Price theory : a policy-welfare approach 0136996949

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PRICE THEORY

a policy-welfare approach

RICHARD K. ARMEY North Texas State University

Prentice-Hall, Inc., Englewood Cliffs, New Jersey 07632

Library of Congress Cataloging in Publication Data Armey, Richard K (date)

Price theory. Includes bibliographies.

1. Microeconomics. I. Title. HB171.5.A69 338.5'21 76-27666 ISBN 0-13-699694-9

© 1977 by Prentice-Hall, Inc., Englewood Cliffs, New Jersey 07632

All rights reserved. No part of this book may be reproduced in any form or by any means without permission in writing from the publisher.

10

987654321

Printed in the United States of America

Prentice-Hall International, Inc., London Prentice-Hall of Australia Pty. Limited, Sydney Prentice-Hall of Canada, Ltd., Toronto Prentice-Hall of India Private Limited, New Delhi Prentice-Hall of Japan, Inc., Tokyo Prentice-Hall of Southeast Asia Pte. Ltd., Singapore Whitehall Books Limited, Wellington, New Zealand

Contents

Preface

xiii

PART 1 INTRODUCTION

Chapter 1 The Scope of Economics

3

Introduction, 3 Economics as a Social Science, 3 Individual versus Social Welfare, 5 The Individual and Institutions, 6 Human Welfare and Economic Welfare, 7 Scarcity and the Economic Problem, 9 Choice, 11 Economic Goals and Success Indicators, 11 Micro versus Macro Efficiency, 17 Prediction versus Explanation, 18 Summary, 19 Problems, 20 Suggestions for Further Reading, 20 VII

Chapter 2 The Methods of Economic Inquiry

21

Introduction: Economics as a Science and an Art, 21 Abstraction, 22 Partial versus General Equilibrium, 28 Pure Theory and Its Relation to Applied Economics, 29 The Question of Value Judgments, 30 Summary, 31 Problems, 32 Suggestions for Further Reading, 32

PART II CONSUMPTION Chapter 3 The Demand Function—How the Consumer Behaves

37

Introduction, 37 The Demand Function, 37 Individual and Market Demand, 54 Summary, 55 Problems, 56 Suggestions for Further Reading, 56

Chapter 4 The Theory of Choice: Utility and Indifference Curve Analysis

57

Introduction, 57 Choice, 57 An Ordinal Theory of Choice: The Indifference Curve Approach, 70 Summary, 82 Problems, 83 Suggestions for Further Reading, 84

Chapter 5 Indifference Curve Analysis of Demand

viii

85

Introduction, 85 Adjustment to Price Changes: Price-consumption Curves, 87 Adjustment to Income Changes: Income-consumption Curves, 95 Adjustment to Changes in Taste, 99

Real Income Implications of Price Changes, 101 Income and Substitution Effects, 103 Summary, 110 Problems, 110 Suggestions for Further Reading, 111 Appendix: Revealed Preference, 111

Chapter 6 The Theory of Choice and Public Policy Issues

118

Introduction, 118 Government Intervention, 118 Consumer Surplus and Project Analysis, 128 The Relative Efficiency of Income and Excise-type Taxes, 132 The Relative Efficiency of Specific Subsidy and Income Subsidy, 135 Efficiency and Equity in Rationing, 138 Summary, 142 Problems, 143 Suggestions for Further Reading, 144

Chapter 7 Exchange and Social Welfare

145

Introduction, 145 Exchange, Specialization, and Self-interest, 146 Pareto Nonoptimality and Social Redistribution, 157 Socially Defined Ethics and Optimality Revision, 159 Summary, 165 Problems, 166 Suggestions for Further Reading, 166 Appendix: The Existence of a Unique Pareto Optimality Configuration, 167

PART III PRODUCTION Chapter 8 An Introduction to Goods Supply

IX

175

Introduction: Entrepreneurship, 175 The Supply Function, 177 Opportunity Cost: Real and Pecuniary, 191 Private versus Social Costs of Production, 193

The Various Measures of Revenue, 194 Summary, 195 Problems, 196 Suggestions for Further Reading, 196 Chapter 9 Production and Cost: The Long Run

197

Introduction, 197 The Production Function, 199 Operating Revenues and Factor Costs: Isocost Curves, 211 The Long-run: Isoquants and Isocosts, 214 Factor Cost Changes and Factor Input Mix, 217 Long-run Return to Outlay and Long-run Average Total Cost, 220 Summary, 228 Problems, 228 Suggestions for Further Reading, 228 Chapter 10 Production and Cost: The Short Run

230

Introduction, 230 The Short-run Production Function, 231 The Short-run Production Function and Pecuniary Costs, 238 Summary, 244 Problems, 245 Suggestions for Further Reading, 246 Appendix: An Isoquant Illustration of the Short-run Production Function, 246 Chapter 11 Pricing and Output under Perfect Competition

252

Introduction, 252 Pricing and Output in the Market: Supply and Demand, 254 Short-run Output under Competitive Conditions, 260 Short-run Revenue, Output, and Employment, 266 Summary, 273 Problems, 274 Suggestions for Further Reading, 275 Chapter 12 Pricing and Output for Monopolies

276

Introduction, 276 Long-run Cost and Monopoly, 282 The Alleged Failures of Monopoly Markets, 284

Government Policies for Monopoly, 290 Summary, 299 Problems, 300 Suggestions for Further Reading, 301 Chapter 13 Imperfect Competition: Oligopoly and Monopolistic Competition

302

Introduction, 302 The Cartel, 306 Price Leadership: Fact or Fiction? 311 Oligopolistic Price Conformity: An Alternative Explanation, 316 Uncertainty and Kinked Oligopolistic Demand, 318 Monopolistic Competition: Imperfect Competition without Profits, 320 Public Policies for Imperfect Competition, 324 Summary, 325 Problems, 326 Suggestions for Further Reading, 326 Chapter 14 Factor Markets and Income Distribution Introduction, 327 Marginal Productivity Theory, 329 Income Redistribution, 339 Summary, 342 Problems, 343 Suggestions for Further Reading, 344

PART IV GENERAL EQUILIBRIUM Chapter 15 General Equilibrium and Welfare

347

Introduction, 347 The Model, 348 Production Efficiency, 351 Distributive Efficiency, 354 Social Optimality, 357 Summary, 361 Problems, 362 Suggestions for Further Reading, 362

XI

Index

363

327

Preface

This book is intended for use by the intermediate microeconomics student. It is to be hoped that the book will help the students develop an interest in the discipline that will carry them forward to continued study. The book is designed to help refine and develop the students’ conventional microeconomic orientation and to introduce them to modern welfare theory. The emphasis on modern welfare theory is designed to demonstrate the importance of microtheory to the understanding of public as well as private decision-makers. When approaching the intermediate microeconomics course either in the classroom or in writing a text, we must be both realistic and candid concerning the course’s role within the broader economics curriculum. The primary contribution of intermediate microeconomics is to the more directly applied courses in the field. Virtually every course or area of inquiry in the field of economics is immeasurably enhanced if it can be approached with microeconomic analytical techniques. This is particularly true of such courses as Public Finance, International Trade, Comparative Systems, and Economic Development where the analysis must necessarily deal with government policy. Intermediate microeconomics courses can provide significant back¬ ground and preparation for these applied courses if they introduce the student to modern welfare theory. The reason is that the applied courses, especially insofar as they deal with government policy, are courses in applied welfare economics. With that in mind, a substantial part of the book is devoted to the traditional task of teaching analytical tools and techniques while, at the same time, emphasizing their importance in applied fields. The importance

and usefulness of these tools will become apparent as their numerous applications in a variety of applied fields are illustrated. In addition to aiding the student in the essential task of learning analytical techniques for use in applied fields, the intermediate microtheory course presents an analysis that leads to both partial and general equilibrium conclusions. The recent thrust of microtheory has been to pursue these conclusions with deepening rigor and mathematically exacting exposition. It seems to many critics of microtheory that there is a decreasing awareness of its tenuous and provisional nature, which results in an unjustified dogmatism on the part of the microtheorist. This has contributed to an unfortunate and widespread lack of appreciation and enthusiasm for the subject. My ex¬ perience leads me to believe that these problems can be largely overcome by modern welfare theory and its emphasis on a positive analysis of normative government decision-making. When preparing a course or a text in microtheory, one must recognize that one cannot do everything, given the limited time and space available for the task. Consequently, decisions must be made with regard to the scope and rigor at which the course is to be presented. In that regard it is not uncommon to limit the scope and extend the level of rigor to higher mathematics. I do not follow that convention. I do not assume that students are incapable of understanding the substantive propositions of welfare theory or even the full scope of conventional theory and at the same time assume them capable of comprehending rigorous mathematics. On the contrary, my experience has convinced me that the typical student of intermediate theory has neither the mathematical training nor the commitment to purpose necessary to handle mathematically advanced techniques. On the other hand, I have discovered that, when pressed, students have the imagination and capacity for innovative thinking necessary to appreciate the discipline’s extensive scope. When they can see the meaning of it all, students generally respond with enthusiasm. I believe that once students understand and appreciate microtheory, they are capable of developing a sense of purpose and a desire to learn more that will serve them well as they pursue the subject at a more rigorous level in advanced courses. As a consequence of this belief, I offer a broad coverage of the held at a relatively low level of mathematical rigor. Where a more mathematically rigorous exposition is desired or thought required, it can bc-introduccd in the classroom, where it would most likely require attention in the first place. Moreover, mathematically trained students will have no trouble in finding any number of mathematically rigorous books where they can pursue the

xiv

subject. Given my belief, derived largely from experience, that intermediatelevel students are curious and imaginative, I have tried to present arguments that will encourage an “innovative mind set.” However, I must remind the student (and the instructor) that, by and large, what we have in micro¬ economics is a fairly satisfying but extremely provisional body of knowledge that we can and should constantly seek to improve. That being the case, we must continually question the arguments before us and search for ways in

which they can be made more complete and more satisfying. Students see through the maze of established wisdom to critical and exciting questions— when they are encouraged to be venturesome. I hope this book provides such encouragement. After all, asking good questions is essential to finding improved understanding. The fact remains that a novice can as often as not see the right question more quickly than those of us who have been properly schooled in “eternal verities.” Nobody writes a manuscript of this length by himself. To do so requires the support and assistance of many people. I am impressed with the generosity and forbearance of my colleagues, family, and friends as they suffered my preoccupation with this project and responded with encouragement and assistance. Such kindness shakes a price theorist, since our analysis is predicated upon an assumption that man is inherently selfish. Nevertheless, rather than let it shake my good theories I shall, hereafter, ignore—or discover ulterior motives for—such unselfishness. Some people were worse than others. They deserve to be identified. I am certain that Providence will deal severely with them for their transgressions. I must mention my friend, Tassos Malliaris from Loyola University in Chicago, who has read every page of the manuscript and has been extremely helpful with his penetrating criticism and fruitful suggestions. Also, Michael Ellis at The University of Central Arkansas has read a substantial portion and was especially helpful as I tried to rework isoquants to fit my version of technology. The helpful suggestions of Professor William Holshan, University of Wisconsin at Milwaukee, and Professor Frederick O. Goddard, University of Florida, are greatly appreciated. I would like to thank Robert M. Biggs for being an outstanding teacher and “turning me on” to economics. Thanks to James Hibdon for doing the same with price theory. Let me also thank Chen Sun and David Ramsett for keeping the fire burning. Of course, the typing was a big job and it was expertly handled by Mary C. Holten and Irene Streets. I must thank my students who always raised thoughtful questions and often challenged my “eternal verities.” In the end all the above must be absolved here of responsibility for any errors in substance or exposition. With the hope that there is more right than wrong, I accept full responsibility. Richard K. Armey North Texas State University

xv

part I

INTRODUCTION

Part I presents a two-chapter introduction. The object is to orient you to the book's purpose and style. Chapter 1 is designed to introduce you to the scope of economics. It begins by arguing that economics is a social science that must draw on the insights of other disciplines. The chapter proceeds to make the point that we must study the individual within social institu¬ tions. Economics must proceed from an understanding of the relationships between human and economic welfare, individual and social welfare, and individuals and their institutions. Scarcity is introduced as the fundamental economic problem that makes choice imperative. Finally, the chapter presents a summary of economic goals and success indicators. Chapter 2 is a survey of the methods used in economics. The essential point is that the practice of economics is an art as well as a science. Abstraction as a method is covered. At this level we must concentrate on learning analytical tools. Economic theory is a servant of applied economics In economic theory we are largely concerned with developing analytical techniques and methods to capture the essence of economic activity. In this way we can obtain fundamental insights concerning trends and tendencies that will help in the work of applied economics. The final discussion in Chapter 2 concerns the question of value judgments and economic analysis. Each of us must come to terms with that problem before we can continue.

chapter 1

The Scope of Economics

INTRODUCTION Economics in general and the special study of microeconomics in particular often seems confusing and pointless to students. It is not uncommon to find people who consider economics and economists to be totally incomprehen¬ sible. This attitude was reflected by George Bernard Shaw, an intimate friend of John Maynard Keynes, when he commented, “If all economists were laid end to end they would not reach a conclusion.” Microeconomics especially has a reputation for irrelevance and is often characterized as having “no relation to the real world.” This misconception must be corrected if we are to fully appreciate the contributions to human knowledge that are available through microeconomic analysis.

ECONOMICS AS A SOCIAL SCIENCE

o

Perhaps the best place to begin correcting false impressions of economic analysis and its worth is to point out that economics is but one of a large number of exciting and fruitful disciplines in a wider area of human knowl¬ edge—the social sciences. The social sciences are a collection of dis¬ ciplines that search for better understanding of human motivations and behavior. The social sciences collectively and interdependently study man in the ordinary business of life. The fundamental question of all social sciences concerns the manner in which people individually and collectively, through

4 INTRODUCTION

social institutions, seek to reconcile themselves and their environment to their inherent goal of achieving and maintaining the highest possible quality of life. Social scientists emphasize that people are social beings. They are interdependent. Consequently, they have historically formed social groupings and institutions to better fulfill their needs. These social groupings and institutions are as diversified and complex as human need. For that reason, it is necessary for the social sciences to employ “division of labor” in order to maximize productivity and insight into the many dimensions of human motivation and behavior. Economics represents only one area of study m this division. Economists must necessarily depend on complementary work in the areas of psychology, sociology, anthropology, political science, history, and many other disciplines and subdisciplines that are devoted to the study of human behavior. In addition, the economist, as well as other social scientists, must also be prepared to work with the knowledge and insight that derive from the efforts of scholars in the physical sciences and the humanities. This point was elegantly made by John Maynard Keynes when he said: The study of economics does not seem to require any specialized gifts of an unusually high order. Is it not, intellectually regarded, a very easy subject compared with the higher branches of philosophy and pure science? Yet good, or even competent, economists are the rarest of birds. An easy subject, at which few excel! The paradox finds its explanation perhaps in that the master-economist must possess a rare combination of gifts. He must reach a high standard in several different directions and must combine talents not often found together. He must be mathematician, historian, statesman, philosopher—in some degree. He must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of man's nature or his institutions must lie entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood; as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.1 In the social sciences it is often necessary to begin with axiomatic propositions. We have already stated one—that people are social beings. This proposition seems to be reasonably well confirmed by observation. We have further implied a second axiomatic proposition concerning people—that they have an inherent goal of achieving and maintaining the highest possible quality of life. This, too, seems a reasonable proposition which can be fairly well confirmed by observation. Yet history seems to be dramatically marked by human behavior that seems to contradict this proposition. One can easily cite examples of such inconsistent behavior, e.g., war, conquest, and waste. How can this be reconciled with the above-mentioned “axiomatic” proposi¬ tion? The answer can be found in understanding the social nature of humans.

1 John Maynard Keynes, “Alfred Marshall,” Essays in Biography (New York: W. W. Norton, 1963), p. 140. Reprinted by permission.

5 The Scope Economics

of

Human needs are complex. We have many needs that must be fulfilled if we are to enjoy the good life. We are also social beings. Social beings group themselves into social institutions separately and collectively. Interdependence has two sides to it; one side is competitive and the other is complementary. The two sides of interdependence relate to two types of behavior. Comple¬ mentary interdependence relates to socially conscious behavior. Competitive interdependence relates to selfish behavior. There is a natural conflict here, and social institutions are the instruments for conflict resolution. The discipline of economics is predicated on the axiomatic assertion that people are inherently selfish. Altruism, on the other hand, is socially or religiously inspired behavior. People are selfish. They are chauvinistic. They seek a high quality of life for themselves and their immediate family, state, and nation before others. The universal fact of scarcity provides an incentive for people to attempt to directly enhance their immediate welfare, even at the expense of others. Scarcity, then, is the villain. There are not enough resources, time, energy, labor, capital, etc., to go around so that we may have all we want of everything we want. Scarcity makes it necessary for us to choose between alternative courses of action, and these choices do not always seem consistent with maximum human welfare. Scarcity makes it necessary for us to establish priorities. Individuals and social groups must decide if they wish to pursue selfish action contributing directly to their personal welfare at the expense of others, or more altruistic action founded in a faith that they will ultimately be best served individually by first serving the collective needs of society. Throughout history we seem to have had an overwhelming record of placing high and immediate priority on private needs. Thus we often find private individual behavior that conflicts with social welfare.

INDIVIDUAL VERSUS SOCIAL WELFARE Understanding the relationship that exists between individual and social welfare is strategic to understanding the scope and relevance of microeconomic theory. Students should clearly understand that microeconomic theory, like all economic theory, is concerned with social welfare. That this is not always obvious derives largely from the fact that microeconomics spends most of its analytical efforts examining individuals in the quest of individual welfare. Of course, this is necessary, since individuals, even within social groups, are self-centered. Nevertheless, the student must realize that the social scientist’s objective is to better understand the relationship between individual and social welfare. This relationship is also interdependent. Consequently, we cannot assume that an independent maximization of individual welfare will, upon summation, be equal to maximum social welfare. This was a major mistake of early classical economists. On the other hand, just as society is comprised of individuals, social welfare is comprised

6

of individuals’ welfare, so a relationship necessarily exists between them.

introduction

Nevertheless, the two are separate and different. The social scientist must recognize that individuals have significant scope for private action within which they seek to maximize their personal and private quality of life. At the same time, the individual’s welfare is dependent upon the action of others around him. Separate individual actions are often in conflict. There is, therefore, a need for social institutions to guide and direct individual actions to the mutual benefit and protection of the social group. Social institutions are the guardians of social welfare. Through these institutions communities regulate selfish individual behavior for the protection of society. They also collectively provide social goods and services that individuals cannot or will not provide. The social scientist must under¬ stand the behavior of individuals when selfishly working for themselves and as social agents working for the common good. Ultimately, the social scientist must be concerned with social welfare. Time and effort devoted to study of the individual are necessary to this concern, but it is not an end unto itself.

THE INDIVIDUAL AND INSTITUTIONS One of the most interesting issues in the humanities and the social sciences is the relationship between the individual and social institutions. Social institutions include not only material institutions such as government, church, and social organizations but also cultural mores and social-ethical systems. The issue is the extent to which individuals are free to make choices concerning their own destiny. On one hand, there is a school of thought that says that each person controls his own destiny. On the other hand, there is a school that claims just the contrary—that the individual is so dominated by institutions that he has, in effect, no choice over his behavior. Neither position is completely right, nor is either completely wrong. As in most cases, the truth lies somewhere in the middle. If one takes an eclectic view of the matter he will quickly see that individuals are members of institutions and that the acceptance of member¬ ship requires the acceptance of institutional constraints to behavior and choice. However, our freedom of choice extends to the institutions we choose to join. For example, we are free to join a church, but if we do we must accept that our membership involves new demands and constraints on our behavior. We must profess certain beliefs and participate in certain ways in the life of the church. We must abstain from certain types of behavior or give up our membership in the church. The point is that though we are free to choose what institutions we will join or accept, we must accept the institu¬ tional constraints to our behavior that go along. But we do have a choice. This is also true with regard to social conventions. We can choose to be married or to live outside of wedlock. If we choose to accept the moralethical-religious institution of marriage, we also accept constraints to our behavior that no longer allow us to live out of wedlock. One often hears the

7

argument that “social conditioning” leaves us no choice in such matters. That

The Scope Economics

Of

is not so. “Social conditioning,” as it is called, is the community’s way of informing us of its behavioral norms and of the costs of choosing not to live within those norms. Nevertheless, the choice is left to the individual. Remember that choices always involve alternatives that have costs and benefits attached to them. Social institutions define the costs and benefits. There are never “free choices” in the sense that costs do not exist. However, the existence of cost does not mean that the individual has no choice. If you join institutions and accept social standards for behavior, it is because you believe the benefits of membership outweigh the newly accepted parameters to choice. If you do not believe that, do not choose to join. Given that understanding of the relationship between the individual and institutions, we can quite rightly direct our attention to individual choice and behavior. That is not to say that we can ignore institutions and the impact they have on individuals. However, we must remember that institutions are man-made and their continued existence is dependent upon their continued acceptance. We observe that institutions change. They are modified, both as physical institutions and as social conventions, to conform to standards of individual acceptance in order that they might survive. It is true that institutions tend to resist modification, but it does take place. It would seem that if the institutions were in command, the modification and even demise of institutions would not take place. In the end, we accept institutions and even institutional influence on individual behavior. This is of little consequence to us. It must be understood and it is easily understood, but it does not change the fact that individual behavior derives from individual choice. If you observe that people do not understand their freedoms and their choices and allow themselves to be manipulated by institutions, I can only say I doubt that you are correct. The more accurate observation would be that people tend to conform to accepted social conventions because it is the least costly course of action, given their complete hierarchy of needs. That is rational, free choice as it necessarily exists within an institutional framework.

