Chapter 6

Consumption and Demand



1. What happens to wealth?

We have seen that the production of wealth uses three

fundamental resources or factors, land, labor, and capital

goods. The wealth is distributed to the owners of these

factors, landowners receiving rent, laborers receiving wages,

and the owners of capital goods receiving a capital yield. This

is the first distribution of the wealth.

The wealth is then subject to two further possible

distributions. The recipients may voluntary transfer some of

their wealth to others, such as to their children, to some

organization such as a church or charity, or to their heirs as

an inheritance. These gifts make up the second distribution of

wealth.

Wealth can also be transferred involuntarily, and forced

transfers make up the third distribution of wealth. The third

distribution is of two types: 1) theft, and 2) taxes. Theft, of

course, is the forced transfer of wealth by private persons,

while taxes are the forced transfer by a government. Note that

government revenues can be obtained by the first two

distributions as well. For example, user fees are a voluntary

payment by persons for specific government services, just like

paying a price for any other consumer goods. Governments may

also earn revenue from their operations, such as running a

subway system. Finally, the government can act as a collection

agency for commonly owned property, receiving the rent and using

it for its operations. In substance, the collection of land

rent, is also a first distribution, rather than a tax, if we

consider the rent to be commonly owned by the members of a

community.

The second and third distributions are called

"redistribution," since they distribute again the wealth that

was already distributed the first time to the owners.

Redistribution normally refers to forced transfers of wealth by

government.

After the wealth has been distributed, it ends up in the

hands of the final recipients as income, which is an increase in

wealth or claims to wealth. People are usually paid in money,

but as we have seen, this money is just a general ticket one can

exchange for real wealth.

Then what happens to the income? It is spent in three

possible ways. First, it can be used to buy consumer goods.

These are goods which are acquired for immediate, personal

consumption. To consume really means to "use up." You buy a

banana, your eat it; you have "used up" the banana. It is

consumed - no longer exists.

Secondly, you can save your income. This income is

usually put in a bank or other financial institution, which then

invests it in new capital goods or in the creation or

improvement of an enterprise (usually, the institution loans the

funds to borrowers who invest it). So savings are usually

directly or indirectly put to use for investment; investments

tend to equal savings. One can also directly invest one's

wealth. Also, since consumption consists of using up wealth, if

one buys a durable good, something like a car that lasts a long

time, then it too is an investment. It gets consumed a bit at a

time; or, as accountants say, it depreciates (as discussed in

Chapter 4 on capital goods). Every year, it loses some value.

Since capital goods have a yield, if you invest your

money, it gets a return. If your investment is more direct,

such as buying a car, you are getting an implicit return. If

you instead had to borrow a car, you would be paying the owner a

periodic fee; so if you own your own car, you are paying it to

yourself, just like if you own land, it has a rent regardless of

whether any explicit or money payments are being made.

The third way of spending income is to waste it. Waste

involves the use of resources in different ways than the owners

would have wanted, and without benefit to them. If a vandal

destroys your car, for example, this is not only your own loss,

but a social loss as well, since this resource has been wasted.

If the government builds a road in a forest that benefits only a

few individuals (say, the owners of a lumber company), then the

wealth of the original owners (from the first distribution) has

been wasted, used in ways they would not desire and do not

benefit from. This road is not a true investment, since its

yield is less than what investors would get in a free market.

Government subsidies, then, are usually wasteful, and costs

imposed by government restrictions and taxes are also a social

waste of resources, since they not only extract funds that

people would want to spend in different ways, but also increase

the price of goods, and this involuntary increase constitutes a

waste.

2. Consumers' utility

What, then, determines how income is consumed? Let's go

back to the foundational principles of economics. Proposition

#8 states that human beings have ends, or goals, desires, and

needs. Proposition #11 states that human values, and thus these

ends, are subjective. Proposition #9 states that people are

able to rank their ends into those of greater and lesser

importance.

The theory of economic values was pioneered by the

founder of the Austrian school of economic thought, Carl Menger

(1871). He defined value as "the importance that individual

goods or quantities of goods attain for us because we are

conscious of being dependent on command of them for the

satisfaction of our needs" (p. 115). Values are thus

subjective, since each individual perceives the importance of

goods from his own needs or desires, from his own feelings and

thoughts. Value originates in the human mind rather than in

things: "Value is thus nothing inherent in goods" (p. 120). We

know from experience that what pleases one person will be

detested by another person.

Goods have utility, or usefulness, because we value

them. As Menger stated it, "Utility is the capacity of a thing

to serve for the satisfaction of human needs" (p. 119). In

ranking our subjective ends or desires, we also rank the

desirability or utility of the various goods that have the

capacity to satisfy these desires.

