then a given percentage increase in the return to savings will cause a higher percentage increase in the quantity of savings. However, if the supply curve for financial capital is highly inelastic, then a percentage increase in the return to savings will cause only a small increase in the quantity of savings. The evidence on the supply curve of financial capital is controversial but, at least in the short run, the elasticity of savings with respect to the interest rate appears fairly inelastic.

Expanding the Concept of Elasticity

The elasticity concept does not even need to relate to a typical supply or demand curve at all. For example, imagine that you are studying whether the Internal Revenue Service should spend more money on auditing tax returns. The question can be framed in terms of the elasticity of tax collections with respect to spending on tax enforcement; that is, what is the percentage change in tax collections derived from a percentage change in spending on tax enforcement?

With all of the elasticity concepts that have just been described, some of which are listed in Table 6, the possibility of confusion arises. When you hear the phrases “elasticity of demand” or “elasticity of supply,” they refer to the elasticity with respect to price. Sometimes, either to be extremely clear or because a wide variety of elasticities are being discussed, the elasticity of demand or the demand elasticity will be called the price elasticity of demand or the “elasticity of demand with respect to price.” Similarly, elasticity of supply or the supply elasticity is sometimes called, to avoid any possibility of confusion, the price elasticity of supply or “the elasticity of supply with respect to price.” But in whatever context elasticity is invoked, the idea always refers to percentage change in one variable, almost always a price or money variable, and how it causes a percentage change in another variable, typically a quantity variable of some kind.

Income\;elasticity\;of\;demand = \frac{\%\;change\;in\;Qd}{\%\;change\;in\;income}
Cross-price\;elasticity\;of\;demand = \frac{\%\;change\;in\;Qd\;of\;good\;A}{\%\;change\;in\;price\;of\;good\;B}
Wage\;elasticity\;of\;labor\;supply = \frac{\%\;change\;in\;quantity\;of\;labor\;supplied}{\%\;change\;in\;wage}
Wage\;elasticity\;of\;labor\;demand = \frac{\%\;change\;in\;quantity\;of\;labor\;demanded}{\%\;change\;in\;wage}
Interest\;rate\;elasticity\;of\;savings = \frac{\%\;change\;in\;quantity\;of\;savings}{\%\;change\;in\;interest\;rate}
Interest\;rate\;elasticity\;of\;borrowing = \frac{\%\;change\;in\;quantity\;of\;borrowing}{\%\;change\;in\;interest\;rate}
Table 6. Formulas for Calculating Elasticity

That Will Be How Much?

How did the 60% price increase in 2011 end up for Netflix? It has been a very bumpy ride.

Before the price increase, there were about 24.6 million U.S. subscribers. After the price increase, 810,000 infuriated U.S. consumers canceled their Netflix subscriptions, dropping the total number of subscribers to 23.79 million. Fast forward to June 2013, when there were 36 million streaming Netflix subscribers in the United States. This was an increase of 11.4 million subscribers since the price increase—an average per quarter growth of about 1.6 million. This growth is less than the 2 million per quarter increases Netflix experienced in the fourth quarter of 2010 and the first quarter of 2011.

During the first year after the price increase, the firm’s stock price (a measure of future expectations for the firm) fell from about $300 per share to just under $54. In 2015, however, the stock price is at $448 per share. Today, Netflix has 57 million subscribers in fifty countries.

What happened? Obviously, Netflix company officials understood the law of demand. Company officials reported, when announcing the price increase, this could result in the loss of about 600,000 existing subscribers. Using the elasticity of demand formula, it is easy to see company officials expected an inelastic response:

\begin{array}{r @{{}={}} l} & \frac{-600,000 / [(24\;million + 24.6\;million) / 2]}{\$6 / [(\$10 + \$16) / 2]} \\[1em] & \frac{-600,000 / 24.3\;million}{\$6 / \$13} \\[1em] & \frac{-0.025}{0.46} \\[1em] & -0.05 \end{array}

In addition, Netflix officials had anticipated the price increase would have little impact on attracting new customers. Netflix anticipated adding up to 1.29 million new subscribers in the third quarter of 2011. It is true this was slower growth than the firm had experienced—about 2 million per quarter.

Why was the estimate of customers leaving so far off? In the 18 years since Netflix had been founded, there was an increase in the number of close, but not perfect, substitutes. Consumers now had choices ranging from Vudu, Amazon Prime, Hulu, and Redbox, to retail stores. Jaime Weinman reported in Maclean’s that Redbox kiosks are “a five-minute drive for less from 68 percent of Americans, and it seems that many people still find a five-minute drive more convenient than loading up a movie online.” It seems that in 2012, many consumers still preferred a physical DVD disk over streaming video.

What missteps did the Netflix management make? In addition to misjudging the elasticity of demand, by failing to account for close substitutes, it seems they may have also misjudged customers’ preferences and tastes. Yet, as the population increases, the preference for streaming video may overtake physical DVD disks. Netflix, the source of numerous late night talk show laughs and jabs in 2011, may yet have the last laugh.

Key Concepts and Summary

Elasticity is a general term, referring to percentage change of one variable divided by percentage change of a related variable that can be applied to many economic connections. For instance, the income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income. The cross-price elasticity of demand is the percentage change in the quantity demanded of a good divided by the percentage change in the price of another good. Elasticity applies in labor markets and financial capital markets just as it does in markets for goods and services. The wage elasticity of labor supply is the percentage change in the quantity of hours supplied divided by the percentage change in the wage. The elasticity of savings with respect to interest rates is the percentage change in the quantity of savings divided by the percentage change in interest rates.

Self-Check Questions

  1. What would the gasoline price elasticity of supply mean to UPS or FedEx?
  2. The average annual income rises from $25,000 to $38,000, and the quantity of bread consumed in a year by the average person falls from 30 loaves to 22 loaves. What is the income elasticity of bread consumption? Is bread a normal or an inferior good?
  3. Suppose the cross-price elasticity of apples with respect to the price of oranges is 0.4, and the price of oranges falls by 3%. What will happen to the demand for apples?

Review Questions

  1. What is the formula for the income elasticity of demand?
  2. What is the formula for the cross-price elasticity of demand?
  3. What is the formula for the wage elasticity of labor supply?
  4. What is the formula for elasticity of savings with respect to interest rates?

Critical Thinking Questions

  1. Normal goods are defined as having a positive income elasticity. We can divide normal goods into two types: Those whose income elasticity is less than one and those whose income elasticity is greater than one. Think about products that would fall into each category. Can you come up with a name for each category?
  2. Suppose you could buy shoes one at a time, rather than in pairs. What do you predict the cross-price elasticity for left shoes and right shoes would be?

References

Abkowitz, A. “How Netflix got started: Netflix founder and CEO Reed Hastings tells Fortune how he got the idea for the DVD-by-mail service that now has more than eight million customers.” CNN Money. Last Modified January 28, 2009. http://archive.fortune.com/2009/01/27/news/newsmakers/hastings_netflix.fortune/index.htm.

Associated Press (a). ”Analyst: Coinstar gains from Netflix pricing moves.” Boston Globe Media Partners, LLC. Accessed June 24, 2013. http://www.boston.com/business/articles/2011/10/12/analyst_coinstar_gains_from_netflix_pricing_moves/.

Associated Press (b). “Netflix loses 800,000 US subscribers in tough 3Q.” ABC Inc. Accessed June 24, 2013. http://abclocal.go.com/wpvi/story?section=news/business&id=8403368

Baumgardner, James. 2014. “Presentation on Raising the Excise Tax on Cigarettes: Effects on Health and the Federal Budget.” Congressional Budget Office. Accessed March 27, 2015. http://www.cbo.gov/sites/default/files/45214-ICA_Presentation.pdf.

Funding Universe. 2015. “Netflix, Inc. History.” Accessed March 11, 2015. http://www.fundinguniverse.com/company-histories/netflix-inc-history/.

Laporte, Nicole. “A tale of two Netflix.” Fast Company 177 (July 2013) 31-32. Accessed December 3 2013. http://www.fastcompany-digital.com/fastcompany/20130708?pg=33#pg33

Liedtke, Michael, The Associated Press. “Investors bash Netflix stock after slower growth forecast – fee hikes expected to take toll on subscribers most likely to shun costly bundled Net, DVD service.” The Seattle Times. Accessed June 24, 2013 from NewsBank on-line database (Access World News).

Netflix, Inc. 2013. “A Quick Update On Our Streaming Plans And Prices.” Netflix (blog). Accessed March 11, 2015. http://blog.netflix.com/2014/05/a-quick-update-on-our-streaming-plans.html.

Organization for Economic Co-Operation and Development (OECC). n.d. “Average annual hours actually worked per worker.” Accessed March 11, 2015. https://stats.oecd.org/Index.aspx?DataSetCode=ANHRS.

Savitz, Eric. “Netflix Warns DVD Subs Eroding; Q4 View Weak; Losses Ahead; Shrs Plunge.” Forbes.com, 2011. Accessed December 3, 2013. http://www.forbes.com/sites/ericsavitz/2011/10/24/netflix-q3-top-ests-but-shares-hit-by-weak-q4-outlook/.

Statistica.com. 2014. “Coffee Export Volumes Worldwide in November 2014, by Leading Countries (in 60-kilo sacks).” Accessed March 27, 2015. http://www.statista.com/statistics/268135/ranking-of-coffee-exporting-countries/.

Stone, Marcie. “Netflix responds to customers angry with price hike; Netflix stock falls 9%.” News & Politics Examiner, 2011. Clarity Digital Group. Accessed June 24, 2013. http://www.examiner.com/article/netflix-responds-to-customers-angry-with-price-hike-netflix-stock-falls-9.

Weinman, J. (2012). Die hard, hardly dying. Maclean’s, 125(18), 44.

The World Bank Group. 2015. “Gross Savings (% of GDP).” Accessed March 11, 2015. http://data.worldbank.org/indicator/NY.GNS.ICTR.ZS.

Yahoo Finance. Retrieved from http://finance.yahoo.com/q?s=NFLX

Glossary

cross-price elasticity of demand
the percentage change in the quantity of good A that is demanded as a result of a percentage change in good B
elasticity of savings
the percentage change in the quantity of savings divided by the percentage change in interest rates
wage elasticity of labor supply
the percentage change in hours worked divided by the percentage change in wages

Solutions

Answers to Self-Check Questions

  1. The percentage change in quantity supplied as a result of a given percentage change in the price of gasoline.
  2. \begin{array}{r @{{}={}} l}Percentage\;change\;in\;quantity\;demanded & [(change\;in\;quantity) / (original\;quantity)] \times 100 \\[1em] & [22 - 30] / [(22 + 30) / 2] \times 100 \\[1em] & \frac{-8}{26} \times 100 \\[1em] & -30.77 \\[1em] Percentage\;change\;in\;income & [(change\;in\;income) / (original\;income)] \times 100 \\[1em] & [38,000 - 25,000] / [(38,000 + 25,000) / 2] \times 100 \\[1em] & \frac{13}{31.5} \times 100 \\[1em] & 41.27 \end{array}

    In this example, bread is an inferior good because its consumption falls as income rises.

  3. The formula for cross-price elasticity is % change in Qd for apples / % change in P of oranges. Multiplying both sides by % change in P of oranges yields:
    \begin{array}{r @{{}={}} l}\%\;change\;in\;Qd\;for\;apples & cross-price\;elasticity\;\times\;\%\;change\;in\;P\;of\;oranges \\[1em] & 0.4 \times (-3\%) \\[1em] & -1.2\% \end{array},

    or a 1.2% decrease in demand for apples.

Chapter 7. Consumer Choices

VII

Introduction to Consumer Choices

32

This is a photograph of students at their outdoor college graduation ceremony.
Figure 1. Investment Choices. Higher education is generally viewed as a good investment, if one can afford it, regardless of the state of the economy. (Credit: modification of work by Jason Bache/Flickr Creative Commons)

“Eeny, Meeny, Miney, Moe”—Making Choices

The Great Recession of 2008–2009 touched families around the globe. In too many countries, workers found themselves out of a job. In developed countries, unemployment compensation provided a safety net, but families still saw a marked decrease in disposable income and had to make tough spending decisions. Of course, non-essential, discretionary spending was the first to go.

Even so, there was one particular category that saw a universal increase in spending world-wide during that time—an 18% uptick in the United States, specifically. You might guess that consumers began eating more meals at home, increasing spending at the grocery store. But the Bureau of Labor Statistics’ Consumer Expenditure Survey, which tracks U.S. food spending over time, showed “real total food spending by U.S. households declined five percent between 2006 and 2009.” So, it was not groceries. Just what product would people around the world demand more of during tough economic times, and more importantly, why? (Find out at chapter’s end.)

That question leads us to this chapter’s topic—analyzing how consumers make choices. For most consumers, using “eeny, meeny, miney, moe” is not how they make decisions; their decision-making processes have been educated far beyond a children’s rhyme.

Chapter Objectives

Introduction to Consumer Choices

In this chapter, you will learn about:

  • Consumption Choices
  • How Changes in Income and Prices Affect Consumption Choices
  • Labor-Leisure Choices
  • Intertemporal Choices in Financial Capital Markets

Microeconomics seeks to understand the behavior of individual economic agents such as individuals and businesses. Economists believe that individuals’ decisions, such as what goods and services to buy, can be analyzed as choices made within certain budget constraints. Generally, consumers are trying to get the most for their limited budget. In economic terms they are trying to maximize total utility, or satisfaction, given their budget constraint.

