When the marginal utility is equal to price for all goods and services, then a consumer cannot improve her well-being by altering her consumption behavior. Suppose that over the course of a year a particular consumer buys 20 comic books and goes to 30 movies. If she buys just enough comic books so that the marginal utility of a comic book is equal to the price, and she goes to just enough movies so that the marginal utility of a movie is equal to the price, then she will be worse off if she goes to fewer movies and buys another comic book.
Suppose that a comic book costs $4 and a movie costs $8. Then to go to another movie, a consumer has to give up two comic books. This is the relative price of movies. Given that relative price, a consumer will go to movies until the marginal utility of the next movie is no more than the marginal utility from two more comic books.
Suppose that comic book prices drop to $3 and movies go up to $9. Now, to go to a movie, you have to give up three comic books. This is an increase in the relative price of movies. In response to this higher relative price, consumers probably will go to fewer movies and buy more comic books. This is known as the law of demand: the quantity of a good that consumers demand is inversely related to the relative price of that good.
Suppose that comic book prices drop from $4 to $3 and movie prices drop from $8 to $6. Then the relative price of movies remains the same. Does that mean that consumers will choose the same number of comic books and movies as before? Probably not. Relative to other goods in the economy, the price of comic books has fallen, and the law of demand would predict that consumers will buy more comic books. The same is true for movies, also.
The law of demand says that as price goes up, demand falls. Can you think of exceptions, in which raising price could actually increase demand for a good? Economists have thought of three possibilities.
Inferior goods. The classic story is that 200 years ago, if your income went up, you would consume more meat and less potatoes. When you consume less of a good as income goes up, we call it an inferior good. Two hundred years ago, potatoes were an inferior good.
If you eat mostly potatoes to begin with, and the price of potatoes goes up, the reduction in purchasing power effectively lowers your income--so that you cannot afford as much meat, and you might even consume more potatoes!
Usually, even with an inferior good, as the price goes up you consume less of it. The inferior good has to be a major part of your consumption basket in order for the possibility to arise that an increase in price could increase demand.
Snob appeal. Thorstein Veblen, an economist of the late 19th century, suggested that some people consume in order to impress others. Think of a luxury sports car, for example. It might be the case that the higher the price of such a car, the more it will appeal to people trying to show off.
Signalling. The 2001 Nobel Prize in economics went to Joseph Stiglitz, George Akerlof, and Michael Spence, who analyzed situations where some people know more about the quality of a good than others. One of their theories is that When buyers do not know the true quality of a good, they may use price as a "signal" of quality. For example, if they see two batteries in a store, they may assume that the higher-priced battery lasts longer. In that case, a higher price could increase demand.
All of these exceptions may be interesting theoretical possibilities. However, none of them is found often enough in practice to make economists question the law of demand. For all practical purposes, it is safe to say that when the price goes up, demand goes down.
Elasticity of Demand
With lower prices relative to other goods in the economy, but the same relative price to one another, will the increase in demand for movies be more, less, or the same as the increase in demand for comic books? This is an empirical question--we cannot predict the outcome of such an experiment based on theory alone.
It could be that a 25 percent drop in the price of movies leads to a 50 percent increase in demand for movies, while a 25 percent drop in the price of comic books leads to only a 10 percent increase in demand for comic books. If this is the case, we would say that the demand for movies is more elastic than the demand for comic books.
The percentage increase in quantity demanded that comes from a one percent drop in price of a good is known as the elasticity of demand for that good. If a one percent price drop leads to a one percent increase in units demanded, then we say that the elasticity is one. If a one percent price drop leads to a two percent increase in units demanded, we say that the elasticity is two. When the elasticity of demand is greater than one, we say that demand is elastic. When the elasticity of demand is less than one, we say that demand is inelastic.
When demand is elastic, a drop in the price of a good leads to an increase in spending on that good. If the price drops by one percent and quantity remained the same, then spending would drop by one percent. However, if quantity increases by more than one percent, then total spending (price times quantity) actually goes up.
If the price of gasoline sold everywhere goes down by 20 percent, your family is not likely to make many changes in your use of cars in the short run. Thus, the demand for gasoline is likely to be inelastic in the short run.
On the other hand, suppose that the price of one brand of gasoline falls by 20 percent, and other brands' prices stay the same. Then many people will switch to the low-priced brand. For that company, demand for gasoline will be very elastic.
Which of the following is likely to have the most elastic demand in the short run? Which is likely to have the least elastic demand in the short run? Why?
The demand for a premium movie channel for Cable TV as a function of the price of that channel relative to the price of a competing movie channel?
