Tuesday, March 4, 2008

Elasticity, Real Income and Bubbles

One question dogging the economy for the past few months has been "why don't consumers seem to be responding to gasoline prices?" The concern being that as prices rose, demand didn't seem to be falling off as we would expect from a classical economic model.

Well, according to this article (subscriber content) in the March 3 issue of The Wall Street Journal, consumers are starting to respond. And the answer lies in a number of economic concepts.

One concept near and dear to those of us teaching microeconomics is price elasticity: the idea that certain goods and services are not as responsive to changes in price as other items. Graphically, we talk about items that are inelastic as having a steep demand curve, representing that large changes in price result in relatively small changes in the quantity demanded.

Another concept that can be used in the discussion, both with economics and personal finance courses is the idea of real vs. nominal income: the idea that the real value of income is not the money we receive but rather what the money will buy. Taken a step further, when we look at our personal situation from this perspective, we see how increases in the cost of one part of our market basket (gasoline) comes at the expense of other parts (entertainment, food, or whatever), and actually reduces our real income. It forces us to choose and give up something (either we drive less or we consume less of something else). It presents us with opportunity cost as we adjust our personal spending or our budget.

But the article also raised another question for me. In the sixth paragraph, the reporter mentions how investors, seeking shelter from inflationary pressures, have sought refuge in commodities, including oil. This has, in turn, driven the prices of commodities higher. The resulting higher commodity prices then contribute to rising producer prices which may or may not put further upward pressure on consumer prices, depending on how much of the cost the producer feels can be passed on.

But what crossed my mind was the possibility that, by seeking refuge, investors may be feeding another market bubble. And when (or many would say "if") oil prices drop, they may drop significantly - depending on investor psychology - "where else can I place my money safely and yet still see a prospect of return?"

Personally, I don't think prices are in the bubble range yet, but it's still a question for me.

What are your thoughts or your students' thoughts? I look forward to hearing from you.

1 comment:

Mike Fladlien said...

i think people will choose to hold more money in cash...