Everyone has their own personal tastes and preferences. The French say: Chacun à son goût, or “Each to his own taste.” An old Latin saying states, De gustibus non est disputandum or “There’s no disputing about taste.” If people’s decisions are based on their own tastes and personal preferences, however, then how can economists hope to analyze the choices consumers make?

An economic explanation for why people make different choices begins with accepting the proverbial wisdom that tastes are a matter of personal preference. But economists also believe that the choices people make are influenced by their incomes, by the prices of goods and services they consume, and by factors like where they live. This chapter introduces the economic theory of how consumers make choices about what to buy, how much to work, and how much to save.

The analysis in this chapter will build on the three budget constraints introduced in the Choice in a World of Scarcity chapter. These were the consumption choice budget constraint, the labor-leisure budget constraint, and the intertemporal budget constraint. This chapter will also illustrate how economic theory provides a tool to systematically look at the full range of possible consumption choices to predict how consumption responds to changes in prices or incomes. After reading this chapter, consult the appendix Indifference Curves to learn more about representing utility and choice through indifference curves.

7.1 Consumption Choices

33

Learning Objectives

By the end of this section, you will be able to:
  • Calculate total utility
  • Propose decisions that maximize utility
  • Explain marginal utility and the significance of diminishing marginal utility

Information on the consumption choices of Americans is available from the Consumer Expenditure Survey carried out by the U.S. Bureau of Labor Statistics. Table 1 shows spending patterns for the average U.S. household. The first row shows income and, after taxes and personal savings are subtracted, it shows that, in 2015, the average U.S. household spent $48,109 on consumption. The table then breaks down consumption into various categories. The average U.S. household spent roughly one-third of its consumption on shelter and other housing expenses, another one-third on food and vehicle expenses, and the rest on a variety of items, as shown. Of course, these patterns will vary for specific households by differing levels of family income, by geography, and by preferences.

Average Household Income before Taxes $62,481
Average Annual Expenditures $48.109
Food at home $3,264
Food away from home $2,505
Housing $16,557
Apparel and services $1,700
Transportation $7,677
Healthcare $3,157
Entertainment $2,504
Education $1,074
Personal insurance and pensions $5,357
All else: alcohol, tobacco, reading, personal care, cash contributions, miscellaneous $3,356
Table 1. U.S. Consumption Choices in 2015(Source: http://www.bls.gov/cex/csxann13.pdf)

Total Utility and Diminishing Marginal Utility

To understand how a household will make its choices, economists look at what consumers can afford, as shown in a budget constraint line, and the total utility or satisfaction derived from those choices. In a budget constraint line, the quantity of one good is measured on the horizontal axis and the quantity of the other good is measured on the vertical axis. The budget constraint line shows the various combinations of two goods that are affordable given consumer income. Consider the situation of José, shown in Figure 1. José likes to collect T-shirts and watch movies.

In Figure 1, the quantity of T-shirts is shown on the horizontal axis, while the quantity of movies is shown on the vertical axis. If José had unlimited income or goods were free, then he could consume without limit. But José, like all of us, faces a budget constraint. José has a total of $56 to spend. The price of T-shirts is $14 and the price of movies is $7. Notice that the vertical intercept of the budget constraint line is at eight movies and zero T-shirts ($56/$7=8). The horizontal intercept of the budget constraint is four, where José spends of all of his money on T-shirts and no movies ($56/14=4). The slope of the budget constraint line is rise/run or –8/4=–2. The specific choices along the budget constraint line show the combinations of T-shirts and movies that are affordable.

The points on the graph show how a budget is affected by spending choices. Spending more money at the movies (y-axis) means that Jose' has less money to spend on T-shirts (x-axis).
Figure 1. A Choice between Consumption Goods. José has income of $56. Movies cost $7 and T-shirts cost $14. The points on the budget constraint line show the combinations of movies and T-shirts that are affordable.

José wishes to choose the combination that will provide him with the greatest utility, which is the term economists use to describe a person’s level of satisfaction or happiness with his or her choices.

Let’s begin with an assumption, which will be discussed in more detail later, that José can measure his own utility with something called utils. (It is important to note that you cannot make comparisons between the utils of individuals; if one person gets 20 utils from a cup of coffee and another gets 10 utils, this does not mean than the first person gets more enjoyment from the coffee than the other or that they enjoy the coffee twice as much.) Table 2 shows how José’s utility is connected with his consumption of T-shirts or movies. The first column of the table shows the quantity of T-shirts consumed. The second column shows the total utility, or total amount of satisfaction, that José receives from consuming that number of T-shirts. The most common pattern of total utility, as shown here, is that consuming additional goods leads to greater total utility, but at a decreasing rate. The third column shows marginal utility, which is the additional utility provided by one additional unit of consumption. This equation for marginal utility is:

MU = \frac{ change\;in\;total\;utility }{ change\;in\;quantity }

Notice that marginal utility diminishes as additional units are consumed, which means that each subsequent unit of a good consumed provides less additional utility. For example, the first T-shirt José picks is his favorite and it gives him an addition of 22 utils. The fourth T-shirt is just to something to wear when all his other clothes are in the wash and yields only 18 additional utils. This is an example of the law of diminishing marginal utility, which holds that the additional utility decreases with each unit added.

The rest of Table 2 shows the quantity of movies that José attends, and his total and marginal utility from seeing each movie. Total utility follows the expected pattern: it increases as the number of movies seen rises. Marginal utility also follows the expected pattern: each additional movie brings a smaller gain in utility than the previous one. The first movie José attends is the one he wanted to see the most, and thus provides him with the highest level of utility or satisfaction. The fifth movie he attends is just to kill time. Notice that total utility is also the sum of the marginal utilities. Read the next Work It Out feature for instructions on how to calculate total utility.

T-Shirts (Quantity) Total Utility Marginal Utility Movies (Quantity) Total Utility Marginal Utility
1 22 22 1 16 16
2 43 21 2 31 15
3 63 20 3 45 14
4 81 18 4 58 13
5 97 16 5 70 12
6 111 14 6 81 11
7 123 12 7 91 10
8 133 10 8 100 9
Table 2. Total and Marginal Utility

Table 3 looks at each point on the budget constraint in Figure 1, and adds up José’s total utility for five possible combinations of T-shirts and movies.

Point T-Shirts Movies Total Utility
P 4 0 81 + 0 = 81
Q 3 2 63 + 31 = 94
R 2 4 43 + 58 = 101
S 1 6 22 + 81 = 103
T 0 8 0 + 100 = 100
Table 3. Finding the Choice with the Highest Utility

Calculating Total Utility

Let’s look at how José makes his decision in more detail.

Step 1. Observe that, at point Q (for example), José consumes three T-shirts and two movies.

Step 2. Look at Table 2. You can see from the fourth row/second column that three T-shirts are worth 63 utils. Similarly, the second row/fifth column shows that two movies are worth 31 utils.

Step 3. From this information, you can calculate that point Q has a total utility of 94 (63 + 31).

Step 4. You can repeat the same calculations for each point on Table 3, in which the total utility numbers are shown in the last column.

For José, the highest total utility for all possible combinations of goods occurs at point S, with a total utility of 103 from consuming one T-shirt and six movies.

Choosing with Marginal Utility

Most people approach their utility-maximizing combination of choices in a step-by-step way. This step-by-step approach is based on looking at the tradeoffs, measured in terms of marginal utility, of consuming less of one good and more of another.

For example, say that José starts off thinking about spending all his money on T-shirts and choosing point P, which corresponds to four T-shirts and no movies, as illustrated in Figure 1. José chooses this starting point randomly; he has to start somewhere. Then he considers giving up the last T-shirt, the one that provides him the least marginal utility, and using the money he saves to buy two movies instead. Table 4 tracks the step-by-step series of decisions José needs to make (Key: T-shirts are $14, movies are $7, and income is $56). The following Work It Out feature explains how marginal utility can effect decision making.

Try Which Has Total Utility Marginal Gain and Loss of Utility, Compared with Previous Choice Conclusion
Choice 1: P 4 T-shirts and 0 movies 81 from 4 T-shirts + 0 from 0 movies = 81      –      –
Choice 2: Q 3 T-shirts and 2 movies 63 from 3 T-shirts + 31 from 0 movies = 94 Loss of 18 from 1 less T-shirt, but gain of 31 from 2 more movies, for a net utility gain of 13 Q is preferred over P
Choice 3: R 2 T-shirts and 4 movies 43 from 2 T-shirts + 58 from 4 movies = 101 Loss of 20 from 1 less T-shirt, but gain of 27 from two more movies for a net utility gain of 7 R is preferred over Q
Choice 4: S 1 T-shirt and 6 movies 22 from 1 T-shirt + 81 from 6 movies = 103 Loss of 21 from 1 less T-shirt, but gain of 23 from two more movies, for a net utility gain of 2 S is preferred over R
Choice 5: T 0 T-shirts and 8 movies 0 from 0 T-shirts + 100 from 8 movies = 100 Loss of 22 from 1 less T-shirt, but gain of 19 from two more movies, for a net utility loss of 3 S is preferred over T
Table 4. A Step-by-Step Approach to Maximizing Utility

Decision Making by Comparing Marginal Utility

José could use the following thought process (if he thought in utils) to make his decision regarding how many T-shirts and movies to purchase:

Step 1. From Table 2, José can see that the marginal utility of the fourth T-shirt is 18. If José gives up the fourth T-shirt, then he loses 18 utils.

Step 2. Giving up the fourth T-shirt, however, frees up $14 (the price of a T-shirt), allowing José to buy the first two movies (at $7 each).

Step 3. José knows that the marginal utility of the first movie is 16 and the marginal utility of the second movie is 15. Thus, if José moves from point P to point Q, he gives up 18 utils (from the T-shirt), but gains 31 utils (from the movies).

Step 4. Gaining 31 utils and losing 18 utils is a net gain of 13. This is just another way of saying that the total utility at Q (94 according to the last column in Table 3) is 13 more than the total utility at P (81).

Step 5. So, for José, it makes sense to give up the fourth T-shirt in order to buy two movies.

José clearly prefers point Q to point P. Now repeat this step-by-step process of decision making with marginal utilities. José thinks about giving up the third T-shirt and surrendering a marginal utility of 20, in exchange for purchasing two more movies that promise a combined marginal utility of 27. José prefers point R to point Q. What if José thinks about going beyond R to point S? Giving up the second T-shirt means a marginal utility loss of 21, and the marginal utility gain from the fifth and sixth movies would combine to make a marginal utility gain of 23, so José prefers point S to R.

However, if José seeks to go beyond point S to point T, he finds that the loss of marginal utility from giving up the first T-shirt is 22, while the marginal utility gain from the last two movies is only a total of 19. If José were to choose point T, his utility would fall to 100. Through these stages of thinking about marginal tradeoffs, José again concludes that S, with one T-shirt and six movies, is the choice that will provide him with the highest level of total utility. This step-by-step approach will reach the same conclusion regardless of José’s starting point.

Another way to look at this is by focusing on satisfaction per dollar. Marginal utility per dollar is the amount of additional utility José receives given the price of the product. For José’s T-shirts and movies, the marginal utility per dollar is shown in Table 5.

marginal\;utility\;per\;dollar = \frac{marginal\;utility}{price}

José’s first purchase will be a movie. Why? Because it gives him the highest marginal utility per dollar and it is affordable. José will continue to purchase the good which gives him the highest marginal utility per dollar until he exhausts the budget. José will keep purchasing movies because they give him a greater “bang or the buck” until the sixth movie is equivalent to a T-shirt purchase. José can afford to purchase that T-shirt. So José will choose to purchase six movies and one T-shirt.

Quantity of T-Shirts Total Utility Marginal Utility Marginal Utility per Dollar Quantity of Movies Total Utility Marginal Utility Marginal Utility per Dollar
1 22 22 22/$14=1.6 1 16 16 16/$7=2.3
2 43 21 21/$14=1.5 2 31 15 15/$7=2.14
3 63 20 20/$14=1.4 3 45 14 14/$7=2
4 81 18 18/$14=1.3 4 58 13 13/$7=1.9
5 97 16 16/$14=1.1 5 70 12 12/$7=1.7
6 111 14 14/$14=1 6 81 11 11/$7=1.6
7 123 12 12/$14=1.2 7 91 10 10/$7=1.4
Table 5. Marginal Utility per Dollar

A Rule for Maximizing Utility

This process of decision making suggests a rule to follow when maximizing utility. Since the price of T-shirts is twice as high as the price of movies, to maximize utility the last T-shirt chosen needs to provide exactly twice the marginal utility (MU) of the last movie. If the last T-shirt provides less than twice the marginal utility of the last movie, then the T-shirt is providing less “bang for the buck” (i.e., marginal utility per dollar spent) than if the same money were spent on movies. If this is so, José should trade the T-shirt for more movies to increase his total utility. Marginal utility per dollar measures the additional utility that José will enjoy given what he has to pay for the good.

If the last T-shirt provides more than twice the marginal utility of the last movie, then the T-shirt is providing more “bang for the buck” or marginal utility per dollar, than if the money were spent on movies. As a result, José should buy more T-shirts. Notice that at José’s optimal choice of point S, the marginal utility from the first T-shirt, of 22 is exactly twice the marginal utility of the sixth movie, which is 11. At this choice, the marginal utility per dollar is the same for both goods. This is a tell-tale signal that José has found the point with highest total utility.

