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.

Rationalize all you want

Think of the most rational person you know. If a friend comes to you with a problem, would you open a spreadsheet document? Would you type Pros at the top of Column A and Cons in Column B? Then I bet you would ask your friend to list all the pros and cons. Maybe you would even ask your friend to assign point values to each item listed. Then you sum up each column. The side with the higher point value would be the answer to the dilemma!

We would describe this kind of rationality as logic or objectivity. Economists assume that, on average and in general, people make decisions rationally. There are exceptions, of course; people who seem to be always irrational or moments in an otherwise rational life when crazy things happen. We know that people aren't always rational. Or at least they don't appear to be rational.

But let me clear what I mean by rational. Remember that economics is all about making choices, such as whether to buy something or not. Rationality means that you would figure out the value of the benefit from the purchase and the value of the cost. Then you would compare the benefit to the cost. If the benefit is greater than the cost, then you would make the buy. If the benefit is less than the cost, then you would not purchase.

Notice how vague the terms benefit and cost are. Benefits and costs will vary from person to person. Benefits and costs may even vary within one person over different periods of time. Emotions can fit under this definition of rational. If our measurement of the benefits includes emotion, we can still act rationally given that we compare that emotional benefit to however we measure the cost. You might call this subjective rationality.

When we see someone acting supposedly irrationally, it may be that we just don't understand how that person is measuring benefits and costs.

Rationality also means that, on average and in general, people make decisions consistently and predictably. Here's an example. How many readers out there like apples better than bananas? Raise your hands and keep them up. There are 20 of you with hands up. Now, how many of you 20 like bananas better than cantaloupes? Keep your hands up. Cantaloupe lovers can put their hands down. OK, there are seven hands left up.

Now, for the rest of you with your hands down, can you make a prediction about these seven people with their hands up? What would you predict these people would answer if I asked if they liked apples better than cantaloupes? You would predict that all seven would like apples better. Why?

You would predict that they would prefer apples over cantaloupes because of the principle of transitivity. If someone likes apples better than bananas and bananas better than cantaloupes, then that person should like apples better than cantaloupes. If A > B and B > C, then A > C. We expect people to act in this consistent and predictable way rather than to answer randomly about fruit preferences. This is another part of rational behavior. When making choices, people do not behave randomly, but instead they make decisions, on average and in general, in predictable ways.

This assumption of rationality is comes from the fact that economics is a social science. As such, economics uses the scientific method. Economists observe human (and sometimes animal) behavior and then ask why does this behavior occur. But different from the physical sciences, it is difficult to conduct economic experiments. Possible, but difficult, and subject to limitations. Almost all economic behavior occurs in real life. It's hard to ask customers in a store to divide into a control group and an experimental group. Therefore, most economic experiments are thought experiments, often reliant on mathematical theory and statistical analysis.

Nevertheless, economists do construct scientific models. There are four parts to a model:

1. assumptions
2. isolation
3. story
4. prediction

Every model begins with some form of the verb to assume. The purposes of the assumptions are to simplify and control the circumstances of the thought experiment. Real life is complex and messy. So, one assumption might be to freeze frame everything, hold everything constant. This eliminates the effects of factors that are beyond the scope of the experiment. For example, we might assume that incomes stay constant while we are studying shopping behavior.

Assuming that everything is held constant, we can then isolate on the factors to be studied. And in many models, especially at introductory levels, we isolate on two things. Why two? Because in economics, everything comes in two's! For example, we might isolate on price (independent variable) and quantity demanded (dependent variable).

A story is a sequence of events, a chain reaction. One thing leads to another. We have isolated on two things in our model and the story begins, "Change one of the things." For example, we might change the price by increasing or decreasing it. Changing the price sets off a sequence of events.

And that sequence of events leads to a conclusion, an ending to the story. Making the same assumptions, isolating on the same two things, and telling the same story, we expect that the ending will always be the same. Therefore, the conclusion becomes a prediction: If these things are true, then we predict that this result will occur.