HUMAN WELFARE AND ECONOMIC WELFARE So far we have progressed from a discussion of individuals pursuing a rather ambiguous notion of the highest possible quality of life to a discussion of individual and social welfare. These terms are not yet clearly defined. Social scientists have discovered that in the quest for the good life we perceive needs that must be fulfilled. These needs are highly diversified and interdependent. Human welfare derives from the fulfillment of these needs and is the substance of the “good life.” The quality of life (welfare) is higher when more needs are fulfilled rather than fewer. When we discuss the search for a higher level of welfare, we observe the pursuit of need fulfillment. Now let us turn our attention to an examination of human needs.

8 INTRODUCTION

An examination of human needs is social-psychological analysis rather than economic analysis. Yet it is the stuff with which economics is ultimately concerned. Therefore, it is necessary to turn to the work of a social psychol¬ ogist for insight into this question. Abraham Maslow is a convenient choice. Maslow is credited with having developed a comprehensive understanding of human needs and their impact on human motivation. He presents a compre¬ hensive list and ranking of needs according to their relative importance under various circumstances. This ordering of needs has come to be known as Maslow’s “hierarchy of needs,” and it represents the manner of priorities established by Western man as he progresses in the satisfaction of needs. Although the list is comprehensive, it is not meant to be exhaustive; nor is the ordering meant to be fixed and infallible. The following discussion summarizes Maslow’s hierarchy of needs.3 The most basic needs are physiological. These are the “survival’ needs, which center around homeostasis and appetites. The need for food and drink is basic and, according to Maslow, must be satisfied to some extent at least before attention can be given to other needs. The second-order needs are the safety needs. These are human needs for security, stability, and dependency. The hierarchy proceeds from safety needs to the higher-order needs—for love and a sense of belonging. At this point the needs begin to be more social and less physiological; they also begin to be less material and more psycho¬ logical. The next order needs are the esteem needs. Individuals want to be liked and respected by others. Finally, after all these needs are fulfilled, there remains one other. That is the need for self-actualization. The individual must feel satisfied that he is doing what he enjoys and is best suited for. Of course, this is just a bare sketch of Maslow’s work. There is no pretense made here to do justice to Maslow with respect to details or insight. Nevertheless, this does serve as a good example of the manner in which the information and insight of one discipline provides background information for another. Maslow presents a comprehensive list of needs, but it is more than that. Each of these needs has a material and a social-psychological side. Each need gives the individual motivation to action. Certain types of behavior are required for the fulfillment of these needs. That behavior can be broadly characterized as economic, social-psychological, political, and so on. It is from these distinct but interdependent types of behavior that the separate disciplines in the social sciences are evolved. Economics concerns itself with the manner in which we seek to fulfill our needs through commercial behavior. From Maslow we deduce that there is a set, which we can call “human welfare,” which is comprised of the myriad needs that, when fulfilled, provide us with comfort and happiness. The instruments by which these needs are fulfilled can be called “goods.” Goods may be material or they may not, but they must always have the property of fulfilling a need. That takes us 2 Abraham H. Maslow, Motivation and Personality, 2nd ed. (New York: Harper and Row, 1970). 3 Ibid., pp. 51-53.

9 The Scope of Economics

to the subject matter of economics. Economics is the study of people in the production, distribution, and consumption of goods. In economics we seek to understand the basis on which people, through their private and social efforts, manage their scarce resources for the maximum satisfaction of their individual and collective needs. It is customary within the discipline of economics to speak of “economic welfare” rather than human welfare. Nevertheless, we must keep in mind that economic welfare is a specific, largely material, subset of phenomena within the larger set of phenomena already described as human welfare. The economics student should keep in mind that an increase in economic welfare does not always result in an automatic increase in human welfare, but that there may even be decreases. For example, it may be possible for one to increase his economic welfare less than he decreases his spiritual welfare by withholding his tithe from the collection plate. In such a case, his human welfare would be diminished by withholding the tithe. Also, we must keep in mind that there are both social economic welfare and private economic welfare, and that one is not always consistent with the other. An example should be helpful here. Perhaps the best example is the 1970 decision concerning federal subsidies to production of the supersonic transport (SST). The economic benefits of production were outlined by interests that favored production. These included increased gross national product, national income, and employment, as well as increased advantages over foreign producers. There seemed to be little doubt that the economic welfare of the community of Seattle in particular but the United States in general would be increased by production—as economic welfare was conventionally understood at that time. On the other hand, the opponents of the project argued that human welfare would be diminished by production and use of the SST. The increased transportation capacity, it was argued, was not needed; real resources needed for its production could better be used elsewhere. Furthermore, it was argued, the SST would result in excessive noise and air pollution that would be detrimental to the nation’s human welfare. Congress weighed the arguments and voted ‘ No. In essence, the decision was that the decrease in human welfare would be greater than the increase in economic welfare if the project were continued. Furthermore, the economic benefits would more specifically accrue to a relatively few individuals, whereas the harmful effects would more pervasively affect society at large. Thus, the potential increase in individual welfare was judged to be less than the potential decrease in social welfare.

SCARCITY AND THE ECONOMIC PROBLEM As was indicated above, it is the fact of scarcity that makes economics and economizing necessary. Scarcity is the ultimate fact of economic life. Scarcity requires us to choose between alternatives and to establish priorities. There is no known limit to our needs and hence our wants. There is, furthermore,

10 INTRODUCTION

no known limit to the numbers and types of goods that we will devise for satisfying these needs and fulfilling these wants. On the other hand, resources and natural wealth are limited in terms of both material balances and technological capabilities for transformation of resources into goods. This is particularly true if we take a futuristic look at life and concern ourselves with the length of time into the future we humans might survive on this globe. The fact of scarcity makes it necessary for humanity to establish priorities among needs, as well as the extent to which we want to maximize fulfillment in the present rather than to save for the future. A word of caution is in order here, because a short-sighted view of resource needs can easily give the illusion that scarcity does not in fact exist. To avoid that not uncommon error it is necessary to examine the question of scarcity in more complete detail and to recognize the difference between a short-term and a long-term view of the matter. Scarcity derives from two limitations. The first is the physical state of materials and material balances available on the globe, and the second is the state of the technological arts. If one takes a short-term view of resource supplies, the most limiting factor is the technological state of production. Technology can enrich resource supplies and increase productivity. This is done through the discovery of new and better ways to produce, thus enabling man to get more goods output per unit of input, and by the discovery of new uses and synthetics for scarce resources. It is not difficult to take a short¬ sighted view of the matter and to put too much faith in technology. It is easy then to conclude that we are not truly limited by physical resource quantities. It is an easy matter then to believe that when shortages occur, we will always find other ways to meet our needs; Mother Invention will always come to our aid, and technology will save the day. Insofar as we have a concern for the future, this is a pernicious view. Such an understanding of scarcity suggests that economy and conservation are not imperative. The sense of the viewpoint varies inversely with the level of concern one has for posterity, but it does not seem reasonable to ignore it completely or even to consider it only within our immediately existing time perspective. In short, if we dismiss long-term concerns with, “In the long run we are all dead,” we will be. A more long-term view of scarcity is one that has a high regard for posterity. That is the view that is taken by this text. Such a view suggests that if humans are to be a success on this globe we will achieve the highest possible quality of life and sustain it for as far into the future as the limits of posterity will allow. In such a case, scarcity derives ultimately from the physical resources on the globe and our ability to economize and conserve these supplies for the future. Naturally, our technological abilities to enhance resources and productivity levels ought to be taken into account, but at the same time we cannot afford to waste or squander our natural wealth. This view makes it necessary for us to consider the relative priority of future resource needs as compared to current needs. Acceptance of this long-term interpretation of scarcity makes it imperative for us to conduct our economic activity in the most rational

11 Economics

(rationing) and conservative manner possible. In short, it forces us to be efficient in our use of resources. Efficient resource use depends upon a constrained choice of the needs to be fulfilled, as well as the extent to which they will be fulfilled, and the employment of technology in order to obtain the highest level of goods output at the lowest level of resource input. The need to use resources efficiently further requires us to make intertemporal choices. We must conduct our activities in the present with a watchful eye toward the impact of current resource use on future resource supplies relative to future needs.

CHOICE The economic problem then is the problem of choice. The fundamental fact of scarcity forces us to make choices. We cannot have everything. We must decide what will be produced, how it will be produced, and for whom it will be produced. Our choices must be made by a combination of individual and social institutions seeking compromise between individual and social welfare and between the present and the future. To the end of maximum social welfare both now and in the future, resources must be rationally allocated, goods must be produced, and they must be distributed. This requires a millionfold decisions every day. It is our task to learn how these decisions are made by individuals seeking their selfish private welfare and how all that selfishness is reconciled by social institutions to serve the social welfare. The predominant social institutions are the market and governments. These are the invisible and visible hands that intervene in private affairs for the good of society. The market and the government are the stuff that economic systems are made of and the arena in which individual choices are made.

ECONOMIC GOALS AND SUCCESS INDICATORS To this point we have established that economics is just one of many disciplines concerned with people in the quest of the good life. We have briefly examined the myriad needs that must be fulfilled in order to achieve a high quality of life and maximize welfare within the context of social existence. Certain of these needs relate specifically to our ability to produce goods. We have further seen that humans are social beings and that they, therefore, form social groups within which they seek collectively to fulfill their needs. One such group is called an economy. An economy usually coexists with a political group and represents a community of individuals striving to fulfill individual and collective needs. The goal is the good life. • Let us now consider the basis by which we might measure success in fulfilling economic goals. These success indicators can also be considered more immediate subgoals of the economy. They are interdependent and

12 INTRODUCTION

subservient to the larger goal stated above—to achieve a maximum quality of life. None of these subgoals is ultimate. Each of the following is to some extent competitive with the others, and relative priorities must be attached to them. These priorities are established in consideration of physical, ethical, religious, and other noneconomic parameters. It turns out that scarcity is so pervasive that there are no free choices, even among goals. In all cases the best that can be hoped for is a constrained choice, where the goals given up are the cost of those chosen. On the other hand, a constrained choice is not the same as no choice at all. In a very important piece of work, Bela A. Balassa presents five success criteria by which we can evaluate economic systems.4 The following discussion is adapted from that work. Balassa suggests the following success indicators: (1) static efficiency, (2) dynamic efficiency, (3) growth, (4) consumer satisfaction, and (5) income distribution. Any economy that manages to strike a reasonable balance between these five success indicators should be judged to be successful. The question is, what is a reasonable balance? The answer depends on many things: the political, ethical, and social value structure of the society in question; the natural resource endow¬ ment; the state of technology and subsequent levels of productivity; and the economy’s development stage. When these conditions change, the relative importance of the alternative success indicators also change. Furthermore, when these success indicators are employed to compare different economic systems, they must be employed with a frank and open awareness of differences with respect to the above-mentioned circumstances. Much of the confusion that surrounds economics stems from a less-than-full awareness of each of these indicators taken separately and the manner in which they relate to one another. It is important, therefore, that the student begin his study of economics with a careful discussion of these strategic concepts.

Static Efficiency in Resource Allocation According to Balassa, “Static efficiency may be defined as production conforming to the preferences of the community when there is no possibility of increasing the production of one commodity without reducing the production of another.”5 This means that the economic system is achieving the most efficient allocation of its scarce resources among alternative goods that are most highly desired by the community. Static efficient resource allocation involves three conditions. First, each resource must be employed in its most productive alternative use. The contribution to total welfare that derives from a unit of production cannot be increased by transferring that

4 Bela A. Balassa, “Success Criteria for Economic Systems,” The Hungarian Experience in Economic Planning (New Haven, Conn.: Yale University Press, 1959), pp. 4-24. 5 Ibid., p. 5.

13 The Scope of Economics

unit from its present employment to some other employment. There are many implications to this condition that will be examined in detail throughout this course. The second condition of static efficiency is full employment of productive factors. For this condition to be fulfilled there must be a full employment of all factors, whether they be land, labor, or capital. Furthermore, each unit of each factor must meet the first condition of static efficiency, namely, that it be employed in its most productive alternative use. That condition is known in the discipline as “allocative efficiency.” It is curious that contemporary American macroeconomists have, by and large, adopted the politically expedient interpretation of full employment that suggests only a full employ¬ ment of the labor force. On the contrary, if there is full employment of the labor force while at the same time there is less than full employment of other factors, i.e., land and capital, there isprima facie evidence of static inefficiency. The third condition of static efficiency is that the final product must conform to the community’s tastes and preferences. That is, whatever is produced must truly be an economic good. It must truly satisfy a need, either physical or psychological. It is at this point that the contemporary American economy comes under heavy attack from many of its critics, e.g., John Kenneth Galbraith.6 These critics question the process by which what goods are produced is decided in America today. As you will see, I do not agree with this criticism. This represents an interesting controversy and is one that will be examined in greater detail later.

Growth Rate of National Output A second success indicator for an economic system is the growth rate of national output. This indicator has historically received high priority in all economic systems. In fact, it often appears as though this is the sole success indicator. The common predisposition is that more is always better than less. Of course, this is a difficult proposition to criticize, but it has limits. Obviously, low-income nations must place a high priority on growth. On the other hand, it seems likely that there is a point at which a nation, though it ought not to ignore the goal of growth, ought to attach a lower relative priority to that goal as opposed to others. There are many economists today who argue for such a change of priorities for the American economy. This text shares that bias. It seems that the United States has today achieved sufficient affluence that we may now turn our attention more toward allocative efficiency to maintain our affluence in the future and to a more equitable distribution for all persons concerned. Contrary to popular opinion, growth is not imperative. Growth in goods output requires increasingly heavier demands on natural resource endowments. A long-term view of scarcity suggests that there may be a limit to resource use that is tenable through time. It is possible that we are fast approaching that limit. 6 John Kenneth Galbraith, The Affluent Society (Boston: Houghton Mifflin Co., 1958).

14

Dynamic Efficiency

INTRODUCTION

Dynamic efficiency, according to Balassa, is a judgment of the hypothetical growth rate achievable by two alternative systems under conditions of identical resource use and savings ratios. This criterion is an almost purely academic success indicator that seems to be useful only in making a speculative guess concerning the relative worth of two alternative economic systems. On the other hand, the notion can be useful in comparing an economy’s actual performance with its potential. When one judges how successful or efficient a system is in practice, one ought to make a comparison with how successful and efficient the system might be if it fulfilled its complete potential. Another interpretation of dynamic efficiency might be as a measure of the economy’s success in achieving growth while at the same time it manages a fairly high level of static efficiency. To forsake one for the other is inefficient in either case. A compromise must be reached between growth and static efficiency. The notion of dynamic efficiency might be a test of the compromise. A brief review of the economic history of the United States provides a good example of this interpretation of dynamic efficiency. To begin with, to properly understand the uniqueness of the American experience one must understand the broader conditions of our nation’s history. Here was a nation of entrepreneurially talented people born in the height of the industrial revolution and with a resource richness unparalled in the history of the world. Furthermore, the dominant Protestant religion and the democratic political beliefs were peculiarly suited to rapid and grandly successful economic growth and development. Needless to say, the American experience is unrivaled. Americans put a priority on growth and development and achieved that goal with astonishing success. We Americans are quite rightly proud of our success, but in recent years our enthusiasm has diminished as we have observed long-term effects on our resource reserves from our historic static inefficiency. Our economic system was predicated on the mistaken belief that we did not suffer the rigors of scarcity. Even in recent years, when we turned our attention to the Keynesian world of full employment, stable prices, and growth, we had an economic system predicated on the tacit assumption of boundless resources. As a consequence, we have had a rather dismal record of static inefficiency, and we are just now beginning to feel the impact of that historic waste. That is not to say that our historic goal priorities were not right for their time. They may well have been appropriate. But conditions change, and as they do, priorities and policies must change. That is an especially important part of the current American dilemma. The time has come when we must place a high priority on static efficiency. Our historical experience has not been in this arena, and we are, therefore, having difficulty in making adjustments.

15

Consumer Satisfaction

The Scope of Economics

.

A fourth economic success indicator is consumer satisfaction. This is an important criterion, since consumer welfare is what economics is all about. If the economy is to be a success, whatever it produces must satisfy the needs and preferences of the consumer. This criterion is also often confused. There is in economics a historic doctrine of consumer sovereignty. This doctrine has been variously interpreted by economists. Three of the most popular interpretations are (1) that the consumer ought to be the sole determiner of what ought to be produced in the economy, before the fact and with complete respect to product specifications; (2) that the consumer ought to receive the highest possible range from which to exercise his choices and thus to decide what is not to be produced through rejection in the marketplace; (3) that the ultimate end of all economic activity is consumption and the welfare of the household sector. The first of the above interpretations should be rejected as a straw man that has meaning only within the context of crank criticism. Obviously, such an interpretation of consumer sovereignty is incompatible with the processes of high mass production. Adherence to such a proposal would automatically restrain the economy to low levels of output. The other two interpretations are more realistic and perfectly consistent with the ultimate goals of an economy. At this point, it is important to realize that the choices made available to the household sector must include both private and public goods. Private goods are those that consumers purchase directly from the market for their exclusive use. Public goods are purchased on behalf of consumers by public bodies for general use. Each fulfills a set of needs, and each is vital to the household sector’s welfare. At the same time, individual tastes and preferences are varied, and a wide range of choice is crucial if each individual consumer is to enjoy the optimum ability to maximize his particular welfare. On the other hand, this range of choice is constrained by scarcity. One important technique employed by modern economic systems to lessen the rigors of scarcity is high mass production on the basis of product uniformity and interchangeable parts. To exploit this potential it is imperative that business, on the basis of market analysis, guess what the consumer might like if offered at a reasonable price and then produce that good, extol its virtues, and allow the consumer to accept or reject it in the marketplace. The range of consumer choice is seriously affected by the economy’s wealth and productivity. As economies become more developed and more affluent, the range of choice inevitably becomes greater and the chances for consumer satisfaction more enhanced.

Income Distribution The fifth success indicator is income distribution. This is largely a moral issue. In a system of private property and private enterprise, income

&

16 INTRODUCTION

distribution is strategically tied to the distribution of rights and privileges, and resource allocation. In such a system those persons who control resources and skills that are most productive in providing highly prized goods will receive the highest relative shares of the nation’s dividend. This system can be quite callous to the unpropertied and unproductive. A popular alternative advanced by Marxism is the more egalitarian formula which prescribes that the economic system ought to take from each individual in accordance with his ability to contribute and give to each in accordance with his needs. This is a more altruistic approach but one that may present problems with respect to motivation and initiative. The two alternatives for income distribution outlined above represent a choice between one that seems callous and one that seems impractical, given the selfish nature of man. In the end, the economic community must reconcile the issue of income distribution on the basis of social choice concerning equity. This is largely a moral and ethical choice tempered by the hard reality that maximum productive effort depends to a considerable extent upon rewards and incentives. The arena for decision-making with respect to this issue is the political arena. The government exercises its prerogatives here through defining, assigning, and enforcing personal and property rights. The economist is a good judge of efficiency considerations related to this issue, but he has no special expertise. He has no expertise from which to issue categorical imperatives. Although this is a critical issue of social w'elfare, it is an issue that is not amenable to hard scientific analysis. In the end the efficiency test for income distribution is the extent to which the general public is happy with the prevailing distribution and/or attempts at redistri¬ bution. Happiness, like welfare, is not an empirically measurable commodity. In the end, reason and common sense must prevail. The five success indicators discussed above must be kept in proper perspective. They do not represent the ultimate goal of the economy. That is something which is far more abstract—the attainment of the highest possible quality of life. However, it is impossible to measure the quality of life and all that it entails, e.g., levels of happiness and welfare. Consequently, the economist must resort to measurement by proxies. We must proceed from an assertion that if the economic system takes the wealth available to it and utilizes it with efficiency and equity it will do all that is within its power to attain the good life. The first four of the above success indicators are measures of efficiency and are thus subject to scientific analysis. This text will present an analysis of optimum conditions for allocative efficiency in production and consump¬ tion. It will further demonstrate some of the basis on which alternative market structures can be judged for efficiency. The fifth success indicator is a measure of equity. This text will introduce the student to some basis by which he may make analyses of equity issues. It will also suggest some basis on which equity decisions can be made at least quasi-objectively. In the end the text will have provided the student with a basis for judging the efficiency of

an economic system in fulfilling the good life, but the final judgment will ultimately rest with the discretion of each individual student.