This argument can be written as a general rule: the utility-maximizing choice between consumption goods occurs where the marginal utility per dollar is the same for both goods.

\frac{MU_1}{P_1} = \frac{MU_2}{P_2}

A sensible economizer will pay twice as much for something only if, in the marginal comparison, the item confers twice as much utility. Notice that the formula for the table above is:

\frac{22}{\$14} = \frac{11}{\$7}
1.6 = 1.6

The following Work It Out feature provides step by step guidance for this concept of utility-maximizing choices.

Maximizing Utility

The general rule, \frac{MU_1}{P_1} = \frac{MU_2}{P_2}, means that the last dollar spent on each good provides exactly the same marginal utility. So:

Step 1. If we traded a dollar more of movies for a dollar more of T-shirts, the marginal utility gained from T-shirts would exactly offset the marginal utility lost from fewer movies. In other words, the net gain would be zero.

Step 2. Products, however, usually cost more than a dollar, so we cannot trade a dollar’s worth of movies. The best we can do is trade two movies for another T-shirt, since in this example T-shirts cost twice what a movie does.

Step 3. If we trade two movies for one T-shirt, we would end up at point R (two T-shirts and four movies).

Step 4. Choice 4 in Table 4 shows that if we move to point S, we would lose 21 utils from one less T-shirt, but gain 23 utils from two more movies, so we would end up with more total utility at point S.

In short, the general rule shows us the utility-maximizing choice.

There is another, equivalent way to think about this. The general rule can also be expressed as the ratio of the prices of the two goods should be equal to the ratio of the marginal utilities. When the price of good 1 is divided by the price of good 2, at the utility-maximizing point this will equal the marginal utility of good 1 divided by the marginal utility of good 2. This rule, known as the consumer equilibrium, can be written in algebraic form:

\frac{P_1}{P_2} = \frac{MU_1}{MU_2}

Along the budget constraint, the total price of the two goods remains the same, so the ratio of the prices does not change. However, the marginal utility of the two goods changes with the quantities consumed. At the optimal choice of one T-shirt and six movies, point S, the ratio of marginal utility to price for T-shirts (22:14) matches the ratio of marginal utility to price for movies (of 11:7).

Measuring Utility with Numbers

This discussion of utility started off with an assumption that it is possible to place numerical values on utility, an assumption that may seem questionable. You can buy a thermometer for measuring temperature at the hardware store, but what store sells an “utilimometer” for measuring utility? However, while measuring utility with numbers is a convenient assumption to clarify the explanation, the key assumption is not that utility can be measured by an outside party, but only that individuals can decide which of two alternatives they prefer.

To understand this point, think back to the step-by-step process of finding the choice with highest total utility by comparing the marginal utility that is gained and lost from different choices along the budget constraint. As José compares each choice along his budget constraint to the previous choice, what matters is not the specific numbers that he places on his utility—or whether he uses any numbers at all—but only that he personally can identify which choices he prefers.

In this way, the step-by-step process of choosing the highest level of utility resembles rather closely how many people make consumption decisions. We think about what will make us the happiest; we think about what things cost; we think about buying a little more of one item and giving up a little of something else; we choose what provides us with the greatest level of satisfaction. The vocabulary of comparing the points along a budget constraint and total and marginal utility is just a set of tools for discussing this everyday process in a clear and specific manner. It is welcome news that specific utility numbers are not central to the argument, since a good utilimometer is hard to find. Do not worry—while we cannot measure utils, by the end of the next module, we will have transformed our analysis into something we can measure—demand.

Key Concepts and Summary

Economic analysis of household behavior is based on the assumption that people seek the highest level of utility or satisfaction. Individuals are the only judge of their own utility. In general, greater consumption of a good brings higher total utility. However, the additional utility received from each unit of greater consumption tends to decline in a pattern of diminishing marginal utility.

The utility-maximizing choice on a consumption budget constraint can be found in several ways. You can add up total utility of each choice on the budget line and choose the highest total. You can choose a starting point at random and compare the marginal utility gains and losses of moving to neighboring points—and thus eventually seek out the preferred choice. Alternatively, you can compare the ratio of the marginal utility to price of good 1 with the marginal utility to price of good 2 and apply the rule that at the optimal choice, the two ratios should be equal:

\frac{MU_1}{P_1} = \frac{MU_2}{P_2}

Self-Check Questions

  1. Jeremy is deeply in love with Jasmine. Jasmine lives where cell phone coverage is poor, so he can either call her on the land-line phone for five cents per minute or he can drive to see her, at a round-trip cost of $2 in gasoline money. He has a total of $10 per week to spend on staying in touch. To make his preferred choice, Jeremy uses a handy utilimometer that measures his total utility from personal visits and from phone minutes. Using the values given in Table 6, figure out the points on Jeremy’s consumption choice budget constraint (it may be helpful to do a sketch) and identify his utility-maximizing point.
    Round Trips Total Utility Phone Minutes Total Utility
    0 0 0 0
    1 80 20 200
    2 150 40 380
    3 210 60 540
    4 260 80 680
    5 300 100 800
    6 330 120 900
    7 200 140 980
    8 180 160 1040
    9 160 180 1080
    10 140 200 1100
    Table 6.
  2. Take Jeremy’s total utility information in Self-Check Question 1, and use the marginal utility approach to confirm the choice of phone minutes and round trips that maximize Jeremy’s utility.

Review Questions

  1. Who determines how much utility an individual will receive from consuming a good?
  2. Would you expect total utility to rise or fall with additional consumption of a good? Why?
  3. Would you expect marginal utility to rise or fall with additional consumption of a good? Why?
  4. Is it possible for total utility to increase while marginal utility diminishes? Explain.
  5. If people do not have a complete mental picture of total utility for every level of consumption, how can they find their utility-maximizing consumption choice?
  6. What is the rule relating the ratio of marginal utility to prices of two goods at the optimal choice? Explain why, if this rule does not hold, the choice cannot be utility-maximizing.

Critical Thinking Questions

  1. Think back to a purchase that you made recently. How would you describe your thinking before you made that purchase?
  2. The rules of politics are not always the same as the rules of economics. In discussions of setting budgets for government agencies, there is a strategy called “closing the Washington monument.” When an agency faces the unwelcome prospect of a budget cut, it may decide to close a high-visibility attraction enjoyed by many people (like the Washington monument). Explain in terms of diminishing marginal utility why the Washington monument strategy is so misleading. Hint: If you are really trying to make the best of a budget cut, should you cut the items in your budget with the highest marginal utility or the lowest marginal utility? Does the Washington monument strategy cut the items with the highest marginal utility or the lowest marginal utility?

Problems

Praxilla, who lived in ancient Greece, derives utility from reading poems and from eating cucumbers. Praxilla gets 30 units of marginal utility from her first poem, 27 units of marginal utility from her second poem, 24 units of marginal utility from her third poem, and so on, with marginal utility declining by three units for each additional poem. Praxilla gets six units of marginal utility for each of her first three cucumbers consumed, five units of marginal utility for each of her next three cucumbers consumed, four units of marginal utility for each of the following three cucumbers consumed, and so on, with marginal utility declining by one for every three cucumbers consumed. A poem costs three bronze coins but a cucumber costs only one bronze coin. Praxilla has 18 bronze coins. Sketch Praxilla’s budget set between poems and cucumbers, placing poems on the vertical axis and cucumbers on the horizontal axis. Start off with the choice of zero poems and 18 cucumbers, and calculate the changes in marginal utility of moving along the budget line to the next choice of one poem and 15 cucumbers. Using this step-by-step process based on marginal utility, create a table and identify Praxilla’s utility-maximizing choice. Compare the marginal utility of the two goods and the relative prices at the optimal choice to see if the expected relationship holds. Hint: Label the table columns: 1) Choice, 2) Marginal Gain from More Poems, 3) Marginal Loss from Fewer Cucumbers, 4) Overall Gain or Loss, 5) Is the previous choice optimal? Label the table rows: 1) 0 Poems and 18 Cucumbers, 2) 1 Poem and 15 Cucumbers, 3) 2 Poems and 12 Cucumbers, 4) 3 Poems and 9 Cucumbers, 5) 4 Poems and 6 Cucumbers, 6) 5 Poems and 3 Cucumbers, 7) 6 Poems and 0 Cucumbers.

References

U.S. Bureau of Labor Statistics. 2015. “Consumer Expenditures in 2013.” Accessed March 11, 2015. http://www.bls.gov/cex/csxann13.pdf.

U.S. Bureau of Labor Statistics. 2015. “Employer Costs for Employee Compensation—December 2014.” Accessed March 11, 2015. http://www.bls.gov/news.release/pdf/ecec.pdf.

U.S. Bureau of Labor Statistics. 2015. “Labor Force Statistics from the Current Population Survey.” Accessed March 11, 2015. http://www.bls.gov/cps/cpsaat22.htm.

Glossary

budget constraint line
shows the possible combinations of two goods that are affordable given a consumer’s limited income
consumer equilibrium
when the ratio of the prices of goods is equal to the ratio of the marginal utilities (point at which the consumer can get the most satisfaction)
diminishing marginal utility
the common pattern that each marginal unit of a good consumed provides less of an addition to utility than the previous unit
marginal utility
the additional utility provided by one additional unit of consumption
marginal utility per dollar
the additional satisfaction gained from purchasing a good given the price of the product; MU/Price
total utility
satisfaction derived from consumer choices

Solutions

Answers to Self-Check Questions

  1. The rows of the table in the problem do not represent the actual choices available on the budget set; that is, the combinations of round trips and phone minutes that Jeremy can afford with his budget. One of the choices listed in the problem, the six round trips, is not even available on the budget set. If Jeremy has only $10 to spend and a round trip costs $2 and phone calls cost $0.05 per minute, he could spend his entire budget on five round trips but no phone calls or 200 minutes of phone calls, but no round trips or any combination of the two in between. It is easy to see all of his budget options with a little algebra. The equation for a budget line is:
    Budget = P_{RT}\;\times\;Q_{RT}\;+\;P_{PC}\;\times\;Q_{PC}

    where P and Q are price and quantity of round trips (RT) and phone calls (PC) (per minute). In Jeremy’s case the equation for the budget line is:

    \begin{array}{r @{{}={}} l}\$10 & \$2\;\times\;Q_{RT}\;+\;\$.05\;\times\;Q_{PC} \\[1em] \frac{\$10}{\$.05} & \frac{\$2Q_{RT}\;+\;\$.05Q_{PC}}{\$.05} \\[1em] 200 & 40Q_{RT}\;+\;Q_{PC} \\[1em] Q_{PC} & 200\;-\;40Q_{RT} \end{array}

    If we choose zero through five round trips (column 1), the table below shows how many phone minutes can be afforded with the budget (column 3). The total utility figures are given in the table below.

    Round Trips Total Utility for Trips Phone Minutes Total Utility for Minutes Total Utility
    0 0 200 1100 1100
    1 80 160 1040 1120
    2 150 120 900 1050
    3 210 80 680 890
    4 260 40 380 640
    5 300 0 0 300
    Table 7.

    Adding up total utility for round trips and phone minutes at different points on the budget line gives total utility at each point on the budget line. The highest possible utility is at the combination of one trip and 160 minutes of phone time, with a total utility of 1120.

  2. The first step is to use the total utility figures, shown in the table below, to calculate marginal utility, remembering that marginal utility is equal to the change in total utility divided by the change in trips or minutes.
    Round Trips Total Utility Marginal Utility (per trip) Phone Minutes Total Utility Marginal Utility (per minute)
    0 0 200 1100
    1 80 80 160 1040 60/40 = 1.5
    2 150 70 120 900 140/40 = 3.5
    3 210 60 80 680 220/40 = 5.5
    4 260 50 40 380 300/40 = 7.5
    5 300 40 0 0 380/40 = 9.5
    Table 8.

    Note that we cannot directly compare marginal utilities, since the units are trips versus phone minutes. We need a common denominator for comparison, which is price. Dividing MU by the price, yields columns 4 and 8 in the table below.

    Round Trips Total Utility Marginal Utility (per trip) MU/P Phone Minutes Total Utility Marginal utility (per minute) MU/P
    0 0 200 1100 60/40 = 1.5 1.5/$0.05 = 30
    1   80 80 80/$2 = 40 160 1040 140/40 = 3.5 3.5/$0.05 = 70
    2 150 70 70/$2 = 35 120 900 220/40 = 5.5 5.5/$0.05 = 110
    3 210 60 60/$2 = 30 80 680 300/40 =7.5 7.5/$0.05 = 150
    4 260 50 50/$2 = 25 40 380 380/40 = 9.5 9.5/$0.05 = 190
    5 300 40 40/$2 = 20 0 0
    Table 9.

    Start at the bottom of the table where the combination of round trips and phone minutes is (5, 0). This starting point is arbitrary, but the numbers in this example work best starting from the bottom. Suppose we consider moving to the next point up. At (4, 40), the marginal utility per dollar spent on a round trip is 25. The marginal utility per dollar spent on phone minutes is 190.

