Thursday, January 17, 2013

Blaug on the Law of Demand

The late Mark Blaug (1927–2011) puts his finger on a crucial point about the law of demand:
“It was Marshall who first drew attention to the fact that the so-called universal law of demand is unfortunately subject to a possible exception, namely, Giffen’s paradox, the case where, to express it in modern language, the negative-income effect of a price change is so large in absolute terms as to cancel out the negative substitution effect of that change. The fact that Sir Robert Giffen never actually stated Giffen’s paradox … is of considerable significance: Marshall was looking, as it were, for Giffen’s paradox and, therefore, was determined to find it. He realized that for practical purposes, we must define individual demand curves as subject to a ceteris paribus clause that includes tastes, expectations about future prices, the money incomes of consumers, and all prices other than the one under consideration. So defined, however, it was not possible to argue that there is in fact one ‘universal’ law of demand.

Marshall also flirted, as Friedman has shown (see Blaug, 1980, pp. 351–3, 369), with a constant-real-income interpretation of demand curves in which the prices of all closely related goods are varied inversely to the price of the good in question (in practical terms, we divide money income by a Laspeyres price index) so as to ‘compensate’ the consumer for any change in real income caused by the price change. Such a constant-real-income or compensated demand curve must indeed be negatively inclined under the very conditions implied in its construction, and hence, Friedman argued, we ought to choose this interpretation as the more preferable one because it alone has an unambiguously testable implication. Alas, a compensated demand curve is never observed, whereas we do at least observe one point on the constant-money-income demand curve. The constant-real-income formulation of demand curves is thus an evasion of issues: the income effect of a price change is as integral a part of real-world consumer behavior as is the substitution effect and to leave it out is to adjust the world to fit our theories rather than the other way round. (Blaug 1996: 140–141).
I hope readers can see the significance of this passage.

There is indeed some confusion about the law of demand: does it require, in its ceteris paribus assumption, that (1) only money income remain constant, or (2) does it assume that real income must remain constant?

Some formulations of the law of demand seem to require that real income must remain constant.

But how is this an even remotely realistic assumption? All price changes must change real income, and it is not possible for a price change to occur in the real world without changing real income. We have a law that is formulated in a way that is grossly unrealistic, if not logically incoherent.

Of course, if one wants to define the ceteris paribus assumption as only referring to money income and not real income, we have a different law.

So advocates of the law of demand must define carefully what they mean by the ceteris paribus qualification.

BIBLIOGRAPHY

Blaug, Mark 1996. Economic Theory in Retrospect (5th edn.). Cambridge University Press, Cambridge.

20 comments:

  1. LK,

    Do you have anything that Austrian's say about this topic?

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    1. "It is possible to visualize this interaction by drawing two curves, the demand curve and the supply curve, whose intersection shows the price. It is no less possible to express it in mathematical symbols. But it is necessary to comprehend that such pictorial or mathematical modes of representation do not affect the essence of our interpretation and that they do not add a whit to our insight. Furthermore it is important to realize that we do not have any knowledge or experience concerning the shape of such curves. Always, what we know is only market prices--that is, not the curves but only a point which we interpret as the intersection of two hypothetical curves. The drawing of such curves may prove expedient in visualizing the problems for undergraduates. For the real tasks of catallactics they are mere byplay."
      Human Action page 330.

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  2. Rothbard discusses the law of demand in ME&S (2009, 2nd edn.), pp. 114ff., though I have not looked in detail at how he defines the ceteris paribus assumption.

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    1. It's simple, really. Individual value scales remain the same. The Law of Demand is an explanation of human behaviour for a given combination value scale.

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  3. As far as I can see if one does change the assumption about income to mean real income and not money income then the law becomes internally consistent and the exceptions (including Giffen goods) are excluded as a violation of the assumptions.

    I agree though that a law based on a number of unrealistic assumptions is of limited use but assume that these things are clear to anyone with beyond a basic knowledge of economics.

    Can you give examples of bad things that are believed by neo-classical economists explicitly based upon a failure to recognize the limitations of the law of demand ?


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    1. Rob Rawlings@January 17, 2013 at 1:44 PM

      (1) I fear you may have misread the post.

      If we define the assumption about income to mean real income (and not money income), then the law becomes logically incoherent. Why? Because price changes always affect real income.