Menger then notes that "these differences in the

importance of different satisfactions can be observed not only

with the satisfaction of needs of different kinds but also with

the more or less complete satisfaction of one and the same need"

(pp. 123-4). For example, you not only desire food, but a

different amounts for different reasons, such as for survival,

health, or enjoyment. The highest rank might be for survival,

then for health, and then for enjoyment, or perhaps some folks

would rank enjoyment greater than health, as we often do some of

the time. Hence, we rank food-value in terms of the decreasing

importance of various amounts. In general, for any good,

different amounts satisfy different types of needs or desires of

different importance, so that as we consume ever more of it,

ever decreasing desires are satisfied, until the amount is

reached when, at some moment, "a more complete satisfaction of

that particular need is a matter of indifference" (p. 125).

Even more consumption would then become a burden.

So the utility derived from some good diminishes as you

obtain more and more of it. Maybe the first small increments

give increasing utility, but eventually the utility of

increasing amounts diminishes. This is called "diminishing

marginal utility."

The value you place on an extra amount of a good depends

on the subjective importance or value of only that extra amount,

regardless of the value of the previous amounts. So what you

would be willing to pay for that amount depends only on that

marginal or extra utility obtained, not on the utility of the

previous amounts. And here is the kicker: when you buy a

certain amount of a good, if all the units of the goods (like

individual oranges in a bag) are priced identically, then the

price you are willing to pay per unit depends on the utility of

the last, the marginal, the least important unit. Otherwise,

you would not buy that extra or last unit!

For example, if apples and oranges are each priced at 20

cents each, but you prefer oranges to apples, you would rather

buy one orange than one apple. You value the second orange (at

that moment) less than the first, but still greater than the

apple. But now, having two oranges, you would rather have one

apple than a third orange. If oranges are priced cheaply,

you'll then take a fourth or fifth one. You don't want an extra

apple because an extra orange is more important at the time.

But if that day oranges are expensive, then you might only take

two, plus one apple, since the first couple of oranges are more

important and valued than the next few. So the price you are

willing to pay for one orange or one apple depends on the value

to you of that last apple or orange taken, rather than the

first.

As Menger put it, "The value of a particular good ... is

thus for [an individual] equal to the importance of the least

important of the satisfactions assured by the whole quantity

available" (p. 139).

Marginal utility explains why water is so cheap where it

is in large supply, even though it is an important commodity

overall. When lots of water is available, the last unit you buy

will be put to a relatively unimportant use, like washing your

car. The marginal value of water, then, is low, even though

some of the water (the first amounts you would buy if it were

scarcer) is very important.

3. The law of demand

"To "demand" in economics does not mean to boldly and

angrily insist on getting something, but simply to both want

something and be able to pay for it. A demand for a product

means the amount that consumers are willing and able to obtain.

The demand of an individual consumer for a product depends on

his subjective value with regards to the good, the utility he

perceives it to have for him. Because of diminishing marginal

utility, people buy more of a good if the price is less, since

they will be willing to satisfy less important desires if the

price is lower.

The price of a good is not just the amount one has to

pay for something, but also the foregone opportunities. If you

spend $100 for a coat, you have lost the opportunity to spend

that amount on something else. The real cost is therefore the

foregone opportunities, not the $100, since that $100 will be

spent on something. At a lower price, the foregone

opportunities are fewer or less valuable. This concept of cost

being a foregone opportunity is called "opportunity cost,"

another concept pioneered by the Austrian school, namely by

Friedrich von Wieser.

Land has an opportunity cost for an individual, but for

an economy as a whole, the land is already there, so there is no

opportunity cost in its use overall (as opposed to use for a

particular purpose). Labor does have an opportunity cost

because the alternative is leisure. Land being dead, it doesn't

care whether it is being utilized 24 hours per day. Because of

the zero real cost of land, the rent not caused by the efforts

of the site users can be considered a social surplus.

Thus, for any good, at different prices there are

different opportunity costs, and the lower the price, the lower

these costs, relative to the subjective value of another unit of

a good. Hence, there is a relationship between different prices

of a good and the amount one is willing to buy: the lower the

price, the more one is willing to forego other opportunities and

buy another unit of the good.

A demand function consists of the various quantities of

a good one demands for each price of a good. We can concisely

describe this function as Q = f(P), quantity bought is a

function of price. The actual relationship for various values

of the function can be written in a schedule or table, or in a

graph. Such a graph has price along the vertical axis, the

opposite from the normal mathematical convention of having the

independent variable on the horizontal, thanks to Alfred

Marshall (1842-1924), the economist who pioneered the analysis

of supply and demand. Quantity is then on the horizontal axis,

and we then draw points showing the quantities demanded for each

of various possible prices. These points are then jointed

together to form a "demand curve."