MICRO VERSUS MACRO EFFICIENCY We have suggested that the social scientist is concerned with humanity in the quest of the highest possible quality of life and that economics is a particular discipline within the social sciences concerned with the production, distribu¬ tion, and consumption of goods necessary for the good life. Economics is the study of scarcity and the consequent need for making choices. Particularly, economics is the study of the conditions of economic welfare and the behavior of people as they seek to attain those conditions. There are two techniques by which the economists might attack their problems. The economist can use the microeconomic approach, which is working from the particular to the general. Economists might otherwise use the macroeconomic approach, which is working from the general to the particular. Each has merit, and each requires some awareness of the other. Both of the two approaches contribute a peculiar kind of insight into economics. We are ultimately concerned with the attainment of efficiency and equity for the economic system as a whole. It seems reasonable to contend that the economy as a whole, the macroeconomy, cannot truly achieve optimum conditions of efficiency and equity unless each of the separate but interdependent parts, the microeconomy, has managed individual optimum

17

relative to each of the other separate parts. Microeconomic analysis seeks to understand efficiency conditions for individual parts and the manner in which choices concerning resource use and goods consumption are made by individuals, firms, and industries. To that end, microeconomic analysis divides the economy into separate markets and examines how each market finds its unique solution subject to constraints imposed upon it by all other individual markets. Microeconomics recognizes interdependent relationships, both competitive and complementary, between micromarkets. The technique is to examine these conditions in microscopic detail as individual circumstances and then to seek a more general under¬ standing of the whole economic system from an investigation of how these individual parts are integrated into the whole. Put within the context of Balassa’s five success criteria, the approach requires a more careful examina¬ tion of static efficiency rather than dynamic efficiency or growth. Macroeconomic analysis begins at the other end of the spectrum. It involves a more direct look at the overall performance of the economic system. To that end it tends to tie performance to the more macroeconomic efficiency criteria such as growth and full employment. Modern macroeconomic analysis implicitly accepts that the economic system cannot completely fulfill the conditions of microeconomic efficiency and that the

18 INTRODUCTION

best that can be hoped for is that it come reasonably close to the mark. The test of the closeness is implied from the extent to which the macroefficiency conditions are met. Modern macroeconomics derives from the work of the great English economist, John Maynard Keynes.7 It is primarily concerned with the manner in which income levels are adjusted in order to fulfill the broad goals of full employment, stable price levels, and growth. Microeconomics, on the other hand, is more concerned with relative prices and the impact of price changes directly on resource allocation. John Maynard Keynes provided us with modern macroeconomic analysis during the depths of the Great Depression. His objective was to demonstrate techniques by which the government could enact policies that would sustain macroeconomic stability specifically with respect to full employment, growth, and stable prices. Since this analysis related so closely with contemporary political goals, it came to dominate. For the past forty years macroeconomics has been considered exciting and relevant, while microeconomics has seemed to many to be irrelevant and academic. That is now beginning to change. We have had great successes in the employment of Keynesian macroeconomic policies even to the extent that we are now fairly well in control of cyclical macroeconomic instability. As a consequence of this success we have managed, particularly in the United States, to reach a level of affluence where we can now afford to turn our attention to less well-understood problems such as pollution control, conservative resource use, and more equitable income distribution. These important problems are not as amenable to macroanalysis as to microanalysis. Consequently, we are now once again seeing an increased awareness of the relative importance of microeconomics, even as it contributes to a more complete understanding of macroeconomics.

PREDICTION VERSUS EXPLANATION Most economists perform in two different roles. They must be careful not to mix them. On one hand we are professional economists involved with discovery and prediction. In that capacity we work, as Professor Samuelson so aptly put it, “for the only coin worth having—our own applause.”8 As professional economists we are interested in developing and applying techniques that will help us predict future behavior. We want to see what will happen if certain policies are or are not implemented. The work is important and difficult, and it requires a certain sobriety and rigor. On the other hand, most of us spend most of our time in the classroom

7 John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt, Brace, and World, 1936). 8 Quoted in William Breit and Roger L. Ransom, The Academic Scribblers (New York: Holt, Rinehart, Winston, 1971), p. 111.

19 The Scope of Economics

as educators. Our objectives in that role are considerably different from our professional objectives outlined above. In the classroom we are concerned with explaining past behavior. Our objective is to help the student better understand how and why things happen and why people behave as they do. In addition, and equally important, our educational role requires us to instruct you in the tools and techniques of economic analysis in order that you too may be prepared someday to perform as professionals, or at least to understand what economists are up to. Even though our educational role is equally important with our professional role, it is one in which we can employ a more relaxed style. There should be no reason why we cannot enjoy ourselves as we learn these tools and techniques. A text is written for the educational role, and therefore it can take time out for some fun now and then. So relax and let us enjoy ourselves.

SUMMARY Economics is one of many social sciences. It is crucially dependent upon other disciplines in the social sciences, humanities, and natural sciences. Economics is particularly concerned with human motivation and behavior in the production, distribution, and consumption of goods. As such, it must understand the relationships between economic and human welfare, between individual and social welfare, and between individuals and institutions. The study of economics proceeds by recognizing the broad variance of human needs and extends to an understanding of how those needs motivate us to produce goods. Goods are defined as anything that has the ability to satisfy a need. There is a wide disparity between needs and our ability to satisfy them. We call that disparity scarcity. Decreases in scarcity can derive only by closing the gap between needs and the ability to satisfy them. That can be done either by decreasing the former or increasing the latter. In any event, scarcity is inevitable. The omnipresence of scarcity requires us to make choices and to establish priorities, both individually and collectively. Economics is largely the study of constrained choice with considerable focus on the source and nature of those constraints. The objective of economic activity is the attainment of a high standard of living. There are five strategic success indicators by which we are able to judge the effectiveness of an economic community. They are static efficiency, dynamic efficiency, growth, consumer satisfaction, and income distribution. Like all things, the omnipresence of scarcity requires choice and the establish¬ ment of priorities among those objectives. The priorities are determined by a wide and complex spectrum of political-social-economic circumstances and will change as those circumstances change. There are two general approaches to the study of economics. Macro¬ economics considers the broad picture and reasons from the general to the particular. Microeconomics considers the individual parts and activities and

20

reasons from the particular to the general. There are two kinds of activity

INTRODUCTION

engaged in by economists. They often act as professionals, m which case they are concerned with discovery and prediction. They also act as educators; in that case they are more concerned with instruction and explanation. In the case of this book, I am acting as an educator and one who believes we ought to enjoy ourselves and each other.

REVIEW PROBLEMS Chapters 1 and 2 deal with metaphysical issues, and there are very few analytical truths. You must consider some of these key issues and decide what you believe to be the “truth” of the matter. You should do so in full recognition of the possibility that you might be right and the book might be wrong.

Note:

1. Most of the discussion found in this book depends upon the assumption that people are inherently selfish. It is imperative that you consider this proposition and decide the extent to which you agree. 2. Another “metaphysical” issue in economics concerns the relationship between individuals and their institutions. Consider what you believe. Do we create and control our institutions, or do they control us? Are we free agents, or are we so dominated that we have no choices? 3. What is meant by scarcity? How can scarcity be worsened? What is the relation¬ ship between scarcity and choice? 4. What do you believe to be the legitimate economic goals of your nation? What priorities do you attach to them? 5. What is “economic welfare” and how does it relate to “human welfare”? Is an unequivocal gain in economic welfare a necessary gain in human welfare?

SUGGESTIONS FOR FURTHER READING Balassa,

Bela

A., “Success Criteria for Economic Systems,” The Hungarian (New Haven: Yale University Press, 1959).

Experience in Economic Planning

E., Economic Row, 1966), Chapter 1.

Boulding, Kenneth

Analysis,

Vol. 1, 4th ed. (New York: Harper &

P., “Economics as a Moral Science,” Vol. XXXII, No. 2 (October, 1974), 186-195.

Cochran, Kendall

Maslow, Abraham

Row, 1970).

H.,

Motivation and Personality,

Review of Social Economy,

2nd ed. (New York: Harper &

chapter

2

The Methods of Economic Inquiry

INTRODUCTION: ECONOMICS AS A SCIENCE AND AN ART We now have some understanding of the work to be done in economics. Therefore, we should turn our attention to the manner in which this work can be carried out. Specifically, to what extent can economics utilize scientific principles and methods? The problem we study—human behavior—restricts the methods available to the economist. Natural scientists in chemistry, biology, and physics have an advantage over economists and other social scientists, since they can investigate their fields with rigorous and disciplined controlled experimentation. Consequently, it is easier for scholars in these fields to maintain “intellectual and emotional objectivity” in their research. These fields are “self-purifying.” When “truth” is discovered in the natural sciences, there is little room for concern that it reflects the investigator’s

21

personal preferences or predilections. At the other extreme, there is an almost completely “unscientific” methodology in the arts and humanities. In these areas it is almost always the case that “truth lies in the eyes of the beholder.” Scholars in the humanities are frankly subjective in their approach. Furthermore, the method of inquiry used by these people is more often one of speculative contemplation rather than rigorous structure and physically controlled experimentation. Such informality does not make the methodology of the humanities and the arts less respectable, nor does it make it less productive than that which is found in the natural sciences. The fact is, the two areas deal with different

22 INTRODUCTION

problems and they must, therefore, use different methods. Each has developed methods that are most appropriate for the work that must be done. There is no sense in debating which methods are superior. The question is one of appropriateness, and that is determined by the type of problem under investigation. Given these methodological extremes, what is appropriate for the social sciences in general and economics in particular? The answer lies in the nature of the problems under investigation. As it turns out, economics must rely to some extent on both methods. However, insofar as the methods of the natural sciences may be generally characterized as scientific and those of the humanities may be characterized as speculative, most economists have a bias toward emulating the former. Modern economists share the natural scientist’s conviction that, insofar as it is possible, intellectual inquiry must be objective and free from the investigator’s personal preferences or values. However, the economist is a social scientist. He is examining human motivation and behavior. It is, therefore, not appropriate for him to ignore ethics, morality, and values, for they are the fountainhead of human behavior. Furthermore, it is impossible for the social scientist and the economist to rigorously control experiments as natural scientists do. Controlled experimentation is largely an intellectual rather than a physical process in the social sciences. For that reason, social science research often takes the form of speculative contemplation as found in the humanities—because that is the only alternative. The problems we must deal with as economists require us to use the methods of both the natural sciences and the humanities. Intuition and common sense are often more important than experimentation and scientific rigor. The discipline is rightly working toward closer methodological emulation of the natural sciences, but, realistically, it must be recognized that the goal can never be fully realized. The problems that economists have elected to study will always include some dimensions that require nonscientific analysis. Therefore, economics is both a science and an art. Yet today economics has a substantial intellectual core for which we can make high claims to objectivity and methodological rigor. That core is largely microeconomic.

ABSTRACTION The process of abstraction is fundamental to all intellectual inquiry. It is curious that people often react adversely to overt abstraction because they think it is “just theory” or “purely academic.” Such reactions merely reflect a misunderstanding of abstraction; it is an inescapable fact of all intellectual activity. The difference between dealing abstractly and being “realistic” is only a matter of degree and awareness. Abstraction, as it turns but, is merely a matter of simplifying the world around us in order that we may manage facts and behavior in a formal and intelligent manner. It is an attempt to

23 The Methods of Economic Inquiry

generalize—to bring order or uniformity to an otherwise seemingly chaotic world. Facts do not speak for themselves, but are meaningful only when they are put into a system or model that lends itself to interpretation. Abstraction begins with categorizing the world’s phenomena into problem areas and disciplines. In economics, for example, we abstract from man’s total motivation and behavior only that which we consider to be economic. We may abstract still further by confining our analysis to individual consumption behavior. In this way we have abstracted away from everything else and have isolated a well-defined and specific problem. We have, in effect, isolated this particular problem from an association that it has, in fact, with an infinite amount of interdependent relationships in the world at large. This abstraction is generally done in a normal and acceptable manner by statements such as “Consider only typical individual consumption behavior.” Such a statement says by implication, “Do not consider produc¬ tion, religion, politics, or any other problem that does not have an immediate and direct relationship to personal consumption behavior.” Abstraction also involves simplifying a problem by identifying and isolating determinants that have an immediate functional relationship. We call the problem under investigation (that which we seek to understand) the dependent variable. Now it is necessary to select and order critical independent or determinant variables to be examined. For example, individual consump¬ tion behavior is immediately determined by tastes, prices, and income. There are many other variables (for example, religion), but they are not necessary to a general explanation of consumer behavior. Consequently, we can abstract from all other variables by simply assuming them away or holding them constant. The level of abstraction varies inversely with the number of independent variables included in the theory or model. Higher levels of abstraction include few variables, and thus the model is far removed from a detailed description. Lower levels include more variables and represent a more detailed description. As a general rule, the level of abstraction ought to be low enough to cover all the critical variables but high enough to allow easy management of the theory or model. To be considered a “critical variable requires that the variable have an immediate, direct, and significant impact on the dependent variable’s behavior.

The Procedure of Abstraction In economics there is a well-established procedure for the process of abstrac¬ tion which provides consistency and objectivity. The object of the abstract theory or model is to provide a reasonably good explanation for specific behavior and/or to make generalizations and predictions concerning behavior. The theory’s conditions and limitations must be clearly stated, and its reliability should be demonstrated in as clear and as rigorous a manner as possible. Therefore, a good theory needs to clearly state its underlying assumptions, to precisely formulate its hypothesis, and to test its validity.

24 INTRODUCTION

Assumptions It is necessary for a theory to begin by stating assumptions concerning the relevant “environment” of the theory. Assumptions often describe conditions which constrain the behavior under consideration but which lie outside the discipline’s ability to explain or control. Therefore, they represent conditions that must be taken as given. Assumptions are generally realistic observations of conditions that either constrain or provide fundamental motivation to the subject under investigation. That is to say, assumptions are generally observations concerning the environment and human nature. However, assumptions may also usefully take the form of unrealistically removing or altering observed conditions in order that one may see what would happen if things were not as they are. In economics assumptions are generally limited to conditions of resource and technological constraints, the institutional structure of the economic environment, and/or psychologicalmotivational characteristics of the individuals whose behavior is to be explained. Preconditions to economic behavior generally derive from the abovementioned areas. The economist’s knowledge concerning these areas derives, by and large, from scholarship in the other fields more specifically equipped to provide such insight. In many cases an assumption s realism can be demonstrated. This is particularly true of the resource-technological and institutional assumptions. Science can tell us the necessary resource inputs and technological requirements of production, and current institutional structures are fairly easily identified. The realism of psychological-motivational assumptions cannot be demonstrated so clearly. The economist can certainly gain insight from other social scientists, but reasonableness is the final test of such assumptions. There is considerable controversy concerning what motivates man. Is he selfish or benevolent? Why does man create? Are businessmen motivated by profits? These questions may never be settled scientifically. As a consequence, economic controversies often reflect differences concerning such assumptions —especially as they relate to human motivation as influenced by goals and values. It is necessary for, generalizations to be made, and these generaliza¬ tions are often the cause of conflict between different economists. Such assumptions deserve careful attention and are often the critical fields of toil in the area of welfare economics. Hypothesis The hypothesis is the main body of a theory. Once the problem has been selected, the relevant level of abstraction has been determined by the selection of the critical variables, and the assumptions have been stated, one must develop a functional hypothesis concerning the nature and order of the relationship between the variables. A functional hypothesis describes the dependency relationship between the phenomenon to be explained and its determinants as well as the conditions under which the relationship can be

25 The Methods of Economic Inquiry

expected to hold. To that end, a hypothesis requires dependent and independent variable(s) and a ceteris paribus condition. The dependent variable represents the behavior that is to be explained. The independent variable represents the critical determinant(s) of the dependent variable’s behavior. The ceteris paribus condition is the formal statement that the hypothesis holds only with respect to the variables under consideration in the defined circumstances and that everything else is considered constant. (The Latin expression, ceteris paribus, translates, “all cither things being equal.”) The condition is an essential part of all hypotheses and can be found either implicitly or explicitly in every case. It is a necessary statement of the limits of the hypothesis and cannot be excluded. The hypothesis with its three ingredients is the formal statement of a theory and the main body of the argument. It is in this manner that generalizations are made concerning relationships and behavioral patterns for given variables under specified assumptions and restrictions. If the hypothesis is valid, it should provide a reasonably good explanation for behavior, as well as some basis on which future behavior may be generalized and predicted. It is the responsibility of the person who formulates the hypothesis to complete his job by providing some testimony concerning the validity of the notion as well as the reliability of the generalization. Testing the Hypothesis

What is the test of a hypothesis? How can one be certain that his theory is valid? Fortunately, most theories in economics are those that seek to explain behavior. Behavior can be observed and measured, and as a consequence one can generally rely on an empirical test of his hypothesis. An empirical test is one that observes and confirms the responses of individuals under conditions relatively close to those postulated in the hypothesis. Empiricism ranges from casual observation to highly sophisticated math¬ ematical and statistical analysis. From a scientific viewpoint, those theories that lend themselves to higher levels of sophistication in empirical observation and validation are generally considered to be better than those that do not. However, economic problems do not always allow such luxury, and we must often be content with less rigorous tests. Nevertheless, as a general rule, we ought to give priority to empirical verification insofar as it is possible. On the other hand, it is important to realize that empirical verification, as it is found in statistical correlation tests, does not prove a theory. Rather, it can only fail to disprove it. A statistical verification of a high corelationship between two variables does not prove that one causes the other. It demon¬ strates merely that a corelationship does exist between the two and that therefore the explanation offered by the hypothesis is plausible and not refuted by the facts. One of the most popular examples of this relationship between hypoth¬ esis and empirical data is found in cancer research. Medical researchers postulated a cause and effect relationship between smoking and lung cancer.

26 INTRODUCTION

Specifically, the hypothesis was that smoking caused lung cancer. They compiled and analyzed statistical data that demonstrated a higher incidence of cancer among smokers than nonsmokers. Furthermore, there was a high statistical correlation between smoking and cancer. Consequently, the hypothesis is widely accepted as being verified by the statistics. However, if one were to hypothesize that cancerous people have a compulsion to smoke that cancer causes smoking—one would also find convincing testimony in the same statistics. What, then, is the truth of the matter? It seems obvious that the most sensible—most realistic—hypothesis is that smoking causes cancer. The statistics do not refute the hypothesis. Any reasonable man must at least consider the high probability that the hypothesis is valid. Smokers, on the other hand, may take some consolation from the other hypothesis— though not much, since they will be more likely to have cancer in either case. Economic inquiry often leads to issues and conclusions that are not empirically verifiable. In such cases the only available test is the proposition’s sense and reasonableness. This can be discerned from our own experience and observation concerning others. Insofar as economics strives to be scientific, this is an unfortunate fact of life, but one that must be met with integrity. We must do the best we can with what we have and not succumb to the temptation to dismiss behavior simply because we have no sophisticated empirical basis for investigating it. After all, a guess gives us some insight. It is helpful to remember that even the most sophisticated empirical estimate is still a guess. In any case, we find ourselves in the position of making the best possible guess, given the limitations of our empirical ability to deal with the problem. To that end, a theory’s validity must be found in both empirical verification and intellectual satisfaction.

Analytical Tools and Techniques Every discipline requires unique and specialized analytical instruments and techniques. This begins with the refinement of a specialized language. Each discipline requires precise communication. Economics is certainly no exception. There are specific and precise uses and meanings attached to words and expressions in economics. This gives economists a highly specialized and accurate basis on which to communicate ideas with a minimum of confusion and misunderstanding. Of course, that precise language seems to be “jargon” to the noneconomist. For that reason you need to learn the discipline’s language. You will also soon learn that the study of economics lends itself readily to mathematical and geometric exposition. It is often convenient to state a hypothesis in mathematical form. For example, the problem of individual consumer behavior used earlier can be stated mathematically by the expression

cx = AT,

P, /)

27 The Methods of Economic Inquiry

The above mathematical statement says that the individual’s consumption of good X is a function of (is dependent upon) tastes T, prices P, and income /. Furthermore, the specialized language of mathematics makes it possible to isolate the functional relationship between consumption and any one of the independent variables for special consideration. For example, we could say that AQ/AP < 0. The above statement says that the sign of the change in quantity consumed of good X in response to a change in price is negative. The notation indicates that consumption of good X varies inversely with changes in the price of good X. The same relationship between consumption and price of good X can be illustrated geometrically by the use of a graph, as in Fig. 2-1.

Price

D

0

FIGURE 2-1

Quantity of Good X THE DEMAND FOR GOOD X

Notice that the graph’s title tells what is being illustrated. Notice also that the labels of the two axes identify the dependent and the independent variables. The dependent variable—quantity of good X— is measured along the horizontal axis, and the independent variable—price of good X—is measured along the vertical axis. The exact functional relationship between the two variables is illustrated by the downward sloping (negative) line on the face of the graph. Notice that in economics we reverse the mathematician’s convention of placing the dependent variable on the vertical axis. We place it on the horizontal axis.

28 introduction

There are, then, three ways in which the hypothesis concerning individual consumption of good X and the price of good X can be stated. verbally, mathematically, and diagrammatically. Each approach has its merits, and each adds something to the exposition. Aside from the expository benefits that these approaches have, their diversity enhances the economist s analytical ability. The mathematical statement has obvious analytical advantages, for in it the variables are arranged succinctly and symbolically. This gives flexibility in manipulating independent variables in order to examine the unique relationship each has with the dependent variable. The geometric exposition has the advantage of allowing one to draw a picture and thus to see what happens. You will discover many new analytical techniques and tools. Most of them are mathematical or geometric. These tools enrich the discipline. They provide increased capacity for analysis, illustration, and precise exposition. The tools must be learned, and skill in their use must be developed, for they are the logistical basis of investigation and communication in all economics, whether purely theoretical or applied. In fact, you are here instructed that your first order of business should be to learn the language and tools of economics. Granting the importance of analytical tools as expository, analytical, and illustrative devices, you must be wary of their use in efforts to demon¬ strate “truth.” These tools do not represent facts, but rather generalized propositions in economics. The validity of what they reveal depends upon the validity of the theory they represent. They can and rightly should be used to illustrate a case, but they can seldom be used to demonstrate a case beyond any question. In short, one does not “prove” with theory. This text will not deal with all the problems of economics, and it will not present all possible analytical tools, but it will present a wide diversity of tools that will make a sound contribution toward better understanding if you will learn them and develop skill in using them. You are also encouraged to recognize that many assumptions made in economic analysis are really analytical tools. They enable us to purposefully misrepresent real-world conditions and by so doing, make it possible for us to see what would be the case if certain conditions were met. The assumption of perfect competition and ceteris paribus are two very important cases.

