Demand everything

Imagine that you are surfing the Net. When you go to your favorite site, a pop-up window appears. It's a market research survey. Bored out of your mind, you decide to take the survey. The subject is music downloads. The survey will present different prices for downloads. For each price, the survey will ask you to key in a quantity of downloads that you would plan to purchase at that price over the next month.

Let's stop for a moment and clarify an assumption. This story about taking an online survey is subject to the freeze-frame assumption. Everything is held constant, such as your income, your amount of leisure time, the technology for listening to music, the prices of other music media, and so on. We are going to isolate on just two things. Why? Because in economics, everything comes in two's! The two things are the price of downloads and the quantity that you would plan to buy in one month.

So, the first price that appears in your pop-up survey is $1.49. You key in that you would plan to purchase one song per month at that price. The next price is $1.24. You respond with two. The survey continues with three more prices, and you answer with three more quantities demanded. The software behind the survey takes your answers and plugs them into a spreadsheet. The first column lists the five prices in descending order. The second column lists your quantity demanded for each price. The results might look like this:

Price......Quantity
-------- -----------
$1.49......1
$1.24......2
$0.99.....3
$0.74.....4
$0.49.....5

A spreadsheet like this is called a demand schedule, using schedule in the sense of a table of numbers.

Do you notice the relationship between the numbers? As your eye goes down the Price column, the numbers get less and less. As your eye goes down the Quantity column, the numbers get more and more. There is a less-and-more relationship between price and quantity demanded. When there is less price, there is more quantity demanded. Where there is more price, there is less quantity demanded. In economics, we have a name for this particular less-and-more relationship. This is the Law of Demand.

Why is the Law of Demand true? Economists have a variety of complex explanations that I am going to skip over. You can do a search on consumer equilibrium or indifference curves to find out more. But let's look at a simplified reason. Remember that economists assume that people have insatiable wants, but scarce resources. Say that you have only $2.50 available to purchase music each month. When music costs $1.49 per download, your budget allows you to purchase only one song per month. You would prefer to download more songs, even an infinite number! But your resources do not allow it. However, when the price of a download drops to $1.24, one song uses less of your resources. Now you can download two songs and still stay under budget.

Anytime you can make a table of numbers, you can make a graph. I entered the demand schedule into a spreadsheet program and produced the following graph of a demand curve:

Now, not everyone reading this may be comfortable with using graphs. They are not that hard to understand. All you need are the Economic Jerk's Four Copyrighted Steps for Understanding Graphs:

1. Notice that the numeral zero is in the bottom left corner. There is a vertical line extending upward from zero and a horizontal line extending rightward from zero. These two lines form the Economics-L. An L has two sides. When you see the L, you know that the graph represents a model that isolates on two things. Why two? Because in economics, everything comes in two's.

2. What are the two things on which the model isolates? Look at the labels on the two sides of the Economics-L, price and quantity demanded. The hidden assumption is that all other things are held constant.

3. Each diamond point on the graph represents two pieces of information. Why? Because everything comes ... Well, you know the rest. For example, the leftmost point indicates that, when the price of a download is $1.49, your quantity demanded would be one. The next point to the right represents a price of $1.24 and a quantity demanded of two. Each point on the blue line corresponds to a row in the demand schedule.

4. Finally, move back from the graph and imagine that you're walking on the graph from left to right. You would be walking downhill. The demand curve is downward sloping. Therefore, the demand curve is a picture of the Law of Demand: there is a less-and-more relationship between price and quantity demanded.

As you might figure, you are probably not the only person who answers the pop-up market research survey. The answers of all the other participants are entered on the same spreadsheet where your answers appear. The prices are in Column A. Your quantities demanded are in Column B. Other people's answers are in Columns C, D, E, and so on. On the far right of the spreadsheet, the researchers create a column that sums up the amounts in all the quantity demanded columns. The values in the summation column are known as market demand, the planned purchases by all of the consumers. When people talk about demand for some product, they usually mean market demand.

Remember that this whole model of demand is based on the assumption that everything other than price and quantity demanded is held constant. But what if this assumption does not hold true? In real life, income, tastes and fashion, the prices of other products. and so on do change. What happens then?

The first thing that happens is that the market researchers realize that all their data is now useless. The data were collected under different circumstances. So, the researchers must delete their spreadsheet and their original graph. They must set up a new survey and collect all new data. The researchers will end up with a new table of numbers, which will generate a whole new graph. If you were to plot the original demand curve and the new demand curve on the Economics-L, it would appear that the original demand curve has shifted to a new position.