    Since 25 < 190, we are getting much more utility per dollar spent on phone minutes, so let’s choose more of those. At (3, 80), MU/PRT is 30 < 150 (the MU/PM), but notice that the difference is narrowing. We keep trading round trips for phone minutes until we get to (1, 160), which is the best we can do. The MU/P comparison is as close as it is going to get (40 vs. 70). Often in the real world, it is not possible to get MU/P exactly equal for both products, so you get as close as you can.

7.2 How Changes in Income and Prices Affect Consumption Choices

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Learning Objectives

By the end of this section, you will be able to:
  • Explain how income, prices, and preferences affect consumer choices
  • Contrast the substitution effect and the income effect
  • Utilize concepts of demand to analyze consumer choices
  • Apply utility-maximizing choices to governments and businesses

Just as utility and marginal utility can be used to discuss making consumer choices along a budget constraint, these ideas can also be used to think about how consumer choices change when the budget constraint shifts in response to changes in income or price. Indeed, because the budget constraint framework can be used to analyze how quantities demanded change because of price movements, the budget constraint model can illustrate the underlying logic behind demand curves.

How Changes in Income Affect Consumer Choices

Let’s begin with a concrete example illustrating how changes in income level affect consumer choices. Figure 1 shows a budget constraint that represents Kimberly’s choice between concert tickets at $50 each and getting away overnight to a bed-and-breakfast for $200 per night. Kimberly has $1,000 per year to spend between these two choices. After thinking about her total utility and marginal utility and applying the decision rule that the ratio of the marginal utilities to the prices should be equal between the two products, Kimberly chooses point M, with eight concerts and three overnight getaways as her utility-maximizing choice.

The graph's various points represent which good is viewed as inferior. The first solid downward sloping line represents the original budget constraint. The second budget constraint represents a different set of options based on the consumer having more money to spend on both items.
Figure 1. How a Change in Income Affects Consumption Choices. The utility-maximizing choice on the original budget constraint is M. The dashed horizontal and vertical lines extending through point M allow you to see at a glance whether the quantity consumed of goods on the new budget constraint is higher or lower than on the original budget constraint. On the new budget constraint, a choice like N will be made if both goods are normal goods. If overnight stays is an inferior good, a choice like P will be made. If concert tickets are an inferior good, a choice like Q will be made.

Now, assume that the income Kimberly has to spend on these two items rises to $2,000 per year, causing her budget constraint to shift out to the right. How does this rise in income alter her utility-maximizing choice? Kimberly will again consider the utility and marginal utility that she receives from concert tickets and overnight getaways and seek her utility-maximizing choice on the new budget line. But how will her new choice relate to her original choice?

The possible choices along the new budget constraint can be divided into three groups, which are divided up by the dashed horizontal and vertical lines that pass through the original choice M in the figure. All choices on the upper left of the new budget constraint that are to the left of the vertical dashed line, like choice P with two overnight stays and 32 concert tickets, involve less of the good on the horizontal axis but much more of the good on the vertical axis. All choices to the right of the vertical dashed line and above the horizontal dashed line—like choice N with five overnight getaways and 20 concert tickets—have more consumption of both goods. Finally, all choices that are to the right of the vertical dashed line but below the horizontal dashed line, like choice Q with four concerts and nine overnight getaways, involve less of the good on the vertical axis but much more of the good on the horizontal axis.

All of these choices are theoretically possible, depending on Kimberly’s personal preferences as expressed through the total and marginal utility she would receive from consuming these two goods. When income rises, the most common reaction is to purchase more of both goods, like choice N, which is to the upper right relative to Kimberly’s original choice M, although exactly how much more of each good will vary according to personal taste. Conversely, when income falls, the most typical reaction is to purchase less of both goods. As defined in the chapter on Demand and Supply and again in the chapter on Elasticity, goods and services are called normal goods when a rise in income leads to a rise in the quantity consumed of that good and a fall in income leads to a fall in quantity consumed.

However, depending on Kimberly’s preferences, a rise in income could cause consumption of one good to increase while consumption of the other good declines. A choice like P means that a rise in income caused her quantity consumed of overnight stays to decline, while a choice like Q would mean that a rise in income caused her quantity of concerts to decline. Goods where demand declines as income rises (or conversely, where the demand rises as income falls) are called “inferior goods.” An inferior good occurs when people trim back on a good as income rises, because they can now afford the more expensive choices that they prefer. For example, a higher-income household might eat fewer hamburgers or be less likely to buy a used car, and instead eat more steak and buy a new car.

How Price Changes Affect Consumer Choices

For analyzing the possible effect of a change in price on consumption, let’s again use a concrete example. Figure 2 represents the consumer choice of Sergei, who chooses between purchasing baseball bats and cameras. A price increase for baseball bats would have no effect on the ability to purchase cameras, but it would reduce the number of bats Sergei could afford to buy. Thus a price increase for baseball bats, the good on the horizontal axis, causes the budget constraint to rotate inward, as if on a hinge, from the vertical axis. As in the previous section, the point labeled M represents the originally preferred point on the original budget constraint, which Sergei has chosen after contemplating his total utility and marginal utility and the tradeoffs involved along the budget constraint. In this example, the units along the horizontal and vertical axes are not numbered, so the discussion must focus on whether more or less of certain goods will be consumed, not on numerical amounts.

The graph shows how price changes influence spending choices.
Figure 2. How a Change in Price Affects Consumption Choices. The original utility-maximizing choice is M. When the price rises, the budget constraint shifts in to the left. The dashed lines make it possible to see at a glance whether the new consumption choice involves less of both goods, or less of one good and more of the other. The new possible choices would be fewer baseball bats and more cameras, like point H, or less of both goods, as at point J. Choice K would mean that the higher price of bats led to exactly the same quantity of bats being consumed, but fewer cameras. Choices like L are ruled out as theoretically possible but highly unlikely in the real world, because they would mean that a higher price for baseball bats means a greater quantity consumed of baseball bats.

After the price increase, Sergei will make a choice along the new budget constraint. Again, his choices can be divided into three segments by the dashed vertical and horizontal lines. In the upper left portion of the new budget constraint, at a choice like H, Sergei consumes more cameras and fewer bats. In the central portion of the new budget constraint, at a choice like J, he consumes less of both goods. At the right-hand end, at a choice like L, he consumes more bats but fewer cameras.

The typical response to higher prices is that a person chooses to consume less of the product with the higher price. This occurs for two reasons, and both effects can occur simultaneously. The substitution effect occurs when a price changes and consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price. The income effect is that a higher price means, in effect, the buying power of income has been reduced (even though actual income has not changed), which leads to buying less of the good (when the good is normal). In this example, the higher price for baseball bats would cause Sergei to buy a fewer bats for both reasons. Exactly how much will a higher price for bats cause Sergei consumption of bats to fall? Figure 2 suggests a range of possibilities. Sergei might react to a higher price for baseball bats by purchasing the same quantity of bats, but cutting his consumption of cameras. This choice is the point K on the new budget constraint, straight below the original choice M. Alternatively, Sergei might react by dramatically reducing his purchases of bats and instead buy more cameras.

The key is that it would be imprudent to assume that a change in the price of baseball bats will only or primarily affect the good whose price is changed, while the quantity consumed of other goods remains the same. Since Sergei purchases all his products out of the same budget, a change in the price of one good can also have a range of effects, either positive or negative, on the quantity consumed of other goods.

In short, a higher price typically causes reduced consumption of the good in question, but it can affect the consumption of other goods as well.

Read this article about the potential of variable prices in vending machines.


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The Foundations of Demand Curves

Changes in the price of a good lead the budget constraint to shift. A shift in the budget constraint means that when individuals are seeking their highest utility, the quantity that is demanded of that good will change. In this way, the logical foundations of demand curves—which show a connection between prices and quantity demanded—are based on the underlying idea of individuals seeking utility. Figure 3 (a) shows a budget constraint with a choice between housing and “everything else.” (Putting “everything else” on the vertical axis can be a useful approach in some cases, especially when the focus of the analysis is on one particular good.) The preferred choice on the original budget constraint that provides the highest possible utility is labeled M0. The other three budget constraints represent successively higher prices for housing of P1, P2, and P3. As the budget constraint rotates in, and in, and in again, the utility-maximizing choices are labeled M1, M2, and M3, and the quantity demanded of housing falls from Q0 to Q1 to Q2 to Q3.

The two graphs show how budget constraints influence the demand curve.
Figure 3. The Foundations of a Demand Curve: An Example of Housing. (a) As the price increases from P0 to P1 to P2 to P3, the budget constraint on the upper part of the diagram shifts to the left. The utility-maximizing choice changes from M0 to M1 to M2 to M3. As a result, the quantity demanded of housing shifts from Q0 to Q1 to Q2 to Q3, ceteris paribus. (b) The demand curve graphs each combination of the price of housing and the quantity of housing demanded, ceteris paribus. Indeed, the quantities of housing are the same at the points on both (a) and (b). Thus, the original price of housing (P0) and the original quantity of housing (Q0) appear on the demand curve as point E0. The higher price of housing (P1) and the corresponding lower quantity demanded of housing (Q1) appear on the demand curve as point E1.

So, as the price of housing rises, the budget constraint shifts to the left, and the quantity consumed of housing falls, ceteris paribus (meaning, with all other things being the same). This relationship—the price of housing rising from P0 to P1 to P2 to P3, while the quantity of housing demanded falls from Q0 to Q1 to Q2 to Q3—is graphed on the demand curve in Figure 3 (b). Indeed, the vertical dashed lines stretching between the top and bottom of Figure 3 show that the quantity of housing demanded at each point is the same in both (a) and (b). The shape of a demand curve is ultimately determined by the underlying choices about maximizing utility subject to a budget constraint. And while economists may not be able to measure “utils,” they can certainly measure price and quantity demanded.

Applications in Government and Business

The budget constraint framework for making utility-maximizing choices offers a reminder that people can react to a change in price or income in a range of different ways. For example, in the winter months of 2005, costs for heating homes increased significantly in many parts of the country as prices for natural gas and electricity soared, due in large part to the disruption caused by Hurricanes Katrina and Rita. Some people reacted by reducing the quantity demanded of energy; for example, by turning down the thermostats in their homes by a few degrees and wearing a heavier sweater inside. Even so, many home heating bills rose, so people adjusted their consumption in other ways, too. As you learned in the chapter on Elasticity, the short run demand for home heating is generally inelastic. Each household cut back on what it valued least on the margin; for some it might have been some dinners out, or a vacation, or postponing buying a new refrigerator or a new car. Indeed, sharply higher energy prices can have effects beyond the energy market, leading to a widespread reduction in purchasing throughout the rest of the economy.

A similar issue arises when the government imposes taxes on certain products, like it does on gasoline, cigarettes, and alcohol. Say that a tax on alcohol leads to a higher price at the liquor store, the higher price of alcohol causes the budget constraint to pivot left, and consumption of alcoholic beverages is likely to decrease. However, people may also react to the higher price of alcoholic beverages by cutting back on other purchases. For example, they might cut back on snacks at restaurants like chicken wings and nachos. It would be unwise to assume that the liquor industry is the only one affected by the tax on alcoholic beverages. Read the next Clear It Up to learn about how buying decisions are influenced by who controls the household income.

Does who controls household income make a difference?

In the mid-1970s, the United Kingdom made an interesting policy change in its “child allowance” policy. This program provides a fixed amount of money per child to every family, regardless of family income. Traditionally, the child allowance had been distributed to families by withholding less in taxes from the paycheck of the family wage earner—typically the father in this time period. The new policy instead provided the child allowance as a cash payment to the mother. As a result of this change, households have the same level of income and face the same prices in the market, but the money is more likely to be in the purse of the mother than in the wallet of the father.

Should this change in policy alter household consumption patterns? Basic models of consumption decisions, of the sort examined in this chapter, assume that it does not matter whether the mother or the father receives the money, because both parents seek to maximize the utility of the family as a whole. In effect, this model assumes that everyone in the family has the same preferences.

In reality, the share of income controlled by the father or the mother does affect what the household consumes. When the mother controls a larger share of family income a number of studies, in the United Kingdom and in a wide variety of other countries, have found that the family tends to spend more on restaurant meals, child care, and women’s clothing, and less on alcohol and tobacco. As the mother controls a larger share of household resources, children’s health improves, too. These findings suggest that when providing assistance to poor families, in high-income countries and low-income countries alike, the monetary amount of assistance is not all that matters: it also matters which member of the family actually receives the money.

The budget constraint framework serves as a constant reminder to think about the full range of effects that can arise from changes in income or price, not just effects on the one product that might seem most immediately affected.

Key Concepts and Summary

The budget constraint framework suggest that when income or price changes, a range of responses are possible. When income rises, households will demand a higher quantity of normal goods, but a lower quantity of inferior goods. When the price of a good rises, households will typically demand less of that good—but whether they will demand a much lower quantity or only a slightly lower quantity will depend on personal preferences. Also, a higher price for one good can lead to more or less of the other good being demanded.

Self-Check Questions

  1. Explain all the reasons why a decrease in the price of a product would lead to an increase in purchases of the product.
  2. As a college student you work at a part-time job, but your parents also send you a monthly “allowance.” Suppose one month your parents forgot to send the check. Show graphically how your budget constraint is affected. Assuming you only buy normal goods, what would happen to your purchases of goods?