PARTIAL VERSUS GENERAL EQUILIBRIUM This book and the course will be largely confined to partial equilibrium analysis. With partial equilibrium analysis we isolate a particular type of activity for special investigation separate from other types, even though it is clear that there is, in fact, a high interdependence between that under investigation and much that is held aside. Thus, under the methodology of partial equilibrium we investigate in great depth, for example, the behavior

29 The Methods

of

Economic inquiry

of the consumer, the producer, the factor of production, or the monopoly market. In each case we assume that everything else is held constant—only one segment of the total market is allowed to vary. Partial equilibrium seeks a generalized explanation of how each of these types of individuals or institutions resolve unique problems. General equilibrium analysis is a much more difficult proposition. With it we collect and integrate the separate individuals and markets in order to examine more precisely the ways in which they are interdependent and the influences that they have on one another. Microeconomic general equilibrium analysis is extremely sophisticated and depends to a large extent on somewhat advanced mathematics. For that reason, it is dealt with in only cursory detail in Chapter 15. However, when you complete this text, you can rest assured that there is even more exciting ground yet to be covered.

PURE THEORY AND ITS RELATION TO APPLIED ECONOMICS In the preface to Value and Capital, the Nobel Laureate Sir John Hicks commented on his wife’s work and the manner in which she constantly reminded him that: “. . . the place of economic theory is to be the servant of applied economics.”1 Hicks makes the point well. It is difficult to improve on that forthright statement. That is the way it is. Some people are blessed and find economic theory inherently enjoyable and worthwhile. For them that is sufficient basis for pursuing it. For most of us, however, there is a need to know the relevance of it all as we struggle along. The answer is found in the relevance of economic theory to investigation in applied fields such as public finance and international trade. Theory provides the language, the analytical instruments, and the techniques for intellectual inquiry directly into the problems of applied economics. You must understand that your first order of business is to learn how to utilize these instruments and techniques. The object, as was pointed out in the first chapter, is to better understand how man has organized his efforts to manipulate his environment to serve his needs. That requires rational action on the part of institutions and individuals. Economic theory provides us with a basis for better under¬ standing of economic behavior. Microeconomics is, then, primarily procedural rather than substantive. We are more concerned with how and why man behaves and chooses than with what he does. For example, in the analysis of consumption behavior, we are more concerned with how and why the consumer makes the choices he makes rather than what choices are made. In fact, it is really not our concern if he chooses apples or oranges. It is for that reason that we are free to work in the sanitized world of goods X and Y. They need no identification 1 Sir John Hicks, Value and Capital (Oxford, England: Oxford University Press, 1939), p. vi. Ursula k! Hicks is an applied English economist of considerable reputation, especially for her work in public finance.

because what they are does not matter to us. We have a substantive body of microeconomics particularly important in general equilibrium theory and public policy analysis. However, all that is extremely provisional, and though we will examine it we must be especially careful not to become dogmatic in those areas.

THE QUESTION OF VALUE JUDGMENTS

30

There is a historic controversy concerning the extent to which it is legitimate for the economist, qua economist, to exercise any concern over value judgments. This is a difficult question, since scientific objectivity requires that the investigator maintain a strict divorcement of his values from his analysis. Yet in economics it is impossible to totally neglect value issues because of their underlying impact on human behavior. For example, the issue has historically centered on the question of what an economic system should produce. The positivist economist has insisted that the investigator take what is produced as a given set of data and concern himself only with the technical question of the most efficient way in which production can be carried out. Rigorous positivists have insisted that the investigator has a legitimate concern only with discussing what is, and he must never concern himself with what ought to be. To be certain that this principle is not compromised, positivists have tended to confine their attention to how man behaves and to rely on empirical information to speak for that behavior. Thus the strict positivist has been reluctant to deal with questions that are concerned with why man behaves as he does. It has been considered imperative by many economists that questions of value and motivation be kept outside the discipline. Yet this approach ignores the most interesting and exciting questions concerning human behavior. One reaction to this historic omission by traditional economics has been the growth of a significant contingent of economists, perhaps beginning with Adam Smith and including such notable economists as Thorstein Veblen, Clarence Ayres, and John Kenneth Galbraith, who are frankly normative. These men tend to insist that the economist must exercise his abilities to criticize human motivation and values and to attempt to redirect them toward “higher levels.” They, in fact, overtly attempt to influence values and to suggest for man what ought to be. Of course, such suggestions have met with harsh criticism by the positivists, who argue that these men ought not attempt to impose their values on others. The point seems to be well taken at least insofar as it insists that to the extent that our prescriptions are concerned with values, they do not derive from professional expertise. That fact must be made perfectly clear. Yet there is also some truth in the proposi¬ tion that we cannot always completely escape normative issues, and in such cases we ought to be frankly normative. These two views of value issues leave us in a bit of a quandary. What is more appropriate: to be diligent in our pursuit of positivist rigor and

31 The Methods of Economic Inquiry

completely exclude normative issues altogether, or to be frankly normative and risk compromising our objectivity? The first approach is not satisfactory, because it results in a limited and seemingly amoral discipline, and the second seems equally unsatisfactory, because it is not “scientific.” Fortu¬ nately, there is a way out of the dilemma: compromise the issue by using a positive analysis of normative issues. That is the methodology of modern welfare economics. Modern welfare economics represents an important bridge between positivist and normative economists. The essence of welfare economics is a recognition of human values and goals as preconditions to human behavior while analysis divorced from the investigator’s values is maintained. The techniques employed by a welfare theorist in examining value issues are positivist. He conducts a special investigation into societal goals and values to determine what they are as they are revealed by society. He then seeks to identify a consensus concerning societal values and goals. Finally, he examines and judges societal behavior with respect to its consistency with those goals. For example, the welfare theorist might argue that if the community wishes to effect a redistribution of income and if the community places high valuation on individual freedom and private property, it will likely be best served by a system of income redistribution that takes the form of direct money grants rather than specific expenditure subsidies. The sense of the conclusion and its scientific accuracy is directly dependent upon the accuracy of the “if” propositions concerning societal goals and values. The approach to the question of values taken by the welfare theorist extends the legitimate range of investigation to questions of optimum behavior given society’s goals and values and the extent to which what is happening is what ought to be happening. It also extends legitimate investiga¬ tion into priorities for action by governmental units, and it gives some basis for a quasi-scientific analysis of income distribution. At the same time, the approach manages to attain at all times at least a quasi-scientific methodology with intellectual rigor and objectivity. Of course, the welfare theorist must constantly police his analysis as he seeks to objectively discern the normative consensus of society. He must be constantly aware that it is society’s values and goals that must be counted and not his own. It is quite easy for one to impute his values and his notions of legitimate social goals to society. This needs to be guarded against. For the most part, a general awareness of the danger and intellectual integrity will be sufficient to avoid the dilemma, but reliance on opinion polls and other instruments can be helpful.

SUMMARY Because of the problems with which it deals, economics is both an art and a science. Nevertheless, economists generally feel that they ought to be as scientific as possible. Modern microeconomic price and welfare theory with

32 introduction

consistent methods of abstraction is scientific. The process of abstraction takes place on a wide variety of levels. It requires a functional description of the environment of the theory through the stipulation of relevant assumptions, the selection of critical variables and the formulation of a functional hypothesis, and a satisfactory validity test. The object of the process is to explain, generalize, and predict behavior. The process by which a discipline matures to high levels of sophisti¬ cation requires the development of language, analytical tools, and methods that are uniquely useful in that discipline. Economics has reached a fairly high level of sophistication. As a consequence, the student of economics finds it necessary to develop an understanding of and an ability to use specialized analytical tools, many of which are mathematical and geometric. The proper basis on which the economist has dealt or should deal with questions concerning values and goals has been an important controversy in the discipline. This book suggests that the best solution to the problem is found in the welfare theory methodology. That methodology attempts to achieve a positive analysis of normative issues and hence to compromise the controversy. In this way it is hoped that the best attributes of the positive and the normative schools of thought can be integrated into one approach.

REVIEW PROBLEMS 1. What is the difference between a high and a low level of abstraction? 2. “Assumptions” in economics can be observations, assumptions, or assertions. Define the difference between them and discuss their relative appropriateness. 3. What are value judgments, and how does this book deal with them? 4. What is meant by the expression ceteris paribus? Why is the expression so useful in economic theory? 5. How does one test the validity of a theory? Is prediction a necessary test? Is it a sufficient test?

SUGGESTIONS FOR FURTHER READING Ayres,

C. E., The Theory of Economic Progress (New York: Schocken Books, 1962).

“The Methodology of Positive Economics,” Essays in Positive Economics (Chicago: University of Chicago Press, 1953), pp. 10-43.

Friedman, Milton,

Galbraith, John Kenneth,

The New Industrial State (Boston: Houghton Mifflin

Company, 1967). N., The Scope and Method of Political Economy (London: Macmillan and Co., 1891).

Keynes, J.

“The Scope and Method of Economics,” Review of Economic Studies, XII (1945-46).

Lange, Oscar,

33 The Methods of Economic Inquiry

P., “Macroeconomics and Microeconomics,” in Ernest Nagel (ed.), Logic, Methodology and Philosophy of Science (Stanford: Stanford University Press, 1962).

Lerner, Abba

-, “Microeconomic Theory” in Alan A. Brown, Egon Neuberger, and Malcolm Polmotier (eds.), Perspectives in Economics (New York: McGrawHill Book Company, 1971), pp. 36-49. L. S., “On the Philosophy of Economics,” Uncertainty in Economics and Other Reflections (Cambridge: Harvard University Press, 1955).

Shackle, G.

Thorstein, The Theory of Business Enterprise (New York: Charles Scribner’s Sons, 1904).

Veblen,

CONSUMPTION

Part II introduces the economic analysis of consumer behavior and motivation. The objectives of the ensuing chapters are (1) to introduce the student to analysis and theory of consumer motivation, choice, and behavior; and (2) to introduce a number of related analytical tools and techniques. In consumption analysis a distinction is made between describing consumer behavior where it can be known and measured and consumer motivation and choice analysis, which is more purely theoretical, in the sense that we can know very little. We must, therefore, speculate concerning why consumers behave as they do. In both descriptive and theoretical demand analysis there are a variety of analytical tools and techniques that can be useful to the student in examining the issues for himself. Primary emphasis should be placed on learning these tools and developing skill in their use. Chapter 3 presents what is known about consumer behavior, in the sense that ft can be empirically verified and described. In this consideration of demand, the student is introduced to various techniques of investigation, verification, and measurement employed in demand analysis as well as some of the more widely accepted generalizations concerning behavior patterns. The object is to summarize what economists know about con¬ sumer behavior. The notion of elasticity is introduced in Chapter 3. This is such a critically important notion that the student is encouraged to master it straightaway. In Chapter 4 the student is introduced to utility and choice, which represent efforts at explaining how the consumer makes consumption choices. The analysis depends upon a good deal of psychological analysis, for it is an attempt to explain why consumers behave as they do. In the

analysis of consumer motivation and choice, the economist knows nothing. The effort is to provide a satisfying explanation through theory. Chapter 4 is a critically important chapter because of the tools, analytical techniques, and special utilitarian analysis presented. A good understanding of the material in that chapter is essential to the remaining chapters in Part II and perhaps the rest of the book. In Chapter 5 the student receives a thorough exposure to contempo¬ rary consumer behavior theory. The principal business of the chapter is to employ the techniques for explaining consumer motivation and choice developed in Chapter 4 in order to conduct a deeper analysis of the types and patterns of consumer behavior identified in Chapter 3. Through that synthesis, the material presented in Chapter 5 represents the most thorough, albeit provisional, understanding of consumer choice currently available to the discipline. In addition, there are new analytical techniques introduced in Chapter 5 that enable us to employ theoretical demand analysis in examining social problems. Chapter 6 introduces the student to government intervention in consumption affairs. The chapter begins with an explanation of the basis for government intervention and proceeds to summarize the types and forms such intervention might take. In addition, the chapter presents four representative types of government intervention and analyzes them with respect to their impact on the individual. When approaching Chapter 6, the student must be aware that the objective of the chapter is narrowly defined. The purpose is not to present a thorough analysis of the selected problems in their full economic and social dimensions. Rather, the object is to illustrate only how the analysis of consumption behavior, as developed particularly in Chapters 4 and 5, can be employed by policy makers in assessing the impact of policy on the individual. Part II ends with Chapter 7, which presents an economic analysis of exchange and social optimum. The object is to demonstrate how in¬ dividuals, acting as free men in a free enterprise environment, might resolve the economic problems of production, distribution, and consumption in order to arrive at a configuration of economic activity that can be judged optimal. Once this task is done, the chapter goes on to discuss government intervention in the private economic community in order to enforce a different "socially optimal configuration" of production, distribution, and consumption. To that end, Chapter 7 leans heavily on the work of Kenneth Boulding concerning patterns of social welfare legislation.

chapter

3

The Demand Function— How the Consumer Behaves

INTRODUCTION There are two dimensions to demand theory. To be complete, demand theory must explain as well as describe consumption behavior. Consumer motivation theory is concerned with why consumers behave as they do. Consumer behavior analysis is concerned with how the consumer behaves. The purpose of this chapter is to present what we can know and how we predict about consumer behavior and to introduce you to demand analysis. Consequently, the ensuing discussion is more descriptive than explanatory. The more difficult and interesting questions of consumer motivation and choice are dealt with in the following two chapters.

THE DEMAND FUNCTION Even a cursory consideration of consumer behavior quickly suggests key generalizations. Consumer behavior is surprisingly consistent both with respect to different consumers and different goods. As consequence of that consistency, it has been possible for economists to make broad generalizations concerning consumer behavior and to examine it within the context of representative consumers and goods. As it turns out, the behavior of all consumers with respect to all goods is, by and large, determined by four critical variables. The generalization is presented by the demand function,

37

which is a defined set of consumption determinants.

38 CONSUMPTION

The quantity demanded of all goods by all consumers is, in general, determined by four critical variables. We can present a mathematical model of these functional determinants in terms of a representative good X as Qx = f(Px- Py, /, T)

(3-1)

The statement says that the quantity demanded of a good Qx is a function of (is dependent upon): the price of the good itself Px, the price of other goods Py, the consumer’s income level /, and his tastes T. Qx is the dependent variable, and everything to the right of the equality sign is an independent (determinant) variable. Px is superior to the other variables both with respect to its immediacy and the ability to generalize concerning its relation¬ ship to Qx. It deserves special notation, which is given by setting it off with a semicolon rather than a comma. Once the critical determinants of consumption behavior are identified, it is possible to examine each particular dependency relationship separately by use of the ceteris paribus assumption. The assumption is that all other variables are constant. It enables us to create a conceptual vacuum within which we can examine the unique relationship between the dependent variable and any selected independent variable. In this way we are able to make generalizations concerning each dependency relationship. These generalizations become the basis for distinguishing between different types of goods and consumption behavior.

Quantity Demanded as a Function of Price The most immediate and obvious determinant of quantity purchased is a good’s own price. The primacy of the functional relationship between price and quantity demanded is well accepted. Consumer behavior is so consistent regarding it that economists feel justified in making the strongest possible generalization concerning the relationship. In studying consumer behavior economists consistently find an inverse relationship between changes in price and quantity demanded. This relationship is generalized by the law of downward sloping demand. Demand theory is sufficiently productive to explain why the inverse relationship between price and quantity prevails so consistently. We shall see the explanation later. However, the law of downward sloping demand was held by economists long before the ability to explain it. Empirical observation has turned up no significant exception to the inverse relationship. Consequently, the law can be accepted as a most rigorous empirical observation. In short, we know it is so because we see that it is so. The law says that if all other things are constant, quantity demanded will vary inversely with changes in price. Like all economic laws, the generaliza¬ tion is strong and holds, if and only if the if statement holds. According to the law, if there is a price increase for gasoline, quantity demanded will decrease. If there is a price decrease, quantity will increase.

39 The Demand Function—How the Consumer Behaves

The functional relationship between quantity demanded and price is illustrated in Fig. 3-1 with a common demand curve. In Fig. 3-1, price is represented on the vertical axis and quantity on the horizontal axis. The curve labeled dd illustrates the functional relationship between the variables. It is easy to visualize the inverse relationship between price and quantity with this instrument, for the demand curve slopes downward. As the price increases, moving up the vertical axis, the quantity demanded decreases, moving from right to left along the horizontal axis. The slope of the line is negative. The slope of a line may be described as the rise over the run. In this case it is the change in price AP divided by the change in quantity AQ. Since price and quantity always vary inversely to one another, the demand curve’s slope is always negative.

Price

Once the functional relationship is understood, it is natural to wonder about its strength. We know that quantity demanded varies inversely with price changes. Now we find it interesting to examine the degree of quantity responsiveness to price changes. In order to examine that question, economists have developed a tool that they call elasticity. Elasticity is a tool by which we measure the degree of a dependent variable’s responsiveness to changes in a determinant variable. Although elasticity has a wide variety of applica¬ tions, many of its most interesting and useful are found in the study of consumption demand. In addition to the conceptual and empirical uses of elasticity, the concept serves as an important taxonomic tool. Goods can

40 CONSUMPTION

often be neatly classified by their elasticity characteristics when other criteria are not sufficiently consistent to be of value. definition Elasticity is a measurement of the percentage responsiveness of a dependent variable to percentage changes in an independent variable.

Price Elasticity—Demand Price elasticity is a specific application of elasticity to understanding the responsiveness of quantity demanded to changes in price. There are three cases of price elasticity. There is the case of elastic quantity response to price changes, where the percentage change in quantity is greater than the percentage change in price. There is the case of unitary elasticity, where the percentage change in quantity is equal to the percentage change in price. The third case is inelasticity, where the percentage change in quantity is smaller than the percentage change in price. Considering that elasticity is a measure of a dependent variable’s responsiveness to changes in an independent variable, it would seem that the natural measure would be the slope of the demand curve AP/AQ. Math¬ ematically this is a meaningful measure. However, the concept of elasticity is important as a technique for making comparisons between the demand for different goods. The absolute comparability of the demand for different goods is not high. For example, to compare the price-quantity responsiveness for an automobile with that for football tickets is nearly impossible. The comparison can be made on a percentage basis, even though it can not be made on an absolute basis. It is for this reason that the percentage change in quantity is divided by the percentage change in price.

Arc Elasticity For most purposes the arc method is the best measure of elasticity. Arc elasticity is a specific expression of the percentage change in quantity divided by the percentage change in price. Mathematically it is the following equation: £ p

_ the percentage change in quantity _

Qt - Q2I[(Qi + Qi)l^\

the percentage change in price

Px — P2l[(Pi + PiM'A

The percentage change in quantity is the numerator and the percentage change in price is the denominator. If the numerator is larger than the denominator, the absolute value of the ratio is greater than one, and demand is said to be elastic at that point. If the numerator is equal to the denominator, the absolute value of the ratio is one, and demand is said to be unitary elastic at that point. If the numerator is smaller than the denominator, the absolute value of the ratio is less than one, and demand is said to be inelastic at that point. Note that the sign of the coefficient of price elasticity is always negative. This is because quantity demanded always varies inversely with changes in price. It is customary to ignore the sign of the coefficient when

41

one discusses price elasticity of demand and to speak only in terms of its

The Demand Function—How the Consumer Behaves

absolute size. However, this can be done only in the case of price elasticity of demand.

TABLE 3-1

THE DEMAND FOR GOOD X

(1)

(2)

(3) Total Expenditure on Good X

Price

Quantity

(ID

(0)

10

1

10

9

2

18

8

3

24

7

4

28

6

5

30

5

6

30

4

7

28

3

8

24

2

9

18

1

10

10

(0)

GO

(4) Change in Total Expenditure

(5) Price Elasticity (Arc)

(0)

GO)

(-00) \

8

-6.3 1

6

-3.4

4

-2.3 1

2

-1.4 )

0

-1.0 }

-2

-0.69 \

-4

-0.45#

-6

-0.28 > III INELASTIC

-8

— 0.15

(-10)

> I ELASTIC

II UNITARY

i

(0)/

(0)

Consider Table 3-1. The table represents a demand schedule of the price-quantity relationships in the demand for a hypothetical good. Notice first that as the price decreases the quantity consumed increases; that is, of course, the pattern of price-quantity response described by the law of downward sloping demand. Now consider column 5, which presents the arc elasticity coefficient as the price decreases. Notice that the sign of the coefficient is always negative and that its absolute size is larger at higher prices and smaller at lower prices. Notice further that there is a unique price change (from 6 to 5) where the coefficient is just equal to minus one (-1). That is the point of unitary price elasticity. At all prices higher than that unique price range (from 6 to 5) the demand is price elastic and at all lower prices the demand is price inelastic. The student ought to try the arc elasticity equation for himself by way of confirming the results listed in the last column.

