December 03
Done
Substitutes Everywhere

Substitutes Everywhere

5/16/2023
 
“Good, old-fashioned econ content”—that’s how one commenter describes a recent post by Alex Tabarrok at Marginal Revolution.
And I agree with this commenter’s assessment—the more econ, the better. This post is smack-dab in the core of what I’m calling “mere economics.”
In March of 2022 a group of top economists released a paper analyzing the economic effects on Germany of a stop in energy imports from Russia (Bachmann et al. 2022). Using a large multi-sector mathematical model the authors concluded that if prices were allowed to adjust, even a substantial shock would have relatively low costs. In contrast, the German chancellor warned that if the Russians stopped selling oil to Germany “entire branches of industry would have to shut down.”
The key to realizing the error in the chancellor’s reasoning is to recognize that substitutes are everywhere. At the same time, substitution is a surprisingly subtle concept:
People often find it easier to imagine new uses rather than ways to reduce existing consumption. However, it is typically the new uses that are scaled back first. Tyler and I illustrate this with our jet and rubber ducky graph. Although jet aircraft won’t shift away from oil even at high prices, rubber (actually plastic) duckies, which are made from oil, can find substitutes–wood, for example–when oil prices rise. And if plastic ducky manufacturers cannot find substitutes, they go out of business, freeing up more oil for other uses. In this way, the market identifies the least valuable goods to cease production, another kind of substitution.”
notion image
Substitution is a more nuanced concept than many people imagine. Here’s another example. Imagine that an economy has an energy-intensive goods producing sector and that there are few substitutes for the fuel used in this sector. Disaster? Not at all. We don’t need a fuel substitute, if we can substitute imports of the energy-intensive goods for domestically produced versions. Storage is also a substitute and notice that the more you substitute away from a fuel in final uses the greater the effective storage. If you use 1 gallon a day a 10 gallon tank lasts 10 days. If you use a quarter gallon a day it lasts 40 days. Everything is connected.”
A temptation is to scorn the chancellor and other political commentators for not knowing “basic economics.” Actually, to my mind, the problem lies much more with professional economists. They’ve increasingly abdicated teaching the basic principles of economics. And when they do prognosticate, it’s (too often) about things that no economist, indeed no human, can know. Interest rate and inflation forecasts, what the Fed will “do,” and so on.
We shouldn’t be surprised, therefore, when a pronouncement about downward-sloping demand curves and substitution is met with skepticism. That’s the greater part of economics, and it’s not exactly up for debate—but you sadly wouldn’t know it from how economists speak to the public. As McCloskey puts it in The Applied Theory of Price:
“You wouldn’t know it from the image of economists as a confused mob of social forecasters. You may have heard about disagreements among economists—that if all the economists were laid end to end they wouldn’t reach a conclusion; that if ten economists went into a conference room they would come out with eleven different opinions. Ha, ha. Very funny. The truth is that when economists disagree it is commonly about macroeconomics—the study of inflation and unemployment—not microeconomics, the study of markets.”