If the change in the assumptions is favorable to demand, if there is a greater quantity demanded for each price, then we call this an increase in demand. The demand curve shifts to the right. If the change in the assumptions is unfavorable, if there is lower quantity demanded for each price, then we call this a decrease in demand. The demand curve shifts to the left.

Decreases in demand spread throughout the economy during the Great Recession of 2008-2009. Higher interest rates were a change outside the model for housing demand. The higher rates were unfavorable for housing demand and the housing demand curve decreased. Higher gas prices did the same thing to SUV and truck demand. As the recession's vicious cycle took over, decreased demand for many products led to unemployment that led to decreased demand and so on.

COPYRIGHT © 2009 by Robert D. Sandman
ALL RIGHTS RESERVED.

Take a Hike

Imagine that you have emerged from the forest's edge and are headed for the river. But first you have to walk up and over the hill. If your goal is to walk as far as you can without getting your feet wet, your task is easy. Walk to the river's bank.

But what if instead your goal is to walk to the top of the hill? How would you know when you have reached the top? You could carry an altimeter. Whenever the instrument shows the highest altitude, you're there. Or you could use your eyes. When you are standing on a spot where you cannot see any land above you, you've reached the top.

But what if we accomplish the goal the way that an economist would do it? Analyze one step of your hike at a time. If your first step takes you upward, take the step. If the next step also takes you upward, take that step, too. If the next step takes you downward, stop and back up. Using this method, analyzing one step at a time, will get you to the top of the hill.

If you've read this far, it probably won't surprise you to know that economists have a name for this one-step-at-a-time method. It's called marginal analysis. Remember that in economics we use common, everyday words, but give them special meanings. In this situation, marginal does not mean on the edge or lower quality. In economics, marginal means taking one step at a time. It might mean consuming just one more unit of some good or service. Or expanding your company's production by one more unit. Or hiring one more worker. The word marginal is going to be your new best friend in economics. It will show up over and over.

Recall that economics is fundamentally about choices. And in its simplest form, a choice is a decision between two options. You pick one and do not choose the other. And economists assume that people behave rationally. Each option has a benefit that has a value and a cost that has a value. If the benefit is greater than the cost, a rational person chooses that option. If the benefit is less than the cost, a rational person does not choose that option. This type of rational decision-making is the key to marginal analysis in economics.

For example, you start up a business. You have to answer the question, How big should my business be? By big, you mean, How many units of product should I produce and offer for sale? You want to produce the number of units at which your profit would be maximized. In other words, you are walking up and over the profit hill. How do you know when you are at the top?

You produce one unit of product and you measure its benefit. In this example, the benefit is the revenue you receive for selling the unit. But, in economics, everything comes in two's. So, you must also measure the cost. If the revenue is greater than the cost, then you are climbing up the profit hill. Make that unit of product. Repeat this analysis for each additional unit of product. If the revenue is greater than the cost, take the step and produce the product. But, when you produce a unit of product for which the revenue is less than the cost, that last unit will take you down the profit hill. Stop! Do not make that last unprofitable unit of product. Back up to the unit just before. That's marginal analysis. You analyze one unit of product at a time, comparing the benefit to the cost.

By the way, how do we measure cost? The simple way is to total up the money spent. But economists use a more general definition. When you make a choice between two options, you pick one and do not pick the other option. The option that you pick obviously has a benefit value. But, here's the thing, the option that you do not pick also has a value. You had the opportunity to choose the rejected option, but you sacrificed that opportunity. The value of the option that you did not choose is called opportunity cost. Sometimes opportunity cost is measured in dollars, but it's not necessarily so. Opportunity cost can be measured in whatever way you are measuring benefits. As a rational person, you will choose the option whose benefit is greater than its opportunity cost.

Here's an example. You had to choose whether to read this blog or do something else like doing an Internet search for a friend from high school. It is my fervent hope that, by choosing to read this blog, you are receiving some sort of benefit. But searching for your long-lost friend also provides some sort of benefit. So, you get a benefit from reading the blog, but you also pay an opportunity cost. The opportunity cost is the benefit that you had the opportunity to choose, but you sacrificed. Your opportunity cost is the benefit that you would have received from searching for an old friend. Because I am making the assumption that you are rational, I believe that the benefit of reading this blog today was greater than your opportunity cost. OK, now you can go search for that old flame.

COPYRIGHT © 2009 by Robert D. Sandman
ALL RIGHTS RESERVED.