Debunking Economics Part 3

THE LOGICAL FLAWS IN THE KEY CONCEPTS OF CONVENTIONAL ECONOMICS.

The belief that price and quant.i.ty are jointly determined by the interaction of supply and demand is perhaps the most central tenet of conventional economics. In Alfred Marshall's words, supply and demand are like the two blades of a pair of scissors: both are needed to do the job, and it's impossible to say that one or the other determines anything on its own. Demand for a commodity falls as its price rises, supply rises as price rises, and the intersection of the two curves determines both the quant.i.ty sold and the price.

This argument still forms the core of modern instruction in economics, and much of economic policy is directed at allowing these twin determinants to act freely and unfettered, so that economic efficiency can be at its maximum. But both mainstream and dissident economists have shown that the real world is not nearly so straightforward as Marshall's famous a.n.a.logy. The next four chapters show that the 'blades of supply and demand' cannot work in the way economists believe.

3 | THE CALCULUS OF HEDONISM.

Why the market demand curve is not downward-sloping.

Maggie Thatcher's famous epithet that 'There is no such thing as society' succinctly expresses the neocla.s.sical theory that the best social outcomes result from all individuals looking after their own self-interest: if individuals consider only their own well-being, the market will ensure that the welfare of all is maximized. This hedonistic, individualistic approach to a.n.a.lyzing society is a source of much of the popular opposition to economics. Surely, say the critics, people are more than just self-interested hedonists, and society is more than just the sum of the individuals in it?

Neocla.s.sical economists will concede that their model does abstract from some of the subtler aspects of humanity and society. However, they a.s.sert that treating individuals as self-interested hedonists captures the essence of their economic behavior, while the collective economic behavior of society can be derived by summing the behavior of this self-interested mult.i.tude. The belief that the economic aspect of society is substantially more than the sum of its parts, they say, is misguided.

This is not true. Though mainstream economics began by a.s.suming that this hedonistic, individualistic approach to a.n.a.lyzing consumer demand was intellectually sound, it ended up proving that it was not. The critics were right: society is more than the sum of its individual members, and a society's behavior cannot be modeled by simply adding up the behaviors of all the individuals in it. To see why the critics have been vindicated by economists, and yet economists still pretend that they won the argument, we have to take a trip down memory lane to late eighteenth-century England.

The kernel.

Adam Smith's famous metaphor that a self-motivated individual is led by an 'invisible hand' to promote society's welfare a.s.serts that self-centered behavior by individuals necessarily leads to the highest possible level of welfare for society as a whole. Modern economic theory has attempted, unsuccessfully, to prove this a.s.sertion. The attempted proof had several components, and in this chapter we check out the component which models how consumers decide which commodities to purchase.

According to economic theory, each consumer attempts to get the highest level of satisfaction he can from his income, and he does this by picking the combination of commodities he can afford which gives him the greatest personal pleasure. The economic model of how each individual does this is intellectually watertight.1 However, economists encountered fundamental difficulties in moving from the a.n.a.lysis of a solitary individual to the a.n.a.lysis of society, because they had to 'add up' the pleasure which consuming commodities gave to different individuals. Personal satisfaction is clearly a subjective thing, and there is no objective means by which one person's satisfaction can be added to another's. Any two people get different levels of satisfaction from consuming, for example, an extra banana, so that a change in the distribution of income which effectively took a banana from one person and gave it to another could result in a different level of social well-being.

Economists were therefore unable to prove their a.s.sertion, unless they could somehow show that altering the distribution of income did not alter social welfare. They worked out that two conditions were necessary for this to be true: (a) that all people have to have the same tastes; (b) that each person's tastes remain the same as his income changes, so that every additional dollar of income was spent exactly the same way as all previous dollars for example, 20 cents per dollar on pizza, 10 cents per dollar on bananas, 40 cents per dollar on housing, etc.

