Say you take an introductory economics course and your professor says you can learn about economics either from Pithy Academy or from a digital textbook. The website and textbook are both free. Let us “assume” that you prefer Pithy Academy more. Which will you choose?
That’s weird, I just got a phone call. I won an award for “dumbest question of the day”. Of course you’ll pick Pithy Academy! If the costs of two options are the same, then you’ll pick the option you prefer more.
But now let’s say the price of using Pithy Academy went up one billion dollars. In that case, even though you prefer Pithy Academy more, you’ll be a little less likely to use it. The price deprives you of the opportunity.
This little story explains a basic principle of demand: it’s determined by an interaction of opportunities and preferences. If you prefer x over y, but you find out x costs significantly more than y, you will want y over x.
I will now use more complicated situations with accompanying graphs to give this simple intuition a bit more nuance.
Say I give you $100 every month to buy things that are intellectually fulfilling. With the money, you can buy random books, which on average costs $10 each, or you can have a lunch date with someone who reads my books for $20 each. In other words, with the $100, you can buy either 10 books or 5 dates.
You can also buy 2 books and 4 dates, 4 books and 3 dates, 6 books and 2 dates, or 8 books and 1 date. All these combinations will cost you exactly $100.
This line represents your opportunities. Note how I said nothing about how much you prefer books over dates (or vice versa). This is just a list of choices you can make if you use all your $100 on these two things. The choice you will actually make will be determined by your preferences.
You can use this line to calculate opportunity cost. It’s basically the change in one variable as you change the other. For example, if you go from 2 books to 6 books, then you would be going from 4 dates to 2 dates, meaning that your opportunity cost for the 4 additional books is 2 dates. If you go from 0 books to 10 books, your opportunity cost for the 10 books is 5 dates.
Remember: Opportunity cost is what you give up (or forego) by picking one choice over another.
There are two things that will change the opportunity line: change in prices and change in income.
If the price of books doubles from $10 to $20, then the opportunity line axis-intersection will go from 10 books (and 0 dates) to 5 books (and 0 dates). If the price halved to $5, then it would go to 20 books (and 0 dates).
A change in price leads to a change in axis-intersection of the opportunity line.
Now say instead of giving you $100, I give you $200. Here, you can go from being able to afford 10 books or 5 dates to being able to afford 20 books or 10 dates.
A change in income leads to an outward shift of the opportunity line.
I don’t know what you want (for once in my life). So let’s talk about what John wants. Of all the possible combinations on the opportunity line, 4 books and 3 dates is his favorite. If this is the combination that he prefers over all others on the line, then the other combinations are NOT the ones he would be indifferent to. So for example, he may be indifferent between buying 4 books and 3 dates and buying 3 books and 4 dates.
What you see there is an indifference curve. It’s the collection of combinations that John would be neither happier nor sadder when having one combination over another. This is one indifference curve; but there are in fact an unlimited amount.
The collection of indifference curves here show the spectrum of preferences John has. The combination he picked from his opportunities was the one that touched an outward curve. The more outward the indifference curve, the more he prefers it.
In general, the combination chosen by any individual will be wherever his or her most-outward-possible indifference curve touches his or her opportunity line.
I hope that all made sense. If not, read again. This site is worth billions of dollars (in my heart); why would you skim it?
There are two extreme relationships between goods: complements and substitutes.
When two goods are perfect complements, having one necessitates that you buy the other. So for example, in a hypothetical world where right and left shoes are sold separately, you would always buy a right to match a left and vice versa. You are indifferent between having 3 right shoes and 3 left shoes and having 3 right shoes and 5 left shoes. Those two extra shoes don’t mean anything without their complements.
When two goods are perfect substitutes, buying one good makes buying the other good totally unnecessary. For example, say you have an illness in which your doctor advised you to use pill A or pill B. Both pills have the same active ingredients, so you’re indifferent between buying 4 pill A’s and 1 pill B and buying 0 pill A’s and 5 pill B’s. Because they’re exactly alike, it doesn’t make a difference how many of either you pick.
