Economics Lecture Four
In Lectures Two and Three we discussed how a government price control, or price ceiling, results in shortages. For example, government controls on the cost of medical services will cause a shortage of medical services, and rationing of medical care becomes necessary to manage the shortage.
Consider this question: why doesn't the government simply order people to provide more of the medical services, so there is no shortage? If government is powerful enough to limit and control the price, which causes a shortage, then why doesn't the government increase the supply by ordering people to provide more of the services at the lower price?
Think about that for a while. The answer is in this footnote.
In this course we have already learned about the supply and demand curves, and examined the economic concept of “elasticity”. Recall that elasticity measures the sensitivity of the quantity demanded to a change in price, as we discussed in the last lecture.
In this lecture we focus on other aspects of “demand”.
The Income and Substitution Effects
Recall that the “Law of Demand” is this: when the price of a good increases, its demand decreases. When the price of a good decreases, its demand increases. This is one of the most fundamental rules of economics: the Law of Demand.
The question we ask and answer now is this: why is the Law of Demand true? There are two reasons.
First, the more expensive something becomes, the less people can afford to buy it. Someone with access to a maximum of $10,000 (in wealth or loans) cannot purchase a good costing $20,000. He cannot afford it. Actually, this person probably cannot afford anything more expensive than about $5,000, because he needs to use his other money for food and shelter and clothing and transportation.
The second reason for the Law of Demand is that even people who can afford something may prefer, as the price of a good increases, to spend their money on an alternative instead. People who can afford to spend $20,000 on a luxury cruise may look at that price and decide to spend that money in a more enjoyable manner, such as renting house at the Jersey shore one week each summer for the next 20 years.
These two reasons, or effects, have been given names in economics. They are called the income and substitution effects. They cause the important "Law of Demand." Let's examine each effect now.
The “income effect” is the effect that a change in price of a good has on a buyer's overall income. When the price of a good decreases, a buyer of the good saves money. This is the same as if he earned more money. "A penny saved is a penny earned." When the price of a good decreases by a penny, the "income effect" is as though the buyer earned an extra penny in income. For example, if you drink a gallon of milk each week and the price of that gallon decreases by 25 cents, then you have 25 cents extra to spend on something else. It is as though your income went up by 25 cents.
Remember how we discussed that an increase in income usually causes people to buy more of a good? Now that you have more income, you may want to buy more milk. Instead of drinking a gallon a week, perhaps you can now afford to drink a gallon and a quart a week. The decrease in price of milk created an income effect (increase in income), which encourages you to buy more milk.
To summarize: the income effect of a decrease in price is to allow the buyer to save more money, and some buyers will use that savings to purchase more of the good. If you went to the store to buy a new pair of socks for $5, and found they were on sale for only $2.50, then you may use that savings to buy two pairs of socks. This "income effect" of a decrease in price causes demand to increase for the good.
The second reason that the Law of Demand is true is because a decrease in price of a good also causes a “substitution effect.” Think of what happens when the price of a good increases. People start to buy substitutes instead, and so the demand for the good with the higher price decreases. Similarly, when the price of a good decreases, people want to buy more of the less expensive good instead of something else. In other words, a decrease in price of a good makes you more willing to buy it as a "substitute" for a similar good. In the milk example, its cheaper price makes it more attractive to purchase. You may want to substitute milk for the fruit juice you used to drink.
Both the “income effect” and the “substitution effect” give you an incentive to buy more of the good that decreased in price. The overall increase in quantity demanded for a good that cut its price is the sum of the income effect and the substitution effect. For a normal good, a decrease in its price causes an increase in real income (the income effect) and an increase in substitution for other goods (the substitution effect), which add together to cause an overall increase in demand. This is typical.