The first a.s.sumption in fact amounts to a.s.suming that there is only one person in society (or that society consists of a mult.i.tude of identical drones) since how else could 'everybody' have the same tastes? The second amounts to a.s.suming that there is only one commodity since otherwise spending patterns would necessarily change as income rose. These 'a.s.sumptions' clearly contradict the case economists were trying to prove, since they are necessarily violated in the real world in fact, they are really a 'proof by contradiction' that Adam Smith's invisible hand doesn't work. Sadly, however, this is not how most economists have interpreted these results.

When conditions (a) and (b) are violated, as they must be in the real world, then several important concepts which are important to economists collapse. The key casualty here is the vision of demand for any product falling as its price rises. Economists can prove that 'the demand curve slopes downward in price' for a single individual and a single commodity. But in a society consisting of many different individuals with many different commodities, the 'market demand curve' can have any shape at all so that sometimes demand will rise as a commodity's price rises, contradicting the 'Law of Demand.' An essential building block of the economic a.n.a.lysis of markets, the market demand curve, therefore does not have the characteristics needed for economic theory to be internally consistent.

The roadmap.

The chapter opens with an outline of Jeremy Bentham's philosophy of utilitarianism, which is the philosophical foundation for the economic a.n.a.lysis of individual behavior. The conventional economic a.n.a.lysis is outlined. The chapter's punchline is that economic theory cannot derive a coherent a.n.a.lysis of market demand from its watertight but ponderous a.n.a.lysis of individual behavior. In addenda, I show that this a.n.a.lysis is only a toy model anyway it can't apply to actual human behavior, and experimentally, it has been a failure.

Pleasure and pain.

The true father of the proposition that people are motivated solely by self-interest is not Adam Smith, as is often believed, but his contemporary, Jeremy Bentham. With his philosophy of 'utilitarianism,' Bentham explained human behavior as the product of innate drives to seek pleasure and avoid pain. Bentham's cardinal proposition was that Nature has placed mankind under the governance of two sovereign masters, pain and pleasure. It is for them alone to point out what we ought to do, as well as to determine what we shall do. On the one hand the standard of right and wrong, on the other the chain of causes and effects, are fastened to their throne. They govern us in all that we do, in all we say, in all we think; every effort we can make to throw off our subjection, will serve but to demonstrate and confirm it. In a word a man may pretend to abjure their empire; but in reality he will remain subject to it all the while. (Bentham 1948 [1780]) Thus Bentham saw the pursuit of pleasure and the avoidance of pain as the underlying causes of everything done by humans, and phenomena such as a sense of right and wrong as merely the surface manifestations of this deeper power. You may do what you do superficially because you believe it to be right, but fundamentally you do it because it is the best strategy to gain pleasure and avoid pain. Similarly, when you refrain from other actions because you say they are immoral, you in reality mean that, for you, they lead to more pain than pleasure.

Today, economists similarly believe that they are modeling the deepest determinants of individual behavior, while their critics are merely operating at the level of surface phenomena. Behind apparent altruism, behind apparent selfless behavior, behind religious commitment, lies self-interested individualism.

Bentham called his philosophy the 'principle of utility' (ibid.), and he applied it to the community as well as the individual. Like his Tory disciple Maggie Thatcher some two centuries later, Bentham reduced society to a sum of individuals: The community is a fict.i.tious body, composed of the individual persons who are considered as const.i.tuting as it were its members. The interests of the community then is, what? the sum of the interests of the several members who compose it. It is in vain to talk of the interest of the community, without understanding what is in the interest of the individual. (Ibid.) The interests of the community are therefore simply the sum of the interests of the individuals who comprise it, and Bentham perceived no difficulty in performing this summation: 'An action then may be said to be conformable to the principle of utility when the tendency it has to augment the happiness of the community is greater than any it has to diminish it' (ibid.).