      Perhaps you mean "if one changes the assumption about income to mean money income and not real income"?

      (2) "Can you give examples of bad things that are believed by neo-classical economists explicitly based upon a failure to recognize the limitations of the law of demand ?"

      Certainly:

      (1) The belief that all or most markets have prices determined by supply/demand dynamics (in reality, price setting/price administration exists in many important markets).

      (2) the belief that all product markets have equilibrium prices.

      Both ideas are false. The belief in a market tendency to general equilibrium (or Mises's final state of rest) is derived directly from (1) and (2).

      The Ludwig Lachmann school of Austrian economics, by contrast, agrees with Post Keynesianism that these ideas are wrong.

      So this critique should not really be new to someone well read in Austrian economics.

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    2. I didn't misread the post. Constant real incomes is a technically possible assumption (for example income could be pegged to the price level) and no more unrealistic than the other ones.

      I do not think that either of your examples depend in anyway upon these assumptions holding in the real world.

      on (1) One could drop them all and still believe that supply and demand explain pricing in an unhampered market. Indeed if you would study Bohm-Bawerk you would see that he has a good theory that explains how price setting itself can be derived from a framework that is fundamentally supply/demand.

      on (2) Perhaps I am missing something but if equilibrium price just means market clearing price then given reasonable real-world assumptions all markets should have one. I suspect you are probably thinking of weird shaped supply or demand curves that never cross but I think these will never occur with real-world assumptions.

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    3. "As far as I can see if one does change the assumption about income to mean real income and not money income then the law becomes internally consistent and the exceptions (including Giffen goods) are excluded as a violation of the assumptions.... Can you give examples of bad things that are believed by neo-classical economists explicitly based upon a failure to recognize the limitations of the law of demand ?"

      Um.. WTF? Rational expectations? If real variables do not rule ALL of New Classical economics falls apart! And then, in turn, ALL of New Keynesian economics falls apart!

      Let's just establish something: do the commentators on here actually follow economics or are they amateurs? I'm serious. Because LK raises questions that are fundamental and if you don't recognise this you're either untrained or an idiot.

      **If real variables do not rule most models fall apart. Just thought I'd mention...

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    4. It's the emphasis that matters because that informs policy - which is what studying economics is about.

      We have designed in the UK an artificial 'market' for power that *doesn't work*. And that was done because of the way 'supply and demand' is described by economists.

      The difference as I see it is one of emphasis. Saying that there is a 'market clearing price' for goods, assumes that a particular market has more than one good in it.

      Given that what a market is is in the eye of the purchaser, and individuals are not rational it's hardly surprising that major anomalies exist at the micro level. Anomalies you can see in any supermarket.

      It's understanding the effects of those anomalies that PK economics is about. Likely if they'd been informing the design of the power market they would have said that the products need to be as homogenous as possible, or they would have said it is unlikely to work because of various cognitive biases.

      Sweeping away all this awkward human behaviour with 'ceteris paribus' is an abstraction too far. You have to bring it back to the real world of interacting human beings.

      Doris matters.

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    5. PK,

      Your logic appears to be the following:

      1. There is a "law of demand" that is based upon some assumptions that clearly do not hold in the real world.

      2. This law is a building block for other economic theories (including all theories that describe how equilibrium can be achieved). These theories share the same assumptions as the so called "law of demand" and as its assumptions don't always hold can likewise be deemed incorrect.

      3. Therefor most of established economics is bunk

      The second statement does not hold.

      Not all theories that describe how equilibrium could be arrived at depend in any way upon the assumptions in the so-called "law of demand".

      Even goods that have partially or fully upward sloping demand curves can be shown to have market clearing prices.

      I think that one could show that a world with a good with an upward sloping demand curve for all parts of the curve would be a single-good economy where that good become the only one produced. That such an outcome is unlikely tells me that eventually for all goods the demand curve will slope downwards but I do not think this is a a pre-requisites for equilibrium to be possible.

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    6. "Not all theories that describe how equilibrium could be arrived at depend in any way upon the assumptions in the so-called "law of demand". "

      All equilibrium theory - if we mean general equilibrium (GE) theory that defines a market tendency to GE as the propensity for all markets to reach their equilibrium prices - is dependent on the law of demand and supply explaining prices.