Learn these two important concepts well -- the income effect and substitution effect. In understanding concepts, it helps to restate them slightly differently until there is a full appreciation of them. The “income effect” is the change in your wealth (income) due to a change in price of something you buy, AND how that change effects what you buy. If the price of milk decreases, then the “income effect” is to make you feel like you have more income AND enable you to buy more milk. If the price of milk increases, then the “income effect” is to make you feel like you have less income because you had to spend more on buying the milk, leaving you less money to spend on other things. Understand this? Reread it again if necessary, and think about how a change in the price of milk affects your decisions about how much milk and other things you can buy.
The “substitution effect” is the change in substitution (one good for another) due to the change in price of one of the two goods. If the price of a good decreases, then that price change makes it more attractive to be used as a substitute for another good. If, for example, chicken sandwiches are on sale at half-price at McDonalds, then more customers are going to choose chicken sandwiches as a substitute for hamburgers. The decrease in price of chicken sandwiches has a “substitution effect” of causing more people to buy them as they move from eating hamburgers to eating the cheaper chicken sandwiches.
For Honors Students Only: Giffen Goods
Last class, we mentioned an odd type of good known as an “inferior” good. You may recall that the demand for an “inferior” good actually increases when income decreases. Examples are margarine (because people with declining income can less afford butter). Bankruptcy services are “inferior”, because when people's income declines, more of them file for bankruptcy, and then there is a greater demand for bankruptcy services.
Question: If a good is inferior, does a decrease in its price cause an increase in quantity demanded?
Think about it. From the prior section, the overall change in quantity demanded is a sum of the “income effect” and the “substitution effect.” Let's look at the income effect first. Ordinarily, the “income effect” when the price decreases is that real income goes up. But for an “inferior” good, an increase in income means a decrease in demand! That’s strange. Thus for an inferior good, when the price decreases, the income effect is a decrease in demand.
However, the “substitution effect” goes up when the price falls, even for an inferior good. Because the income effect and substitution effect move in opposite directions, it is difficult to predict what will happen to their sum, which is the overall demand. A “Giffen good” is an inferior good for which the income effect dominates, and thus it has the unusual characteristic that a fall in price of the good causes a fall in demand. A Giffen good violates the Law of Demand. It is difficult to think of an example.
It is worth defining a “Giffen good” again, this time in terms of a price increase: A "Giffen good" is a good which has an increase in demand when its price increases. Raise the price of a Giffen good, and the demand for this good increases. (All other goods have a decrease in demand when the price of the good increases.)
A Giffen good could be an “inferior” good that responds so negatively to an increase in income that the income effect outweighs the substitution effect. In the 1895 edition of the classic “Principles of Economics,” Alfred Marshall wrote: “As Mr. Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring [British spelling] families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it.”
Another textbook example of a “Giffen good” is the potato during the terrible Irish famine of 1846-1849. This famine caused nearly a million Irish to die of starvation, and forced nearly another million to emigrate to the United States, Britain, Canada and Australia. Economists say that the potato during the famine was Giffen good. The potato crops failed and there was less supply of potatoes, which caused its price to increase. But the poor Irish, after paying the higher price for potatoes, had less money left to buy more expensive foods. So they had no choice but to buy even more potatoes to try to fill their stomachs! In other words, the increase in the price of the potato wiped out the savings of the Irish, who then bought even more potatoes despite its increase in price. Note that the potato could have been a Giffen good only if it was also an “inferior” good that saw a surge in demand when people had less income (less money to spend).
Other economists suggest that tortillas are a Giffen good in Mexico today. But further investigation shows that neither potatoes in Ireland nor tortillas in Mexico actually qualify as Giffen goods.
Rice and noodles are now described as Giffen goods among the poor in China. Do you believe it?
Giffen goods are exceptions to the Law of Demand ... if Giffen goods really exist! Many, including your teacher, are skeptical that there really is such a thing as a Giffen good.
Economist Thorstein Veblen suggested that a "status symbol," like a fancy car or diamond, can have an increase in demand when its price goes up. While "status symbols" certainly do exist, it is questionable whether the demand for them ever increases due to an increase in price. If it does occur, then it is a "Veblen good." Notice that a "Giffen good" is not a status symbol as a "Veblen good" would be.
