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Post No.: 0680demand


Fluffystealthkitten says:


While the law of demand in microeconomics assumes that prices will always go up as demand increases, and down as demand decreases – we actually frequently see ‘sticky prices’, and customers will deem it unfair if prices rise merely if demand rises (e.g. if umbrellas priced at $7 increased to $10 as soon as it rained). Prices don’t always fall just because demand falls either. Prices in reality don’t change that much or that often (e.g. ice cream prices don’t change from day to day, or even month to month, according to the weather, and thus demand).


If prices are generally sticky in reality then quantity is the only thing that dynamically changes; and it’ll fluctuate dramatically because prices aren’t dynamically changing to keep demand reasonably stable. A consequence of this is that, to counteract these wild fluctuations in demand, firms must constantly hire or fire staff in order to match demand, when they could instead just change their prices in order to manage demand i.e. drop prices if demand decreases, to increase demand to an acceptable level again; or raise prices if demand increases, to decrease demand to a manageable level again.


But a firm cannot do this alone because if it decreases prices while its competitors don’t then its own marginal profits will be cut; or if it increases prices while its competitors don’t then it’ll lose customers to them. Therefore no individual firm will change its prices (which is a typical case of ‘it’s best for me and everyone if we all move, but I’m not moving unless everyone else moves, hence I’m not going to move’), and the whole assumption of market forces and supply and demand being dynamically self-stabilising fails in reality. Prices do change eventually but not dynamically and often enough – thus they react too slowly in reality and result in large changes in sudden, and potentially shocking, bursts, which can contribute to bubbles and crashes.


So the markets don’t respond and self-correct like they should in theory. That’s why centralised interventions like adjustments to interest rates, inflation rate management and liquidity injections are required to try to counteract these booms and busts, by getting the whole market to respond to changes in market conditions when it should do.


Stock market prices do dynamically change but the financial markets aren’t part of the ‘real economy’, where real goods and services are traded. Without real goods and services – stocks and shares would almost certainly be meaningless. Real value is created via these goods and services, not in the financial markets. And shocking corrections also occasionally occur in the financial markets anyway!


We see ‘sticky wages’ too. ‘Nominal rigidity’ is the term that covers stickiness in general. The existing wage, price, rental rate, terms or information sets a reference point, which has the nature of an ‘expectation’ that mustn’t be contravened – it’s considered unfair for a firm to impose losses on its employees and/or customers relative to the relevant reference point (‘reference-dependent fairness’).


Therefore the exploitation of market power to impose losses on others is considered unreasonable, even though classical economic models assume such behaviours. So high wages tend to stay high in recessions rather than drop to allow more people to be employed because those who are currently employed will feel that it’d be unfair on them to do the same work but now for less, even though the surrounding economic conditions have changed. A long-term employee who normally gets paid $15/hour subsequently being paid $10/hour as soon as unemployment and competition for jobs increases, is considered unconscionable. Yet if this employee leaves and is replaced by someone who is paid $10/hour, this is considered fine(!) The reference point is therefore personal.


However, if the employer’s own profitability is threatened (e.g. business is dropping or costs have gone up), it’s not considered unfair for the employer to transfer even all of its own losses onto its employees and/or customers. Firms are thus quicker to raise prices when costs increase than if demand increases.


Firms that violate these informal rules of fairness are punished by reduced productivity from employees and sales from customers. Customers who also learn that a product’s price has been vastly reduced only soon after they’ve purchased that product will reduce their future purchases from that supplier – they’ll perceive the new lower price as the revised reference point and think of themselves as having been ripped off by paying more than what they could have.


So any actions made to avoid reduced profits are considered acceptable compared to any actions made to merely improve profits at the expense of others. Yet asymmetrically, if a firm faces lower production costs, the rules of fairness don’t require it to share this gain with either its employees or customers! Thus any improvements in profits are only considered acceptable if they’re perceived as not coming at the expense of others.


Unfairly imposing losses on others can be risky if they’re in a position to retaliate. Strangers who merely witness unfairness dealt to others often also join in to punish an unfair party. This ‘altruistic punishment’ activates the reward centres of the brain – suggesting that maintaining moral fairness in society is intrinsically rewarding, and that it evolved as a rewarding instinct because it improved survival. Our brains evolved to punish antisocial meanness more reliably than to reward generosity; for better or worse.


Due to stickiness, once a company gives a dividend to its shareholders, those dividends can only ever increase or at least remain at the same levels otherwise shareholders will interpret it as bad news – which means that companies will sometimes even borrow money in order to pay a dividend even though they made a loss and cannot afford to. Investors react to signs of emotional confidence, not just dispassionate figures.


Classical economic theory is fixated on ‘ideal’ behaviours (where economic behaviour is ruled by self-interests while concerns for fairness and morality are generally irrelevant) rather than on real-world behaviours (that take into account variables like fairness and morality that may curb the maximisation of self-interests). But empirical data mustn’t be ignored in favour of a neat and tidy theory on paper.


