Prices provide information and incentives. But how do consumers respond to these price signals? Chapter 3 begins to answer this.
It might seem daunting to understand consumer responses. We are unique and respond differently. However, Stigler claims
"In the response to price and income changes, consumers behave in a tolerably reliable and predictable way. The invariably obey one law as universal as any in social life; they buy less of a thing when its price rises. Their buying propensities are a stable function of prices and income..." (pg 20)
This stable relationship forms price theory.
The Price of the Goods
Prices, usually talked about as dollars or euros, are simply the exchange ratios between two goods or what consumers have to give up for the good. If a hamburger is a dollar and a drink is 50 cents, two drinks exchange for one hamburger. The money facilitates this exchange. When Stigler talks about price, he means exchange ratio between goods.
From this, we know people demand more of a good when the price falls. Fewer other goods are required to obtain it.
However, the demand depends on other factors. It is important to explicitly hold these constant throughout the analysis. The other factors are
- Prices of other goods
- Income of the consumer
- Tasters or preferences of the consumer
Only with everything else constant can price theorists analyze relationships.
Downward and Continuous Demand Curves
The most stable and true aspect of these relationships is that prices affect consumption. The graph of these two quantities is the demand curve, like the one at the top.
Demand curves slope down, the famous "Law of Demand." If the price of a good rises, people demand less. This law always holds. It is an empirical rule and impossible to "prove", like MWG and Rothbard attempt. However, the examples are everywhere, if we have the right understanding of price as opportunity cost. Unfortunately, Stigler does not emphasize this.
The claim that demand curves are continuou is more bold. An infinitesimally small change in price will change demand by an infinitesimally small amount. These seems odd. Can the price of apples rise 0.000000001 cents? If the price of apples rises, will a consumer buy .000000001 fewer apples? No.
Unlike MWG, Stigler attempts to defend continuous changes as an approximation reality. Stigler adds three reasons continuity makes sense, on top of the one I mentioned about rates of consumption.
- Through rental or joint ownership, a consumer can use part of a good.
- Consumers can vary the quality and size of a good. This changes the problem from demand for a specific good to a demand for a more general good. Stigler does not call this is a different good, unlike Rothbard. Rothbard claims that a demand curve applies only to goods that are subjectively the same.
- Markets better approximate continuous functions. Not every consumer will cut consumption with small changes in price, but some will. Then the market, as a whole, has reduced consumption.
How responsive demand changes are to price changes is the slope of the demand curve or the elasticity of demand. It is negative, since price increases drive demand decreases.
Besides the direction, it is hard to say much about elasticities in general. "The only general rule is that the elasticity of demand will be (numerically) greater, the better the substitutes for the commodities" (Pg 24). If a consumer can switch between similar goods, then when prices change in one consumers will switch to the close alternative.
Elasticity also depends on the time-frame. Demand curves are more elastic over longer periods. If the price of oil rises, most people will not change their consumption tomorrow. However, if it stays up, people will discover alternatives to use less oil.
This analysis of quantity adjustment to changes in price is at the center of price theory. However, we have so far assumed that everything, besides price, remains constant. This is rarely true and Stigler mentions how three other changes affect demand.
The prices of related goods are the second factor in demand. Demand for hot dogs will depend on the price of buns (complement) and the price of hamburgers (substitute). The change in price of one good affects the demand for a related good. We could create a cross-elasticity between these goods, if needed.
The demand curve only makes sense if the prices of substitutes and complements is held constant. This is rarely true, making headaches for economists. Nevertheless, it is important to distinguish between the direct effect of changes in price with the indirect effect of changes in related prices.
The third factor in demand is income. Consumer will consumer different quantities depending on income. Just with cross-elasticities of goods, this change is positive or negative. The consumption of some goods increases with income. These are normal goods. Sometimes the consumption will decrease with income. These are inferior goods. As college students get jobs and more income, they often decrease their consumption of ramen noodles.
Tastes are the fourth factor. If the consumer's tastes change a lot, then it would be impossible to analyze these consumers. These unobservable changes in taste would overpower and change in prices, income, or prices of other goods.
However, Stigler believes that tastes are stable, since stable relationships exist between prices or income and demand. Even apparent differences in tastes, such as old people ride motorcycles less because they like riding less, is not actually a different in tastes. Instead, it is a difference in costs, since older people are more likely to get seriously hurt in an accident.
An explanation that relies on differences in taste is no explanation at all for the economist. You cannot predict or understand the nature of actions if tastes are the driving factor. Instead, Stigler assumes that tastes are fairly consistent across people.
If a prediction is made on the basis of an economic analysis that assumes tastes to be fixed, and if the prediction is confirmed by experience, then the neglect of tastes has been justified." (Pg 39)
Stigler makes two assumption about tastes. First, human wants are never fully satisfied. They are insatiable. Secondly, tastes are varied. People want different goods. Both of these assumptions are found in MWG and Rothbard.
The easiness of price theory makes it extremely attractive, compared to the cumbersome nature of Rothbard and MWG. It provides an easy tool for analysis. But, is it the right analysis? That is the important question.
Stigler completely ignores utility theory. There is are no preferences, mapping of indifference curves, or utility functions. This leaves price theory less comprehensive. However, it also avoids the most questionable aspects of microeconomic theory. He does not need to make all the questionable assumptions about preferences to arrive at the answer. Instead, price theory focuses on what can be observed, prices.
This emphasis is not perfect. Stigler switches between the observable price to the unobservable cost without being explicit. It would be nice to see this clearly. Price and costs are different, though related.
Stigler also switches between individual consumer demand to market demand without always being clear. Specifically, that market demand is more continuous than individual demand is not an argument for continuous consumer demand. The focus should stay on individual actors. I understand why Stigler switches. It makes the story easier, but it is begging the question.