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Chapter 2. Why Economists Like Market Outcomes for Ordinary Goods

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Chapter 2. Why Economists Like Market Outcomes for Ordinary Goods Chapter 2. Why Economists Like Market Outcomes for Ordinary Goods We enjoy the ordinary goods we consume for many diverse reasons. One person might buy and eat broccoli because it is “healthy,” despite not much liking the taste; another might consume broccoli for its delicious taste, uninterested in whether it is healthy or not. One might place a great value on a refrigerator to keep beer cold; another might value the refrigerator largely to keep ice cubes or ice cream cold; yet another might value the refrigerator because of a “fresh vegetable motive” for having a refrigerator. Economists do not generally care about the psychological reasons for “why” people like the things they like and dislike the things they dislike.1 In fact, economists don’t usually even care much about why people consume the levels of various goods that they do.2 Rather, economists tend to be interested in “price elasticities” and “income elasticities.” These esoteric- sounding terms are just particular measures of how responsive changes in demands or supplies are to changes in prices or income. Why people value the things they do has no bearing on resource allocation for ordinary goods like broccoli or a refrigerator, as long as those tastes (preferences) are “stable.” If tastes are stable, that is, if you don’t suddenly dislike–for whatever reason–things you used to like and vice versa, it is only relative opportunities (prices and incomes) that result in changed behavior.3 1Monetary economics is an exception, with motives for holding money broken into “medium of exchange,” “asset,” and “precautionary.” Yet, even here, these distinctions do not alter what economists do–they look at relative price effects (interest rate differentials in this case) and income effects. 2Economic historians sometimes provide exceptions. For example, in wondering why we drink relatively large amounts of coffee in the U.S., while England drinks relatively large amounts of tea, the historian might attempt to look at consumption levels before and after the “Boston Tea Party,” the colonists’ protest against taxation without representation. 3Actually the text condition is stronger than necessary, since we are mostly interested in market rather than individual behavior. As long as those who suddenly like something more are roughly offset by those who suddenly like it less, such taste changes will “wash out,” leaving only relative opportunities to systematically affect behavior. For environmental goods, we shall see later that the case is very different–the nature of preferences actually matters, and might matter greatly, to proper resource allocation. Nearly all tastes for ordinary private goods are driven by what might be called “use” values–we want goods because we can use them. We wear clothes, live in houses, eat food, and so on...those are “use” demands, and we are willing to pay to use the goods we buy. But, there are other non-use values that underlie human willingness-to-pay for certain kinds of goods, particularly for environmental goods. For example, we might want a good, not for current use, but because we want to have the option to use it, an option demand. Or, we might, personally, not care about ever using the good, but we might want to give our offspring the chance to use the good, a bequest value. And, we might even be willing to pay to keep goods from being used at all, a preservation demand. As we shall see in great detail later in the book, economists are much better at determining use values than they are at gauging how important the various non-use values are. With the preceding discussion lurking in the background, we turn now to why economists, and many others–but not everybody–like market outcomes for ordinary private goods. The use values that characterize ordinary private goods, making us willing to pay for them, stem from their having the property of being both rivalrous and excludable. That is, consumption is rivalrous in the sense that if you are wearing the t-shirt, nobody else can be wearing it; if you eat the steak, nobody else can eat it. Similarly, for ordinary private goods, “excludability” means that you can keep people from consuming the good, unless they pay for it. Without excludability, it would never be profitable to supply any good–most people would just But the key insight is that if tastes are stable, it is only changing opportunities–income and relative prices–that lead to changed behavior. use it without paying, because that would leave them with more resources available for other things. Since ordinary private goods are rivalrous, there must be some way to decide who gets what is produced. In the market system, those who are willing to pay the going price for a good are able to acquire it. So, the interesting question becomes, “How much would people want to buy at various prices?” The Law of Demand, properly understood, is not controversial. It say merely that at lower prices people will buy more and at higher prices people will buy less, other things equal. Some people who did not buy any of a good at all at high prices will begin to buy a good as it gets less expensive, while those already buying the good will buy larger quantities at lower prices. The law of demand could be expressed in many ways (e.g. algebraically or as a table of prices and quantities), but we will find it convenient and informative to use graphs. Graphically, the relationship between price and quantity demanded is downward-sloping, higher prices resulting in reduced quantities demanded (a so-called inverse relationship). The “other things equal” caveat is important, however, in that if anything else changes (income, tastes, prices of other goods, expectations of future prices and so on) at the same time that price changes, the negative effect of higher price on quantity demanded might be swamped by the other variable. That is, suppose that the price of constant-quality cars rises, yet we observe more cars sold, rather than fewer–does this imply that people desire cars more at higher prices than at lower prices? No, it must be the case that something else has changed (probably income in this case4). An upward-sloping relationship is theoretically possible–just as it is possible that 4One can easily imagine coming out of a recession, with rising income causing greater demand for cars; the greater demand for cars causing their price to rise, encouraging a casual observer to conclude that people buy more cars at higher prices. A rise in income would cause both greater car sales and the higher car prices; in other cases, unicorns exist–but, like unicorns, such relationships have never been observed in properly conducted studies. That buyers prefer lower prices is hardly earth-shaking–most people I have asked would love to have a Ferrari or Rolls Royce automobile if it were available for $300. So, we all would like to pay lower prices for the things we buy or might buy...if we could actually buy them at those lower prices. But, this requires that we think about supply, since suppliers are quite unlikely to offer Ferraris and Rolls Royces for $300! The Law of Supply is also straightforward. It argues that at higher prices people will supply larger quantities, other things equal. Recall that rational decision-makers, will be producing where marginal benefits (price for competitive suppliers) equal marginal costs, to make themselves as well off as possible. Hence, with a now-higher price, the many existing suppliers will find that their marginal benefits of producing exceed marginal costs at current production levels. If producers offer a variety of products, they will want to produce relatively more of the product whose price has risen. Even if only producing the product whose price rises, it will be in their interest to increase output by hiring more variable inputs (this might involve running the machinery faster, adding shifts, overtime for workers, and so on). As with demand, supply relationships could be depicted with algebra, tables, or graphs. The latter is most convenient, especially when we put demand and supply on the same graph, for reasons that will become clear. Most demand and supply curves have a “time-dimension.” Consider some ordinary good, say steak. If you were to ask someone much steak she consumes, the answer “three pounds” would not be meaningful. Three pounds would be a great deal of steak if that much were eaten daily, but might not be abnormally high or low for week consumption–if the three pound answer some other variable might be confounding the relationship between price and quantity demanded. applied to yearly consumption, she hardly eats steak at all. Throughout the remainder of the book, it will not matter greatly what time period is being considered, but bear in mind that some time period is typically implicit.5 To postpone problems that we will return to, particularly for environmental goods, some simplifying assumptions are made for the rest of this chapter. It is assumed that “many” buyers have perfect information about their tastes and the prices of the available goods and that “many” sellers have perfect information about production technology and the prices of both the goods they sell and the inputs hired to produce the goods. The “many” here means so many that no one buyer or seller, and no small group in collusion, can affect market price by how much they buy or sell. Moreover, though not critical, we shall assume perfect mobility of resources.6 Figure 2.1 shows a traditional supply and demand curve diagram, say for monthly consumption of steak.
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