How Far Can You Get with the Law of Demand?

August 8, 2022
 
A friend who I won’t name once joked, in grad school, “we’ve covered downward sloping demand curves—is there anything else to teach them?”
Less flippantly, Armen Alchian was once asked about what he taught in his PhD (?) Micro course.
He replied to the effect of, “I teach the theory of demand.”
“And after that?” his conversation partner persisted.
“I teach the theory of demand,” Alchian replied.
See for yourself just how much of his magisterial Universal Economics he devotes to the law of demand. More than any other textbook I know of.
The problem, for those of us (all of us) who are less gifted than Alchian, is that we can leave students with the sense that they’ve mastered the law of demand if they but memorize the inverse relationship between “p” and “q.”
Deep understanding only occurs when students become capable of making pattern predictions about markets, predictions informed by what the law of demand says. The purpose of Robinson Crusoe constructs is ultimately to apply economic theory to human interaction. Markets are aggregations.
My own research interests lie beyond “p’s” and “q’s.”
But…
If the only economics you knew was the law of demand, how far could you get? As I tell my students in Econ 101, very, very far. Not as far as you get with the rest of it, of course. Economics is more than rational choice, though it’s not less.
That there is an inverse relationship between “p” and “q,” other things held constant, is easy enough to recall. But it’s far more challenging to apply consistently, persistently, and aggregately.
In what follows, I acknowledge a debt to McKenzie and Tullock’s, The New World of Economics, for several of the examples. In other cases, I’ve forgotten the source. My presentation is intentionally short in order to get the gist across, so yes, I’m leaving out details.
Paul Samuelson was once asked for an insight from economics that was at once true and non-obvious. He offered the law of comparative advantage.
If I had just a few minutes to convince someone of the power of economics, I’d offer these examples of the law of demand as succinctly as I could. What perhaps distinguishes the law of demand from comparative advantage is that the law of demand is even obvious!
And yet, as Coase might say, “much cited, little used.”
Here are a few of my favorite examples.
1.
Safety in the Sky
A 1988 fiery plane crash prompted two Republican legislators to propose a piece of legislation that would have surely cost lives on net, had it passed. Their law stipulated that any child under the age of two be strapped into a protective seat, like a car seat for planes. Economists were quick to condemn this proposed law—not because they are sociopaths, but because they grasped the relevance of the law of demand.
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Imagine a mother traveling with a child. This law would have increased the price of her air travel by 100%. Instead of paying for a single seat and holding the child on her lap, the law would have required her to pay for two seats. (Let the public choice analysis commence).
When the price of something rises, people do less, but more importantly, they search for substitutes. People don’t take to the waterways when flying gets more expensive—they drive! In the late 1980’s, when this legislation was proposed, driving was thirty-five times more likely to kill a person than was flying. The ratio for serious injuries was even more lopsided in flying’s favor.
Had the law passed, it would almost certainly have cost infant lives, on net.
The best demand examples teach other foundational economics concepts along the way. I like this one because it leads right into a public choice discussion—cui bono? Who benefits from this regulation? The example is also instructive because of just how “invisible” infant deaths on the roadways would have been. Who would have connected a tragic car accident—five years later—to the passage of this law? Lastly, intentions don’t guarantee outcomes. And as Rosolino Candela and Vincent Geloso have recently argued, it’s possible to combine a process-focused unintended consequences story with public choice analysis.
2.
Rubber Tariffs
A full-orbed grasp of the Law of Demand requires thinking in terms of substitutes. That was true for fliers and it’s true for consumers buying any other good. Substitutes are ubiquitous.
Yet, substitutes are not always easy to spot. In fact, they’re entirely subjective, as Wicksteed reminds us. A graduate micro question once asked me to what extent pickles might substitute for taxi rides.
When tariffs increase the price of rubber, it decreases the quantity of tires produced domestically. The price of tires rises. This seems like the flying example in reverse—in a way, driving has become more expensive, so do people fly, saving lives? Probably, on the margin, there’s just a little bit of that. But the effect swamping it is that people substitute old, worn tires for new ones with tread.
Old tires are a substitute for new tires.
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3.