Review Questions

  1. As a general rule, is it safe to assume that a change in the price of a good will always have its most significant impact on the quantity demanded of that good, rather than on the quantity demanded of other goods? Explain.
  2. Why does a change in income cause a parallel shift in the budget constraint?

Critical Thinking Questions

Income effects depend on the income elasticity of demand for each good that you buy. If one of the goods you buy has a negative income elasticity, that is, it is an inferior good, what must be true of the income elasticity of the other good you buy?

Problems

If a 10% decrease in the price of one product that you buy causes an 8% increase in quantity demanded of that product, will another 10% decrease in the price cause another 8% increase (no more and no less) in quantity demanded?

Glossary

income effect
a higher price means that, in effect, the buying power of income has been reduced, even though actual income has not changed; always happens simultaneously with a substitution effect
substitution effect
when a price changes, consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price; always happens simultaneously with an income effect

Solutions

Answers to Self-Check Questions

  1. This is the opposite of the example explained in the text. A decrease in price has a substitution effect and an income effect. The substitution effect says that because the product is cheaper relative to other things the consumer purchases, he or she will tend to buy more of the product (and less of the other things). The income effect says that after the price decline, the consumer could purchase the same goods as before, and still have money left over to purchase more. For both reasons, a decrease in price causes an increase in quantity demanded.
  2. This is a negative income effect. Because your parents’ check failed to arrive, your monthly income is less than normal and your budget constraint shifts in toward the origin. If you only buy normal goods, the decrease in your income means you will buy less of every product.

7.3 Labor-Leisure Choices

35

Learning Objectives

By the end of this section, you will be able to:
  • Interpret labor-leisure budget constraint graphs
  • Predict consumer choices based on wages and other compensation
  • Explain the backward-bending supply curve of labor

People do not obtain utility just from products they purchase. They also obtain utility from leisure time. Leisure time is time not spent at work. The decision-making process of a utility-maximizing household applies to what quantity of hours to work in much the same way that it applies to purchases of goods and services. Choices made along the labor-leisure budget constraint, as wages shift, provide the logical underpinning for the labor supply curve. The discussion also offers some insights about the range of possible reactions when people receive higher wages, and specifically about the claim that if people are paid higher wages, they will work a greater quantity of hours—assuming that they have a say in the matter.

According to the Bureau of Labor Statistics, U.S. workers averaged 38.6 hours per week on the job in 2014. This average includes part-time workers; for full-time workers only, the average was 42.5 hours per week. Table 10 shows that more than half of all workers are on the job 35 to 48 hours per week, but significant proportions work more or less than this amount.

Table 11 breaks down the average hourly compensation received by private industry workers, including wages and benefits. Wages and salaries are about three-quarters of total compensation received by workers; the rest is in the form of health insurance, vacation pay, and other benefits. The compensation workers receive differs for many reasons, including experience, education, skill, talent, membership in a labor union, and the presence of discrimination against certain groups in the labor market. Issues surrounding the inequality of incomes in a market-oriented economy are explored in the chapters on Poverty and Economic Inequality and Issues in Labor Markets: Unions, Discrimination, Immigration.

Hours Worked per Week Number of Workers Percentage of Workforce
1–14 hours 6.9 million 5.0%
15–34 hours 27.6 million 20.1%
35–40 hours 68.5 million 49.9%
41–48 hours 11.9 million 8.6%
49–59 hours 13.3 million 9.6%
60 hours and over 9.3 million 6.8%
Table 10. Persons at Work, by Average Hours Worked per Week in 2013 (Total number of workers: 137.7 million). (Source: http://www.bls.gov/news.release/empsit.t18.htm)
Compensation, Wage, Salary, and Benefits $30.92 per hour
Wages and Salaries $20.92
Benefits
Vacation $2.09
Supplemental Pay $0.84
Insurance $2.15
Health Benefits $2.36
Retirement and Savings $1.24
Defined Benefit $0.57
Defined Contribution $0.064
Legally Required $2.46
Table 11. Hourly Compensation: Wages, Benefits, and Taxes in 2014. (Source: http://www.bls.gov/news.release/pdf/ecec.pdf)

The Labor-Leisure Budget Constraint

How do workers make decisions about the number of hours to work? Again, let’s proceed with a concrete example. The economic logic is precisely the same as in the case of a consumption choice budget constraint, but the labels are different on a labor-leisure budget constraint.

Vivian has 70 hours per week that she could devote either to work or to leisure, and her wage is $10/hour. The lower budget constraint in Figure 1 shows Vivian’s possible choices. The horizontal axis of this diagram measures both leisure and labor, by showing how Vivian’s time is divided between leisure and labor. Hours of leisure are measured from left to right on the horizontal axis, while hours of labor are measured from right to left. Vivian will compare choices along this budget constraint, ranging from 70 hours of leisure and no income at point S to zero hours of leisure and $700 of income at point L. She will choose the point that provides her with the highest total utility. For this example, let’s assume that Vivian’s utility-maximizing choice occurs at O, with 30 hours of leisure, 40 hours of work, and $400 in weekly income.

The graph shows how raised wages can influence the opportunity set.
Figure 1. How a Rise in Wages Alters the Utility-Maximizing Choice. Vivian’s original choice is point O on the lower opportunity set. A rise in her wage causes her opportunity set to swing upward. In response to the increase in wages, Vivian can make a range of different choices available to her: a choice like D, which involves less work; and a choice like B, which involves the same amount of work but more income; or a choice like A, which involves more work and considerably more income. Vivian’s personal preferences will determine which choice she makes.

For Vivian to discover the labor-leisure choice that will maximize her utility, she does not have to place numerical values on the total and marginal utility that she would receive from every level of income and leisure. All that really matters is that Vivian can compare, in her own mind, whether she would prefer more leisure or more income, given the tradeoffs she faces. If Vivian can say to herself: “I’d really rather work a little less and have more leisure, even if it means less income,” or “I’d be willing to work more hours to make some extra income,” then as she gradually moves in the direction of her preferences, she will seek out the utility-maximizing choice on her labor-leisure budget constraint.

Now imagine that Vivian’s wage level increases to $12/hour. A higher wage will mean a new budget constraint that tilts up more steeply; conversely, a lower wage would have led to a new budget constraint that was flatter. How will a change in the wage and the corresponding shift in the budget constraint affect Vivian’s decisions about how many hours to work?

Vivian’s choices of quantity of hours to work and income along her new budget constraint can be divided into several categories, using the dashed horizontal and vertical lines in Figure 1 that go through her original choice (O). One set of choices in the upper-left portion of the new budget constraint involves more hours of work (that is, less leisure) and more income, at a point like A with 20 hours of leisure, 50 hours of work, and $600 of income (that is, 50 hours of work multiplied by the new wage of $12 per hour). A second choice would be to work exactly the same 40 hours, and to take the benefits of the higher wage in the form of income that would now be $480, at choice B. A third choice would involve more leisure and the same income at point C (that is, 33-1/3 hours of work multiplied by the new wage of $12 per hour equals $400 of total income). A fourth choice would involve less income and much more leisure at a point like D, with a choice like 50 hours of leisure, 20 hours of work, and $240 in income.

In effect, Vivian can choose whether to receive the benefits of her wage increase in the form of more income, or more leisure, or some mixture of these two. With this range of possibilities, it would be unwise to assume that Vivian (or anyone else) will necessarily react to a wage increase by working substantially more hours. Maybe they will; maybe they will not.

Applications of Utility Maximizing with the Labor-Leisure Budget Constraint

The theoretical insight that higher wages will sometimes cause an increase in hours worked, sometimes cause hours worked not to change by much, and sometimes cause hours worked to decline, has led to labor supply curves that look like the one in Figure 2. The bottom-left portion of the labor supply curve slopes upward, which reflects the situation of a person who reacts to a higher wage by supplying a greater quantity of labor. The middle, close-to-vertical portion of the labor supply curve reflects the situation of a person who reacts to a higher wage by supplying about the same quantity of labor. The very top portion of the labor supply curve is called a backward-bending supply curve for labor, which is the situation of high-wage people who can earn so much that they respond to a still-higher wage by working fewer hours. Read the following Clear It Up feature for more on the number of hours the average person works each year.

The graph shows that the labor-leisure budget constraint can be influenced in several ways based on higher wages and the numbers of hours worked.
Figure 2. A Backward-Bending Supply Curve of Labor. The bottom upward-sloping portion of the labor supply curve shows that as wages increase over this range, the quantity of hours worked also increases. The middle, nearly vertical portion of the labor supply curve shows that as wages increase over this range, the quantity of hours worked changes very little. The backward-bending portion of the labor supply curve at the top shows that as wages increase over this range, the quantity of hours worked actually decreases. All three of these possibilities can be derived from how a change in wages causes movement in the labor-leisure budget constraint, and thus different choices by individuals.

Is America a nation of workaholics?

Americans work a lot. Table 12 shows average hours worked per year in the United States, Canada, Japan, and several European countries, with data from 2013. To get a perspective on these numbers, someone who works 40 hours per week for 50 weeks per year, with two weeks off, would work 2,000 hours per year. The gap in hours worked is a little astonishing; the 250 to 300 hour gap between how much Americans work and how much Germans or the French work amounts to roughly six to seven weeks less of work per year. Economists who study these international patterns debate the extent to which average Americans and Japanese have a preference for working more than, say, Germans, or whether German workers and employers face particular kinds of taxes and regulations that lead to fewer hours worked. Many countries have laws that regulate the work week and dictate holidays and the standards of “normal” vacation time vary from country to country. It is also interesting to take the amount of time spent working in context; it is estimated that in the late nineteenth century in the United States, the average work week was over 60 hours per week—leaving little to no time for leisure.

Country Average Annual Hours Actually Worked per Employed Person
United States 1,824
Spain 1,799
Japan 1,759
Canada 1,751
United Kingdom 1,669
Sweden 1,585
Germany 1,443
France 1,441
Table 12. Average Hours Worked Per Year in Select Countries. (Source: http://stats.oecd.org/Index.aspx?DataSetCode=ANHRS)

The different responses to a rise in wages—more hours worked, the same hours worked, or fewer hours worked—are patterns exhibited by different groups of workers in the U.S. economy. Many full-time workers have jobs where the number of hours is held relatively fixed, partly by their own choice and partly by their employer’s practices. These workers do not much change their hours worked as wages rise or fall, so their supply curve of labor is inelastic. However, part-time workers and younger workers tend to be more flexible in their hours, and more ready to increase hours worked when wages are high or cut back when wages fall.

The backward-bending supply curve for labor, when workers react to higher wages by working fewer hours and having more income, is not observed often in the short run. However, some well-paid professionals, like dentists or accountants, may react to higher wages by choosing to limit the number of hours, perhaps by taking especially long vacations, or taking every other Friday off. Over a long-term perspective, the backward-bending supply curve for labor is common. Over the last century, Americans have reacted to gradually rising wages by working fewer hours; for example, the length of the average work-week has fallen from about 60 hours per week in 1900 to the present average of less than 40 hours per week.

Recognizing that workers have a range of possible reactions to a change in wages casts some fresh insight on a perennial political debate: the claim that a reduction in income taxes—which would, in effect, allow people to earn more per hour—will encourage people to work more. The leisure-income budget set points out that this connection will not hold true for all workers. Some people, especially part-timers, may react to higher wages by working more. Many will work the same number of hours. Some people, especially those whose incomes are already high, may react to the tax cut by working fewer hours. Of course, cutting taxes may be a good or a bad idea for a variety of reasons, not just because of its impact on work incentives, but the specific claim that tax cuts will lead people to work more hours is only likely to hold for specific groups of workers and will depend on how and for whom taxes are cut.

Key Concepts and Summary

When making a choice along the labor-leisure budget constraint, a household will choose the combination of labor, leisure, and income that provides the most utility. The result of a change in wage levels can be higher work hours, the same work hours, or lower work hours.

Self-Check Questions

  1. Siddhartha has 50 hours per week to devote to work or leisure. He has been working for $8 per hour. Based on the information in Table 13, calculate his utility-maximizing choice of labor and leisure time.
    Leisure Hours Total Utility from Leisure Work Hours Income Total Utility from Income
    0 0 0 0 0
    10 200 10 80 500
    20 350 20 160 800
    30 450 30 240 1,040
    40 500 40 320 1,240
    50 530 50 400 1,400
    Table 13.
  2. In Siddhartha’s problem, calculate marginal utility for income and for leisure. Now, start off at the choice with 50 hours of leisure and zero income, and a wage of $8 per hour, and explain, in terms of marginal utility how Siddhartha could reason his way to the optimal choice, using marginal thinking only.

Review Questions

  1. How will a utility-maximizer find the choice of leisure and income that provides the greatest utility?
  2. As a general rule, is it safe to assume that a higher wage will encourage significantly more hours worked for all individuals? Explain.

Critical Thinking Questions

  1. In the labor-leisure choice model, what is the price of leisure?
  2. Think about the backward-bending part of the labor supply curve. Why would someone work less as a result of a higher wage rate?
  3. What would be the substitution effect and the income effect of a wage increase?
  4. Visit the BLS website and determine if education level, race/ethnicity, or gender appear to impact labor versus leisure choices.

