Tuesday, July 22, 2008

The Demand Curve Slopes Downward: Who Would've Guessed?

I ran across this article in yesterday's edition of USA Today. And while the implied theme would hardly qualify as news to anyone studying economics, it is still worth drawing attention to the story. The idea that demand for a good or service decreases as the price increases, and vice versa, is fundamental to understanding the price mechanism. One can detour into discussions of elasticity of demand - how much does the quantity demanded change as price changes. But the basic description of demand is not surprising. That is why there's no news in the headline. But the story offers more to consider.

While the author is correct that economic conditions can change behavior, I believe drawing a parallel between now and the behavior change brought about in the 1970s is ambitious. The fundamental long-lasting type of change referred to in the article is a result of long-lasting economic circumstances. The type of behavior change cited in the article was the result of a decade-long period of rising inflation and stubbornly high unemployment. It was that long period that changed behavior.

Consumer (and producer for that matter) behavior is fundamentally forward-looking, but it is based on past experience. A decade of difficulty tends to loom larger in the memory than a year of difficulty. And while individuals are changing behavior as a result of current housing and gasoline prices, it is probably too early to call that change a long-run phenomenon. Even if it takes another year for the economy to fully emerge from the present funk, individuals can quickly revert to previous models if the economy picks up steam quickly. The slow recovery from the recession of the early 1990s was all but forgotten (along with many lessons) within five years - remember irrational exuberance?

But this article is worth discussing with your students for a number of reasons. First, have them look for parallels in their behavior and the behavior of the individuals mentioned in the article. Ask them how they and their families have adopted to current prices.

Second, have your students extrapolate from their experiences to the larger national picture. How does what they experience get reflected in the national economic picture (inflation, growth, employment)?

Finally, ask them how long they think it would take them and their families to "return to normal behavior" if the economy started to show improvement in the next couple of months? Would they quickly revert to old patterns of buying? Would yhey reexamine decisions to purchase something major? And if so how?

These types of questions can be useful not only in an economics course, but in personal finance classes as well. We shape our budget, largely on our expectations, but conditions changing for the better do not necessarily imply a pressing need to increase the spending category of the budget.

I look forward to your comments.

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