Utility and Diminishing Marginal Utility
Money isn’t everything. We have many expressions for this concept. “There’s more to life than money.” “It’s only money.” “What’s your job satisfaction?” The basic point is that dollars and cents do not capture our overall happiness or satisfaction as a consumer. You may buy the most expensive music CD on the market, or watch the most popular movie, or buy the fanciest clothes, but that does not mean you will like those items the best. Often our favorite goods are not the most expensive ones.
“Utility” is concept in economics created to include non-monetary satisfaction. “Total utility” is defined as a consumer’s overall satisfaction. “Marginal utility” is defined as the additional satisfaction of a consumer in buying an additional unit of a good.
As we discussed in Lecture One, Economics is not only about money. The economic concept of “utility” encompasses everything worthwhile, whether it has to do with money or not. Helping someone has “utility”, for example, even though it is voluntary and not for money. Charity has utility even though nothing is obtained in return.
Let’s take an example. Suppose you are on a family road trip by car out West. You left your campsite near Phoenix just after you woke up, and you’re driving through the desert to Los Angeles. You have not eaten all day. Hour by hour goes by and you do not see any place to eat.
Finally, at 4 o'clock in the afternoon, you see the golden arches of McDonalds appear on the horizon. You drive closer and the arches appear bigger. It’s not a mirage!
When you arrive, you run in and order its famous french fries. You’re famished. When the food arrives, you take your first handful of french fries. Wow, it is really satisfying to eat that first bunch of french fries with an empty stomach. Your marginal utility is extremely high. You might have even been willing to pay $5 for that first mouthful of french fries because you are so hungry. Then you eat your second handful of french fries. Your marginal utility is still high, but not quite as high as the first one. You wouldn’t have paid as much for the second handful either. By the time you finish all the french fries, the last few bites were not so satisfying. In fact, you’ve gotten sick to your stomach. The marginal utility of that last french fry was very low. Perhaps even less than zero!
You have just experienced the Law of Diminishing Marginal Utility: the marginal utility of each additional unit (e.g., french fry) always declines (in a given period). This is similar to the "Diminishing Returns" experienced by a producer of goods.
In general, the rational consumer will always try to maximize his or her total utility. How is this done? The consumer always purchases the good with the highest marginal utility in order to maximize his total utility.
Suppose you go to a shopping mall with $80. You can buy food or clothes or anything else you find in a mall. Would you spend it all on food? Of course not. The marginal utility of your food purchases declines as you eat more. Ideally, you wouldn’t even buy enough food to fill your stomach, because you can always eat more cheaply at home. To maximize your utility, you would spend every dollar in a way that has the most marginal utility. Your first purchase would be what you want most, and then your next purchase would be your second choice, and so on. If you really want something that happens to cost $80, then you may spend all your money on that one item.
The rational consumer maximizes utility by spending each dollar in a way to maximize marginal utility for that dollar. For such a consumer, the marginal utility of every good divided by that good’s price must be equal. MUx/Px = MUy/Py=MUz/Pz, where MUx is the marginal utility of good “x” and Px is the price of good “x”. This is known as the Law of Equiproportion Marginal Benefit.
Lack of Utility
You might notice that you, like most people, waste many hours each day on thoughts or activities that have no utility at all. Once you recognize this, you can minimize the wasted utility and start to focus on maximizing your utility.
"Alarmism" and "anxiety" are examples of wasted time, and loss utility. Time spent worrying can be much better spent maximizing utility, either by earning money or doing something else (such as charity) that increases your utility. Jesus may have been making the same point when He said, "Who of you by worrying can add a single hour to his life?" If something is not done for God and has no utility for you either, then why are you wasting time on it?
The economic concept of utility is helpful in combating distractions and minimizing time wasted on alarmism and anxiety. Occasionally ask yourself, what utility was achieved in the last hour of my time? Did I maximize my utility during that hour?