This last statement implies measurement, and Bentham was quite confident that individual pleasure and pain could be objectively measured, and in turn summed to divine the best course of collective action for that collection of individuals called society.2 Bentham's attempts at such measurement look quaint indeed from a modern perspective, but from this quaint beginning economics has erected its complex mathematical model of human behavior. Economists use this model to explain everything from individual behavior, to market demand, to the representation of the interests of the entire community. However, as we shall shortly see, economists have shown that the model's validity terminates at the level of the single, solitary individual.

Flaws in the gla.s.s.

In most chapters, the critique of conventional theory has been developed by critics of neocla.s.sical economics, and neocla.s.sical economists are unaware of it because, in general, they cope with criticism by ignoring it.

This isn't the case with this first critique because, ironically, it was an 'own goal': the people who proved that the theory was flawed were themselves leading neocla.s.sical economists, who were hoping to prove that it was watertight.

It is not. While economics can provide a coherent a.n.a.lysis of the individual in its own terms, it is unable to extrapolate this to an a.n.a.lysis of the market.

Since this critique was developed by neocla.s.sical economists themselves, many mainstream academic economists are aware of it, but they either pretend or truly believe that this failure can be managed with a couple of additional a.s.sumptions. Yet, as you'll see shortly, the a.s.sumptions themselves are so absurd that only someone with a grossly distorted sense of logic could accept them. That twisted logic is acquired in the course of a standard education in economics.

This 'education' begins with students being taught conclusions which would apply if the theory had no logical flaws. Students normally accept that these conclusions have been soundly derived from the basic economic propositions of individual behavior, and they are in no position to believe otherwise, since the basic building blocks of this a.n.a.lysis are not taught at the introductory level because they are 'too hard.' This abbreviated induction is sufficiently boring to dissuade the majority of business students from pursuing further economics, and they graduate in some other discipline. However, a minority find the game intriguing, and continue on to another year.

In later undergraduate years, they finally encounter indifference curves and the derivation of the individual demand curve. The mildly relevant 'Engel curves' and the complete chimera of the 'Giffen good' are explored as apparent applications of the theory. Market demand curves, and sometimes the basic concepts of 'general equilibrium' (the conditions under which many markets will simultaneously be in equilibrium), are discussed again, without considering whether the step from the individual to the aggregate is valid.

Most economics graduates seek employment in the private sector, and parts of the public sector, where they normally champion the neocla.s.sical perspective. However, a minority of this minority pursues further study, to seek employment as academic economists and in search of education rather than remuneration, since academic salaries are far lower than private and even public sector ones. Once they have embarked upon this road to ordination as an economist, most students are fully inculcated in the neocla.s.sical way of thinking.

Finally, in honors, master's or PhD courses, they study the full exposition given below, and finally learn that the aggregation of individual demand is valid only under patently absurd conditions. However, by this time the indoctrination into the neocla.s.sical mindset is so complete that most of them cannot see the absurdity. Instead, they accept these conditions as no more than simple devices to sidestep pesky but minor problems, so that 'rational' economic a.n.a.lysis can be undertaken.

It would be easy to accede to a simplistic conspiracy theory to explain why economic education takes such a convoluted route on this issue. However, I believe the explanation is both more mundane and more profound.

At the mundane level, the proposition that individual behavior is motivated by utility maximization, the concept of a downward-sloping demand curve, and the vision of society as simply an aggregate of individuals are easier to grasp than the many qualifications which must be applied to keep these notions intact. Academic economists therefore instruct their students in the easy bits first, leaving the difficult grist for higher-level courses.

At the profound level, it reflects the extent to which economists are so committed to their preferred methodology that they ignore or trivialize points at which their a.n.a.lysis has fundamental weaknesses. Were economics truly worthy of the moniker 'social science' these failures would be reason to abandon the methodology and search for something sounder.

Whatever the reasons, this lazy pedagogy trifurcates economics students into three camps. The vast majority study a minimum of economics in a business degree, and graduate unaware of any flaws in the gla.s.s. Members of the second, much smaller group go on to professional academic careers, and treat the flaws as marks of a fine crystal, rather than clear evidence of a broken vessel. The third, a handful, become critics within the profession, who aspire to build more realistic theories and, sometimes, try to make the second group see the cracks in their beloved but broken goblet. These sentiments may appear extreme now, but I doubt that they will appear so by the time you have read this chapter.