The Total Expenditure Test The most significant reason for concern over price elasticity of demand is a desire to know or predict changes in total expenditure (or receipts) when

42 CONSUMPTION

price changes. This would be a concern to a businessman contemplating a price change or a government policy maker contemplating the impact of a tax or tariff. It turns out that the case of elasticity can be easily and clearly classified by a total expenditure test. This technique not only makes it possible to better understand elasticity, but it also defines it within the context of the reason for concern. The test simply classifies elasticity according to the net impact of price change on total expenditure. The law of downward sloping demand stipulates that quantity purchased always varies inversely to price changes. Consequently, the impact on total expenditure of a change in price is always countervailed by the impact of the subsequent change in quantity. For example, a price increase tends to increase total expenditure, but it also tends to decrease quantity purchased. The decrease in quantity purchased is consequent to the price increase, and it, in turn, tends to cause decreases in total expenditure. Elasticity is a measure of the extent to which the impact of the quantity change on total expenditure is greater than, equal to, or smaller than the impact of the price change. If the impact of the quantity change is greater than that of the price change, the elasticity coefficient is greater than one. (In the ratio the numerator is larger than the denominator.) The net change in total expendi¬ ture is dominated by the quantity change, and the change in total expenditure varies inversely with the price change. This is an elastic response. If the impact of the quantity change is just equal to that of the price change, the elasticity coefficient is equal to one. (The numerator is equal to the denom¬ inator.) There is no change in total expenditure, because the countervailing forces just cancel each other out. It is a case of unitary elasticity. If the impact of the quantity change is less than that of the price change, the elasticity coefficient is less than one. (The numerator is smaller than the denominator.) The net change in total expenditure is dominated by the price change. This is an inelastic response. A quick review of the arc elasticity equation is a good reminder that the extent to which the impact on total expenditure of the quantity change is more than, equal to, or less than the impact of the price change depends upon the proportion of the percentage changes. Consider Column 3 in comparison with Column 5 in Table 3-1. Column 5 presents the elasticity coefficient as the price decreases. Column 5 illustrates how the demand schedule can be broken into three parts. Part I is the price range at the higher end from 10 to 6 inclusively, where the demand is price elastic. Part II is the very special price change from 6 to 5, where the demand is unitary price elastic. Part III is the lower range of prices from 5 to 1, where the demand is price inelastic. In the price elastic range it is possible by examining Column 3 to see that as the price decreases total expenditure increases. At the unitary price change, total expenditure is seen to decrease as price decreases. The above-described trends are confirmed by Column 4, which indicates the change in total expenditure as the price decreases. Consider this only in terms of price decreases, and you can see that the sign of the total expenditure

43

change is inverse to the sign of the price change when demand is price

The Demand Function—How the Consumer Behaves

elastic (Part I). Total expenditure change is zero when demand is unitary elastic (Part II). Finally, the sign of the change in total expenditure conforms to the sign of the price change when demand is price inelastic (Part III). The total expenditure test gives us special insight when we contemplate price changes, taxes, or tariffs. We know that if the good is one for which there is price elastic demand, an increase in its price (either direct or indirect through a tax or tariff) will result in a decrease in total expenditure due to a relatively larger decrease in quantity demanded. Conversely, we know that a decrease in price, when there is price elastic demand, will result in an increase in total expenditure. If we are dealing with a good for which there is unitary price elasticity, we can anticipate that a change in the price (increase or decrease) will be just countervailed by a change in quantity and there will then be no net change in total expenditure. Finally, if we are dealing with a good for which the demand is price inelastic, we know that a price change will dominate net change in total expenditure and that a price decrease will cause total expenditure to go down and an increase will cause it to go up. Armed with this special insight, policy makers understand that if they wish to levy a tax or a tariff for revenue purposes, they should levy it on goods for which there are price inelastic demands, e.g., cigarettes and liquor. They also understand that efforts to decrease the consumption of goods with price inelastic demands through excise taxes will be largely frustrated. The businessman also has certain advantages in deciding his pricing practices if he understands the nature of elasticity. Imagine the pricing advantage that would be enjoyed by a single seller of a good for which there is a price inelastic demand.

Elasticity Is Not the Slope of the Curve Perhaps the most common misconception that plagues students in their efforts to understand price elasticity of demand is the natural tendency to think of it as the slope of the demand curve. This tendency is reinforced by the fact that a perfectly inelastic demand is represented by a vertical demand curve and a perfectly elastic demand is represented by a perfectly horizontal demand curve. Without thinking about it, it seems reasonable, then, that a downward sloping curve with a slope of -1 ought to perfectly represent a unitary price elastic demand. After all, the slope of the line is minus one, is it not? And is it not right that a coefficient of elasticity of minus one is unitary? Therefore, the innocent student reasons that the two must be the same, and from there the confusion mounts. A quick review of arc elasticity shows the error of the above reasoning. It is true that price elasticity is associated with the slope of the line, but the slope is only part of the equation and then actually the inverse of the slope; change in quantity over change in price. There is more to the equation. As it turns out, a straight downward sloping demand curve has all three cases of elasticity. Consider, for example, a demand curve representing the demand schedule presented in Table 3-1.

44 CONSUMPTION

The data presented in Table 3-1 are presented graphically by the demand curve in Fig. 3—2. Notice that the curve is linear with a slope of minus one (-1). Consider the elasticity at any point on the curve. The point elasticity equation applies here. The point elasticity equation is more simple than the arc elasticity equation. The arc equation defines the percentage change as the change in quantity or price divided by the average quantity or price. The point elasticity equation defines the percentage change as the change in price or quantity divided by the original price or quantity, thus:

The problem with using point elasticity is that it does not give consistent results. For example, if we were to apply the point equation to a price change from $7 to $6 and a quantity change from 4 to 5, using the higher price as the original (P^ in the equation), we would obtain a coefficient of — 1.75. If, on the other hand, we were to measure this same change by the point equation, using $6 and 5 as the original price and quantity, we would obtain a coefficient of - 1.20. The point equation tends to overstate price elasticity for price decreases and understate for price increases. What, then, is the correct coefficient, -1.75 or -1.20? The obvious answer is an average of the two, or —1.45. That is the coefficient one obtains with the arc equation (see Column 5, Table 3-1). Furthermore, the arc equation gives the same result irrespective of which price is treated as the original.

Price

FIGURE 3-2

ELASTICITY IS NOT DEMAND SLOPE

45 The Demand Function—How the Consumer Behaves

To get back to the point—that elasticity is not slope—take point R, which is the midpoint on the curve. Point R associates a quantity demanded OK with a price KR. To measure elasticity at point R, we begin with the point elasticity formula:

A0 A P

Qxl ~r\

AQ Px —— x — Qx A/>

(3-4)

This formula can be restated by the mathematically equivalent statement:

AQ Py — x — AP Q!

(3-5)

On the demand curve, AP/AQ represents the slope of the curve. Geomet¬ rically, the slope of the curve in Fig. 3-2 at point R is KR/KA. But we are interested in the inverse of KR/KA. We see that AQ/AP is equal to KA/KR. Of course, the inverse of the slope is only part of the formula; it must be multiplied by P/Q to make the formula complete. Geometrically, the price at point R is KR and the quantity is OK. Therefore, the second part of the elasticity formula, P/Q, is equal to KR/OK. Therefore, Eq. (3-5) above can be rewritten as

_ KA

KR

KA

(3-6)

p ~ KR X OK~ OK

The student can readily see that the fraction KA/OK represents the potential quantity demanded at prices lower than the point in question divided by the potential quantity at prices higher than the point in question. At point R in Fig. 3-2, KA = OK—the numerator equals the denominator. Therefore, the absolute size of the elasticity coefficient is equal to one (1) and the price elasticity of demand is unitary at that point. At all prices higher than that represented by point R in Fig. 3-2, the numerator is larger than the denominator {KA > OK), and demand is price elastic. At all prices lower than that represented at point R, the numerator is smaller than the denominator {KA < OK), and demand is price inelastic. It is clear, then, that as price decreases on a straight-line demand curve, the case of elasticity goes from elastic, to unitary, to inelastic. Incidentally, since at the origin, OK is equal to zero, the coefficient of elasticity is infinite at that point. Likewise, at the curve’s intercept with the horizontal axis (point A), KA is zero and the coefficient of elasticity is zero. An infinite coefficient of elasticity represents the perfectly elastic case, and a zero coefficient represents the perfectly inelastic case.

46 CONSUMPTION

Figures 3-3 and 3-4 illustrate the only two cases where price elasticity can be concluded from the slope of the demand curve. Figure 3-3 illustrates a perfectly vertical demand curve. In such a case, as the price changes there is no change in quantity. If there is no change in quantity, the percentage change in quantity in the elasticity ratio is equal to zero. Of course, any time you divide zero by a real number (in this case the percentage change m price), the result is zero. A zero coefficient of price elasticity indicates perfect price inelasticity. Figure 3-4 represents the opposite case, where even the smallest change in price results in an infinite change in quantity. The demand curve is perfectly horizontal, which indicates an infinite demand for the good at the prevailing price. If the price is either raised or lowered by e\en the smallest amount, there is an undefined change in quantity at that price. That is, the demand curve does not tell what will happen if price changes. It says only

0 FIGURE 3-3

Quantity Demanded PERFECT PRICE INELASTICITY

Price

FIGURE 3-4

PERFECT PRICE ELASTICITY

47 The Demand Function—How the Consumer Behaves

that an infinite quantity can be sold at the prevailing price. This is an important case, as we shall see later. Right now, it is enough for us to see that it is one of the two cases where something definitive can be said concerning the price elasticity of demand from consideration of the slope of the demand curve alone. The Determinants of Price Elasticity of Demand

Why is it that consumers tend to exhibit a price elastic response for some goods and price inelastic response for others? There must be some differences between goods and between consumers that account for these divergent behavior patterns. There are some generalizations that can be made concerning differences in goods and the manner in which they are perceived by different consumers that account for different elasticities. The most important of these differences are discussed below. The availability of substitute goods. The availability of good substitutes, when recognized as such by the consumer, is perhaps the most important elasticity determinant. This recognition is critical to the consumer’s attitude toward all other goods, and it also affects nearly every one of the other elasticity determinants. If a good has many close substitutes, its demand will tend to be elastic. Naturally, if a good is satisfying (or believed to be satisfying) a particular want, and if the price of that good increases while at the same time there are other goods that may satisfy the same want nearly as well, there will be a tendency to substitute the relatively cheaper good for that which has experienced a price increase. Consider cigarettes: Most smokers believe that they must have a cigarette. They carry a pack with them at all times and are haunted by a dread fear of being caught without them. Of course, if things get rough, there are substitutes. The smoker can chew gum, eat candy, smoke a pipe, or bite his fingernails. Nevertheless, these are poor substitutes for a cigarette. The cigarette smoker sees no good substitute for a cigarette. Consequently, the demand for cigarettes as a class tends to be price inelastic. On the other hand, within the general class of goods, cigarettes, there are many brands. Most smokers are more or less devoted to a particular brand that they believe to be the “best.” Indeed, it is not uncommon to hear the issue debated. Still, a smoker devoted to Kent cigarettes will, if the price of Kent rises unilaterally, find that Pall Mall makes an acceptable substitute. Consequently, the quantity response of a particular brand tends to be less price inelastic than that of cigarettes as a class of goods—simply because there is no substitute for a good cigarette except another good cigarette. Expenditure on a good as a proportion of total income. For goods that take a relatively large portion of the consumer's total income, price elasticity tends to be greater than for those that take a relatively small portion. For this reason, the price elasticity of automobiles tends to be

48 CONSUMPTION

greater than that of bicycles. At the same time, the extent to which the prevailing price happens to fall at the upper end of the spectrum of possible prices rather than at the lower end will tend to make price elasticity of quantity response greater. This is almost a purely mathematical phenomenon, which is nicely illustrated by the previous discussion of Fig. 3-2, but there is also a nonmathematical explanation. For example, the consumers awareness of percentage change in prices is greater when prices are higher as compared to when they are lower. Necessities. When a consumer considers a good to be a necessity, he will exhibit price inelastic responses in his demand. It is almost impossible to give a “scientific” definition of a necessity. Consequently, it is necessary to develop a functional definition. Such a definition exists in the peculiar language of economics as anything the consumer thinks he must have. The functional relevance of such a definition is important, for if a consumer thinks he must have a particular good, that belief governs his consumption behavior. For example, people who have habits or addictions think that they must have the good to’which they are tied. That belief governs their behavior. Smokers think that they must have a smoke. Drinkers think that they must have a drink. How often do we hear testimony concerning an individual's inability to get along without a cup of coffee in the morning? These kinds of beliets are of paramount importance as determinants of consumption behavior, and it is that behavior that we wish to understand. In point of physiological fact there are few, if any, particular goods that are absolute necessities, and use of the term in that sense is too restrictive for economic analysis. Most of our physiological needs can be met with a variety of goods, and we are often willing to freely substitute one for the other. It is only in very special cases, such as insulin for diabetics, that a particular good (if not a particular brand) is an absolute physiological necessity. In economic analysis, it is not necessary that the good be a necessity per some scientific definition of the term but rather that the consumer acts as if it were a necessity. The consumer will be unresponsive to changes in price if he believes the good to be a necessity, even though more rational people see that it is detrimental to his health or that there are good substitutes. Consider the abrasiveness of the nonsmoker's “rationality" to smokers. Smokers often resent that nonsmokers “preach" about the evils of a good without which they are convinced they could not tunction. It may be ‘all in their heads” but to a smoker, a cigarette is a necessity and his lack of price responsiveness is a good indicator of that “fact. Time as a determinant of elasticity. Time is an elasticity determinant because it takes time to obtain and appreciate information about price changes. Time is also related to habit. Consumption behavior is often habitual. Habitual consumption behavior is rational. Once knowledge about needs, the ability of goods to satisfy needs, and prices is established, it is rational and convenient to consume by habit.

49 The Demand Function—How the Consumer Behaves

Habitual consumption saves time and energy needed for search, comparison, and evaluation of consumption information in routine matters. That time and energy can then be devoted to more important matters. Habits are hard to change, and it takes time for them to change. Consequently, elasticity tends to be greater over a longer period of time after a price change than it is immediately after a price change. The student ought to be advised that each of these price elasticity determinants has only a unique tendency to cause demand to be price elastic or inelastic. Every consumer is influenced by a perception of the good that is comprised of each of these determinants. The determinants will at times complement each other and at other times will conflict with one another in their impact on elasticity. The final determination of elasticity depends upon the consumer, the good, and the net impact of the several determinants as they are perceived and weighed by the consumer. Consequently, the observer can only examine a good and guess what its elasticity might be on the basis of these determinants and the importance that he attaches to them. Students often tell me that my demand for Borden’s milk ought to be price elastic, because there are so many good substitutes in the form of other brands. That may be so to them, but to me there is no good substitute, because I believe that Borden’s has more cream and is better than the other, inferior brands. As a consequence of that belief, taken with my belief that milk is a necessity (recent medical reports to the contrary notwithstanding), and the fact that my total expenditure on milk is low relative to my total income, I have a price inelastic response in my demand for Borden’s milk.

Quantity Demanded as a Function of the Price of Other Goods The second most immediate and powerful determinant of consumption quantity is the dependency of demand changes on price changes for other goods. This relationship represents the fact that goods are interdependent within consumption- patterns. This interdependence manifests itself as opportunity cost. The cost involved in consuming a good is the foregone opportunity to consume other goods. Scarcity, you will recall, does not allow us to do everything. We must make choices, and each choice involves what we decide to do and what we decide not to do. To that extent, it can be said that all goods are ultimately in competition with one another for the scarce consumption dollar. Complementarity

Interdependence manifests itself in two distinct ways. An interdependent relationship can be complementary, or it can be one of substitutability. That is how it is with interdependence between goods. Some goods are comple¬ mentary to one another, like coffee and cream. Jointly consuming two complementary goods enhances each one’s ability to satisfy. It is possible to

50 CONSUMPTION

easily identify many combinations of goods that are complementary in their relationships. When a complementary relationship exists, the quantity consumed of one good varies inversely with price changes for the other. For example, if the price of coffee increases, consumers will tend to buy less cream. Since cream is used in conjunction with coffee, and since coffee consumption tends to decrease, there is a subsequent tendency to decrease cream consumption as the price of coffee increases. The same relationship exists between razor blades and razors; automobiles and gasoline, scotch and soda; and cameras and film. Substitutability

There is another side to interdependence which is described by substitute goods. Certain wants can be fulfilled by different goods. Goods that relate to the same wants are substitutes in their relationship. Such is the case of coffee and tea, or Coke and 7-Up. In each case, both goods relate to the satisfaction of a perceived want, and they are substitutes in consump¬ tion behavior. This substitute relationship suggests that as the price of one good varies, the quantity consumed of the other will vary in the same direction. As the price of Coke increases, consumers tend to decrease their Coke consumption and increase their 7-Up consumption as a substitute. Independence

There are also combinations of goods where the interdependent relationship is insignificant and indiscernible. The relationship always exists between goods, but for many combinations it is indiscernible. Such is the interrelationship between chewing gum demand and automobile prices. In such cases it is common to agree that there is no interdependent relationship. The goods are then said to be independent. That is not exactly correct. It is more accurate to agree that the interdependence is insignificant and not discernible from naturally generated data. Cross Elasticity

In the functional relationship between changes in the price of one good as a determinant of changes in the demand for another, it is not easy to make broad generalizations, as it is in the case of the relationship between the quantity demanded and changes in a good’s own price. Notice that we use the expression, change in demand when referring to the ceteris paribus relationship Qx = f{Py) and change in quantity demanded in reference to the ceteris paribus relationship Qx = f(Px). The difference between the two italicized expressions is more than semantic. When there is a change in demand in response to a change in the price of other goods (and/or incomes or taste), there is a change in the overall willingness to purchase the good at all possible prices. Since the standard treatment of demand explicitly illustrates the

51 The Demand Function—How the Consumer Behaves

ceteris paribus relationship between quantity demanded and the good’s own price, Qx = f(Px), change in demand made in response to the other determinant variables is illustrated by shifts in the demand curve. Figure 3-5 illustrates changes in demand. Notice that there are two demand curves, labeled DD and D'D'. Increases in demand are illustrated by a movement to the right from DD to D’D'. Decreases are illustrated by a movement to the left from D'D' to DD.

Price

In the case of changes in quantity demanded, the sign of the functional relationship is always negative. The sign of the functional relationship between the price of one good and quantity demanded of another may be positive or negative. The absolute size of the relationship’s coefficient may be great or small, depending upon the extent to which the relationship is complementary or competitive and strong or weak. The nature of the relationship, as well as its strength, can be measured with an elasticity concept. The particular elasticity notion employed in measuring the inter¬ relationship between goods is that of cross elasticity. Cross elasticity measures the quantity responsiveness of one good to changes in the price of another. The ceteris paribus functional relationship is defined mathematically as Qx = f(Py). The cross elasticity equation is a simple revision of the price

52

elasticity equation, in which Py is substituted for Px. If the arc elasticity

CONSUMPTION

equation is used, it reads percentage change in Qx _ QxX - QX2l[(Qi + Ecxy

percentage change in Py

^.7)

Pyl - Py2/[(P 1 + p2)/^]

The coefficient of cross elasticity may be greater than zero. If that is the case, the nature of the interdependent relationship is described as competitive. That is, the two goods are substitutes for one another, and, therefore, the quantity consumed of one increases (decreases) as the price of the other increases (decreases). There is a positive coefficient of cross elasticity. The closeness of the substitute relationship is defined by the coefficient’s absolute size. Whether or not the two goods are close substitutes is a judgment that can be made only when the size of the coefficient of cross elasticity is known. The larger the coefficient, the closer the substitute relationship. The coefficient of cross elasticity may be less than zero. If that is the case, the nature of the interdependent relationship is described as being complementary. That is, the two goods are used in conjunction with one another, and, therefore, the quantity consumed of one increases (decreases) as the price of the other decreases (increases). There is a negative coefficient of cross elasticity and an inverse relationship between price changes for one good and changes in the demand for another. Again, the closeness of the complementary relationship is revealed by the absolute size of the coefficient of cross elasticity. The coefficient of cross elasticity may turn out to be zero. The first thing this tells us is that our statistical data and methods are not sharp enough to measure the relationship. Nevertheless, the data are usually good, and methods are fairly sound. Consequently, we can conclude from the zero coefficient that there is no empirically discernible and, therefore, no statistically significant relationship between the two goods. They cannot, then, be defined as either close substitutes or close complements. They are, then, called independent.

Quantity Demanded as a Function of Income A third critical determinant of consumer behavior is the consumer’s income level. Naturally, there is a critical functional relationship between income changes and changes in consumption quantity. The ceteris paribus functional relationship is defined mathematically as Qx — /(/). That mathematical statement says that the quantity of good X purchased is a function of (is dependent upon) the consumer’s income. Changes in the quantity of X may be inverse (less than zero), direct (more than zero), or not discernible (equal to zero), relative to income changes. There is not a great consistency of response by consumers with respect to quantity variation for different goods

53 The Demand Function—How the Consumer Behaves

as incomes change. Consequently, it is difficult to make strong generalizations with respect to this functional relationship. However, it is possible to distinguish between different types of goods on the basis of the typical sign and degree of consumers’ quantity response to income changes. Income Elasticity

To measure quantity response to income changes, we use income elasticity. It is essentially the same as the previous elasticity notions. It is a measure of the responsiveness of the dependent variable Qx to changes in the independent variable I. The income elasticity equation is analogous to the price elasticity equation. One simply substitutes income and income changes for prices and price changes. Mathematically, the equation is Eix = percentage change in Qx = Qxl - Qx2l[(Qx + Q2)/2\ percentage change in /

Ix - I2I[(IX + I2)j2]

^ "

Inferior Goods

If the income elasticity coefficient turns out to be negative (less than zero), the good is classified as inferior. In such a case, quantity demanded will vary inversely with income changes. Income increases will result in quantity decreases. Conversely, income decreases result in quantity increases for inferior goods. Such goods can be characterized as “poor substitutes” for more highly preferred goods. For example, a student on a tight budget with little or no allowance will eat cafeteria food, even though that food is generally conceded to be a poor substitute for “real” food. As the student receives an increase in his income, perhaps through a part-time job or through an increase in his allowance, he will tend to decrease his purchase of cafeteria tickets and “eat out” more often. Normal Goods

If the income elasticity coefficient is positive (greater than zero), the good is classified as a normal good. In such a case, there is an increase (decrease) in quantity consumed in response to an increase (decrease) in the consumer’s income. Normal goods are of sufficient quality as to be worthy of our aspirations. Married students, for example, live in “white collar poverty” during their school years, especially with respect to housing. When their incomes increase upon completion of their degrees, they tend to move into a nice apartment with special amenities such as a swimming pool, a dishwasher, and recreational facilities. This is a normal good and one that they feel they deserve as compensation for their years of sacrifice. Further¬ more, they feel that their spouses also deserve this consumption good for heroic efforts and sacrifices in the past years. In order to obtain this good, graduates increase their expenditure on housing as their incomes increase.