Since a greater quantity is demanded at a lower price, a

demand curve slopes down, diagonally to the right. This is

called the "law of demand," a fundamental principle of

economics. As we have seen, the law of demand is derived from

the diminishing marginal utility for increasing amounts of

consumer goods. Demand curves can also be horizontal (where the

price is always the same) or vertical (where the quantity is

always the same).

The quantity of goods demanded can be of two types. For

flows, goods in continuous production and consumption, the

quantity is an amount per unit of time. For example, the demand

for oranges is a certain amount per week or month. The quantity

axis is then Q/T, quantity per time interval.

The other type of good is a stock, a certain quantity at

one moment of time. For example, the demand for a certain rare

stamp is that of a stock. No more of these stamps are being

produced; there is no flow of product. Instead, collectors bid

already-existing stamps from one another, competing for a fixed

stock. At any moment in time, there will be bids and offers for

stamps, and an exchange takes place when a bid and offer match

in price. The demand for the stamps are therefore the number of

bids at any particular moment in time at some price. At a

higher price, fewer collectors are willing to bid for a stamp.

So the demand curve for stocks of goods also slopes down, but

the quantity axis is for bids at a certain moment. The market

for land is such a market, since people bid for existing

parcels, buying from a previous owner rather than for newly

manufactured or imported land!

The demand for consumer goods depends of many variables,

such as subjective preferences (or tastes), income and wealth,

and alternative goods and prices.

The demand curve for a good for an entire economy is

simply the addition of all the demand curves of the individuals.

4. Shifts in demand

If someone says "demand has gone up," the correct

response from an economist is, "what demand do you mean?" This

language is ambiguous because it can mean two different things.

First, it can refer to an increase in quantity demanded when the

price goes up, which would be a movement along the demand curve

or schedule. Secondly, it can refer to a shift of the entire

demand curve, when consumers want more of the good at all price

levels. When an economist talks about an "increase in demand,"

the meaning is that there has been a shift in the demand curve

towards greater quantities at all prices.

5. Elasticity or responsiveness

An entrepreneur wishes to know how much more of his

product will be bought if he lowers or increases the price.

What he wants to know is called the "price elasticity of

demand." We can blame Alfred Marshall for this confusing

terminology, just as he is to blame for switching the

demand-curve axes. A better term for elasticity would be

"responsiveness." The price elasticity is the responsiveness of

the quantity demanded to a small change in the price of a good.

It is measured as the proportionate (or percentage) change in

quantity divided by the proportionate change in price. The

technical calculation is as follows: -(change in

quantity/quantity)/(change in price/price). There is a minus

sign in front of the first term because by convention economists

want the ratio to be positive, and the numerator is negative,

since an increase in price leads to a decrease (negative amount)

of quantity change.

Demand is said to be elastic if the price elasticity

(quantity responsiveness) is high. This means a small change in

price leads to a relatively large change in quantity demanded.

By convention, demand is calculated as elastic if its value is

greater than one, which means the proportionate change in

quantity is greater than in price.

The opposite is an inelastic demand, if the quantity

responsiveness is low, less than 1. If it is exactly 1, then it

has "unitary elasticity." These elasticities are important in

applied economics, since enterprises want to know the effects of

price changes, and they experiment to see what the quantity

responsiveness is. So an education in economics needs to

include these concepts and terms.

There are two other elasticities relevant to demand.

One is (again confusingly called) the "income elasticity of

demand," which would be better called the "quantity

responsiveness to income." Here, we measure the change in

quantity demanded when there is a change in income. This is

calculated as the percentage change in quantity divided by a

percentage change in income - this time with no minus sign.

Again, there is a practical application, since if we expect

incomes to rise, an enterprise wants to know how the demand

curve for his product will shift.

The third type is the "cross elasticity of demand,"

which means, in English, the responsiveness of the quantity

demanded of one good when the price of another good changes. It

is calculated as the percentage change in quantity for one good

divided by the percentage change in price for another good.

This cross-price elasticity is important in being able to tell

which goods are substitutes and which are complements.

A good is a substitute for another if one can switch

from one to the other without much loss in utility. For

example, if you don't much care whether your pencil is colored

yellow or blue on the outside, they are close substitutes. We

can measure this with the cross-price elasticity. If it is

positive, the goods are substitutes, because it means an

increase in the price of one good (blue pencils) induce an

increase in quantity demanded in another good (yellow pencils).

A big increase in the price of green apples would likely lead to

people buying less of them and more of its substitute, red

apples.

If the cross elasticity is negative, the goods are

complements. A complement is a good that is used together with

another one. For example, your left shoe is a complement to

your right one. Suppose they were sold separately, and the

price of right shoes went way up. You would not only buy fewer

right shoes, but also fewer left ones, since you want both

together. The cross price elasticity would be negative, since

an increase in the price of left shoes leads to a decrease in

quantity bought of right shoes.

If the cross price elasticity is zero, then there is no

relationship between the two goods.