Now pour yourself a strong cup of coffee or any other appropriate stimulant. The next few sections are crucial to understanding both economic theory and its weaknesses, but they can't help but be boring.

'The sum of the interests'

Bentham's statement that 'The community is a fict.i.tious body [...] The interests of the community then is [sic] the sum of the interests of the several members who compose it' is no more than an a.s.sertion. To turn this into a theory, economists had to achieve two tasks: to express Bentham's a.n.a.lysis mathematically, and to establish mathematically that it was possible to derive social utility by aggregating individual utility.

One century after Bentham, the founders of neocla.s.sical economics accomplished the first task with relative ease. Over time, the representation of these concepts matured from simple but flawed notions to arcane but watertight models of individual behavior.

The individual consumer as represented by economic theory In keeping with the notion that beneath all individual actions lie the motivations of pleasure-seeking and pain avoidance, early attempts to use utility theory to explain behavior by which economists meant almost exclusively the consumption of commodities3 postulated that each unit consumed of any commodity yielded a certain number of underlying units of satisfaction, called 'utils.' Additional units of a given commodity resulted in a smaller number of additional utils. The picture is as shown in Table 3.1.

TABLE 3.1 'Utils' and change in utils from consuming bananas For example, one unit of a commodity say, a banana yields 8 'utils' of satisfaction to the consumer. Two bananas yield 15 utils, so that the second banana has contributed seven additional utils to the consumer's satisfaction: one less than the first banana, but still a positive quant.i.ty. Three bananas yields 19 utils, so that the change in utils from consuming the third banana is 4 utils.

3.1 Rising total utils and falling marginal utils from consuming one commodity.

This concept, that a consumer always derives positive utility from consuming something, but that the rate of increase in utility drops as more units of the commodity are consumed, is the key concept in the economic a.n.a.lysis of human behavior. The change in total utility is known as 'marginal utility,' and the essential belief that this falls as the level of consumption rises is known as the 'law of diminishing marginal utility.' This 'law' a.s.serts that marginal utility is always positive, but always falling: more is always better, but each additional unit consumed gives less satisfaction than previous units.

Obviously, utility is derived from consuming more than just one commodity. Economists a.s.sume that the law of diminishing marginal utility applies across all commodities, so that additional units of any commodity give the consumer positive but falling amounts of utility. This is shown in Table 3.2, where the first commodity is bananas, and the second, biscuits. Each number in the table shows how many utils the consumer garnered from each combination of bananas and biscuits. Graphically, this yields a set of 3D bars, with the bars getting ever higher as more biscuits and bananas are consumed.

TABLE 3.2 Utils arising from the consumption of two commodities.

3.2 Total utils from the consumption of two commodities.

However, this representation is already clumsy. For a start, while it is possible to show the absolute number of utils given by any combination of bananas and biscuits, it is a c.u.mbersome way to show the change in the number of utils caused by going from any one combination of biscuits and bananas to any other. Since marginal utility is a key concept, this was a major technical failing of this approach. It is also impossible to provide a geometric picture for more than two commodities.

However, there is another, more obvious shortcoming. By postulating an objective measure of utility, it mooted an apparently impossible degree of precision and objectivity in the measurement of something so intrinsically subjective as personal satisfaction. As a result, the 'cardinal' concept of objectively measurable utility gave way to an 'ordinal'4 notion, where all that could be said is that one combination of commodities gave more or less satisfaction than another combination.5 3.3 Total 'utils' represented as a 'utility hill'