54 CONSUMPTION

Quantity Demanded as a Function of Taste The functional relationship between a consumer’s tastes and his consumption behavior is, perhaps, the single most comprehensive determinant of consump¬ tion. This comprehensiveness derives from the fact that tastes determine what consumers perceive in goods. Tastes are the basis on which a consumer decides the potential or realized want-satisfying capacities of different goods and whether or not those goods are “necessities” and unique in their ability to satisfy wants. Tastes are reflective of the myriad human needs and motiva¬ tions, and they are subject to change as those needs and motivations change. For that reason, they are unpredictable. As the philosopher said, “There ain’t no accounting for tastes.” As a consequence of this lack of account¬ ability, it is nearly impossible to make generalizations concerning tastes and consumption behavior. Every change must be judged as it occurs, and its impact on consumption is manifest. It is possible, however, to generalize that tastes change slowly and that they can often be assumed to be constant. This generalization enables us to recognize taste as a critical determinant variable and legitimately to deal with it in our analysis, especially in the short run. Yet, when important taste changes do occur, as, for example, they did in the sixties when young people decided that marijuana had all the advantages but none of the disadvantages of booze, we are able to observe and analyze the impact of that change on related markets. Although taste manifests itself as a determinant of individual con¬ sumption behavior, it is largely a socially determinant variable. It is important to recognize that tastes are largely affected by social institutions and cultural mores. This naturally leads us to question the extent to which consumption behavior is reflective of “true” or of socially and institutionally determined needs. The conventional theorist tends to cling to the notion that although individual behavior is greatly influenced by social determinants, his behavior is still, in the end, a reflection of his peculiar needs and tastes and his personalized priorities regarding them. This text shares that bias.

INDIVIDUAL AND MARKET DEMAND The market is comprised of individuals. In the same way, market demand is comprised of individual demands. Consequently, market demand is determined by the same variables that determine individual demands. Market demands exhibit qualitative functional relationships and elasticity coefficients that reflect the weighted average of individuals. A description of market behavior derives, conceptually, from summing up the behavior of individuals. In actuality, a description of market behavior is derived by observing and gathering aggregate data. Nevertheless, those data reflect the aggregate behavior of consumers in the market.

55 The Demand Function—How the Consumer Behaves

Individual 1 Price

This relationship is illustrated in Fig. 3-6, which presents a horizontal ‘alignment of three individual demand curves for consumers 1, 2, and 3, and an aggregate demand curve for the market. Notice that the price-quantity combinations in the aggregate are the summation of those that occur in the individual demand curves. Notice further that the slope of the aggregate demand curve is a composite of the slopes of the individual demand curves. In each case, the individual and the aggregate, the price-quantity relationship is illustrated, other determinant variables being implied by the position and curvature of the demand curves. The graphical representation is described mathematically as Qx = f(Px; Py, /, T), where everything to the right of the semicolon is assumed constant. It is from those variables that demand changes will derive and manifest themselves graphically as demand curves shift. Any individual change affects the aggregate. Of course, the extent to which an individual change can affect the aggregate significantly depends upon the number and relative sizes of the individuals. In most cases, the numbers and sizes of buyers in a market are such that the impact of change in a given demand function is barely perceptible in the aggregate.

+

Individual 2 Price

+

Individual 3 Price

=

Market Demand Price

Demanded FIGURE 3-6 DEMANDS

THE MARKET DEMAND IS THE HORIZONTAL SUMMATION OF THE INDIVIDUAL

SUMMARY In order to understand consumer behavior and the relationship that it has to consumer welfare and hence to economic welfare, it is useful to begin with an analysis of how consumers behave. This is at least a quasi-empirical analysis in which the critical determinants of consumption behavior are identified, the nature of the functional relationships are defined and examined, and the mathematical basis for quantitative analysis is established. It turns out that the demand function is comprised of four critical variables that determine quantity consumed. These determinant variables can

56 CONSUMPTION

be generalized for all consumers and with respect to their consumption of all goods, even though specific importance will vary among individuals and among goods. The determinate variables are the price of the good, the prices of other goods, incomes, and tastes. It is possible to make varying degrees of generalizations concerning the strength and quality of the determinant relationship between each of these variables and quantity demanded. There is a general concept, elasticity, which provides an empirical basis for even more complete understanding and classification of consumption activities, depending upon the responsiveness of the dependent to the independent variables. There are three specific elasticity notions that have relevance to demand analysis: price elasticity, cross elasticity, and income elasticity. Demands for goods are defined as elastic, inelastic, or unitary elastic, depending on the absolute value of the (always) negative coefficient of price elasticity. The interdependent relationship of goods consumption can be defined as complementary or substitutive. This requires the concept of cross elasticity. Goods can be generally characterized as normal or inferior, depending upon the sign of income elasticity. There are no elasticity concepts by which we can measure the relationship between consumption and tastes. The aggregate demand for goods is a summation of individual demands. Actual information about aggregate consumption behavior can best be gained by collecting data concerning aggregate sales. However, those data represent a weighted average behavior of individuals in the market.

REVIEW PROBLEMS 1. John exhaustively consumes goods X and Y. The price of X increases, and the total amount of money he spends on Y increases ceteris paribus. What is the cross elasticity of goods X and Y and the price elasticity of good XI 2. John consumes good X. His income increases, and the quantity he consumes of X decreases. What is the sign of the income elasticity of good XI How would

you describe the good? 3. Why are habitual consumption practices rational?

.

4 What is “horizontal summation”? Illustrate the procedure. 5. If you increase your study time by 10 percent and your grade increases by 20 percent, what is the “study-time” elasticity of grades?

SUGGESTIONS FOR FURTHER READING hibdon, James E., Price and Welfare Theory (New York: McGraw-Hill Book

Company, Inc., 1969), Chapter 2. Leftwich, R. H., The Price System and Resource Allocation, 4th ed. (Hinsdale, Ill.:

The Drysden Press, Inc., 1969), Chapter 2. Marshall, Alfred, Principles of Economics, 8th ed. (London: Macmillan & Co.

Ltd., 1938), Book III. Mishan, Edward J., “Theories of Consumer’s Behavior: A Cynical View,” Economica, N.S., Vol. XXVIII (Leb. 1961), 1-11.

chapter

4

The Theory of Choice: Utility and Indifference Curve Analysis

INTRODUCTION Chapter 3 provided only limited insight into consumption behavior. The analysis is only descriptive. Chapter 3 presented some generalizations concerning the critical determinants of consumer behavior. It is possible with that analysis to predict, with varying degrees of accuracy, changes in consumption as those determinant variables change. The analysis gives little insight into why consumers behave as they do. From Chapter 3, it is possible to observe and predict consumption under various circumstances; it is not possible to understand consumption. Chapter 4 examines consumer motivation with a goal of understanding rather than knowing and predicting behavior. The analysis presented in this chapter should enable the student to understand why consumers select some goods rather than others, how they decide the goods combinations they consume, and how they attempt to maximize their individual satisfaction through consumption. A completely new set of ideas and theoretical instruments is introduced. A higher level of abstraction is necessary. The analysis is further removed from empirical observations. It is more concerned with the underlying psychologicalmotivational determinants of consumption decisions.

CHOICE

57

Every consumer has a unique problem of scarcity. We cannot have all we want of everything we want. Consequently, we are forced to choose from among alternative goods combinations. There are limitations to our choice

58 CONSUMPTION

which derive from fixed incomes and the fact that goods are not free. As the philosopher said, “There ain’t no such thing as a free lunch.” It is impossible to consume a good without incurring an opportunity cost of consumption. Something must be foregone. The cost of consuming a particular good is explicitly revealed by the good’s price. There are other, implicit, costs as well. Implicit consumption costs exist in the form of the time and incon¬ venience of consumption.1 The consumer has limited ability to incur both implicit and explicit consumption costs. Consequently, consumer choice is constrained choice.

Rational Consumption Choice Once it is recognized that the consumer’s choices are constrained, it is necessary to postulate a principle of decision-making that may help to explain consumption behavior. The principle of rational consumption choice is the postulate that governs the following analysis. That principle states that individuals with limited means and unlimited wants attempt to ration their expenditure among alternatives in an effort to maximize the satisfaction of their needs as they perceive them. In order to understand the principle of rational consumption choice, it is necessary to understand what it does not suggest. For example, the principle does not require that consumers always achieve maximum want satisfaction. It merely suggests that they always attempt to do so. It says that the consumption goal is maximum want satisfaction. The extent to which the goal is attained depends on the accuracy of choice. If we could reasonably assume: (1) that the consumer has full, accurate, and costless information concerning (a) his wants, (b) the extent to which different goods will satisfy his wants, and (c) the range and cost of goods available to him; and if we could assume (2) that he never makes a mistake in assessing that complete information, then we could assume that he always maximizes his want satisfaction. Unfortunately, we cannot realistically make those assumptions. Therefore, we assume that the consumer attempts, to the best of his limited ability, to maximize his want satisfaction. The principle of rational consumption choice does not argue that it is only a consumer’s “economic” wants that he attempts to satisfy. It does not suggest that a consumption decision is completely rational, in an arbitrary sense of being intelligent or sensible. Rational consumption choice suggests only that consumers have limited alternatives and they must ration them in an effort to maximize the satisfaction of their complete hierarchy of wants as they see them and as they attach priorities to them. This is true with Implicit consumption costs are generally internal to the consumer and are implied in his preference for a good. For example, one may want a beer while watching the football game, and the beer may be available to him if he is willing to get up and get it. But to do so will involve a cost—he may miss part of the action. In economic analysis it is impossible to take explicit account of these internal, implicit costs. We recognize their existence, account for them in the preferences of the consumer, and conduct our analysis in terms of external, explicit costs, i.e., price.

59 The Theory of Choice: Utility and Indifference Curve Analysis

respect to both physiological and psychological desires. In any case, only the consumer can identify his wants and understand their relative intensity. The complete spectrum of human wants determines the makeup of the individual’s motivation. The consumer does not make a distinction between economic and other desires and then attempt to fulfill these desires independent of one another. Indeed, we cannot make such a distinction. We attempt to maximize our complete needs hierarchy.2 Consumption decisions are made at the margin. Consumers make decisions on the basis of what they expect to be the net contribution to their satisfaction when the action is taken and the returns present themselves. Rational consumers can, and often do, make mistakes, but we assume that they always attempt to maximize their happiness or welfare. Since every decision involves both benefits and costs, consumers always engage in at least implicit benefit/cost analysis when making choices. The essence of decision-making is a juxtaposition of expected costs and expected benefits. The rational choice is the one that maximizes expected net benefits.3 The principle of rational consumption choice is neither as arbitrary nor as pretentious as it is often alleged to be. All that it stipulates is that consumers have constrained options, and that they attempt to exercise those constrained options in choices which are most consistent with their desire to achieve maximum want satisfaction. The many interesting and divergent points of view concerning the sources of human wants do not refute the sense of the proposition. It does not matter whether or not the wants themselves are “inherent” or learned. All that matters is that they are perceived and are, therefore, real desires to the individual. Furthermore, to say that wants are socially or institutionally determined and are, therefore, not “rational” is not a meaningful rebuttal of the argument.4 The point of the matter is that 2 Economists often act as if it were possible to separate the economic from the political, aesthetic, social, or other needs in the complete human welfare function. Such a separation cannot be made and is not made by the individual. However, the economist can isolate those types of behavior that are economic and which make a contribution to the individual’s welfare for specific analysis. That is what is done when one isolates consumption. See S. K. Nath, A Reappraisal of Welfare Economics (New York: Augustus M. Kelly, 1969), Chapter I. 3 The theory of cost/benefit is fundamental to the theory of choice. When the individual is choosing between alternatives that he desires, he judges the comparative benefit/cost ratio with the aim toward maximizing net benefits. When he is forced to choose between alternatives that are undesirable; e.g., submitting to the draft or going to prison, he judges the comparative cost/benefit ratios with a goal of minimizing net costs. For further reading see Roland N. McKean, “The Nature of Cost-Benefit Analysis,” in Efficiency in Government through System Analysis (New York: John Wiley & Sons, 1958). 4 Professor Galbraith’s notion of the dependence effect, which argues that in modern times with modern marketing techniques, the consumer’s wants are “manufactured” by the producer, is often employed as a rebuttal to the “conventional theory of consumption choice.” Notice that we have said nothing about the source of the consumer’s wants, only that they exist and that he attempts to ration his scarce alternatives in order to achieve their maximum fulfillment. The question of the origin and the legitimacy of wants is really a much broader question than what is dealt with here. We do not claim that the consumer does achieve maximum possible welfare. We claim only that he attempts to. If he is actually the unwitting dupe of Madison Avenue, who really minimizes his welfare, we are unable to see it.

60 CONSUMPTION

people have wants that are beyond their capacity to completely fulfill, and that they do the best they can, given their constraints. They do the best they can by rationally allocating their limited budget among a seemingly limitless variety of goods in order to achieve a constrained maximum satisfaction of their unlimited desires. This seems to be a reasonable place to begin an analysis of consumption behavior.

Consumption and Utility

Consumers attempt to fulfill their desires through the consumption of goods. A good is defined as anything that has the ability to satisfy a need. Economists have come to call the want-satisfying property of goods utility. In fact, when one buys a good, it is not the good that is desired but the utility that one believes will be derived from the good. Goods are desired for their perceived ability to satisfy wants. Consequently, goods may be best described as the vehicles through which utilities accrue to consumers. However, utility is not inherent in goods. Goods have utility because it is imputed to them by consumers who perceive in the good an ability to satisfy a want. For that reason, a particular good will have more utility for some people than it will have for others. As the philosopher said, “One man’s meat is another man’s poison.” Furthermore, for a given individual, a particular good will have differing amounts of utility, depending upon the amount consumed. The utility of a particular good will vary as the quantity consumed varies. Therefore, in a technical sense, each unit of a particular good will be distinct from each other unit. The distinction derives not only in the want that the good is perceived to fulfill, but in the value of the good in fulfilling the want for different individuals and among different quantities. What, then, can we say about utility? Some generalizations can be made concerning the utility or wantsatisfying capacity of goods. First, as we have said, a good is not a good unless it has the perceived capacity to satisfy a want. That capacity is called utility. Just as one cannot measure satisfaction or happiness, one cannot measure utility. To be precise, it is not possible to have a cardinal measure of utility. We cannot know how much utility a good has as compared with some other good. We cannot say, for example, that there are 10 “utils” in an apple and that there are 20 “utils” in an orange. That is cardinal measure¬ ment. We can observe that apples have fewer “utils” than oranges, which is to say that apples have less want-satisfying capacity than oranges and are, therefore, less preferred than oranges. We can also say that the first apple has more (or less) utility than the second, but we cannot say by how much. We can have an ordinal utility ranking by examining preferences and priorities given to different kinds or quantities of goods. From past observation, economists accept some generalizations about utility-quantity characteristics of goods.

61 The Theory of Choice: Utility and Indifference Curve Analysis

Early Utility Analysis and Consumption Theory The first major breakthrough in consumption theory came in the 1870’s. This occurred in the works of Karl Menger, William Stanley Jevons, and Leon Walras as they searched for a theory of value. Their work, implicitly in most cases and explicitly in the case of Walras, assumed that utility could be measured by cardinal means. According to Walras: I shall, therefore, assume the existence of standard measure of intensity of wants or intensive utility, which is applicable not only to similar units of the same kind of wealth, but also to different units of wealth.5 Walras and the other “marginalists” developed a theory based on measuring utility changes. They used both total and marginal utility. Total utility simply represented the total utility at any quantity consumed. Marginal utility was the critical concept. The notion was the measure of the change in total utility as quantity was changed, or, symbolically, AU/AQ. In addition to those two assumed measures, the utility theory of choice was built around the additional assumption that the utility derived from a good was uniquely a function of that good alone and that there was a universal tendency for total utility to level off and approach a maximum as quantity consumed was increased. This later was the key to the theory and is popularly understood as the principle of diminishing marginal utility. The principle of diminishing marginal utility contends that any time a consumer increases the quantity consumed of a given good by constant amounts in a given time period with all other things constant, he will even¬ tually reach a point where the contribution to total utility derived from the last unit consumed will diminish. After that point total utility will increase at a decreasing rate, and continued consumption will lead to a maximum total utility. definition

Utilitarian analysis is illustrated by Fig. 4-1, which shows the assumed relationship between utility and quantity. It is generally accepted that, in a given time period, total utility will increase at an increasing rate for the first few units consumed. Such is the behavior of the total utility curve in the quantity range from 0 to Qx in Fig. 4-1. Notice that in that quantity range, marginal utility as illustrated by the marginal utility curve MU increases. This is a range of increasing marginal utility. However, according to the assertion of diminishing marginal utility, there is an inevitable point at which total utility will begin to increase at a decreasing rate. Such is the point Qu where the total utility curve inflects and becomes convex from above. Notice that the marginal utility curve turns downward at the point Qx. That, of course, is illustrative of diminishing marginal utility. Notice further that the 5 Leon Walras, Elements of Pure Economics, translated by William Jaffee (London: George Allen & Unwin, Ltd., 1954), p. 11.

62

Utility

CONSUMPTION

FIGURE 4-1 QUANTITY

UTILITY AS A FUNCTION OF

declining marginal utility curve eventually reaches a point of intercept with the horizontal axis (point Qm), at which point marginal utility is equal to zero. The point of zero marginal utility is also the point at which total utility reaches a maximum.

An Example Consider the total and marginal utility curves of Fig. 4-1 carefully. Notice that their curvature properties depend on the assertion of diminishing marginal utility. Validation of that “law” depends upon empirical confirma¬ tion. Walras assumed the ability to empirically confirm, but such confirmation has never actually existed. We must recognize the extremely provisional and conjectural nature of the “law.” It is a purely speculative basis for the construction of a theory. Yet for all our inability to confirm empirically diminishing marginal utility, it has a high credibility as we test it against our own experience. In fact the case is often discussed with respect to certain goods. Such is a typical discussion concerning “how I can hold my liquor.” Consider beer consumption in light of your own experience. When we dedicate a specific time period to serious beer drinking, we must begin with the first unit (can or bottle). Before even the first unit is consumed, however, we must perceive utility in the good. Begin by assuming that you do. Generally, that first unit is extremely gratifying, i.e., it has an extremely high marginal utility. The drinker is often moved by its gratification to exclaim its satisfaction. The next few units are also gratifying and may even increase satisfaction at an increasing rate. However, in the consumption of beer, drinkers soon reach the point where total satisfaction begins to increase

63 The Theory of Choice: Utility and Indifference Curve Analysis

at a decreasing rate, and they tarry between drinks, look for diversion, and generally demonstrate a decreasing commitment to purpose. We are all aware that there is a point at which we receive maximum total satisfaction from beer consumption. We feel euphoric, our cares seem minimal, our inhibitions are low, and we are generally very happy. If we are wise, we know, in more sober moments, we should not continue beyond that quantity. Alas, we are not always wise. We ask for one more for the road. If we drink that one (and perhaps a few more), our total satisfaction diminishes. Our heads hurt, we have trouble seeing and walking, and we often get sick—self-inflicted ’flu. In the morning we have a hangover, and we proclaim our dismay over not having stopped when we felt so good. If we are economists, we will likely proclaim our dismay over not having at least stopped when our total utility was maximized and marginal utility was zero. I have made exactly that proclamation. I have had sophisticated misery. I know with conceptual exactitude what I did wrong—but it is small consolation to me.

The Consumption Decision: The Single Good Case To continue now with early utility theory, consider a consumer who is faced with only a single good attempting to decide the quantity he will consume in a given time period. At an earlier point in the chapter, the consumption decision was characterized as an implicit benefit/cost decision. The consumer is described as attempting, to the best of his ability, to maximize his net benefit from the consumption of the good. The essence of the decision is his attempt to consume that quantity which he expects to confer the greatest surplus of total benefits over total cost. Figure 4-2 illustrates the decision. Figure 4-2 represents utility as a function of quantity (as was illustrated by Fig. 4-1) and the cost of the good in terms of its purchase price. The horizontal axis measures alternative quantities. The vertical axis measures both cost and utility. Total utility, total expenditure, marginal utility, and marginal expenditure are all illustrated on the face of the graph. Total and marginal utility are the same as discussed earlier. The explicit cost of consuming the good is defined by the price of the good. In this case, the price of good X is equal to the distance 0 — Px on the vertical axis. Assume that the price is the same for all units. The total expenditure curve is represented by the rising straight line TEX. Total' expenditure is defined as price times quantity. Since price is constant, total expenditure rises at a constant rate. The first derivative of total expenditure is represented by marginal expendi¬ ture, which is illustrated by the curve Px = MEX. Marginal expenditure is the increase in total expenditure that must be incurred in order to purchase an additional unit. It is the change in total expenditure divided by the change in quantity (AE/AQ). Since the price is assumed to be constant, the marginal expenditure curve is a horizontal line equal to the price.