Now that we understand the important concept of utility, we can graph it by using an "indifference curve." In a simple case, consider having separate utilities for two different goods. The goods could be food (like two types of candy), or they could be websites (like Conservapedia and Facebook), or they could be modes of transportation (like a car or a bicycle). The point is that there is a trade-off in utility when you substitute one good for the other. Your overall utility will increase, remain the same, or decrease, when you give up some of one of the good in exchange for more of the other good.
When the quantity for one of these two goods is graphed on the x-axis, and the quantity for the other good is graphed on the y-axis, then we can draw a line that represents constant utility as we substitute one good for the other.
The indifference curve is a graph of utilities such that every point along a curve has the same amount of total utility. A person should be "indifferent" to where he is along the curve, because it shows where his total utility is constant.
Let's take a simple example. Suppose you like chocolate and peanut butter equally well, and you are "indifferent" between receiving one chocolate bar and one peanut butter candy bar. Plotting the good for a chocolate bar on the x-axis and the good for a peanut butter candy bar on the y-axis, the indifference curve will be a straight line with a negative slope of 1. Give up a chocolate bar but receive a peanut butter bar, and you're on the same indifference curve: your overall utility has not changed. But give up a chocolate bar and receive TWO peanut butter bars, and you've increased your overall utility and you've left that original indifference curve. You're better off with that deal and are not "indifferent" to it. You want the improvement in utility in the 2-for-1 deal.
Let’s take another example that illustrates the usefulness of an indifference curve. Suppose you are working on the homework for this course with three friends - Chris, Stephanie and Kevin. Someone says they are hungry and go to look for snacks. You see a half-eaten bag of potato chips and you pop a bag of popcorn. However, there is not enough food for everyone, so you have to ration who receives what.
You count 24 potato chips and 40 kernels of popcorn. Uh oh. There are four of you. On average, that’s only 6 potato chips and 10 kernels of popcorn per person. You tell everyone that.
But Chris likes potato chips more than corn; Stephanie prefers the opposite. To decide how to allocate the food, you ask Chris and Stephanie to draw their "indifference curves" with potato chips on the y-axis and corn on the x-axis. You learn from the curve that Chris is just as happy with 9 potato chips and 2 kernels of popcorn as he would be if he received 6 potato chips and 10 kernels of corn. Chris’s overall utility (or satisfaction) is the same in both cases. Meanwhile, Stephanie is just as happy receiving 18 kernels of popcorn and 1 chip. Fine, you give Chris 9 chips and 2 kernels and Stephanie 18 kernels and 1 chip.
Was this worth it? Yes: now you have two extra potato chips that you would not have had by splitting everything equally. Chris and Stephanie are just as happy, and you can share the additional chips with Kevin.
The graph below is for a typical set of three indifference curves (I1, I2 and I3) for someone for two goods X and Y. Note that this graph does not compare Price and Quantity, but compares the Quantity of good X (on the x-axis) with the Quantity of good Y (on the y-axis). As one goes down a specific curve, the person is "indifferent" with giving up Quantity of good Y in exchange for more of good X. The person becomes more satisfied or happier when he shifts to an entirely new curve, as in moving from I1 to I2.
The next graph below is for two goods X and Y that are perfect substitutes for each other (like our example above of a chocolate bar and a peanut butter candy bar). In the case of perfect substitutes, the person is happy to substitute one good for the other on a one-for-one basis, and hence the slope of the curves is a perfect negative one.
“Consumer surplus” is a concept that illustrates the power of the free market as it drives down the price of goods. When we buy goods and services, most of us would pay at a higher price if we had to. For example, our families would pay twice the cost of milk because we would still want to drink milk even if the price were higher. We may not buy as much milk at a higher price, but we would still buy some. We get extra value when we can buy milk at a price lower than what we would really pay if we had to.
The "consumer surplus" is the net benefit (in dollars) that a consumer obtains from buying a good. Thus (consumer surplus) = (total benefit) - (total cost). The "consumer surplus" is never negative, because people would not purchase goods or services if their total benefit is less than their total cost. They would be better off keeping their money and not making the purchase.
