Consumer Theory at Play!

One of the purposes of this blog is to share and expound on the things I'm currently studying. I'm enrolled in an Economics class on Price Theory and have spent the last two months studying the intricacies of consumer behavior in response to various inputs such as income, prices, value, etc. It all looks nice when demonstrated in the polished graphs in the book, but does it work in the real world?  It sure does! Allow me to pontificate.

WARNING: The following paragraphs may come off as extremely esoteric and boring for most anyone but myself. Also, just so you are aware, I have abstracted the world to an extremely basic level and there are many other factors at play I do not discuss. This was a conscious decision. You may continue if you wish.

So, the United States economy has experienced some dramatic fluctuations during the past few years. Economic growth at the onset of the new millennium was followed by an unanticipated recession. This offers several fascinating case studies of economic principles in action, particularly the consumer theory. I want to focus mainly on the United States transit system over the past 6 years, where we can really see how people alter their behavior (via substitution) in response to changes in prices and income.

An LA times article in 2009 explained that  a “dramatic spike in gas prices that began in 2005 sent Americans flocking to trains, buses and subways, a trend that appears to have held up even as gas prices have dipped.”  This observation is an economic feast.  It alludes to substitution and income effects, normality of goods, and differences in demand shifts (pretty much all of consumer theory). To dig in, let’s visualize the trend by abstracting down to a two good world of traveling by car vs. traveling via mass transit.

First, in 2005 Gas prices spiked. With gas prices up, driving became a more costly good and consumers drove less. Thus, economically speaking, ‘driving cars’ follows the law of demand (ie. price and quantity are negatively correlated). Now, this shift in transportation costs changed the budget constraints of the modern commuter, and thus their behavior. All of the sudden, the ‘bang for buck’ of driving your own car wasn’t as great as it had been, and yet mass transit prices had remained constant. We envision this as an inward swing of the budget constraint, and in order to remain at the same level of utility (or to go the same distance with your dollar… literally) people abandoned their own cars for the cheaper alternative of mass transit.

The article backs up this expected behavior by referencing the behavior of one commuter, Demetrius McClain, “The choice between the train and his car was a no-brainer: Gas prices were more than $3.60 a gallon and climbing. His commute on the Tri-Rail … cost him $4 per day. Even with lower gas prices, the train still saves him money.” So for Demetrius, and all commuters, driving and using mass transit are substitutes. The shift is appropriately called the Substitution Effect and is a result of a change in demand caused solely by prices(like this example) and/or utility while income is held constant (Marshallian Demand).

I don't know what kind of bus these people took to work... but it couldn't have been legal.

Now here’s where our economic feast gets juicy. The same initial quote from the LA article stated that the trend towards mass transit “appears to have held up even as gas prices have dipped.” How is that possible, considering the logic we just followed?  Well there’s one more piece we need to add to the puzzle: The Recession.

According to the NY Times, the National Bureau of Economic Research (NBER) pins the beginning of the recession to December 2007 and defines a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales."  The key here is that the recession caused a “decline … in real income”. This means that, whether attributed to decreased wages or increased prices across the board, spending power was not what it had been and an individual’s income was effectually lower.  

Funny enough, one article at smartplanet.com expressed surprise that mass transit had ‘weathered a slowed economy.’ This is somewhat ironic because as it turns out, mass transit’s recent success is actually very attributable to the ‘slow economy.’

The drop in income pushes us into a world where demand is no longer concerned with substituting to live at the same level of luxury (or utility, a la Marshallian Demand), but now substituting to live within income and prices as dictated (Hicksian Demand). The drop in income produced an effect on top of the substitution effect: the income effect.  The income effect is how people change their consumption behavior based on a complete shift of their budget constraint. With income down, both driving and mass transit were relatively more expensive, so people had to settle on living a little less luxuriously (on a lower utility curve).  And even though gas prices eventually decreased, the drop in income led people to cut back on luxury and take mass transit. This trend shows that mass transit is an inferior good (ie. as income decreases, people consume more of it).

It is imperative that people are able to make substitutions like this when prices and income change. If not, the population operates at a lower economic efficiency than they could be. This means more lost money and less happiness (utility) per dollar spent. This is interesting because the government seems to recognize the general slowness of people to change their behavior and tries to incentivize it. This is evidenced by billions of dollars being handed out to cities to encourage their mass transit (alluded to in President Obama’s recent state of the union address).  

I told you it was fascinating. 

And/or boring. But that's why I'm going to be an Economist and you're not.

In the future, we will all ride giant pencils to work