Sugar Tariffs
Food in Europe and South America just tastes better than food in the United States. No, it’s not just the halo effect of being a tourist. The food really is better.
The United States has had sugar tariffs for decades. As a result, sugar prices in the U.S. are higher than in Europe or South America.
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Producers found a low-priced substitute in high fructose corn syrup (i.e. poison). High fructose corn syrup doesn’t just taste worse than natural cane sugar; it’s terribly unhealthy.
There is some debate in the economics of food and health literature on all the factors contributing to American obesity. Undoubtedly, the substitution of high fructose corn syrup for natural cane sugar is a contributor.
Once again, tariffs kill.
4.
Licensing
Rates of death by electrocution are not constant across U.S. states, and the law of demand explains why. Neither, by the way, are rates of dental cavities or incidents of rabies in pet dogs.
In states where occupational licensing restrictions are the tightest, the supply of electricians, dentists, and veterinarians is the most constricted. Their labor services are therefore more expensive in these states.
The logic of substitutes—which comprises the lion’s share of using the law of demand effectively—kicks in again. People substitute DIY YouTube videos for electricians, visit the dentist less frequently, and are less likely to avail themselves of a vet for their pets in states where licensing for these professions is the tightest.
Think about how perverse these outcomes are as compared to the ostensible stated goals of such regulation. We’d like to have fewer unqualified people messing around with dangerous wires; instead, we get more.
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5.
Sin Taxes
Tax policy can pursue pecuniary or anti-sumptuary ends, but not both.
If the goal of a sales tax is to raise money, it must be placed on a relatively inelastically demanded good. If the goal is to quash consumption, success will only obtain if buyers are highly sensitive to price changes—elastic.
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It’s obvious, even trivial, that taxes can reduce a good’s consumption. But is that actually the stated goal of sin taxes? Usually, the stated goal is something like: “make people healthier (by making cigarettes more expensive).”
Yet, when governments increase taxes on cigarettes, ceteris paribus, marginal consumers switch to other substances which might be worse for their health. Alcohol is a common substitute. Most of these “marginal switchers” come from the ranks of the young, whose demand for cigarettes is more elastic, on average, than are the demands of the old.
Want to create a community full of alcoholics? Tax, at exorbitant rates, other substances with addictive qualities.
6.
Prohibition
The price elasticity of demand goes 90% of the way toward explaining Prohibition’s failure and the concomitant success of bootlegging gangsters.
The demand for alcohol was very inelastic. That’s virtually enough to explain Prohibition’s failure. Though supply contracted under Prohibition, the best estimates suggest that the decrease in quantity demanded was small. Peoples’ habits went underground.
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When demand is inelastic, a supply-induced price rise also increases the total revenue that sellers earn. That’s the piece of the puzzle that explains gangsters’ wild success. First, the enormous revenues attracted the seedier element—say, those already involved in criminal acts—to the bootlegging enterprise. But these massive revenues also capitalized underground producers. They could afford investments in weaponry and—another important cost of doing business—paying authorities to look the other way.
The result was a violent thirteen-year experiment.
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7.
Subsidies
The preceding examples dealt with changes to the quantity demanded because of a changing price.
There are plenty of great examples stemming from demand changes too.
The figures are a bit outdated now, but McKenzie and Tullock’s book (mentioned above) is great for giving back-of-the-envelope estimates of how much U.S. ethanol subsidies contribute to world hunger.
It’s not trivial.
Ethanol subsidies increase the demand for corn, ethanol’s main ingredient. Corn-based products (i.e. tortillas) are a staple in temperate parts of the world, where an enormous part of the world’s population lives.
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2.
Reasoning from a Price Change
That’s something Scott Sumner reminded us that we should all be on board with. Our own and our students’ reasoning would improve by keeping this front and center.
Financial journalists commit this sin all the time.
Here’s my favorite:
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“Beer is cheaper in countries where consumption is higher.” Yes. It’s called the law of demand.
For various reasons, usually taxes or regulations, the supply of alcohol is dramatically different across EU countries. So is the price and therefore the quantity demand.
My own experience has been that each of these example is surprising, non-obvious to non-economists. I’d be the last to suggest the law of demand is all you need to analyze the social world.
But if I only had one concept at my disposal, it’s what I’d choose.