Glossary

backward-bending supply curve for labor
the situation when high-wage people can earn so much that they respond to a still-higher wage by working fewer hours

Solutions

Answers to Self-Check Questions

  1. This problem is straightforward if you remember leisure hours plus work hours are limited to 50 hours total. If you reverse the order of the last three columns so that more leisure corresponds to less work and income, you can add up columns two and five to find utility is maximized at 10 leisure hours and 40 work hours:
    Leisure Hours Total Utility from Leisure Work Hours Income Total Utility from Income Total Utility from Both
    0 0 50 400 1,400 1,400
    10 200 40 320 1,240 1,440
    20 350 30 240 1,040 1,390
    30 450 20 160 800 1,250
    40 500 10 80 500 1,000
    50 530 0 0 0 530
    Table 14.
  2. Begin from the last table and compute marginal utility from leisure and work:
    Leisure Hours Total Utility from Leisure MU from Leisure Work Hours Income Total Utility from Income MU from Income
    0 0 50 400 1,400 160
    10 200 200 40 320 1,240 200
    20 350 150 30 240 1,040 240
    30 450 100 20 160 800 300
    40 500 50 10 80 500 500
    50 530 30 0 0 0
    Table 15.

    Suppose Sid starts with 50 hours of leisure and 0 hours of work. As Sid moves up the table, he trades 10 hours of leisure for 10 hours of work at each step. At (40, 10), his MULeisure = 50, which is substantially less than his MUIncome of 500. This shortfall signals Sid to keep trading leisure for work/income until at (10, 40) the marginal utility of both is equal at 200. This is the sign that he should stop here, confirming the answer in question 1.

7.4 Intertemporal Choices in Financial Capital Markets

36

Learning Objectives

By the end of this section, you will be able to:
  • Evaluate the reasons for making intertemporal choices
  • Interpret an intertemporal budget constraint
  • Analyze why people in America tend to save such a small percentage of their income

Rates of saving in America have never been especially high, but they seem to have dipped even lower in recent years, as the data from the Bureau of Economic Analysis in Figure 1 show. A decision about how much to save can be represented using an intertemporal budget constraint. Household decisions about the quantity of financial savings show the same underlying pattern of logic as the consumption choice decision and the labor-leisure decision.

The graph shows that since the 1980s, people have begun to save much less of their earnings. In 1982, the percentage of income being saved was just less than 10%. In 2012, the percentage of income being saved was less than 4%.
Figure 1. Personal Savings as a Percentage of Personal Income. Personal savings were about 7 to 11% of personal income for most of the years from the late 1950s up to the early 1990s. Since then, the rate of personal savings has fallen substantially, although it seems to have bounced back a bit since 2008. (Source: http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm)

The discussion of financial saving here will not focus on the specific financial investment choices, like bank accounts, stocks, bonds, mutual funds, or owning a house or gold coins. The characteristics of these specific financial investments, along with the risks and tradeoffs they pose, are detailed in the Labor and Financial Markets chapter. Here, the focus is saving in total—that is, on how a household determines how much to consume in the present and how much to save, given the expected rate of return (or interest rate), and how the quantity of saving alters when the rate of return changes.

Using Marginal Utility to Make Intertemporal Choices

Savings behavior varies considerably across households. One factor is that households with higher incomes tend to save a larger percentage of their income. This pattern makes intuitive sense; a well-to-do family has the flexibility in its budget to save 20–25% of income, while a poor family struggling to keep food on the table will find it harder to put money aside.

Another factor that causes personal saving to vary is personal preferences. Some people may prefer to consume more now, and let the future look after itself. Others may wish to enjoy a lavish retirement, complete with expensive vacations, or to pile up money that they can pass along to their grandchildren. There are savers and spendthrifts among the young, middle-aged, and old, and among those with high, middle, and low income levels.

Consider this example: Yelberton is a young man starting off at his first job. He thinks of the “present” as his working life and the “future” as after retirement. Yelberton’s plan is to save money from ages 30 to 60, retire at age 60, and then live off his retirement money from ages 60 to 85. On average, therefore, he will be saving for 30 years. If the rate of return that he can receive is 6% per year, then $1 saved in the present would build up to $5.74 after 30 years (using the formula for compound interest, $1(1 + 0.06)30 = $5.74). Say that Yelberton will earn $1,000,000 over the 30 years from age 30 to age 60 (this amount is approximately an annual salary of $33,333 multiplied by 30 years). The question for Yelberton is how much of those lifetime earnings to consume during his working life, and how much to put aside until after retirement. This example is obviously built on simplifying assumptions, but it does convey the basic life-cycle choice of saving during working life for future consumption after retirement.

Figure 2 and Table 16 show Yelberton’s intertemporal budget constraint. Yelberton’s choice involves comparing the utility of present consumption during his working life and future consumption after retirement. The rate of return that determines the slope of the intertemporal budget line between present consumption and future consumption in this example is the annual interest rate that he would earn on his savings, compounded over the 30 years of his working life. (For simplicity, we are assuming that any savings from current income will compound for 30 years.) Thus, in the lower budget constraint line on the figure, future consumption grows by increments of $574,000, because each time $100,000 is saved in the present, it compounds to $574,000 after 30 years at a 6% interest rate. If some of the numbers on the future consumption axis look bizarrely large, remember that this occurs because of the power of compound interest over substantial periods of time, and because the figure is grouping together all of Yelberton’s saving for retirement over his lifetime.

The graph shows how present and future consumption choices are impacted by changes in rates of return.
Figure 2. Yelberton’s Choice: The Intertemporal Budget Set. Yelberton will make a choice between present and future consumption. With an annual rate of return of 6%, he decides that his utility will be highest at point B, which represents a choice of $800,000 in present consumption and $1,148,000 in future consumption. When the annual rate of return rises to 9%, the intertemporal budget constraint pivots up. Yelberton could choose to take the gains from this higher rate of return in several forms: more present saving and much higher future consumption (J), the same present saving and higher future consumption (K), more present consumption and more future consumption (L), or more present consumption and the same future consumption (M).
Present Consumption Present Savings Future Consumption (6% annual return) Future Consumption (9% annual return)
$1,000,000 0 0 0
$900,000 $100,000 $574,000 $1,327,000
$800,000 $200,000 $1,148,000 $2,654,000
$700,000 $300,000 $1,722,000 $3,981,000
$600,000 $400,000 $2,296,000 $5,308,000
$400,000 $600,000 $3,444,000 $7,962,000
$200,000 $800,000 $4,592,000 $10,616,000
0 $1,000,000 $5,740,000 $13,270,000
Table 16. Yelburton’s Intertemporal Budget Constraint

Yelberton will compare the different choices along the budget constraint and choose the one that provides him with the highest utility. For example, he will compare the utility he would receive from a choice like point A, with consumption of $1 million in the present, zero savings, and zero future consumption; point B, with present consumption of $800,000, savings of $200,000, and future consumption of $1,148,000; point C, with present consumption of $600,000, savings of $400,000, and future consumption of $2,296,000; or even choice D, with present consumption of zero, savings of $1,000,000, and future consumption of $5,740,000. Yelberton will also ask himself questions like these: “Would I prefer to consume a little less in the present, save more, and have more future consumption?” or “Would I prefer to consume a little more in the present, save less, and have less future consumption?” By considering marginal changes toward more or less consumption, he can seek out the choice that will provide him with the highest level of utility.

Let us say that Yelberton’s preferred choice is B. Imagine that Yelberton’s annual rate of return raises from 6% to 9%. In this case, each time he saves $100,000 in the present, it will be worth $1,327,000 in 30 years from now (using the formula for compound interest that $100,000 (1 + 0.09)30 = $1,327,000). A change in rate of return alters the slope of the intertemporal budget constraint: a higher rate of return or interest rate will cause the budget line to pivot upward, while a lower rate of return will cause it to pivot downward. If Yelberton were to consume nothing in the present and save all $1,000,000, with a 9% rate of return, his future consumption would be $13,270,000, as shown on Figure 2.

As the rate of return rises, Yelberton considers a range of choices on the new intertemporal budget constraint. The dashed vertical and horizontal lines running through the original choice B help to illustrate his range of options. One choice is to reduce present consumption (that is, to save more) and to have considerably higher future consumption at a point like J above and to the left of his original choice B. A second choice would be to keep the level of present consumption and savings the same, and to receive the benefits of the higher rate of return entirely in the form of higher future consumption, which would be choice K.

As a third choice Yelberton could have both more present consumption—that is, less savings—but still have higher future consumption because of the higher interest rate, which would be choice like L, above and to the right of his original choice B. Thus, the higher rate of return might cause Yelberton to save more, or less, or the same amount, depending on his own preferences. A fourth choice would be that Yelberton could react to the higher rate of return by increasing his current consumption and leaving his future consumption unchanged, as at point M directly to the right of his original choice B. The actual choice of what quantity to save and how saving will respond to changes in the rate of return will vary from person to person, according to the choice that will maximize each person’s utility.

Applications of the Model of Intertemporal Choice

The theoretical model of the intertemporal budget constraint suggests that when the rate of return rises, the quantity of saving may rise, fall, or remain the same, depending on the preferences of individuals. For the U.S. economy as a whole, the most common pattern seems to be that the quantity of savings does not adjust much to changes in the rate of return. As a practical matter, many households either save at a fairly steady pace, by putting regular contributions into a retirement account or by making regular payments as they buy a house, or they do not save much at all. Of course, some people will have preferences that cause them to react to a higher rate of return by increasing their quantity of saving; others will react to a higher rate of return by noticing that with a higher rate of return, they can save less in the present and still have higher future consumption.

One prominent example in which a higher rate of return leads to a lower savings rate occurs when firms save money because they have promised to pay workers a certain fixed level of pension benefits after retirement. When rates of return rise, those companies can save less money in the present in their pension fund and still have enough to pay the promised retirement benefits in the future.

This insight suggests some skepticism about political proposals to encourage higher savings by providing savers with a higher rate of return. For example, Individual Retirement Accounts (IRAs) and 401(k) accounts are special savings accounts where the money going into the account is not taxed until it is taken out many years later, after retirement. The main difference between these accounts is that an IRA is usually set up by an individual, while a 401(k) needs to be set up through an employer. By not taxing savings in the present, the effect of an IRA or a 401(k) is to increase the return to saving in these accounts.

IRA and 401(k) accounts have attracted a large quantity of savings since they became common in the late 1980s and early 1990s. In fact, the amount of IRAs rose from $239 million in 1992 to $3.7 billion in 2005 to over $5 billion in 2012, as per the Investment Company Institute, a national association of U.S. investment companies. However, overall U.S. personal savings, as discussed earlier, actually dropped from low to lower in the late 1990s and into the 2000s. Evidently, the larger amounts in these retirement accounts are being offset, in the economy as a whole, either by less savings in other kinds of accounts, or by a larger amount of borrowing (that is, negative savings). The following Clear It Up further explores America’s saving rates.

A rise in interest rates makes it easier for people to enjoy higher future consumption. But it also allows them to enjoy higher present consumption, if that is what these individuals desire. Again, a change in prices—in this case, in interest rates—leads to a range of possible outcomes.

How does America’s saving rates compare to other countries?

By international standards, Americans do not save a high proportion of their income, as Table 17 shows. The rate of gross national saving includes saving by individuals, businesses, and government. By this measure, U.S. national savings amount to 17% of the size of the U.S. GDP, which measures the size of the U.S. economy. The comparable world average rate of savings is 22%.

Country Gross Domestic Savings as a Percentage of GDP
China 51%
India 30%
Russia 28%
Mexico 22%
Germany 26%
Japan 22%
Canada 21%
France 21%
Brazil 15%
United States 17%
United Kingdom 13%
Table 17. National Savings in Select Countries. (Source: http://data.worldbank.org/indicator/NY.GNS.ICTR.ZS)

The Unifying Power of the Utility-Maximizing Budget Set Framework

The choices of households are determined by an interaction between prices, budget constraints, and personal preferences. The flexible and powerful terminology of utility-maximizing gives economists a vocabulary for bringing these elements together.

Not even economists believe that people walk around mumbling about their marginal utilities before they walk into a shopping mall, accept a job, or make a deposit in a savings account. However, economists do believe that individuals seek their own satisfaction or utility and that people often decide to try a little less of one thing and a little more of another. If these assumptions are accepted, then the idea of utility-maximizing households facing budget constraints becomes highly plausible.

Behavioral Economics: An Alternative Viewpoint

As we know, people sometimes make decisions that seem “irrational” and not in their own best interest. People’s decisions can seem inconsistent from one day to the next and they even deliberately ignore ways to save money or time. The traditional economic models assume rationality, which means that people take all available information and make consistent and informed decisions that are in their best interest. (In fact, economics professors often delight in pointing out so-called “irrational behavior” each semester to their new students, and present economics as a way to become more rational.)

But a new group of economists, known as behavioral economists, argue that the traditional method leaves out something important: people’s state of mind. For example, one can think differently about money if one is feeling revenge, optimism, or loss. These are not necessarily irrational states of mind, but part of a range of emotions that can affect anyone on a given day. And what’s more, actions under these conditions are indeed predictable, if the underlying environment is better understood. So, behavioral economics seeks to enrich the understanding of decision-making by integrating the insights of psychology into economics. It does this by investigating how given dollar amounts can mean different things to individuals depending on the situation. This can lead to decisions that appear outwardly inconsistent, or irrational, to the outside observer.

