by Isaac Crawford
It’s amazing how much of microeconomics is common sense rigorously applied. In fact, much of the entire field can be summarized in the phrase “Demand curves slope downwards.” This is the punch line of most microeconomic research. Often times it is left unsaid, but if you ask why the results of their study hold true, the inevitable response is that demand curves slop downwards.
But what does it mean? There is quite a bit of theory and mathematics behind it, but the important part can be explained using intuition alone. Since we all have a limited budget, it turns out that the more things cost, the less we can buy. That doesn't sound very interesting, but it turns out that that assumption leads to some very important results. So what’s all this downwards sloping business? If we were to make a chart that had the price of a good on the vertical axis and the quantity they would buy on the horizontal axis, you would see a downward sloping line made up of all of the combinations of price and quantity that could be chosen by the consumer.
Technically it would be a downward sloping curve, and this is known as a demand curve because it represents a consumer’s demand of a good at any given price. In the above graph, it shows that at 14 thousand dollars, the consumer would purchase zero quantity and that at zero cost, the consumer would acquire 14 of this particular product. This particular example is completely made up but it is of the same shape of any other demand curve out there. It doesn’t matter what good you’re talking about or which consumer you ask. The curve will always be downward sloping. Always? Yes, always. Remember, when faced with finite budgets, demand curves must slope downwards.
The graph above describes a consumer's demand for all goods vs. putting his money under the mattress. We will assume that he has 18 units of money available to him in total. You can see that if he decides not to buy anything at all, he would have 18 (Dollars? Thousands of dollars? The graph doesn't say). If he spent all of his money, he would have 10 units of goods. These are the outside possibilities of his budget, all other options have to be somewhere in between. That gives you a downwards sloping demand curve automatically, there is no other choice. Then more he buys (moving right along the horizontal axis), the less money he has. The less he buys (moving to the left on the horizontal axis), the more money he has. Strictly speaking, this is not a demand curve but a budget constraint, but the same idea applies. Surely there are items that are desired because they are expensive. That would mean that they have a positive sloping demand curve, right? Maybe, but what would a good that had an upwards sloping demand curve be? It would be a good that the more expensive it was, the more people would buy.
The graph above shows what a positively sloping demand curve implies. If Lexus automobiles were being given away, the consumer would not get any but if they cost 150 thousand dollars, he would buy 20. And the trend would continue, the more expensive the cars became, the more he would buy. Clearly this does not reflect reality, the demand curve must slope downwards.
A Lexus is a luxury good, maybe it is desired because it is expensive. Would they sell more or less if they cut the price in half? The car is exactly the same, but half the price. It's a safe bet that they would sell more, not less. If they doubled the price from today's prices, they would sell less. Demand curves slope downwards.
Economics starts from something that is straightforward, and indeed our look at a budget constraint is simply a reformulation of the law of demand. This law states that all things being equal, the more a good costs, the less will be consumed. A little bit of logic is all it takes to understand the essence of this law. Everyone has a finite budget. Let's assume that there was a good that you liked so much that you would not consume anything else, every bit of your budget would go to this good. Well, as the price of that good rose, you would be able to consume less and less of it. Economists assume that this is true, and at a casual glance it would seem that they are justified in doing so, but it is actually a bit deeper than it first appears.
The first thing that needs to be addressed is the all things being equal thing. This means exactly what it says, everything must be the same for the law to hold. For example, if there were two cars available at two different dealers that were identical in every way, the consumer would pick the one that is less expensive. This does NOT mean that the person would always pick a Ford Focus over a BMW since the Focus is cheaper. There are enough differences in the two vehicles that someone may feel that the BMW is “worth it”. To put it a different way, a Ford Focus and a BMW 5 series car are not the same good. The BMW and the Ford Focus have different demand curves, both of which slope downwards. In addition, if the cars were the same, but you hated one of the dealers, then once again, not all is equal. If there are two companies that you could choose from (say Coke and Pepsi), but you hated the environmental practices of one, that would once again change the all things being equal equation.
A less obvious aspect of the law but perhaps more important is the idea of cost. In everyday language, a cost is measured in dollars and cents and is easily compared and evaluated. Economists use the term total cost. The total cost of something is not only the dollars and cents, but the next best thing you give up in order to consume that particular good. This is what is known as an opportunity cost. For example, if a person has $500 dollars to spend they have to decide what to do with it. He might choose to buy a TV, or he may buy a ticket to LA to visit some friends. If he decides to go to LA, he gives up the option of the TV. In this example, the trip to LA cost him a TV. Money is no longer the emphasis of cost, it only represents possibilities that one has to choose from. This is important because you can then use the same structure to analyze non monetary decisions. Good microeconomics goes way beyond dollars and cents.