Metaphorically, this treated utility as a mountain, and the consumer as a mountain-climber whose objective was to get as high up this mountain as possible. The mountain itself was a peculiar one: first, it started at 'sea level' zero consumption gave you zero utility and then rose sharply because the first units consumed give you the highest 'marginal utility'; and secondly, it went on for ever the more you consumed, the higher you got. The 'utility mountain' would get flatter as you consumed more, but it would never become completely flat since more consumption always increased your utility.6 The final abstraction en route to the modern theory was to drop this '3D' perspective since the actual 'height' couldn't be specified numerically anyway and to instead link points of equal 'utility height' into curves, just as contours on a geographic map indicate locations of equal height, or isobars on a weather chart indicate regions of equal pressure.7 3.4 The contours of the 'utility hill'

This representation enabled a conceptual advance which basically gave birth to modern consumer theory however, as we shall see later, it also introduced an insurmountable intellectual dilemma. Since consumers were presumed to be motivated by the utility they gained from consumption, and points of equal utility height gave them the same satisfaction, then a consumer should be 'indifferent' between any two points on any given curve, since they both represent the same height, or degree of utility. These contours were therefore christened 'indifference curves.'

3.5 Indifference curves: the contours of the 'utility hill' shown in two dimensions Since indifference curves were supposed to represent the innate preferences of a rational utility-maximizing consumer, economists turned their minds to what properties these curves could have if the consumer could be said to exhibit truly rational behavior as neocla.s.sical economists perceived it. In 1948, Paul Samuelson codified these into four principles: Completeness: If presented with a choice between two different combinations of goods, a consumer can decide which he prefers (or can decide that he gets the same degree of satisfaction from them, in which case he is said to be indifferent between them).

Transitivity: If combination A is preferred to combination B, and B to C, then A is preferred to C.

Non-satiation: More is always preferred to less. If combination A has as many of all but one commodity as B, and more of that one than B, then A is necessarily preferred to B.

Convexity: The marginal utility a consumer gets from each commodity falls with additional units, so that indifference curves are convex in shape (shaped like a 'slippery dip').

This meant that indifference curves had a very specific shape: they had to look like a slippery dip that was steepest at its start, and always sloped downwards: the more of a good was consumed, the flatter the curve became, but it never became completely horizontal. And there were a mult.i.tude of such curves stacked on top of each other, with each higher one representing a higher degree of utility than the ones below. Economists then used these curves to derive the consumer's demand curve.

3.6 A rational consumer's indifference map.

Deriving the individual demand curve.

Obviously, since utility rises as more is consumed, the consumer would eat an infinite number of bananas and biscuits (yes, I know this is absurd) if not constrained by some other factors. The constraints are the consumer's income, and the prices of bananas and biscuits, so the next step in the economic saga is to notionally combine indifference curves with a consumer's income and prices to determine what a consumer will buy.

In terms of the 'utility mountain' a.n.a.logy, this amounts to slicing the base of the mountain at an angle, where the slope of the slice represents the prices of biscuits and bananas, and cutting the mountain off at a distance that represents the consumer's income. There is now an obvious peak to the mountain, representing the highest point that the consumer can climb to.

In the '2D' model that economists actually use, the consumer's income is shown by a straight line which connects the quant.i.ty of bananas he could buy if he spent all his income on bananas, and the quant.i.ty of biscuits he could buy if he spent all his income on biscuits. If the consumer's income was $500, and biscuits cost 10 cents each, then he could purchase 5,000 biscuits; if bananas cost $1 each, then he could purchase 500 bananas. The budget line then connects these two points in a straight line so that another feasible combination is 4,000 biscuits and 100 bananas.

3.7 Indifference curves, the budget constraint, and consumption According to economists, a rational consumer would purchase the combination of biscuits and bananas which maximized his utility. This combination occurs where the budget line just touches a single indifference curve in the 3D a.n.a.logy, it's reaching the edge of the cliff at its highest point. If the consumer purchased any other feasible combination of biscuits and bananas using his income, then he would be forgoing some utility, which would be 'irrational.'8 Have you started to fall asleep yet? Sorry, but as I warned, this stuff is boring. But have some more coffee and stay tuned; after a few more introductory bits, things start to get interesting.