6. Amount of goods demanded

We can now determine that amount of each good that a

consumer will buy in a market economy. Foundational principle

#12 states that people economize. Henry George (p. 170) stated

that this principle "is to political economy what the attraction

of gravity is to physics - that men will seek to gratify their

desires with the least exertion." Economizing implies too that

people will want to maximize their utility or wealth for any

given cost.

Consumers will then want to buy that basket of goods

that gives them the most satisfaction. Since for each good

there is diminishing marginal utility, to maximize utility,the

last amount of each good bought needs to be equal in utility to

the last amount of every other good bought, relative to their

prices. For example, if oranges and apples each cost 20 cents,

then you will buy 4 oranges and 2 apples if the 4th orange

provides as much marginal utility as the 2nd apple. If the 5th

orange provided more utility, then instead you would buy it

instead of the 2nd apple. If tomatoes are 10 cents each, and

you like two tomatoes as much as one apple for all quantities,

then you would buy twice as many as apples since they cost half

the price.

In general, the basket of goods that gives you as much

utility as possible is that in which for each good, the marginal

utility of each good is proportional to its price. The marginal

utility of each good, divided by its price, equals the marginal

utilitity divided by price of all other goods. In that case,

the last dollars or pounds spent on all goods give the same

amount of utility, and you can't do any better.

7. Consumer demand and the factors of production

In our model in Chapter 3 on rent, we had only one crop,

corn, and the rent and wages were calculated in terms of corn.

But in a complex economy with many goods, which goods determine

the value of wages and rent?

We again turn to Menger (who is a good complement to

George!). We have seen that the values of consumer goods are

subjective. As you recall from chapter 4, capital goods are

called by Menger "goods of higher order" than consumer goods.

As Menger put it, "the value of goods of higher order is always

and without exception determined by the prospective value of the

goods of lower order in whose production they serve" (p. 150).

In other words, if consumers value corn highly relative to other

goods, then the goods of higher order used to produce those of

lower order will have value. Land and labor used in growing

corn have value because corn has value, or is expected to have

value. The value of corn is not due to the costs of growing it;

on the contrary, the resources used in growing it have value

because the product has value. If you worked all day making mud

pies, your labor would have a value of nill, since no one would

want that product (unless your mother bought some).

As Menger recognized, the determination of the factors

land and labor from the expected value of their final products

is consistent with the law of rent, as analyzed in Chapter 3:

"The existence of the special characteristics that land and the

services of land ... exhibit is by no means denied. In any

country, land is usually available only in quantities that

cannot be easily increased; it is fixed as to situation; and it

has an extraordinary variety of grades" (p. 169). Menger's

theory deepens our insight into why land and labor have value at

all. It was because the corn had value that the differential

rent appeared in the first place and that the wages paid in corn

had any value. But it is not the value of corn alone that would

determine the rent of a particular lot of land.

As Menger wrote (p. 169), a factor of production will

also have a greater value if complementary factors have a

smaller value. Suppose that we need irrigation in order to use

a particular area of land. If this water is cheap, then land

rent will be higher than if the irrigation is more expensive.

So the value of a capital good is determined by the relative

physical productivity of the good, the expected value of the

consumer good it helps to produce, and the cost of complementary

factors.

8. Cost-influenced choice

Building upon the theory of subjective values, James

Buchanan (1969), a pioneer of public choice theory which uses

economics to analyze government, developed the theory of choices

by private versus public agents. If you are choosing among

goods with your own money, your choice will be "cost

influenced," since each choice has an opportunity cost of

foregone alternatives.

However, if your are a government official choosing

among different goods for government spending, you do not

personally bear the cost. The cost is borne by the taxpayers.

Thus, this choice is not cost-influenced.

Recall in the beginning of the chapter that we had three

categories of spending, consumption, investment, and waste.

Consumption is a cost-influenced choice. Some government

spending is also consumption and investment, since the taxpayers

would, if given a direct choice over their funds, want to buy

some of the things government buys, such as perhaps highways and

wildlife conservation. But much of government spending will not

have been so chosen, and it constitutes waste.

An individual may choose to buy an item he later regrets

having bought. In retrospect, it was a waste. But since he did

not know this beforehand, the spending is consumption. The key

is whether the choice is cost-influenced. If at the moment of

choice, you bear the cost and make a free choice, then the item

bought is in the category of consumption or investment. The

relevant utility of an item is that which is made at the very

moment of choice. The fact that you might then have buyers

remorse is irrelevant so far as the consumption is concerned.

It's too late. The spending is now a sunk cost. Economics

looks forwards to the future. Prices are always based on the

expected utilities, not on the actual utility once a choice has

been made. The past is important in influencing the future. A

bad product will not be bought much in the future, if the word

gets around. The past guides our future, but our expectations

about the future determine our utilities and therefore the

prices of goods.