This should be fairly obvious when dealing with things like apples, cars, movie tickets etc. It gets a little more interesting when you start thinking about things like justice, clean air, and even life. Like so much of microeconomics, much of it looks obvious when you think about it a little, but it’s surprising how quickly and easily people ignore this type of common sense. Most of microeconomics concerns itself with pointing out obvious outcomes that are buried under obvious expectations. A prime example of this is the minimum wage law. Minimum wage laws are brought about in order to help low income workers. The results are the opposite, low income workers are hurt by minimum wage laws. Why? You should know the answer by now, demand curves slope downwards. Don’t see it? Imagine an employer's demand curve for labor.
At zero dollars per hour, he would employ anyone that would want to work for him up to the point that everyone got in each others way and productivity actually went down, lets say 190 people. At 42 dollars per hour, he would not hire anyone. Between these two extremes there is a curve that describes his hiring of the same labor at different prices. SInce it is downwards sloping, any movement up the vertical axis (higher wages) corresponds with a shift to the left on the horizontal axis, lowering the amount of labor he hires. Any movement to the right (larger numbers of people employed) travels down the vertical axis resulting in lower wages. We’re going to assume that the minimum wage law raises the salary of the workers (otherwise, why pass the law at all?). Now that the same workers cost more, the employers will hire fewer employees. The result is more unemployment among the people that the minimum wage law is supposed to help. It can’t happen any other way, more unemployment will always be the result of minimum wage laws because of finite budgets, in other words, demand curves slope downwards. The same happens with mandatory union hiring. The Union demands a higher compensation package than the workers would otherwise get. The result is that fewer people are employed (albeit at higher wages usually) and more are unemployed.
Think about this, what cost would you be willing to incur to insure the safety of your family? Your initial reaction is probably anything. I’m willing to bet that it would be quite a bit less. Remember, we’re talking about total cost. Would you be willing to move to another part of the country? Sure, no problem. How about changing jobs? Again, in order to protect my family I’d do that in a heartbeat. How about overseeing the slaughter of tens of thousands of innocent women and children and working the same number of men to death? Wait a minute, that’s not realistic. You’re ducking the question, besides I can think of at least one situation that meets that exact cost. There were probably more than a couple of guards and workers of Nazi concentration camps that had to make that exact choice. Would you do it? You’d probably have to think about it, and even if you did do it, you could now imagine something that would cause you to say no, the price is too high. The demand curve for the safety of your family is downwards sloping.
That's not to say that demand curves are static. They can shift up and down and they can vary in their slope. The slope determines what economists call the elasticity of the good. The steeper the slope, the less dramatic the change in quantity demanded when the cost changes. For example, when gas goes up by 50 cents a gallon, the change in quantity demanded doesn't change much (but it does change). If chewing gum goes up by 50 cents, there would be a dramatic decline in the use of chewing gum. Gum is more elastic than gasoline, but both have downward sloping demand curves.
If there is a sudden spike in the demand for a good (for example programmers in the .com boom) it usually corresponds to a shifting of the demand curve upwards. When it is shifted upwards, the consumer is willing to consume more at any given price, but the amount demanded still goes down as the price increases. So, if the demand for programmers shifts upwards, that means that employers are willing to hire more programmers at $50,000 each a year than they did before. But they will hire less as the salary of each programmer increases because demand curves slope downwards. When a demand curve shifts downwards (steel workers in Pittsburgh in the late 70's), the consumer is willing to consume less at any given price. Demand curves can move around, but they always slope downwards because of the law of demand.
It's important to understand that demand curves don't exist in the real world. We cannot look up someone's demand curve for something and know what they are going to do as price changes. These curves are a handy (and accurate) way of describing and predicting what markets do. Economists rely on what they call revealed preference to determine the shape and slope of demand curves. In other words, they look at what people actually do and what they have done before when it comes to making decisions based on price. It is due to revealed preference that we know that demand curves really do slope downwards and it is not just the wishful thinking of theorists.
The term Rational choice theory is sometimes used instead of microeconomics when dealing with non monetary decisions. When thought of in these terms, microeconomics is no longer so mysterious. There is a lot of theory and mathematics in the workaday world of the micro-economist, but the foundations are based on what most people would call common sense. If you ever truly get your head around the concept of downward sloping demand curves, you will understand a large percentage of what microeconomics can offer the nonacademic.