Economic models help us predict human behavior. A scientific model that accurately predicts real-world behavior is called a theory. Economists never say, "Oh, that sounds good in theory, but it would never work in practice." If it doesn't work in practice—if it doesn't predict real-world behavior—then it isn't a theory. The idea is instead a failed hypothesis.

The basic economic models presented in this blog have been tested by time and do a good job of predicting real-world behavior.

Note to behavioral economists
Advocates of behavioral economics question the assumption of rationality. They criticize many economic models and equations that primarily revolve around benefits and costs measured in money. Behaviorists believe that most economic models assume that all people consistently behave the same way all the time. Predictable behavior based on money might be called objective rationality.

Objective rationality, however, applies only to simple economic models with one or two independent variables. The same models can be expanded by adding parameters and still meet the standards of marginal analysis and transitivity. This is the foundation of subjective rationality.

COPYRIGHT © 2008 by Robert D. Sandman
ALL RIGHTS RESERVED.

Meditate at Lunch

Think for a moment about the last lunch you had. What did you eat? For me it was some pulled pork with barbecue sauce. I made a sandwhich with two pieces of sliced white bread. I also had a golden delicious apple, potato chips, and a glass of milk.

Here is a question. Where did the parts of my lunch come from? The pork and sauce came from a local restaurant. The bread, apple, chips, and milk came from the grocery store. When we purchased the pork or the groceries, we were the buyers. The restaurant or the grocery store were the sellers, who handed the food over. But there's no such thing as a free lunch, right?

In order to take the food, we had to pay money. There at the checkout register, a trade was made. Food flowed from the seller to the buyer and money flowed in the other direction. This is what a market is, a place where buyers and sellers come together and make a trade.

But where did the restaurant get the pork? Probably from a wholesale restaurant food distributor. And notice a subtle shift. The distributor is the seller. Now the restaurant is the buyer. Most people and organizations in the economy play this double role, both buyer and seller. You are a buyer when you are a customer in a store. You are a seller of your labor to your employer. Your organization acts as a buyer through its purchasing department and as a seller through its sales and marketing departments.

In any event, the restaurant buyer and the distributor seller came together and made a trade. The restaurant might have issued a purchase order for a delivery of some number of pounds of pork every few days. After the delivery, the distributor's accounts receivable department sent an invoice to the restaurant. Later, the restaurant's accounts payable department sent a check to the distributor. Buyer and seller came together and made a trade. Food moved from the distributor to the restaurant and money moved the other way.

The wholesale distributor purchased the pork from a processor. Now the distributor was the buyer. In the market, pork moved from the processor to the distributor and money flowed from the distributor to the processor. In a similar way, the processor acted as a buyer and hog farmers acted as sellers.

The pork traveled through a long, complicated supply chain in order to be available in the restaurant when we were ready to purchase it. At every stage in the supply chain, buyers and sellers came together and made a trade. We could describe the same process for the bread that I used to make my sandwich, the apple, the potato chips, and the milk. The food that you ate yesterday and the meals for all the people reading this blog also were delivered by similar supply chains. Same thing for the clothes you are wearing or the computer you are using.

Now comes the miracle of economics, the kind of astounding insight that turned me into an economics jerk. There is no government official or corporate headquarters coordinating all these supply chains and making them work to deliver the products that we want to consume. The supply chains work all by themselves because buyers at each stage are motivated to buy products and sellers are motivated to earn money. This is what the concept of the Invisible Hand is all about.

Imagine for a moment that you are point of light floating in space. Now imagine that the companies from which you purchase goods and services are also floating points of light. Your market trades with them are beams of light connecting you to them. But each of those selling companies also purchase; so, they are connected by beams to many other points of light. Keep going and eventually you can visualize an enormous ball of points of light with many, many beams connecting them in a complicated web.

This connectivity illustrates the Basic Economic Truth: Everything is connected to everything else. So there is something to think about at your next meal. Where did your food come from? What steps did it go through to get to you? How many times did buyers and sellers make a trade? And then tell your friends and family what you're thinking. You'll be an economics jerk!
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COPYRIGHT © 2008 by Robert D. Sandman
ALL RIGHTS RESERVED.