To illustrate how powerful the concept of the "consumer surplus" is, let’s define another term: “demand price.” That is the most someone is willing to pay for something. When you go to see a movie, there is a maximum amount you are willing to pay for a ticket. It varies for different consumers. It also depends on what the movie is.
A consumer’s demand price is his marginal benefit from obtaining the good or service (not including what he had to pay for it). You may walk out of a movie theater after seeing a movie you really liked, and conclude that it gave you $25 worth of benefit. Your marginal benefit is thus $25 from the movie (not subtracting what you paid to see it). The total benefit in the market is thus the sum of all the demand prices, which is the area under the demand curve.
The consumer surplus is the demand price (the most a consumer would pay) minus the price paid (the amount the consumer actually has to pay). Suppose you were effusive (i.e., very enthusiastic) about a particular movie, and wanted very much to see it. You were so excited that you were willing to pay $20 to see that movie. But if the theater charges you only $8, then your consumer surplus is $20 - $8 = $12.
Consumers stop buying a good when the demand price falls slightly below the sales price. For movies, the demand price falls the longer it keeps playing in a theater. After you’ve seen the movie once or twice, you’re not willing to pay so much to see it again. Over time people stop paying to see the same movie, and the theater stops playing it and begins showing a new movie instead.
Almost every time someone buys something, he benefits from the consumer surplus of that transaction because he would probably pay a little more than he did. If you value a chocolate candy bar at $1.05 but can buy it for $1, then you acquired extra wealth of 5 cents as your consumer surplus. You would have paid $1.05 for it, but paid only $1 and then had both the candy bar and the extra 5 cents. You became wealthier from the transaction by an amount equal to your consumer surplus. And you became fatter too!
A force perhaps even stronger than the “invisible hand,” or perhaps a variation of the invisible hand, is charity. The desire to give something of benefit to others, without demanding as much in return, is enormous. “Give and ye shall receive” is advice from the Bible. The giving may be in one form (money), and the receiving may be in another form (heavenly reward, which could be described as part of an overall "utility"). Look around, and you will notice numerous important charitable acts by others and yourself.
An immense advantage of charity is that it has no transaction costs. One person simply gives money, or goods, or services, to someone else (or to a church), and the recipient of the donation then uses it in the best way possible. A person giving $10 in a collection basket at church does not fill out any paperwork or require any commitments on how the church uses the donation. It is assumed that the church will use the money as best it can, perhaps even in an unexpected way during the following year. Pure charity is often purely efficient, with little waste in terms of transaction costs. Charitable transfers are not taxed either, so none of it is spent on harmful government programs.
America’s health care system, by far the greatest in the world, was built on a foundation of charity. People and religious organizations giving time, money and expertise to care for individuals who could never afford to pay all the costs. Education, too, was developed in this country largely through charity. In recent years, both health care and education have lost their charitable identities and been taken over in significant ways by the government, and the results of government involvement have not been positive. Costs have gone up and quality has gone down.
Most economics courses avoid charity entirely. When charity is mentioned, it is described as a minor add-on to the invisible hand of self-interest. But is this backwards? Is the invisible hand of self-interest actually a wrapper around a basic foundation of charity? These are thoughts to consider throughout this course.
The size and importance of charitable institutions in the world is immense. All religious institutions are charitable, as are nearly all private schools. Many hospitals are still charitable, including the Seventh-Day Adventist hospital in Hackettstown, New Jersey. On a trip to Orlando, I saw another Seventh-Day Adventist hospital there. Many religious organizations operate hospitals through the United States, just as they built most of our leading universities. Harvard, Yale, Princeton and Columbia, for example, were all built by charitable religious organizations.
The renowned Sloan-Kettering Cancer Center was built with the generosity of Alfred Sloan and Charles Kettering. They acquired wealth as senior executives of General Motors and ultimately donated their money to the cause of medicine. It has operated on a non-profit basis to this day.