The demand for generic orange juice as a function of the price of generic orange juice relative to the price of major brands of orange juice?
The demand for Internet connections from America Online as a function of the price of AOL compared with competing service providers?
One of the most important decisions that a consumer must make is how much time to spend working. Although some people enjoy their jobs, it is safe to say that most people prefer leisure. Economists treat leisure as a good, and work as a "bad" (something people try to avoid).
The price of an hour of leisure is the money income that you give up by not working that hour. Therefore, the price of leisure is your hourly wage.
Economic theory says that you optimize with respect to your choice of leisure just as you optimize other consumption decisions. To optimize, you take enjoy leisure until the marginal utility of the next hour of leisure is no longer greater than your hourly wage.
There are a number of peculiarities in the labor-leisure trade-off. For one thing, taxes play a role. The money income from work is taxed through the income tax and the Social Security tax. Your leisure time, including time spent doing odd jobs around the house, is not taxed. In addition, when you spend money income on goods and services, you pay sales taxes. On the other hand, the pure consumption of leisure (just sitting around) does not give rise to sales taxes. The effect of taxes is to reduce your take-home pay, or net wage. Thus, taxes lower the relative price of leisure. The higher the tax rate on the next hour of labor, the more leisure you will consume.
Another peculiarity is that for many people, the work week is an "all-or-nothing" 40-hour package. You may not be able to choose to work 27 hours and 13 minutes a week, even if that is what you calculate to be the point where your marginal utility of leisure equals your wage rate. By the same token, people who work for a salary often cannot increase their money income by working extra hours on top of what is expected.
If these peculiarities were not present, then I would expect to see fewer people doing household projects, like papering their walls or planting shrubs. Instead, someone would work additional hours and use the income to pay professionals to do wallpapering or shrub planting. If my comparative advantage were planting shrubs, then I should plant shrubs for a living. The fact that I do not plant shrubs for a living suggests that I am better at something else. I tell friends that if I ever plant shrubs, that is a sign that markets are not working as well as they should.
Explain how higher taxes could lead to more "do-it-yourself" projects. Explain how the rigid 40-hour week could lead to "do-it-yourself" projects. What other factors might account for "do-it-yourself" projects?
Leisure as a Unit of Measurement
One way to measure the cost of something you buy is to count how many hours you have to work in order to pay for it. For example, if a movie costs $8 and you earn $6 an hour, then you have to work one hour and twenty minutes to pay for a movie. That is, a movie costs you one hour and twenty minutes of leisure. In this way, leisure becomes a unit of measurement.
For someone who earns $16 an hour, the leisure cost of a movie is less. You only have to give up half an hour of leisure to pay for the movie.
One way to describe economic growth is that it has dramatically reduced the leisure cost of many goods for the average person. The sticker prices on cars are higher than they were 50 years ago, but much of that change represents general inflation. Using leisure as the unit of measurement is a way to abstract from inflation. John Shepler points out that
a 1908 Ford Model T cost most people about 2 years wages. A 1997 Taurus has an equivalent cost of 8 months...
But what about gasoline? Surely the oil crisis of the mid 70's and the continuing tensions in the Middle East have made cheap gas a luxury of the past. Not really. Those prices at the pump truly are less than a few years ago. Now get this. You worked 5.4 minutes to buy a gallon of gas in 1997. You worked 6.6 minutes to buy that same gallon in 1970, before the Arab oil embargo and about the time I remember handing quarters to the station attendants.
Think milk is expensive? A half-gallon took 39 minutes to earn in 1919, 16 minutes for our folks in 1950, 10 minutes in 1975 and it's down to 7 minutes for us today. Ground beef has followed a similar pattern, dropping from 30 minutes a pound in 1919 to 6 minutes in 1997. In fact a market basket of typical food items has slid from 9.5 hours work in 1919 to 3.5 hours in 1950 and is now only 1.6 hours.
Cox and Alm, in Myths of Rich and Poor, point out that the average leisure cost of a pair of Levis was 9 hours and 42 minutes in 1900, compared to just 3 hours and 24 minutes a few years ago. The average leisure cost of a three-pound chicken has fallen from 2 hours and 40 minutes to 14 minutes. The cost of a Hershey chocolate bar has fallen from 20 minutes to 2.1 minutes. In 1910, a 3-minute coast-to-coast phone call cost 90 hours and 40 minutes of leisure! Today, many people treat such phone calls as free.
Although better technology has lowered the average leisure cost of many products, there are some goods that are more expensive than they were years ago. For example, a movie ticket cost 19 minutes recently, and it cost only 17 minutes in 1960.