      Of course, if one wants to re-define equilibrium as plan coordination (Hayek) or pattern coordination (O'Driscoll and Rizzo), then that is a different story.

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    7. They are dependent upon the law of demand and supply explaining prices, they are just not (as far as I can see) dependent upon the assumption that every single good has a downward sloping demand curve.

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    8. Should have been clearer "They are dependent upon demand and supply explaining prices " not "the law of supply and demand" with all its bad assumptions

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    9. "Not all theories that describe how equilibrium could be arrived at depend in any way upon the assumptions in the so-called "law of demand"."

      You claim that equilibrium theories do not in themselves depend on the same assumptions in the Law of Demand (LOD). One of assumptions of LOD is to take human action as static, basically wanting us to envision a world that is not ontological uncertain and where people have subjective expectations.

      Can you provide a theory of equilibrium that does take in consideration uncertainty (in the ontological sense) and subjective expectations?

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  4. Price setting is not inconsistent with prices being determined by supply and demand, because the prices people set are influenced by supply and demand. People "set" the price of their house when they put it on the market. If they set it at double the price of similar homes, no one would buy it. If they set it at half the price of similar homes, they would be deluged with competing offers. What you call "administered prices" are just another type of market price.

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    1. No one is arguing that price is not influenced by S+D. What is argued is that the S+D framework does not directly determine price. For example take this Hicks passage:

      “… The traditional view that market price is, at least in some way, determined by an equation of demand and supply had now to be given up. If demand and supply are interpreted, as had formerly seemed to be sufficient, as flow demands and supplies coming from outsiders, it is no longer true that there is any tendency over any particular period, for them to be equalized: a difference between them, if it were not too large, could be matched by a change in stocks. It is of course true that if no distinction is made between demand from stockholders and demand from outside the market, demand and supply in that inclusive sense must be equal. But that equation is vacuous. It cannot be used to determine price, in Walras’ or Marshall’s manner. For what matters to the stockholder is the stock that he is holding: the increment in that stock, during a period is the difference between what is held at the end and what was held at the beginning, and the beginning stock is carried over from the past. So the demand-supply equation can only be used in a recursive manner, to determine a sequence (It is a difference or a differential equation); it cannot be used directly to determine price, as Walras and Marshall had used it.”

      http://unlearningeconomics.wordpress.com/2013/01/17/the-market-which-market-alternative-theories-of-demand-and-supply/#comment-10527

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  5. I haven't read the book, but it seems that Blaug endorsed the Kirznerian view of price discovery and competition:

    http://www.coordinationproblem.org/2011/11/mark-blaug-1927-2011-fellow-traveller-of-austrian-economics.html

    "firms jostle for advantage by price and nonprice competition, undercutting and out-bidding rivals in the market place... all for the sake of head-start profits that they know will soon be eroded. In these chapters, there is never any doubt that competition is an active process, of discovery, of knowledge formation, of ‘creative destruction’. I call this ‘the Austrian view of competition’ because it is most firmly enshrined in the writings of such Austrian economists as Hayek, Schumpeter and, more recently, Kirzner.”

    I can't really agree that perfect competition models don't have "the slightest possibility of ever being practically relevant," as he says--I think markets tend to evolve from monopolistic competition towards perfect competition--but overall I agree with this.

    Seems like a great book, btw.

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  6. Re: price changes and real income--I don't see how this makes a huge difference. I see your point, but it seems like price change effects on income would be too small to significantly affect consumer behavior, and would not lead to Giffen-type behavior. But perhaps I'm missing something.

    (1) The belief that all or most markets have prices determined by supply/demand dynamics (in reality, price setting/price administration exists in many important markets).

    (2) the belief that all product markets have equilibrium prices.

    Both ideas are false. The belief in a market tendency to general equilibrium (or Mises's final state of rest) is derived directly from (1) and (2).


    Even assuming all of these points are wrong, what are the "bad" effects resulting from these false ideas? I'm guessing you mean EMH (and the inevitability of "free markets" to lead to asset bubbles) or the idea of labor market clearing wages following recessions--something along these lines?



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  7. FYI, A couple people are talking about you over at my blog

    http://radicalsubjectivist.wordpress.com/2013/01/18/the-law-of-demand-and-austrian-economics/

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    1. That is a fascinating quote from Menger and Lachmann you cite. It bears further study.

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