The first private medical clinic in the United States was the Mayo Clinic, established by the Mayo family of physicians in 1889. Their sponsor was the Sisters of St. Francis, which built St. Mary’s Hospital in Rochester, Minnesota.
Likewise, the successful American colonies were initially more religious and charitable than commercial. Pennsylvania was founded on religious principles by the Quaker William Penn, who in turn established Philadelphia as the City of Brotherly Love. Within merely a few decades it grew to become the second most successful city in the British Empire, after London. Another successful city, Boston, was built on the religious values of Puritans.
It is primarily on the solid foundation of religious values and charity that the flower of free enterprise blossoms.
Read and, if necessary, reread the above lecture. Answer any six out of the following seven questions, and the extra credit question at the end can be answered by anyone (honors questions can also be completed):
1. A consumer's overall satisfaction is expressed in economics as his _________________.
2. Suppose you see a sleek-looking used sports car and you immediately want to buy it. You think to yourself, "I can paint that car and fix it up so it looks brand new!" You like it so much that you would very work hard for a year and save up $10,000 to buy it. You ask the owner how much he'd sell the car for, and he says $9,000. If you buy it for $9,000, then what is your "consumer surplus"? What does that concept mean?
3. Suppose your favorite hobbies are reading books and hiking, and imagine that they have the following values for marginal utility. The first hour that you hike gives you lots of utility: 10 units. But as you start to tire, you enjoy and benefit from it less. The next hour of hiking is worth only 8 units of utility (in other words, it has a marginal utility of 8 units rather than 10), and the next hour of hiking is worth only 5 units, and then 3, then 1, and then zero for the next hours, in that order. Your marginal utility for reading books does not decline so quickly. In the first hour, reading a book gives you utility of 6 units; the next hour is worth 5 units; the next hour is worth 4 units; and then 3, 2, 1 and 0. Suppose that you have 5 extra hours today. How should you spend those hours on hiking and reading in order to maximize your utility, and what will be your total utility for those 5 hours? Explain your answer.
4. Suppose you plan to buy a brand new car for $25,000. When you go to the car dealership to make your purchase, you notice that there is a car on the lot that looks brand new but no longer has the sticker price on it. The dealer says it was returned by someone after driving it only 500 miles. You like the color and ask if you can buy it. The dealer, seeing that you’re so interested, says he’ll sell it to you for the same price as a brand new car that has never been sold. You’re willing to buy it at full price, and do not mind one bit that someone else used it briefly and returned it. But you notice that other people (the “market”) would not pay full price for a returned car. Should you pay the price of a brand new car for this car that has been driven 500 miles? Explain.
5. Explain why the shape of an indifference curve for two goods that are perfect substitutes is a straight line going from the upper left down to the lower right. Extra credit: why must its slope be negative 1?
6. Describe either the "income effect" or the "substitution effect." Take your pick.
7. Charity is based on the foundation of a successful free market. Or is a successful free market based on a foundation of charity? Describe and explain which is the "cart", and which is the "horse" (in other words, which comes first or is most important, charity or the free market).
Write in about 300 of your own words on one or more of the following topics:
8. "A penny saved is a penny earned!" In fact, once taxation is taken into account, "a penny saved is almost two pennies earned!" Discuss one or both of these quotations.
9. Do you think a Giffen good really exists? Can you see any possible political bias in the claim that Giffen goods exist? Your views, please.
10. Prove the Law of Demand as simply as you can, perhaps using the assumption that the consumer always tries to maximize marginal utility.
11. Discuss the Irish Potato Famine between 1846 and 1849, and whether you think potatoes were an "inferior good" then.
Extra Credit for Anyone
- The Thirteenth Amendment to the U.S. Constitution, which was passed to ban slavery, generally prohibits compelling people to work.
- "There is no way to buy more potatoes when there are fewer potatoes. Thus, the Giffen legend concerning the great potato famine appears at best to be a misinterpretation of some observed but misunderstood phenomenon, and at worst a kind of hoax."
- Luke 12:25 (NIV).