The way the mind works, according to this view, may seem inconsistent to traditional economists but is actually far more complex than an unemotional cost-benefit adding machine.
For example, a traditional economist would say that if you lost a $10 bill today, and also got an extra $10 in your paycheck, you should feel perfectly neutral. After all, –$10 + $10 = $0. You are the same financially as you were before. However, behavioral economists have done research that shows many people will feel some negative emotion—anger, frustration, and so forth—after those two things happen. We tend to focus more on the loss than the gain. This is known as loss aversion, where a $1 loss pains us 2.25 times more than a $1 gain helps us, according to the economists Daniel Kahneman and Amos Tversky in a famous 1979 article in the journal Econometrica. This insight has implications for investing, as people tend to “overplay” the stock market by reacting more to losses than to gains. Indeed, this behavior looks irrational to traditional economists, but is consistent once we understand better how the mind works, these economists argue.

Traditional economists also assume human beings have complete self-control. But, for instance, people will buy cigarettes by the pack instead of the carton even though the carton saves them money, to keep usage down. They purchase locks for their refrigerators and overpay on taxes to force themselves to save. In other words, we protect ourselves from our worst temptations but pay a price to do so. One way behavioral economists are responding to this is by setting up ways for people to keep themselves free of these temptations. This includes what are called “nudges” toward more rational behavior rather than mandatory regulations from government. For example, up to 20 percent of new employees do not enroll in retirement savings plans immediately, because of procrastination or feeling overwhelmed by the different choices. Some companies are now moving to a new system, where employees are automatically enrolled unless they “opt out.” Almost no-one opts out in this program and employees begin saving at the early years, which are most critical for retirement.

Another area that seems illogical is the idea of mental accounting, or putting dollars in different mental categories where they take different values. Economists typically consider dollars to be fungible, or having equal value to the individual, regardless of the situation.

You might, for instance, think of the $25 you found in the street differently from the $25 you earned from three hours working in a fast food restaurant. The street money might well be treated as “mad money” with little rational regard to getting the best value. This is in one sense strange, since it is still equivalent to three hours of hard work in the restaurant. Yet the “easy come-easy go” mentality replaces the rational economizer because of the situation, or context, in which the money was attained.

In another example of mental accounting that seems inconsistent to a traditional economist, a person could carry a credit card debt of $1,000 that has a 15% yearly interest cost, and simultaneously have a $2,000 savings account that pays only 2% per year. That means she pays $150 a year to the credit card company, while collecting only $40 annually in bank interest, so she loses $130 a year. That doesn’t seem wise.

The “rational” decision would be to pay off the debt, since a $1,000 savings account with $0 in debt is the equivalent net worth, and she would now net $20 per year. But curiously, it is not uncommon for people to ignore this advice, since they will treat a loss to their savings account as higher than the benefit of paying off their credit card. The dollars are not being treated as fungible so it looks irrational to traditional economists.

Which view is right, the behavioral economists’ or the traditional view? Both have their advantages, but behavioral economists have at least shed a light on trying to describe and explain behavior that has historically been dismissed as irrational. If most of us are engaged in some “irrational behavior,” perhaps there are deeper underlying reasons for this behavior in the first place.

“Eeny, Meeny, Miney, Moe”—Making Choices

In what category did consumers worldwide increase their spending during the recession? Higher education. According to the United Nations Educational, Scientific, and Cultural Organization (UNESCO), enrollment in colleges and universities rose one-third in China and almost two-thirds in Saudi Arabia, nearly doubled in Pakistan, tripled in Uganda, and surged by three million—18 percent—in the United States. Why were consumers willing to spend on education during lean times? Both individuals and countries view higher education as the way to prosperity. Many feel that increased earnings are a significant benefit of attending college.

Bureau of Labor Statistics data from May 2012 supports this view, as shown in Figure 3. They show a positive correlation between earnings and education. The data also indicate that unemployment rates fall with higher levels of education and training.

The graph shows the unemployment rate and median weekly earnings in 2012 for various levels of education. People with professional degrees made around $1,735 a week and suffered a 2.1% unemployment rate. People with doctoral degrees made around $1,624 a week and suffered a 2.5% unemployment rate. People with Master’s degrees made around $1,300 a week and suffered a 3.5% unemployment rate. People with Bachelor’s degrees made around $1,066 a week and suffered a 4.5% unemployment rate. People with Associate’s degrees made around $785 a week and suffered a 6.2% unemployment rate. People with some college, no degree made around $727 a week and suffered a 7.7% unemployment rate. People with a high school diploma made around $652 a week and suffered an 8.3% unemployment rate. People with less than a high school diploma made around $471 a week and suffered a 12.4% unemployment rate.
Figure 3. The Impact of Education on Earnings and Unemployment Rates, 2012. Those with the highest degrees in 2012 had substantially lower unemployment rates whereas those with the least formal education suffered from the highest unemployment rates. The national median average weekly income was $815, and the nation unemployment average in 2012 was 6.8%. (Source: Bureau of Labor Statistics, May 22, 2013)

Key Concepts and Summary

When making a choice along the intertemporal budget constraint, a household will choose the combination of present consumption, savings, and future consumption that provides the most utility. The result of a higher rate of return (or higher interest rates) can be a higher quantity of saving, the same quantity of saving, or a lower quantity of saving, depending on preferences about present and future consumption. Behavioral economics is a branch of economics that seeks to understand and explain the “human” factors that drive what traditional economists see as people’s irrational spending decisions.

Self-Check Questions

  1. How would an increase in expected income over one’s lifetime affect one’s intertemporal budget constraint? How would it affect one’s consumption/saving decision?
  2. How would a decrease in expected interest rates over one’s working life affect one’s intertemporal budget constraint? How would it affect one’s consumption/saving decision?

Review Questions

  1. According to the model of intertemporal choice, what are the major factors which determine how much saving an individual will do? What factors might a behavioral economist use to explain savings decisions?
  2. As a general rule, is it safe to assume that a lower interest rate will encourage significantly lower financial savings for all individuals? Explain.

Critical Thinking Questions

  1. What do you think accounts for the wide range of savings rates in different countries?
  2. What assumptions does the model of intertemporal choice make that are not likely true in the real world and would make the model harder to use in practice?

References

Holden, Sarah, and Daniel Schrass. 2012. “The rose of IRAs in U.S Households’ Saving for Retirement, 2012.” ICI Research Perspective 18.8 (2012). http://www.ici.org/pdf/per18-08.pdf.

Kahneman, Daniel and Amos Tversky. “Prospect Theory: An Analysis of Decision under Risk.”
Econometrica 47.2 (March 1979) 263-291.

Thaler, Richard H. “Shifting Our Retirement Savings into Automatic.” The New York Times, April 6, 2013.
http://www.nytimes.com/2013/04/07/business/an-automatic-solution-for-the-retirement-savings-problem.html?pagewanted=all.

UNESCO Institute for Statistics. “Statistics in Brief / Profiles” Accessed August 2013. http://stats.uis.unesco.org/unesco/TableViewer/document.aspx?ReportId=121 &IF_Language=en&BR_Country=5580.

Glossary

behavioral economics
a branch of economics that seeks to enrich the understanding of decision-making by integrating the insights of psychology and by investigating how given dollar amounts can mean different things to individuals depending on the situation.
fungible
the idea that units of a good, such as dollars, ounces of gold, or barrels of oil are capable of mutual substitution with each other and carry equal value to the individual.

Solutions

Answers to Self-Check Questions

  1. An increase in expected income would cause an outward shift in the intertemporal budget constraint. This would likely increase both current consumption and saving, but the answer would depend on one’s time preference, that is, how much one is willing to wait to forgo current consumption. Children are notoriously bad at this, which is to say they might simply consume more, and not save any. Adults, because they think about the future, are generally better at time preference—that is, they are more willing to wait to receive a reward.
  2. Lower interest rates would make lending cheaper and saving less rewarding. This would be reflected in a flatter intertemporal budget line, a rotation around the amount of current income. This would likely cause a decrease in saving and an increase in current consumption, though the results for any individual would depend on time preference.

Chapter 8. Challenging the Role of Utilitarianism

VIII

The Role of Value(s) in the Economics Discipline

37

Chapter Objectives

In this chapter, you will learn about:

  • Value Theory in Economics
  • Value as it is Defined by Orthodox Economics
  • The Relationship between Utilitarian Philosophy and the Economics discipline.
  • Critique of the Utilitarian Approach.
  • The Application in Economics of Philosophies other than Utilitarianism.

8.1 Economics and Value

38

Learning Objectives

By the end of this section, you will be able to:

  • Define the term value.
  • Identify different interpretations of the term value.

The term value and the concept of value theory have taken on two distinct definitions in relation to economic theory.  The first definition of the term value pertains to the role of normative analysis within economic theory.  As discussed in chapter 1, for orthodox economic thinkers there is little room for normative thinking in the rigorous world of scientific economics.  Subjective or moral judgments are discouraged in favor of utilizing a positive, value-free approach that is not a statement of anyone’s value judgment or subjective feelings, but rather of what “is.”  By the standard orthodox textbook definition, the term “value” relates to personal biases and subjective beliefs.  Also, recall from Chapter 2, the positive versus normative conflict presented by orthodox economics represents a false dichotomy.  As has been discussed by non-orthodox economic theorists, subjective values tend to be present in all economic paradigms and are unavoidable.

The second definition of value that is common in economics is the one most people think of when they think of the term “value.”  For most people when they think of the value of something, such as a product, they are simultaneously thinking of the price of that product.  Therefore, the term value and the term price tend to be used interchangeably.  As a result, for many economists it is important to develop a theory of value because the theory of value provides the theorist with a sense of the origin of prices.  After all, if an economist can identify the root source of value, then the same economist will also understand the root origin of prices.  Since prices are incredibly important informational signals, being able to explain from where prices originate adds an important depth to economic theory.

On the surface both usages of the term “value,” as described above, appear to be mutually exclusive.  However, closer inspection reveals two interrelated issues.   Scientists, economists included, already tend to, whether knowingly or unknowingly, assert subjective values within their theories.  Values not only generate a necessary entanglement of facts and values, but they then become present throughout the very act of theorizing.  In the case of economics, this means that the economic ideas that theorists present will include elements of their basic worldview or, as some would say, their philosophy.

The remainder of this chapter is laid out in such a manner as to explore the role of philosophy in economics.  First, the philosophical foundation of orthodox economics, and its history, is explored.  As will be shown, orthodox economics relies upon utilitarian philosophy for its value-based understanding of human action and motivation.  As such, orthodox economics believes that the concept of utility holds the key to understanding the origin of prices.  Additionally, utilitarianism forms the basis for the ethical perspective presented by orthodox economics.  Upon closely examining the orthodox story of utility, the chapter moves on to identify important limitations that develop as a result of the use of utility.  The chapter then moves on to provide alternative examples from heterodox economics, pointing out philosophical worldviews outside of utilitarianism that can form the basis of economic thought.  Importantly, the alternative approaches presented do not suffer the pitfalls that are present within the orthodox, utilitarian approach.

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Learning Objectives

By the end of this section, you will be able to:

  • Identify the history of utility and its relationship to economic ideas.
  • Define use-value
  • Contrast Adam Smith and Jeremy Bentham with regard to their view of utility.
  • Contrast cardinal and ordinal utility
  • Define revealed preference theory

For those interested in the study of economics the concept of utility has a long history.  Going back to the time of antiquity, great thinkers such as Aristotle made reference to the importance of the creation of use-value.  From an Aristotelian standpoint use-value is the idea that human material production ought to be directed toward the creation of things that benefit human beings.  Aristotle prioritized usefulness and discouraged wastefulness.

The role of the utility theory of value as a central component of the preferred ideological vision of orthodox economists of today, in some ways dates back to the time of Adam Smith.  Smith, continuing the Aristotelian line of thinking, also saw significance in the concept of use-value.

Use-Value – The idea that the value of an object is based on how useful the product is to the consumer.  Products have an intrinsic value to their consumers. 

For Smith though, use-value represented the perceived benefit that people would derive from consumption.  For Smith, consumers would be more apt to buy products that they perceived as useful as opposed to products that they believed are not useful.  Still, Smith’s analysis remains a long way from how utility is utilized by orthodox economists.

Although Smith does not go into much further development beyond his acknowledgement that consumers attach some kind of use-value to useful items, it is clear that Smith opens the door to the potential development of the idea that utility plays a role in determining the prices of products.  Consider, if utility, or use-value, is important to consumers, then, presumably, utility must play a role in determining consumers’ interest in purchasing a product.  Because consumer demand is a reflection of consumer purchasing interests, consumer demand will be essential to the determination of the prices of products.  It is with the evolution of economic ideas in the 19th century that the relationship between utility and prices is cemented within orthodox economic thought.

In order to understand the role of utility in contemporary orthodox economics, the place to begin is with the early 19th century philosopher and political economist Jeremy Bentham.  Bentham possibly had the most prominent influence on the philosophical development of utility.  Bentham’s perspective is known as utilitarianism.  Bentham describes utility as the cornerstone of the “Greatest Happiness Principle.”  In Bentham’s usage, utility evolves beyond a description of usefulness into the embodiment of happiness.  Utilitarianism espouses the belief that people are pleasure maximizers and pain minimizers.  Therefore, any action that a person engages in must be driven by the desire either to gain happiness or to reduce pain.  Taken to the field of economics, in Bentham’s view, people desire products because those products bring the person happiness.  Clearly, Bentham’s perspective had a profound effect on orthodox economics, given the many references that this textbook has made in Chapters 2 and 6 to consumers being driven to maximize their utility.