Other violations of the law of demand – which states that, as prices rise, demand decreases, and as prices fall, demand increases – include ‘Veblen goods’, which are products where demand increases despite prices rising (e.g. vintage wines, luxury cars, jewellery). It’s related to conspicuous consumption or conspicuous leisure, status symbols and the ‘snob effect’, which is when consumers assume that price is always proportional to quality. The higher the price, the more coveted such a good is – when the quantity of a good demanded should have an inverse relationship with its price.


Not violations but a ‘normal good’ is a good that exhibits increases in demand when consumer incomes increase (e.g. sparkling wine), and an ‘inferior good’ is a good that exhibits decreases in demand when consumer incomes increase (e.g. cheap instant ramen). A special type of inferior good disputably exists though, known as ‘Giffen goods’, which are products that people consume more of directly as a result of price increases, and vice-versa. This would therefore exhibit an upward-sloping demand curve, which runs counter to the expected downward-sloping demand curve.


Inflation also tends to be neglected in the real world as people continue measuring their income and wealth in terms of the absolute number of dollars (or whatever currency) they have rather than in terms of what they can buy with it; thus creating a money illusion. Consequently, people are more willing to accept, or acquiesce to, a fall in purchasing power due to increases to their income that are lower than the increases in inflation, than they would to a numerical cut to the number of dollars they take home. (Inflation is often referred to as a ‘hidden tax’ because it surreptitiously removes some of the effective income and wealth of those who have it, and conversely benefits those who have debts since these are also devalued by rising prices unless interest rates adapt in line with inflation.)


Consumers typically behave irrationally when it comes to ‘two-part pricing’ (e.g. being drawn to a cheap razor but which requires expensive blades) and ‘switching costs’ (e.g. when reluctant to switch mobile provider even when the arithmetic adds up). Consumers may neglect accounting for ‘friction costs’ (the total direct and indirect costs of a transaction), ‘learning costs’ (e.g. overestimating the costs in time and effort to learn how to use a product from an unfamiliar brand) and ‘opportunity costs’ (the potential benefits one misses out on for choosing one alternative over another).


Consumers aren’t the dynamic, perfectly rational, ultimate-best-payoff-seeking actors that the classical or non-behavioural economic models hypothesise. Real-world customers express brand loyalty and don’t always shop around for the best deals, so they don’t always get what they pay for. More expensive products that are made in the exact same factories on the exact same product lines except sold under a different brand name (like some premium branded versus cheaper branded/unbranded medicines or sunglasses) shouldn’t really sell well at all, but they do. (Many consumers won’t even try out cheaper generic drugs once the patents expire.) People in real life don’t migrate to where the work is as much as the on-paper models expect. Most people don’t like working more than they need to, yet by their own choices (in some cultures at least) would rather work an extra one hour to earn $10 than spend one minute trying to haggle a price down by $10. People are irrational for being drawn to buy chocolate at the most expensive times of year (e.g. Easter) even though chocolate is available all-year-round!


‘Arbitrage’ is when the prices of identical or similar products in different markets or forms are different, hence one can exploit this by buying it where it’s cheapest whilst simultaneously selling it where it’s most expensive, then pocketing the difference without risk. Such opportunities exist as a result of market inefficiencies, although these trades will then resolve them.


Pollution and global warming are examples of the repercussions of market failures. ‘Tragedy of the commons’ situations include wanting everyone to collectively avoid over-fishing open-access waters because it’d be unsustainable, yet over-fishing oneself because of serving one’s own self-interests – which means that industry self-regulation fails. The commons belong to all but can be depleted by a few for their own individual profits. There are plenty of critical situations where people know something will be good for them all collectively in the long-run but their short-term shellfish interests lead to problems that’ll harm everyone collectively and individually. And because rare species fetch higher prices, this leads to a fishious cycle towards extinction rather than conservation. Meow!


Some economic models assume no frictions or information asymmetries, and assume perfectly competitive and perfect markets – even in being able to borrow as much as you ever want, or if there’s an opportunity to rent out a property then it’ll assume you’ll always find a lodger, for instance. In fact, in a perfectly competitive (pure competition) market (as per the theoretical models of free competition) – competitive pressures would drive down all prices so that no firm would be able to realise any economic rents/profits (returns in excess of the opportunity cost of capital). Some models even make no qualms about the rich getting richer and the poor getting disproportionately poorer i.e. inequality is predicted to widen without interventions.


Meow! In summary, insistently trusting in outmoded economic models is like still trusting in Isaac Newton’s laws regarding Mercury’s orbit even though they fail to describe what’s actually observed in reality. Like Newton’s laws again, they can still be useful under certain conditionsbut reality needs to be ultimately trusted over any on-paper hypotheses. We must trust in what ‘is’ according to the evidence over what ‘ought to be’ according to someone’s formulae, no matter how respected they might be.


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