Saturday, December 17, 2011

[Economy] Price and Demand

Most people think that, all other things equal, higher prices lead to lower demand. This is obviously wrong for goods which are bought because they cost a lot of money, like wine. But it can also be wrong for another kind of good.

Imagine you find yourself reborn very poor. With 6, when you first start to actually 'think', you find yourself alone, completely uneducated and with no possessions at all. Your picture of the world is massively lacking but you do understand your immediate surroundings. Somehow you manage to make a living.

Most of the time you buy the cheap but nutritious product A to survive. For example potatoes, or rice. Usually you also have a little bit of money left. This money you spend to buy the occasional product B. For example a fruit. It's not as nutritious per dollar but tastes better. Now imagine that the price of product A increases. What happens?

Let's assume that on average your body requires a few hundred calories per day, which is a pretty conservative assumption. But we are not talking about western-style living here. Before the price increase, on an average month, you satisfied this requirement by eating a lot of product A and a bit of product B.

But now, after the price of the cheap, but nutritious product A increased, you cannot buy the same amount of product A and product B anymore. What do you do? Well, you could continue to buy the same amount of product B every month, and just less of product A. But in that case you would starve to death. Consequently, you will continue to buy at least as much of product A as before. Which means that you cannot buy as much of product B.

But you would still starve to death. You require a specific amount of average calories per day and just scaling back on product B enough to consume the same of amount of product A as before would leave you short on calories. Your stomach strictly disagrees.

Product B might be tastier, but it is not as nutritious as product A per dollar. That's why you continue to scale back on product B to buy even more of product A than before the price increase. And thus a higher price has lead to more demand.
You might still die early because product B was necessary for your health in the medium-term. But at least you satisfied your calories-per-day requirement and didn't starve to death.

Such circumstances are difficult to find in reality - especially in this pure form. But the example shows that classic economic theory does rely on assumptions that aren't always correct. In the given situation the idea of 'competition' in 'free markets' for the 'greater good' is turned upside down; even (especially) if all actors are perfectly rational.


  1. The fact that classical economics relies on rational actors and perfect competition, in defiance to all available evidence to the contrary, is enough by itself to cast a pall over most conclusions.

    Growing up in a poor environment, I saw this irrationality every day. When you don't have money for entertainment or leisure activities, you typically get depressed, and then turn to those things which assuage depression: drugs, booze, cigarettes, etc. The money for those things usually comes out of your meager budget for food or "investments" (repair money for car, gas money), not to mention the deleterious effects on your long-term health. Essentially, a death spiral of even more crushing poverty.

    Humans aren't rational; our predisposition is towards short-term thinking, which served us well in the evolutionary sense. Supply/Demand (etc) "make sense," but your wine example is not the only one in which humans choose to do the exact opposite as the model suggests.

  2. First of all - current economic theory proven to be poor predictor of actual events. That much is certain. I'm sure behavioural economics will lead to much better models eventually.

    But, isn't this post a bit of strawman argument? As many things, price/demand curve works as long as you agree that initial assumptions apply. Model in "public mind" is greatly simplified, and assumptions are often lost. I'm fairly certain strict price/demand models say something along the lines of "assuming rational actors, and price being the only deciding factor", while you add additional factors here - total calorie intake as deciding factor, and limited one-person funds. Just looking at "price elasticity of demand" on wikipedia, you can get to , which is exactly the kind of good you're mentioning - and i'm sure there are many articles that explain how they work in rational market (oh, and "money as Giffen Good" that shows up in first results on Google is interesting line of thought too) :)

    Thus, attacking centuries-old theory that had all kinds of debates using simple mind experiments isn't practical - smart people who are sure theory is still right (and so, interested to defend it with confirmation bias) will find counterarguments easily :)

    If you're talking about attacking "public perception" of theory though, sure, this can work :)

    But it's probably easier to show that economic actors are irrational, work with imperfect information, and, lately, unable to consider even medium-term consequences of their actions.

  3. Shalcker, I don't want to prove that economics doesn't work. Of course it's not as good as we might want it to be, but it's still quite illuminating.

    Also, that humo economicus is a bad assumption is widely known and also accecpted by now. I think this example is interesting exactly because it does not rely on any 'irrationality'. At the very least it is important to understand that, given the right circumstances, it makes sense for a businessman to ask for a higher price. It does not reduce demand, but actually increases demand - in addition to the fact the he already makes more money per unit sold!

    In my last sentence I criticize classic economic theory for a reason. Nowadays economists (hopefully) don't work all that much with the classic theory. ;)

    But again, the important point here is that even if actors were 100% rational, higher prices can lead to higher demand. Which turns the entire 'competition' idea of free markets upside down.

  4. If there are any "Giffen Good" remaining that can survive huge price hike, i'm sure they are all government-controlled - either heavily subsidised, or having price ceilings set to prevent social unrest. :)

  5. Well, that depends on the giffen good, Shalcker. With rice and potatoes and in the developed/ing world I agree.

    But look at MMOs. We spend a certain amount of money to fill our free time with 'stuff'. Now imagine the price for playing MMOs increases, but is still extremely low per hour. In that case it might very well come to happen that people go less to the cinema and fill their free time with playing even more MMOs, because it's still much cheaper.

    I'm not saying that this necessarily works. I'm just saying that the 'giffen' effect is not necessarily restricted to potatoes and rice.

    And there's no irrationality here. The consumer acts 100% rational.

  6. Nils, I disagree (what else is new :)). What can also happen is that the person turns to product C. This product is cheaper than product A or B, tastes like crap but meets the daily calorie requirement. So the product mix gets more complex.

    Or since this is really a capitalist situation a company comes out with a third or even fourth alternative.

    Or being a human experiment there are additional options such as charity, handhouts (government or private) and of course crime. If the person is starving these alternatives will be explored.

    I know you said that your example was basic but being that simplistic means it can't be used in any predictive manner.

  7. It is a proof on concept, Goodmongo. A thought experiment. If even such a simple example can disqualify one of the cornerstones of classical economics - then what about more complex situations? Is it smart to assume that complexity always leads to what made sense at first glance?

    The main reason for this post was to make readers question economic laws that seem to make sense at first glance.

  8. The problem is the simple example does not disqualify the economic model. The assumption and premise of the thought experiment is incorrect and can't apply.

    You made the incorrect assumption that restricted means simple. You didn't use a simple example but instead used a restricted premise for the thought experiment.

    So therefore, the results could only apply in the same restricted environment.