64 CONSUMPTION

Utility Expenditure

FIGURE 4-2 THE CONSUMPTION DECISION: THE SINGLE GOOD CASE

In the benefit/cost decision, the maximizing quantity is that where total benefit less total cost is at a maximum. In this case total benefit is defined by total utility, and total cost is defined by total expenditure. The consumer will, of course, not consume a unit of the good unless its benefit is greater than its cost. As long as marginal expenditure is less than the marginal utility, the consumer will continue to buy the good. The maximum difference between total utility and total expenditure is illustrated in Fig. 4-2 as the quantity at which there is a maximum distance between the total utility and the total expenditure curves. That is the quantity Qc. Notice that a line drawn parallel to the total utility curve at the quantity Qc(tt) has the same slope as the total expenditure line. Consequently, the slope of the total utility curve and the total expenditure curve are equal at the point of their maximum distance. Since the slope of the total utility curve is equivalent to marginal utility and since the slope of the total expenditure is equivalent to marginal expenditure, the satisfaction-maximizing quantity is that quantity where marginal utility is equal to marginal expenditure. Consequently, the satisfaction-maximizing quantity is that quantity where MUX = MEX

(4-1)

The point is equally well illustrated by the relationship of the marginal utility curve and the price-marginal expenditure curve at the satisfactionmaximizing quantity. The two are equal at the point Qc. Marginal utility is equal to marginal expenditure. At all quantities less than the satisfaction-

The Theory of

fn dtftoenee'Curve Analysis

maximizing quantity Qc, the marginal utility of each unit is greater than the marginal expenditure. Naturally, the consumer wants to consume each unit f°r which the mar8inal benefit is greater than the marginal cost. At all quantities greater than the satisfaction-maximizing quantity, the marginal utility of each unit is less than the marginal expenditure. The consumer does not want to consume a unit where marginal benefit is less than marginal cost. It is only at that satisfaction-maximizing quantity where the consumer has taken advantage of all units in which there is a net marginal benefit without consuming a unit for which there is a net marginal cost. Therefore, total net benefits are maximized by consuming that quantity. As long as goods have positive prices, satisfaction-maximizing quantity will lie in the range of diminishing marginal utility. In Figs. 4-1 and 4-2 that range is defined by the quantities between Qx and Qm. It is only in that range where the slope of the total utility curve can be equal to the slope of an increasing total cost curve. Consequently, one can conclude that as long as goods have positive prices, the relevant range for the consumption decision is the range of diminishing marginal utility. Imagine, for example, that the good is free to the consumer—that it has a price equal to zero. In such a case, there is no external constraint to consumption. In that case, the satisfaction-maximizing quantity is Qm. At the quantity Qm, total utility achieves its maximum distance from total expendi¬ ture, which is zero. If the good were free, the range of increasing marginal utility (0 to Qx) would have only a limited relevance, which would be negated by the fact that total utility continued to rise throughout the subsequent range of diminishing marginal utility. If the good had a negative price, the range of negative returns would be the relevant range, and the maximum quantity would be that at which the total utility curve in that negative range (beyond Qm) would be parallel to a negative total expenditure curve. A negative price is a situation where the consumer would be paid for consuming the good, or would pay not to consume it, which in fact would be bad, at least in the relevant range. Such a situation is so improbable that it hardly deserves further discussion. Certain conclusions can be drawn from the preceding analysis. First, it can be concluded that rational consumers will maximize their consumption satisfaction, to the best of their constrained ability, from a single good with a positive price by consuming that quantity where the surplus of total utility over total expenditure is greatest. That quantity exists and is illustrated graphically by the maximum difference between total expenditure and total utility. That maximum difference exists at the point where the slopes of the two curves are equal, and that, in turn, is most likely to be in the range of diminishing marginal utility.6 The satisfaction-maximizing quantity can be further illustrated by the point at which marginal utility is equal to marginal expenditure. Therefore, the consumption maximizing decision can be said to 6 Except, as we have seen, in the unlikely case that the price of the good is equal to zero or is negative.

66 CONSUMPTION

be achieved if one consumes that quantity where MUX — MEX. A second and very important conclusion is that, as along as goods have positive prices, the relevant range for the consumption decision must be the range of diminishing marginal utility. Given the propositions just advanced—that there is always a range of the total utility function that is characterized by diminishing marginal utility and that consumption of goods having positive prices must take place within that range, and that the specific satisfaction-maximizing quantity is that at which MUX = MEX—it is possible to explain the behavior defined by the law of downward sloping demand. If at a given price marginal utility is equated to price and the consumer therefore has achieved a constrained maximum satisfaction, changes in the price will require changes in quantity that allow the equality once again to prevail. Therefore, if the price decreases there will be an inequality in the relationship between marginal utility and marginal expenditure until the marginal utility is decreased by enough once again to make the two equal. Given the assumption of diminishing marginal utility, the only way to decrease marginal utility is to increase quantity. Therefore, a price decrease requires a quantity increase for the equality between marginal utility and marginal expenditure to prevail. The Equimarginal Principle and Allocative Efficiency We have just completed the classical utilitarian explanation of how a consumer arrives at a unique quantity consumed of a given good in a given time period. The explanation concludes that the consumer will attain a maximum contribution to consumption satisfaction from that quantity. We have considered the good independent of other goods and have stipulated that consumption satisfaction is maximized by fulfilling the condition that the quantity consumed be such that MUX = MEX

(4-2)

The condition is that we consume such a quantity that marginal utility equals marginal expenditure. Marginal expenditure is defined by the price. If we now define marginal expenditure in a different manner as marginal utility of expenditure, we can make the case for consumption satisfaction more general by extending it to all goods consumed in a given time period and their maximum efficient relative quantities. The fact is that consumers do not consume only one good. Consumers have fixed income, and they must divide that income between alternative goods to purchase a basket of goods that will afford them a (constrained) maximum consumption satisfaction. The conditions by which they make such decisions have been developed with utility analysis, and they are presented below. Obviously, it is necessary to have a common denominator in order to compare different things. In economics that common denominator is money. The argument is that goods have utility and if money is the means by which

67 The Theory of Choice: Utility and Indifference Curve Analysis

one acquires goods it, too, must have utility and hence marginal utility. The assumption is made that a consumer with a given money income has a constant marginal utility of that income. (This is important.) Thus we would have a constant term indicating change in utility as income changes— AU/AI. Let us use the term A (lambda). With that term we now restate marginal expenditure as marginal utility of expenditure. Since price of the good defines marginal expenditure, marginal utility of expenditure is price times the marginal utility of income or PA. Equation (4-2) can now be rewritten as (4-2a)

MU = PA

Equation (4-2a) stipulates the condition for maximum satisfactory quantity in terms of the marginal utility of expenditure, which is price times the constant marginal utility of income. That condition can now be understood to indicate that the consumer should consume a good until the marginal utility gained from its consumption is equal to the marginal utility of expenditure. Consider the consumer as he determines the quantities that he will consume of two goods (taken separately). He consumes goods X and Y. If he makes the satisfaction-maximizing choice in both cases he will consume good X in such a quantity that MUx = Px- A

(4-2b)

and he will consume Y in such a quantity that he fulfills the condition MUy = Py-A

(4-2c)

Equations (4-2b) and (4-2c) can be easily rewritten as

(4-2d) and, MUy

= A

(4-2 e)

Py

When the consumption-maximizing conditions for both goods X and Y are stated as they are in Eqs. (4-2d) and (4-2e), they indicate that the ratio of the marginal utility of the good to the price of the good is equal to the marginal utility of money. Since the marginal utility of money is constant and the same in both equations, they can be restated in the form MUX _ MUy =

(4-3)

68 CONSUMPTION

Equation (4-3) stipulates that the basket of goods should be such that they are purchased in relative quantities where the ratio of the marginal utility of each good to its own price is equal to that ratio for each other good. Furthermore, the ratio of marginal utility to price for each good is equal to the constant marginal utility of money income. The condition stipulates that the goods should be purchased in such relative quantities that the marginal utility of expenditure for each good is equal to the marginal utility of expenditure for each other good. That is tantamount to saying that the last dollar’s (or fraction thereof) worth of each good has a marginal utility just equal to the last dollar’s worth of each other good by virtue of its equality with the marginal utility of the dollar.7 Equation (4-3) can now be generalized to an /7-goods case without any problem. In such a case the equation would simply be expanded to cover «-goods, thus: MUx 1Px

MUy ~

Py A

MUn ~~

1Pn

(4-3a)

That condition can be combined with the common sense proposition that if the consumer is to maximize his satisfaction subject to the broad constraint of a fixed income, he must use his total income.8 That proposition is stated mathematically for an /7-goods basket by Eq. (4-4) below. M ~

QXPX

+

QyPy

+ ■ ■ • +

Q,fin

4-4)

(

Equation (4-4) states that the total money income M must be equal to the total expenditure on goods which is the summation of the quantities times the prices of the goods purchased. Students often misinterpret this condition. They often get the impression that it precludes savings. That is not so. Simply define savings as future goods and consider it as good N. Now we have two conditions [as defined in /7-goods by Eqs. (4-3a) and (4-4)] that must be met if the consumer is to achieve maximum satisfaction from the expenditure of a fixed income on a varied basket of goods in a given time period. These conditions have been formulated from utility theory but

7 The symbol A (lambda) in Eq. (4-3) is representative of the mathematical notion of a Lagrangian multiplier to which the ratio of marginal utility to price of every good is equated. Since the ratio for each good is equal to A, each ratio is equal to each other. The economic interpretation of A is that it symbolizes the marginal utility of money. Therefore, one often hears the relationship described in Eq. (4-3) discussed as a situation in which the goods are purchased in such a combination that the last dollar’s worth of X is just equal to the last dollar’s worth of Y, etc., or that the marginal expenditure on each good should yield marginal utility equal to the marginal utility of money. The math¬ ematically trained student may wish to pursue this in a definitive source such as Paul A. Samuelson, Foundations of Economic Analysis (Cambridge: Elarvard Universitv Press 1947), pp. 97-100. 8 Although this condition can be derived rigorously, it need not be, since its common sense appeal makes it all but obvious. The interested student should see Samuelson, op. cit.

69 The Theory of Choice: Utility and Indifference Curve Analysis

under conditions that required too many bothersome assumptions. Further¬ more, utility theory failed to recognize critical relationships in consumption and preference patterns. Consider the following criticism of utility theory. The Measurement of Utility In spite of an explicit contention that utility is not measurable, the processes by which we arrived at the equimarginal condition expressed by Eqs. (4-1), (4-3), and (4-3a) have all required implicit utility measurement. It is true that the previous discussion of diminishing marginal utility was not based on attempts actually to measure utility but rather on patterns of quantity-utility behavior. Still, when it came right down to defining a satisfaction-maximizing quantity, marginal utility was equated with a defined measure—price, marginal expenditure, or marginal utility of expenditure. The upshot of that was undeniably to measure marginal utility, with money being used as the measuring unit. This practice was not well received by earlier economists, who clearly saw its inconsistency. The Utility of a Good Assumed To Be Independent A careful review of the preceding discussion reveals that it proceeded on the tacit assumption that a good’s utility is exclusively dependent on that good alone. That this assumption is implied is obvious in the one-good case. It is almost as obvious in the multiple good discussion, where the equi¬ marginal rule was developed. In that discussion the consumer selected that quantity of each good that equated its marginal utility with the marginal utility of expenditure. Each good was considered in splendid isolation from other goods. The ratios of the marginal utilities to the prices of goods were brought into equality with one another only through their mutual but independent equality to the constant marginal utility of income. The analysis did not recognize cross-relationships in utility properties between goods. The analysis did not account for the fact that the marginal utility of pretzels is appreciably affected by beer, for example. The Assumption of Constant Marginal Utility of Income One of the most disconcerting and controversial of the issues sur¬ rounding marginal utility analysis is its dependency on the assumption of constant marginal utility of income. This concern is especially important when it comes to questions concerning adjustments in quantity and quantity combinations as prices change. As we shall shortly see, when price changes, there is an effective change in real income, even though nominal income is constant. Obviously, then, there will be changes in the marginal utility of money income as prices change. Utility theory fails to explain such changes. For this inadequacy as well as its inconsistencies, utility theory is not sufficiently accurate nor productive to serve the economist’s needs. Conse¬ quently, we have developed a more modern approach, called the indifference curve approach, which we shall now consider.

70 CONSUMPTION

Before we go on to indifference curve analysis, it might be wise to respond to the question that you must surely be raising. You ask: “If utility analysis is inadequate and even inconsistent, why cover it? Why not go directly to the indifference curve approach?” Such a reaction is under¬ standable, but if you review what you have read you will see that we did not say that the analysis was not productive. It most certainly is. It should be noted that, at least in the main, utility analysis preceded indifference curve analysis. Furthermore, the primary work by which indifference curve analysis was developed was prompted by a need to correct the deficiencies of utility analysis.9 It might be safe to conclude that in the history of these ideas, the development of indifference curve analysis was somewhat dependent on understanding gained from utility analysis. Similarly, understanding utility analysis is a useful foundation for today’s student as he attempts to under¬ stand indifference curve analysis. That may well be its primary contribution today.

AN ORDINAL THEORY OF CHOICE: THE INDIFFERENCE CURVE APPROACH Utility theory of consumer motivation and choice represented quite a dilemma for economists. They accepted the fundamental proposition discussed earlier—the postulate of rational consumption behavior. They accepted the proposition that consumption choice must be made within clearly defined constraints—money income and prices. They further accepted that it was reasonable to postulate that the consumer faced with these constraints was forced to ration his money income and that his objective was (constrained) maximum satisfaction of his wants as he saw them and as he attached priorities to them. Finally, they accepted the conclusions of utility theory that said there was a unique combination of goods that would assure such a constrained maximum and that the combination was one that would meet the equimarginal and the budget conditions presented in Eqs. (4-3a) and (4-4) above. They accepted much more of utility theory that is implied by the above-defined acceptable aspects of the theory. Economists accepted the fundamentals of rational consumption and the necessary conditions for maximum satisfaction. They did not accept the method by which the conclusions had been obtained. Economists realized that, in spite of the acceptability of rational consumption, utility theory was not acceptable because it was too presumptuous. They recognized a need for a less presumptuous theory by which they could arrive at the conditions of maximum consumption choice. Such a theory should be free from implicit as well as explicit cardinal utility measurement. It should recognize the

9 See, for example, J. R. Hicks, Value and Capital, 2nd ed. (Oxford, England- Oxford University Press, 1946), Chapter 1.

71 The Theory of Choice: Utility and Indifference Curve Analysis

interdependence of the need-satisfying ability of goods—that the utility of a good is dependent upon other goods as well as itself. They further needed a theory that could provide greater flexibility with regard to the marginal utility of income and would not depend upon the assumption that it is constant. Credit for resolving this dilemma is generally given to the English economists R. G. D. Allen and J. R. Hicks in the early 1930’s. However, it must be emphasized, as Hicks and Allen emphasized, that their work was a synthesis and refinement of the contributions made by many other people. The result was, nevertheless, a formal indifference curve theory of consumer choice that proceeds from the postulate of rational consumption to the equimarginal and budget conditions with more acceptable analysis. The analysis, as we shall see, utilizes different and exceedingly more productive analytical instruments than those employed in utility theory. The description of consumption constraints was not an issue with critics of utility theory. Fixed money income and prices can be empirically verified. What was at issue was the manner in which the consumer assessed different goods and goods combinations with regard to the contribution they made to consumption satisfaction. Utility theory had its problems, and they are now clear to us. Modern analysts circumvented these problems by going to the heart of the issue. In the final analysis, they reasoned, what was desired was an explanation for the maximum satisfying basket of goods achievable by a consumer with given needs and constraints. The modern theorist requires only the following assumptions concerning the consumer. First, since he knows (albeit imperfectly) his wants and what he perceives to be the utility of various available goods respective to them, he can be assumed to know his preferences. That is, the consumer can be safely assumed to know what goods and what goods combinations he prefers. Furthermore, even though the consumer cannot be assumed to measure satisfaction in cardinal terms, he can be assumed to be able to order his preferences. This assumption is eminently acceptable from our own experience. You may know, for example, that you like economics more than mathematics and you like mathematics more than philosophy. You do not know by how much you like economics, except that it is by a great deal, and you do not know by how much you like economics more than you like mathematics, except that you like it more. Furthermore, when you decide how much you enjoy economics and how much you enjoy mathematics, how much in terms of exact cardinal measurement does not matter. Incidentally, because you like economics more than mathematics does not suggest that you are “irrational” if you spend time on mathematics rather than studying economics. You may well do both, for, as the philosopher said, “Man does not live by economics alone.” To return to the point, we can safely and quite acceptably assume that the consumers know and are able to rank their preferences. That includes the ability to rank two alternative baskets of goods equal in their capacity to satisfy. In such cases he is said to be indifferent

72 CONSUMPTION

between the two combinations. For example, you may be equally satisfied by one hour spent contemplating economics and three hours contemplating mathematics as you might be by two hours contemplating mathematics and two hours contemplating economics. The second necessary and acceptable assumption concerning the consumer’s ability to judge his preferences is that rankings are transitive. By that we mean if the consumer prefers economics to mathematics and if he prefers mathematics to philosophy, he must prefer economics to philosophy. Fie cannot prefer economics to mathematics and mathematics to philosophy and philosophy to economics. Transitivity of preference ordering is necessary if our theory is not to be chaotic and meaningless, but, more important, it is eminently reasonable to assume transitivity. Transitivity of preference ranking also requires that if one prefers economics equally to mathematics and if he prefers mathematics equally to philosophy, he must prefer economics equally to philosophy. In such a case he will be indifferent to which of the three he works with—irrespective of whether he loves them or hates them equally. Given the above assumptions, it is possible to make some broad generalizations concerning likely differences in total satisfaction between different baskets of goods. First, any time the consumer chooses between two baskets where basket A has more of at least one good and not less of any good than basket B, basket A is unequivocally larger than B. There seems to be no question that in such a case the basket with more can be assumed more preferred than that with less. Second, any time a basket has more of one good and less of another good, relative to some other basket, the two baskets are capable of being equally satisfying and the consumer is capable of being indifferent between them. There ought to be many such baskets for a given level of consumption satisfaction. Furthermore, in order for an economist to judge two alternative baskets to be equally satisfying—equally preferred—they must be such that one has at least more of one good and less of another than the other basket. Now, armed with these minimally demanding assumptions about consumer preferences, we should be able to proceed and arrive once again at the conditions of consumption maximum without resort to cardinal utility measurement. The problem now becomes one of consumers indicating preferences between baskets of goods when it is assumed that they can know their preferences even though they cannot, do not, and need not measure them. We begin with goods having utility, which is the ability to satisfy, and the basis on which they are preferred by the consumer. The consumer has a set of constraints that are defined by his income and the prices he faces. We can call that the budget constraint. The budget constraint defines what the consumer can do. The consumer also has a preference field in which he ranks alternative baskets of goods relative to his wants and the expected satisfac¬ tions they promise. The preference field reflects what the consumer is willing to do. In order to understand what consumers really do, it is necessary to understand both the budget constraint and the preference field.

73 The Theory of Choice: Utility and Indifference Curve Analysis

The Budget Constraint Figure 4-3 illustrates a consumption budget constraint in a given time period and for a two-good choice. Quantities of good X are measured on the horizontal axis and quantities of good Y are measured on the vertical axis. The consumer has a fixed money income M, which can be divided between goods X and Y. If the consumer spent all of his income on good X, he could buy an amount equal to M\PX. If he spent all of his income on good Y, he could buy an amount equal to MjPy. The ratio of the prices is then defined as (MIPX)I(M/Py). If in that ratio the fraction in the denominator is inverted and used to multiply the fraction in the numerator, the M drops out, and one gets Px/Py, which is the slope of a line connecting the point on the vertical axis representative of spending all income on Y and the point on the horizontal axis representative of spending all income on X. Such a line is illustrated in Fig. 4-3 as the line M\Py — M\PX. That line represents the consumer’s budget constraint. The budget constraint indicates that the consumer can spend his money income completely on good X, completely on good Y, or on any combination on a line defined by the ratio of the prices of the two goods. The budget constraint thus indicates how much X must be given up in order to acquire more Y and vice versa. The budget constraint illustrates the parameters of consumption choice as they are defined by fixed income and prices. Under ceteris paribus conditions, the budget constraint defines the alternative combinations of goods that can be bought. definition

Good /

FIGURE 4-3 THE BUDGET CONSTRAINT: CHANGE IN INCOME

74 CONSUMPTION

The budget constraint illustrates what the consumer can do, subject to the constraints of his fixed money income and goods prices. It is representa¬ tive of a consumption possibilities frontier. The consumer can buy any combination of goods that exists on that frontier. If he is a rational consumer and fulfills the budget condition described earlier by Eq. (4-4), he will spend all his income and be on that frontier. He cannot buy combinations to the right of the budget constraint, because he does not have enough money. He will not buy combinations to the left, because to do so would not exhaust his full capacity for goods acquisition. The budget constraint represents the consumer’s highest attainable range of consumption possibilities. It is assumed that the rational consumer will attempt to exploit that full potential. Changes in the consumer’s income, with prices constant, can be represented by shifts in the budget constraint with the slope unchanged. Such a change is illustrated in Fig. 4-3 by the line M'/Py - M'\PX. The M' budget constraint is to the right of the M budget constraint and is farther from the origin on both axes. This illustrates an increase in money income with prices constant. Decreases in income would be illustrated by shifting the budget constraint to the left as from M' to M.