The relationship between most goods are in between, since most goods neither necessitate the inclusion nor the exclusion of other goods. People’s indifference curves for two goods therefore are usually between 90 degrees and 180 degrees. Pointless trivia, just thought I should mention that.
In the hypothetical world where right and left shoes are sold separate, based on the price and James’ income, he is willing to buy 2 pairs of shoes a year. What happens when the price of the left shoe increases or decreases?
That’s right, if the price of the left shoe decreases significantly, he’ll buy more pairs of shoes. If the price increases significantly, he’ll buy less pair of shoes. A price change of one complementary good affects the demand for both goods in the same way. This is the complement effect.
In the hypothetical world where pill A and pill B are exactly alike, what happens when the price of one pill falls below the other?
That’s right, you stop buying the other pill completely. A rational person who is fully informed will not buy a higher-priced product when the low-priced product has the exact same value. This is the substitution effect.
When you consider a good inferior, you will prefer it less as your income increases. Say Danny prefers Chipotle to McDonald’s, but eats more McDonald’s because it’s wallet-friendly. If his income increases significantly, he’s gonna start eating less and less McDonald’s and more and more Chipotle.
As your income increases, the optimum point of your indifference curves will begin to shy away from inferior goods. That is the income effect.
There is a second part to the income effect which states that as income increases, demand for normal goods increases. If you consider books and dates to be normal goods, then you’ll buy more of each as your income increases.
I just took three intuitions you learned from the supply and demand course (the complement, substitution and income effect) and allowed you to see it expressed more clearly via graphs. There’s Pithy Academy’s Economic courses working again, making those abstract intuitions more concrete. In return, I expect a billion dollars in my mailbox by next Monday. No refunds. Thank you.
Something I haven’t factored in on the opportunity lines are the constraints of time and effort. You’re more likely to want to buy a product across the street from your house than one you have to go half way across the country for, even if the total cost of buying both are the same. Opportunities aren’t limited just by the money it takes to get a good; it’s also limited by the time and effort it takes to get it. Spending time and effort can feel as bad as spending money.
More specific constraints to consider (that can involve time, effort and money) are search costs, information costs, bargaining costs, switching costs, etc. They all can create limitations when trying to attain a particular good or service, and they can thus influence the choices you make.
Remember that the comparison here is between two options. The unfortunate truth is that I can’t control you. You can do whatever you want with the $100. You have a limitless number of choices. Where your multi-dimensional opportunity figure touches the lowest point of your highest multi-dimensional indifference figure will determine how you actually spend that money (it’s the same idea as the previous points, except extended from 2 products to n products, from 2 dimensions to n dimensions, etc). The basic idea to take away from all this is that, given the limitations of your disposable income, your money will tend toward the combination of goods and services you want the most.
And the combination you want the most will change as prices and your income changes.
Imagine a life where money wasn’t an issue. A world where you could buy and do whatever you wanted. Go, close your eyes for 20 seconds and imagine that life.
Alright, now that you’re back, tell me: would you prefer that fantasy over the reality you have now? If you’re like most people, your answer is probably yes.
No matter what we have in life, we will always prefer to have more. What stops us from getting more is the lack of easy opportunities. We all want a billion dollar home, but things like the risks, luck, work, immorality and sacrifices it would take to get that home stops us from wanting it.
Many people define Economics as the study of how humans allocate limited resources in a world of unlimited wants. In a capitalist economy, allocation of resources is determined by production and consumption choices for goods and services, the quantities of which are determined by price.
We talked here about how opportunities and preferences determine how much consumers are willing to buy (i.e. how much they demand). In the next lesson, we’ll talk about how different costs determine how much producers are willing to sell (i.e. how much they supply). As you learned from the previous course, demand and supply are interlinked and work together to determine the quantity of each good and service that are sold, via their price.
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