Bentham’s story, for all of its applicability to contemporary orthodox economics, is still only a partial analysis.  One area in which Bentham’s argument is incomplete is in his treatment of the measurability of utility.  When describing how a consumer may assign utility to a product, Bentham freely employed both cardinal and ordinal measures of utility.

Cardinal utility – Is the idea that the utility a consumer assigns to a product is objective and, therefore, quantifiably measurable.

Ordinal utility – Is the idea that the utility that a consumer assigns to a product is subjective, in the mind of the consumer, and is, therefore, not directly quantifiably measurable.

As a rule Bentham seemed to generally acknowledge ordinal utility as being conceptually sound in comparison to cardinal utility.  Bentham understood that cardinal utility cannot be objectively measured, a person cannot be attached to a device that measures units of happy (utils).  There are, however, indirect measures that can allude to cardinal utility, such as the order in which consumers purchase products.  Given two products with an identical price, if a consumer purchases one of the products prior to the other, it stands to reason that the first product purchased retain greater utility than the second product.  Regardless, in absolute terms, how much utility a consumer actually assigns to a product cannot be empirically measured, rendering it subjective to the consumer.  Limitations aside, Bentham frequently developed examples that required cardinal measures of utility.

Another area in which Bentham’s analysis was incomplete pertained to the relationship between utility and the origins of prices of products.  Recall the principle of diminishing marginal utility described in Chapter 7.  Bentham anticipates the idea of diminishing marginal utility by describing instances in which a person can acquire more of something but feel less satisfaction from the additional unit than they received from earlier units.  Bentham’s depiction, however, remains abstract rather than appearing “scientifically” concrete.

Portrait of Jeremy Bentham
Figure 1. Portrait of Jeremy Bentham (Source: Wellcome Images, Wikimedia, CC-BY 4.0)

Resolving some of the incomplete features of Bentham’s story are the marginalists of the 1870s.  Independent of one another, a group of thinkers triggered what is now referred to as the marginalist revolution.  The marginalists famously apply differential calculus to utility analysis.  Differential calculus focuses on rates of change between two variables.  In the case of utility, differential calculus can be used to tell a story about how, as a consumer consumes more of a product, the happiness derived from that product will change.  The marginalists attempted to demonstrate, in a more concrete way, the idea that as more of something is consumed, the satisfaction or utility per unit would decline.  By applying calculus, and drawing pictures to reflect the conclusions drawn from the mathematical presentation, the marginalists create the appearance of a scientific advancement in the study of utility in economics.  In terms of legacy, the marginalists use of calculus is a hallmark of modern orthodox economic theory.

As much as the marginalists influence the apparatus of modern orthodox economics, their analysis still remained incomplete in that the marginalists do not resolve the issue of ordinal versus cardinal utility.  It is not until the 20th century that orthodox economic theorists settle on the use of ordinal utility as the foundation of their measurement of utility.  The thinker most responsible for solidifying ordinal utility’s place within economics is Paul Samuelson.  Paul Samuelson develops a theory known as Revealed Preference.  On the surface, revealed preference theory articulates the idea that the amount of utility that any one person derives from the consumption of a product is purely subjective to the consumer in question.  However, once a consumer identifies that which brings them the greater happiness, the consumer then reveals their preferences to everyone by consuming the product that they desire.  In this respect, revealed preference theory seeks to quantify utility by identifying utility as a consequence of a consumer’s actions.

The Application of Utilitarians within Orthodox Economics and its Implications

Whether an unwitting or a conscious choice, utility continues to be the preferred philosophical starting point for contemporary orthodox economists.  Utility also carries with it a specific interpretation of human actions and interactions.  Recall, for orthodox economics, the human being is a hedonist continually in search of greater pleasure or diminished pain.  Any socially determined characteristics are given (not analyzed, merely accepted), yielding an isolated utility maximizer.  Also, recall, that this notion of a hedonistic person is deeply controversial with respect to its application in economics.  There simply does not exist irrefutable evidence that individuals only pursue products because those products provide the individual with pleasure.  Human motive can be defined in many ways with hedonism being just one of many interpretations.

Regardless of its accuracy or inaccuracy, orthodox economists perceive that, for individuals, utility is maximized through the act of exchange.  At any particular point in time, an individual, possessing an initial endowment (income), begins engaging in the act of exchange with some other individual economic agent.  As all exchanges are assumed to be voluntary, any exchange that two parties are willing to engage in must be an exchange that will make both parties better off, otherwise neither party would engage in the exchange.  Because being made better off means, according to orthodox economic theory, acquiring more utility, the act of exchanging is the act increasing one’s holdings of utility.  Any and all exchanges then must be increasing individual, and subsequently, society’s total utility.  Presumably, once some kind of round of exchanges is complete, any and all parties that engaged in exchanges are now better off because now they have more utility as a result of their exchanges.

Of course, no one really knows whether or not the result of these exchanges really has made the participants better off or worse off because there is no device that measures utility.  Utility is purely subjective and non-empirical, which means that the revealed preference argument yields an outcome in which it must be assumed that all exchange participants are made better, otherwise they would not have participated in the exchange.  Assuming people are better off does not mean that people are actually better off.

Glossary

use-value

the idea that the value of an object is based on how useful the product is to the consumer.  Products have an intrinsic value to their consumers

cardinal utility

the idea that the utility a consumer assigns to a product is objective and, therefore, quantifiably measurable

ordinal utility

the idea that the utility that a consumer assigns to a product is subjective, in the mind of the consumer, and is, therefore, not directly quantifiably measurable

8.3 Utility and Pareto Optimality: The Orthodox Economic View of Social Welfare

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Learning Objectives

By the end of this section, you will be able to:

  • Define Pareto optimality
  • Explain how orthodox determines the conditions for societal well-being to be maximized.
  • Analyze the ethical issues surrounding Pareto optimality.

For orthodox economists the ideal outcome for an economy is an outcome in which Pareto optimality is achieved.  The concept of Pareto optimality owes its origins to a 19th century Italian mathematician Vilfredo Pareto.  Stated simply, the Pareto criterion for determining whether an economy has produced the “best” or “ideal” outcome is fulfilled when economic outcomes are such that there is no way to make any one or many people better off without making any one person or many worse off.

On its own the Pareto criterion for social well-being is an attractive proposition.  After all if someone is harmed in order to improve the plight of someone else or many others, then it appears obvious that someone is being granted preferential treatment at the expense of someone else or many others.  The granting of preferential treatment hardly seems fair or equitable.  In this context, the utilization of the Pareto criterion eliminates the need to make those choices.

Additionally, the granting of preferential treatment opens the door to a long series of ethical questions that can be avoided by applying the Pareto criterion.  On what basis is the decision to harm or benefit being made?  How or when are interventions that inflict harm or bestow benefits decided? If an intervention does take place, who is making the decision to inflict harm or bestow benefits?  What is the degree of harm or benefit triggered by an intervention?  What is the ethical basis for intervening?  In many ways, whenever a government must make budgetary decisions, it is asking and answering these questions.  For example, perhaps government policymakers would like to expand the size of the military.  Expanding the size of the military requires that the government finance the expansion of the military.  Financing military expansion may require that other government spending programs be reduced.  Alternatively, perhaps taxes will be raised to pay for the military expansion.  Either way, whomever is responsible for financing the military expansion is directly paying for someone else to benefit.  In defense of expanding the military, policymakers may have to justify to the public why the public will, presumably, benefit from the expansion of the military.  The Pareto criterion appears to clearly answer these questions.  If a society knows when it is in a position of maximum benefit, then, on the basis of the Pareto criterion, no justification can be made to either harm or benefit anyone, causing all of the above questions become moot.

Something important has now been revealed.  The Pareto criterion only becomes applicable when there is a measure of what it means for someone, or many, to benefit and for someone, or many, to be harmed.  If some kind of metric exists, then, once measured, a society will know when no one person or many can be made better off without someone or many being harmed.  Therefore, what is essential to the Pareto criterion is the mechanism a theorist uses to measure and determine a society’s overall well being.  For orthodox economists, the measure of individual and social well-being is the amount of utility that individuals and society has derived.

Utility Maximization and Pareto Optimality: Ethical Implications

Given the nature of utility maximization, human social interaction is reduced to exchange between individuals.  Clearly the utility assumption generates a distinct depiction of human beings, human needs, and human society.  The utility maximizing assumption also generates a specific conception of what is an economically “just” society.  In other words, orthodox economics has a specific view of what it believes is the best way for society to be organized economically.

The orthodox worldview can be neatly summarized.  If people desire utility, then people can acquire utility by exchanging with others.  Once people exchange with others, the act of exchanging makes them better off.  Once all exchanges are complete, all people are as well off as they can become economically.  If everyone is as well off as they can become, then no one, or many, can be made better off without someone, or many, being made worse off.  As far as orthodox economics is concerned, society has reached its ideal, Pareto optimal, outcome because people were free to make choices within an economy that facilitates exchanges, namely a market based economy.

At this point it should be clear that utilitarianism provides the philosophical foundation supporting orthodox economics while Pareto optimality represents the final outcome of the orthodox social welfare theory.  If utility is the initial proposition on which orthodox theory is built, and Pareto optimality is the culmination of orthodox economic theory, then the utility and Pareto optimality must be intrinsically linked.

The dilemma for orthodox economics is that by accepting the utility theory of value and adopting the Pareto criterion as a social welfare measure, orthodox economics produces a very specific, and ethically limited, framework.  For example, by focusing exclusively on the point of exchange, orthodox economics tends to ignore situations in which people are in disagreement with one another, circumstances of conflict.  The reason why conflict is generally ignored is because the conditions of exchange are assumed in advance.  For orthodox economics, the institutions of exchange, such as markets, contract law, and contract enforcement, are assumed to be in place prior to economic agents exchanging.  Additionally, by assuming that initial endowments are given, orthodox economics assumes the existence of income on the part of trading parties, but generally fails to recognize where income originates.

The trouble for orthodox economics is that it is not hard to imagine a world in which one’s income is affected by discriminatory factors such as racism, sexism, sexual orientation or any other divisive perception. In fact, imagination is not necessary, as the real world is filled with examples of discrimination and exploitation.  Regardless of form, the outcome of discrimination is the same, some are able to exploit others by virtue of their power to discriminate.  Or, in another example, it is clear that conditions of inequality can empower some relative to others.  People that disproportionately benefit from economic outcomes are endowed with more income and have the power to acquire resources.  In instances in which the acquisition of resources becomes concentrated in the hands of a small number of people, those with great wealth and/or income may have the power to exploit their positions of power at the expense of others.  Of course, with exploitation, conditions of inequality may be worsened allowing unequal situations to become further entrenched.

Conscientious observers of a capitalist market system, including utilitarians, are aware that situations of exploitation are not only present, but virtually unavoidable.  Given the existence of conflict and inherent disparities of power, it is easy to imagine that someone might want to intervene in economic affairs in order to level the playing field.  For example, someone might advocate to pass laws to penalize discriminatory behavior so as to reduce its prevalence, or others might seek to impose taxes on some so as to redistribute income or wealth in the hopes of reducing inequality.  The interventions in questions would certainly be designed to make someone, or many, better off at the expense of someone else, or many others.  As a result, no matter how justified the interventionist actions may be, and they are certainly justifiable in the examples provided above, within the utilitarian and Pareto criterion context the interventionist actions cannot be supported!

If the significance of utilitarianism and the Pareto criterion remains obscure, then perhaps less abstract and much more obvious examples may be useful.  The following situations, using subjective measures of utility, are Pareto sub-optimal and cannot be justified:

  1. The defeat of Nazi Germany because Adolf Hitler was made worse off.
  2. The end of slavery in the American South because slave owners were made worse off.

Clearly, to any reasonable observer the defeat of Nazi Germany and the end of slavery in the American South are justifiable as they ended horrible chapters in human history.  However, by following the utilitarian belief and coupling it to the Pareto criterion, orthodox economics cannot really make any argument to defend the destruction of Nazi Germany and the conclusion of slavery in the American South.  Subjectively speaking, Hitler’s loss of utility may have more than offset the world’s gain in utility and thus made the world worse off.  Or, subjectively speaking, the loss of utility to slave owners in the South may have more than offset the gain in utility experienced by the former slaves.  After all, if no quantifiable measure is possible it is actually impossible to know whether or not total utility has become larger or smaller so there is no way for a utilitarian to justify an intervention in the above, albeit extreme, cases.  Additionally, any intervention in the above cases required someone or many being made worse off in order to make some or many better off.  The utilitarian tradition has no adequate way of applying anything more than some kind of hedonistic, happiness seeking, value judgment to human action.  Obviously, there are serious moral and ethical weaknesses associated with the acceptance of utilitarianism.

In summary, the significance and value-laden implications of accepting utility, appears to elude most orthodox economists.  In neoclassical theory price and utility are equalized, specifically price and marginal utility.  Therefore, price equals value and this concludes the story.  The neoclassical oversimplification of value theory, which treats value and price as synonyms, fails to recognize that by believing in utility, the orthodox economist is believing in a set of pre-ordained value judgments.  The importance of this point cannot be overstated.  Observe the significance of prices in a capit