Good Y

FIGURE 4-4 THE BUDGET CONSTRAINT: CHANGE IN THE PRICE OF X

Changes in the pnces of goods would be illustrated by changes in the slope of the budget constraint. For example, in Fig. 4-4 there is a budget constraint M/Py - M/Px, which represents an original amount of income and an original ratio of prices. If the price of X were to decrease from Px to Px* the budget constraint would still intersect the vertical axis at its

75 The Theory of Choice: Utility and Indifference Curve Analysis

original point, because there is no change in the price of Y. Since income is not changing, the quantity of Y that could be bought if all income was spent on Y would not change. However, with the decrease in the price of X, the quantity of X that can be purchased with the constant income will increase. This is illustrated in Fig. 4-4 by the budget constraint MjPy — M\P'X, which intersects the horizontal axis at a point that is further from the origin than the original budget constraint.10 Decreases in prices are illustrated by intersections of budget constraints with the axis at points further removed from the origin, and increases are illustrated by intersections at points closer to the origin.

Indifference Curves The budget constraint discussed in the previous section describes what the consumer can do. In order to understand what the consumer would like to do, it is necessary to examine the other side of the issue. The famous English economist, F. Y. Edgeworth, has developed an analytical and illustrative tool called an indifference curve. It is used to illustrate the relationship between two goods in the consumer’s preference field. definition An indifference curve is a locus of goods combinations in a consumer’s preference field that represents a constant level of total satis¬ faction. Since each combination on an indifference curve is equally preferred to all others, the consumer is said to be indifferent between them.

The indifference curve describes all possible quantity combinations of two goods that yield a given and constant level of total satisfaction. There are many different quantity combinations that are consistent with a constant level of total consumption satisfaction. The consumer is said to be indifferent to these different combinations, as long as they all yield an equal amount of total satisfaction. Because he is indifferent, he will accept any of the combi¬ nations that give him that level of total satisfaction. This relationship is illustrated by Fig. 4-5. Figure 4-5 illustrates a consumer’s preference field for alternative combinations of two goods in a given time period. Good X is represented on the horizontal axis and good Y on the vertical axis. There are two indifference curves represented on the face of the graph. Consider first only that indifference curve which is labeled Ix. That indifference curve represents a given level of total satisfaction attainable by a variety of quantity combi¬ nations of goods X and Y. The consumer is thought to be equally happy with any combination of the two goods on that line. The indifference curve slopes 10 Notice that the budget constraint, which reflects the consumption possibilities frontier after the price decreases, is to the right of the one before the price decrease. This implies that the consumption possibilities frontier has, in effect, increased as if there had been an increase in income. In fact, as we shall see, every price change is also an effective income change.

76

Good Y

CONSUMPTION

2

2

0 FIGURE 4-5

Good X INDIFFERENCE CURVES (MAP)

downward, indicating that if the total satisfaction is to remain constant with changes in quantity combinations, there must be an increase in one good that is offset, in its impact on satisfaction, by a decrease in another good. More specifically, the increase in utility that derives from consuming more of one good must be just matched by a decrease in utility that derives from consuming less of the other. The slope of the indifference curve is called the marginal rate of substitution of X and Y (MRS^). It defines how much X the consumer is willing to give up in order to obtain an increase in Y and vice versa and not be made better or worse off. Mathematically, it is A 7/AX. The consumer only consumes goods for their perceived utility. Consequently, the slope of the curve indicates how much decrease in utility from X given up will result in an equal countervailing change to the gain in utility from Y as the quantity of Y is increased. The utility given up must be just equal to the utility gained if total utility is to be unchanged. The change in utility from a change in quantity consumed of either good is the good’s marginal utility times its respective change in quantity. Therefore, the condition that the utility gained must equal the utility lost can be defined as MUy ■ A Y = MUx • AX

(4-5)

Divide both sides of that equality by MUy • AX, and it turns out that AY/AX is equal to MUx/MUy. Since AY/AX is the slope of the indifference curve, and is called the marginal rate of substitution of X and Y, and since MUx\MUy is equal to AY/AX, we can say that

(4-6)

77 The Theory of Choice: Utility and Indifference Curve Analysis

The slope of the indifference curve, the marginal rate of substitution, is of paramount importance for a determinant analysis. The objective is to explain how the consumer chooses a unique basket of goods, given his budget constraints. That unique basket must be one that fulfills the equimarginal condition as well as the budget condition. Not only must he be on his budget constraint, but he must go to a unique point on the budget constraint. The ability to explain that point rests heavily, as we shall see, upon the slope and curvature of the indifference curve. There are two properties to be considered: first, the indifference curve must slope downward; second, it must be convex to the origin. The negative slope of the indifference curve is easily explained. It merely reflects the assumption that the marginal utility of each good at each point on the indifference curve is positive. Recall the meaning of the indifference curve. It represents all alternative baskets of goods with which the consumer can be assumed to be equally satisfied and, therefore, between which he will be indifferent. If that is the case, utility increases in one good must be offset by decreases in the other, because an increase in one good not offset by a decrease in the other would require that total utility increase unless the good that increased had a zero marginal utility. However, as we have seen, if a good had a zero marginal utility, there would be no incentive to increase its consumption. With regard to Fig. 4-5, the downward slope suggests that as more of good X is consumed, there must be a decrease in good Yconsumed for total satisfaction to remain constant, i.e., the consumer remains on indifference curve Ix. This requires the marginal rate of substitution for goods X and Y to be negative. The convexity of the indifference curve is another matter. It is not so easily demonstrated. Technically, the convexity condition requires that the marginal rate of substitution decrease. Consider the MRS in terms of good Y in Fig. 4-5. The convexity of the curve indicates that as long as the consumer has a great deal of good Y relative to X, he is willing to substitute Y for X quite freely in order to acquire more of X. However, as he moves along the indifference curve, substituting X for Y in the direction of larger relative quantities of good X, his willingness to substitute Y for X diminishes. Although diminishing marginal rate of substitution is not incompatible with the idea of diminishing marginal utility, it is not the same thing. The diminishing marginal rate of substitution simply says that as one acquires more of one good relative to another, he is less willing to substitute the one in which he experiences decreasing quantities for the one in which he experiences increasing quantities in spite of his absolute preferences for the two. Consider an example. Suppose that you are choosing between bread and crackers. Suppose further that you like bread immensely more than you like crackers. Should that be understood to imply that you will consume only bread and never crackers? No; after a full diet of bread you are ready within a given time period to substitute crackers for bread. However, the rate at which you are willing to make the substitution diminishes as you move from a little to a lot of crackers. Eventually, you may be happy once again to substitute bread for crackers.

78 CONSUMPTION

To get back to the problem, the indifference curve represents alternative baskets of two goods that are equally preferred. The negative slope indicates that there is an inherent substitute relationship between the component goods. If total satisfaction is to remain constant while more of Y is consumed, there must be an attendant decrease in X consumed. Consider Fig. 4-6 momentarily. It presents a straight line indifference curve. Such a curve would indicate a constant marginal rate of substitution, as illustrated by its constant slope. Such a curve could be understood to illustrate a “perfect” substitute relationship between the two goods at a constant rate irrespective of relative quantities. For example, you might always be willing to give up one loaf of bread for two boxes of crackers no matter what your absolute amounts of the two are in the immediate experience. That is not very likely. Good Y

I

u

FIGURE 4-6

Good X CONSTANT MARGINAL RATE OF

SUBSTITUTION

Now consider Fig. 4-7, which indicates a “zero” substitute relationship between the two. Figure 4-7 suggests that there is only one combination that will be consumed, that being at the point A. It further suggests that as X increases with Y constant, and vice versa, there will be no change in total satisfaction. The two goods do not substitute and must be purchased in a unique combination. Common sense quickly tells us that neither the “perfect” nor the “zero” substitute case is likely to exist very often. Rather, there would be, for most goods combinations, an “imperfect” and diminishing rate of substitution between goods that would best be illustrated by a convex indifference curve, such as those in Fig. 4-5. We end up with two good reasons for assuming negatively sloping, convex indifference curves. The first is the inherent sense of the assumption. The second is that the assumption

79 The Theory of Choice: Utility and Indifference Curve Analysis

is necessary to a unique solution. As we shall see, the exact rate of the MRS does not matter. All that matters is that it diminishes at least in the area of the quantity combination actually selected on a budget constraint.

Good /

I

I A

0

FIGURE 4-7

Good X ZERO MARGINAL RATE OF

SUBSTITUTION

Now that you understand the nature of an indifference curve, consider different indifference curves. Indifference curve represents a given level of total consumption satisfaction, and indifference curve I2 represents a higher level. The consumer’s overall level of welfare is higher at all points on indifference curve I2 than at all points on indifference curve Ii. Notice that each point on curve I2 represents at least an increase in one good with the quantity of the other constant relative to some point on Ii. The consumer will naturally aspire to be on curve I2 rather than Iv In fact, if the consumer is interested in always attaining the highest possible consumption satisfaction, he will always consume on the highest attainable indifference curve, ceteris paribus. Every point on line /2 is preferable to every point on line 1\. That being the case, it would be logically inconsistent to construct indifference curves that intersect one another. If they did intersect, it would imply that there is a point on one curve that is equally preferred to a point on another curve. One final point needs to be made about indifference curves. They do not exist in statistically verifiable fact. The reason is that they represent distinct levels of satisfaction. Satisfaction cannot be measured. Indifference

80 CONSUMPTION

curves are purely theoretical instruments that represent what is believed to be the substitutability characteristics of goods at a given constant level of satisfaction. Figure 4-5 suggests that distinctions can be made between levels and can be illustrated by distances between indifference curves. That is not completely true. If indifference curves existed, they would be infinites¬ imally close together and would then be indistinguishable from one another. The economist represents different levels of satisfaction as if he were able to distinguish between them. Each indifference curve can be most accurately understood as a representation of an attainable level of satisfaction. Graphs such as Fig. 4-5 that illustrate multiple indifference curves and, thus, multiple attainable levels of satisfaction are called indifference maps. Rational Choice

It is only when the consumer reconciles what he can do as defined by budget conditions with what he would like to do as defined by his preference field, that he is able to arrive at a consumption decision. The consumption decision will be maximum (to the best of the consumer’s ability) if the consumer is using all of his purchasing power and if he is consuming alternative goods in efficient relative quantities. What the consumer can do is illustrated by the budget constraint and what he would like to do by the indifference map. The satisfaction-maximizing choice is represented by the condition that the consumer be on his budget constraint at a point that also places him on his highest attainable indifference curve. Figure 4-8 illustrates this proposition.

Good Y

FIGURE 4-8 MAXIMUM CONSUMPTION CHOICE: THE INDIFFERENCE CURVE APPROACH

81 The Theory of Choice: Utility and Indifference Curve Analysis

Figure 4-8 is a synthesis of Figs. 4-3 and 4-5. It presents both the consumer’s budget constraint and his indifference map on the same graph. Again, good X is represented by the horizontal axis, and good Y is represented on the vertical axis. The budget constraint is represented by the line M/Py — M\PX. Of course, the budget constraint illustrates a fixed amount of money income from which the consumer can purchase goods X and Y and the alternative combinations of the two goods that he can buy as determined by the ratio of their prices. Two indifference curves are represented. They illustrate the alternative combinations of the two goods that the consumer finds equally acceptable for two different levels of total satisfaction. The slopes of the two indifference curves are defined by the marginal rate of substitution, which is assumed to be negative and diminishing. Since indifference curves are convex to the origin, the consumer’s highest attainable indifference curve can be reached by his budget constraint only at their point of tangency. This is illustrated by point E in Fig. 4—8. Since indifference curves are infinitesimally close to one another, any budget constraint that intersects one curve must be tangent to some higher curve. Furthermore, the budget constraint is tangent to the highest attainable indifference curve at only one point. That point is the point at which the two curves are parallel to one another. There is an equality of the slopes at that point. Since the slope of the budget constraint is PJPy and the slope of the indifference curve is its MRS or MUxIMUy, and since the tangency of the two curves defines the attainment of the highest possible indifference curve, consumption is maximized when Px\Py = MUx\MUy. If both sides of that equation are multiplied by the fraction MUy\Px, the relationship can be restated by the equivalent mathematical equality:

MUy _ MUx P

* y

P

(4-7)

± x

Since the marginal utility represents marginal benefit and marginal cost is represented by price, the above mathematical statement can be interpreted as a maximum consumption satisfaction (benefit/cost) condition. The statement says, in essence, that maximum consumption satisfaction will be attained when goods are consumed in such relative quantities that the ratio of the marginal benefit to the marginal cost of the last unit consumed of each good is just equal to that ratio for every other good. The fact that point E in Fig. 4-8 is on the budget constraint indicates that the consumer has exhausted his total budget. Thus, when the consumer purchases the quantity indicated by point E, he not only fulfills the equi¬ marginal consumption efficiency condition for relative quantities, but he also fulfills the budget condition concerning total expenditures. At the quantity combination indicated by point E, the consumer has exhausted his total purchasing power in the consumption of the two goods. The budget condition that M — PXQX + PyQy is fulfilled. The fulfillment of these two conditions together suggests a maximum consumption decision, because the consumer is spending all his income, and he is purchasing the two goods in relative

82 CONSUMPTION

quantities such that the utility derived from the last dollar spent on X is just equal to the utility derived from the last dollar spent on Y. In this way, what the consumer can do is just reconciled with what he would like to do. Examine point E for a moment. There is no other combination of goods X and Y that the consumer can achieve that would not make him worse off. He could go to points A or B on the budget constraint, which would also be points on an indifference curve. To do so would make him worse off, since it would require him to move from indifference curve /2 to a lower indifference curve Such a move would not be consistent with the assumption that the consumer always strives to attain the highest possible indifference curve. The consumer would be equally satisfied on any other point on indifference curve /2 as he is on point E. For example, he would be totally indifferent between consuming that quantity combination indicated by point Tand that indicated by point E. However, his income and the ratio of the prices of the two goods define a budget constraint in such a way that the combination F is not attainable by him. Although he would be willing to go to F, he cannot because of his budget constraint. The consumer attains an equilibrium when he moves to point E, because there is no incentive for him to change from that point.

SUMMARY Chapter 4 approaches the issue of consumer demand from a completely different perspective than that of Chapter 3. The object of the material in Chapter 3 was to present an empirical description of consumer behavior as a function of critical variables. The material in Chapter 4 presents an insight into the underlying psychological-motivational determinants of consumption behavior with a goal of gaining insight into why consumers behave as they do. The essence of Chapter 4 is the theory of choice with special emphasis on consumption choice. The theory of choice begins with a recognition of constraints to choice and postulates that the goal of choice is maximization of the decision maker’s private welfare. The fundamental postulate is the notion of rational choice, which stipulates that the consumer will, to the best of his ability, exercise those options that he expects will make the maximum contribution to his personal welfare. That, in turn, requires that he do all he is capable of doing and that he select among alternatives in maximizing relative quantities. The decision-making process is essentially a benefit/cost decision. The object is to maximize net benefits. The analysis of consumption decision-making requires many new notions and instruments. Perhaps the most important single notion is that of the margin. The fact is that all decisions are made at the margin. One examines his current status in light of his wants and alternatives for future fulfillment of his wants and makes a decision on the bais of those expecta¬ tions. Utility curves, budget constraints, and indifference maps have been

83 The Theory of Choice: Utility and Indifference Curve Analysis

introduced in order to illustrate what economists believe to be the utility characteristics of goods and the benefit/cost reaction of consumers in the decision-making process. In the end it was demonstrated that the consumer attains his highest possible equilibrium in want satisfaction when he fulfills two conditions of consumption efficiency to the best of his ability. The first condition is that he spend all his income among his alternatives, and thus utilize his full but constrained capacity for want-satisfaction. The second condition is that he choose among alternatives in such a way that the utility derived from the last dollar spent on each good is equal to that of the last dollar spent on each other good. In that way, the ratio of the marginal benefits to the marginal costs of each good is equal to the ratio of each other good.

REVIEW PROBLEMS 1. A masochist and a sadist are sitting on a park bench. The masochist says, “Hit me,” and the sadist says “No.” Is this rational behavior as we economists use the expression? Is that different from asking if being a masochist or a sadist is rational? Explain. 2. Assume that each $1,000 has a utility equal to “one unit.” Fill in the missing values in the following table. Plot the data in the table on a graph with quantity on the horizontal axis and S/utility on the vertical.

Quantity 1 2 3 4 5 6 7 8 9 10

Total Utility 5 11 18 24 29 33 36 38 39 38

Marginal Utility 5 6 7 ? 5 4 3 ? l -l

Price ME $4 4 4 4 4 4 4 4 4 4

Total Expenditure $ 4 8 12 ? 20 24 28 ? 36 40

Net Utility TU - TE 1 7 6 8 9 ? 8 6 3 -2

What is the satisfaction-maximizing quantity if the price is zero? What is the satisfaction-maximizing quantity if the price is $4.00? Illustrate what would happen if the price went to $7.00. What then would be the satisfactionmaximizing quantity? 3. John knows who won the Super Bowl and who rushed for the most yards. He also knows that New York City is larger than Chicago. Milton knows who won the Super Bowl; what the score was; how many first downs each team had; how many yards each team had rushing, passing, and returns; and who had the most yards and how many. Who is the cardinal thinker and who is the ordinal thinker? What is the difference? What are you?

84 CONSUMPTION

4. In The Cowboys, John Wayne said, “If death comes and you have done all you

can and you have done the best you can, I guess you are ready for it.” How does this compare with the two conditions of efficient consumption choice? 5. Perhaps the most mischievous misconception of contemporary America is the “no-choice-myth” that we are so constrained by social-legal institutions that we do not have a choice. When was the last time you had no choice? When was the last time you allowed yourself to be carried by circumstances as if you had no choice? Who do you allow to manipulate you?

SUGGESTIONS FOR FURTHER READING Ferguson, C. E., Microeconomic Theory, rev. ed. (Homewood, Ill.: Richard D. Irwin, 1969), pp. 28-36. Harris, Thomas A., I’m O. K.—You’re O. K. (New York: Harper & Row, 1969), Chapter 2. Hicks, J. R., Value and Capital,

2nd ed. (Oxford: Clarendon Press, 1946), Chapters

1 and 2. Scitovsky, T., Welfare and Competition, rev. ed. (Homewood, Ill.: Richard D. Irwin, 1971), Chapter 3.

chapter O

Indifference Curve Analysis of Demand

INTRODUCTION Chapter 4 explained consumption behavior as rational choice. Rational choice depends upon informed assessment of costs and benefits and equating net benefits among alternatives. Choice and demand, therefore, can be defined as a function of costs and benefits. Costs are defined by prices, and the consumer’s ability to incur costs is defined by his income level. Benefits are defined by the consumer’s preferences, which, in turn, are defined by tastes. Consequently, consumption demand can be expressed by the function

D = f(Px, Py, M; T)

85

(5-1)

Equation (5-1) expresses demand as a function of costs and benefits, where costs are the variables to the left of the semicolon. Specifically, Eq. (5-1) expresses demand as a function of the price of the good under consideration Px, the price of other goods Py, money income M, and consumer tastes T. We have seen how the three cost variables are illustrated with a consumer’s budget constraint and how the single but complex benefit variable is illustrated by the indifference curve. In Chapter 4 we saw how the consumer arrived at a rational consumption choice through reconciling these benefit/cost considerations. Satisfaction-maximizing consumption choice was defined in Chapter 4 as a situation in which the consumer spent all his income on such a combination that the ratio of marginal benefits to marginal costs of each

86 CONSUMPTION

good was equal to that ratio for each other good. The two conditions of rational choice, for a single consumer with a fixed income choosing between two goods, are given by the equations

M = PXQX + PyQy

(5-2)

and

MUx _ MUy

(5-3)

These conditions are illustrated in Chapter 4 for a static case, where all the variables are constant, by the tangency of an indifference curve with a budget constraint. It is now appropriate in Chapter 5 to turn the technique to an examination of changes in consumer behavior as determinant variables change. This will be done in the same manner as it was done in Chapter 3, by changing each variable in its turn while holding the others constant in order to examine changes in consumption choice under controlled conditions. The object is the same as that of Chapter 4—to gain insight into and understanding of consumer behavior. The illustrative merits of the indifference curve and the budget constraint are demonstrated well in Chapter 4. The tools are also useful as analytical devices. They are employed analytically in this chapter. However, these are geometric tools and though it is possible to go beyond two dimen¬ sions in geometric exposition, the marginal return to insight and under¬ standing that derive from such elaboration is rarely worth the cost. Consequently, it is necessary to abstract to a level that can be illustrated in two dimensions. This can be done with no sacrifice in realism when the object is to illustrate generalities and principles of behavior. Maximum consumption choice was described for the single consumer in Chapter 4 at the two-goods level of abstraction. The analysis was static. The conditions of choice were fixed and invariable. The following analysis is concerned with the consumer’s reestablishment of equilibrium when choice conditions vary and upset equilibrium. The method is comparative statics. With the comparative static method, it is not possible to observe the process of change but only the results. This method requires: (1) a description of equilibrium before a change; (2) a description of the change that upsets the equilibrium; and (3) a description of the reestablished equilibrium. The analysis illustrates the results, if not the process, of the consumer’s adjustment to change. In this way it sheds light on consumer behavior. The comparative static method is a “before and after” method that is extremely useful in all economic analysis. It is therefore, a method that you must understand. The usual ceteris paribus assumption is employed to isolate changes in particular variables while other variables are held constant. In this way, it is possible to see the unique adjustment in choice that might occur in response to a change in any of the determinant variables.

ADJUSTMENT TO PRICE CHANGES: PRICE CONSUMPTION CURVES Consider point Ex in Fig. 5-1. Point Ex is an initial equilibrium for a hypothetical consumer with a given level of income spent on goods X and Y. From the analysis and understanding presented in Chapter 4, it is clear that point Ex is an equilibrium point because it is the point of tangency of budget constraint AB and indifference curve Ix. Budget constraint AB defines a given level of income and a given ratio of prices for goods X and Y. Good Y

£

\

.QO I >