Substitute goods and reasoning from a price change
David Henderson has a good post on the way that textbooks teach the substitution effect. I have one other bone to pick with principles textbooks—they don’t clearly explain to students how to avoid “reasoning from a price change.” Start with the textbook definition of substitute goods:
If the price of good A rises, the demand for good B rises.
Now apply it to a real world example. Suppose there is a scientific study indicating that drinking coffee causes cancer. How does this impact the demand for tea? Most students will understand that tea is a substitute for coffee, and hence that the demand for tea will rise. But they won’t get the right answer by applying anything they learned in economics. After all, the coffee scare would depress the price of coffee. So the demand for tea is rising despite the fall in the price of coffee.
On could argue that other things equal, a lower coffee price should lead to less demand for tea. But even that’s not quite right, as “other things equal” a lower coffee price would lead to a shortage of coffee. That’s because if you assume “other things equal” you are assuming that only the price of coffee has changed, nothing else. The supply and demand curves for coffee stay where they are. And in that case there is more demand for tea due to the coffee shortage.
Of course students who take advanced economics understand that a health scare in coffee causes a big increase in the demand for tea, whereas the accompanying fall in coffee prices makes the increase in tea demand a bit smaller, but that’s way over the heads of principles students. I see so much reasoning from a price change that I wonder whether even 1% of economics students actually understand supply and demand. Many students believe they are taught that “in years when coffee prices soar much higher, we would normally expect to see a rise in the demand for tea,” which is not at all what we are trying to teach.
In Mankiw’s Principles text he says:
Suppose that the price of frozen yogurt falls. The law of demand says that you will buy more frozen yogurt.
(That’s the third edition, p. 68, perhaps it’s been fixed in later editions.) Of course the law of demand says no such thing. It depends why the price of yogurt fell. Defenders of Mankiw tell me that there’s no problem, because he is implicitly assuming the demand curve for frozen yogurt is stable. And how many students will understand that subtlety? The vast majority will leave economics thinking that they’ve been taught that you can expect people to buy more when the price is lower. And then we wonder why the public is confused when economists complain about deflation.
Recently I’ve had lots of debates about the effect of a change in interest rates. In fact, it’s nonsensical to talk about a change in interest rates having any sort of predictable effect on the economy. Rather it’s the things that cause interest rates to change that will have an effect. Back in 1992, Milton Friedman complained about how the profession reasons from a price change, assuming that low interest rates always mean easy money:
Declining or low interest rates may at times correspond to easy money, but so may rising or high interest rates. To illustrate the first possibility, the short-term commercial paper rate remained around 0.75% from 1939 to 1946, while the money supply nearly tripled and the price level rose by 60%. To illustrate the second, the federal funds rate hit 20% in January 1981, and again in July, a period when both M2 and consumer prices were rising at nearly 10% a year. If the Fed can control interest rates, does anyone really believe that we would have seen the federal funds rate at 20%?
Unfortunately, I haven’t seen any signs of improvement since 1992, if anything the profession is going backwards. I see people say “normally you’d expect more investment when rates are low” or “normally the government should invest more in infrastructure when rates are low” or “normally you’d expect more bank lending when rates are low,” all reasoning from a price change.
Update: Speaking of Reasoning From a Price Change, there is a new podcast where Russ Roberts interviews me on that very subject.
PS. Years ago when I was teaching principles I used Mankiw’s text because I thought it was the best one available, so don’t take this post as trashing his book. It’s actually very difficult to teach anything in economics without cutting some corners here or there.
PPS. The coffee example is not some sort of weird trick question. A priori, you’d expect roughly 50% of price changes to be due to demand shifts and 50% due to supply shifts. We’d like our principles models to be more accurate than a coin flip
HT: Benjamin Cole