The impact of changing prices on consumer demand.

At this point, we have presented only the economic explanation of how a consumer will determine the consumption of any one bundle of commodities, given a fixed income and fixed prices. But what interests economists is what they call a 'demand curve,' which shows how demand for a commodity changes as its price changes, while the consumer's income remains constant.

This last condition is crucial and as we'll see shortly, it is where the whole enterprise comes unstuck. Economists are trying here to separate how a consumer's behavior changes when prices change, from how behavior changes when incomes change. To do this, they have to a.s.sume that a change in prices won't change the consumer's income. This is OK if we're considering an isolated consumer who makes a living from, say, producing clothing: changing the price of bananas will have precious little impact on the income he makes from producing clothing.

If we consider a lower price for bananas, then the number of bananas the consumer can buy rises. If at the same time his income and the price of biscuits remain constant, then the budget line moves farther out on the bananas axis, but remains in the same spot on the biscuits axis. In the 3D a.n.a.logy, this is like cutting a slice through the utility mountain at a different angle. The maximum point in the biscuits direction remains the same, but the maximum point in the bananas direction rises, and the overall hill is larger too the consumer's maximum utility has risen because he can buy more.

3.8 Deriving the demand curve.

Economic theory then repeats this process numerous times each time considering the same income and same price for biscuits, but a lower and lower price for bananas. Each time, there will be a new combination of biscuits and bananas that the consumer will buy, and the combination of the prices and quant.i.ties of bananas purchased is the consumer's demand curve for bananas. We finally have a demand curve, which normally slopes downwards as economists predicted. But it doesn't have to there is still one wrinkle left. This is because, when the price of one good falls, and your income remains fixed, it's possible to increase the consumption of all goods not just the one that has become cheaper.

It is even possible that your consumption of the good that has become cheaper could actually fall as its price falls, if it is so undesirable that you consume it simply because you are poor. Economists call such commodities 'Giffen Goods,' and their favorite alleged example is potatoes during the potato famine in Ireland in the nineteenth century. They argue that as the price of potatoes rose during the famine, the Irish could no longer afford to buy more palatable goods like pork, so their consumption of potatoes actually rose as the famine continued and the price of potatoes also rose.

3.9 Upward-sloping demand curve How's that coffee cup going? Empty? Then it's time you got a refill! There are two more tedious sections to come before the punchline that makes this ba.n.a.l trudge worthwhile.

Income and subst.i.tution effects and the 'Law of Demand'

The fact that a fall in price actually lets you consume more of everything can mean that it's possible for the demand curve for a given good to slope upwards at some points to show the consumer consuming less as its price falls (and therefore more of it as its price rises!). This anomaly occurs because when the price of a commodity falls, the consumer's real income in effect increases.

This can be seen in our bananas and biscuits example: if the price of bananas falls while income and all other prices remain constant, then the consumer can buy more bananas without reducing his purchases of any other commodities. Therefore he is materially better off, even though his income hasn't changed.

This in turn can lead to perverse effects if one item in his shopping basket is relatively undesirable compared to more expensive alternatives say, instant coffee rather than freshly ground beans and it plays a large role in his budget. If the price of this commodity falls, it is possible the consumer could respond to the effective increase in income by consuming less of this product, even though it has become cheaper.

The increase in overall well-being due to the price of a commodity falling is known as the 'income effect.' It can lead you to consume more of the product, or it can lead you to consume less it depends on the commodity. The pure impact of a fall in price for a commodity is known as the 'subst.i.tution effect.' So long as we are dealing with 'goods' things which increase the consumer's utility then the subst.i.tution effect is always going to be in the opposite direction to the change in price.

For this reason, economists say that the subst.i.tution effect is always negative. They don't mean that subst.i.tution is a bad thing, but that price and quant.i.ty move in opposite directions: if price falls, consumption rises. The income effect can be negative too so that you consume more of a good as the fall in its price effectively increases your real income. But it can also be positive: you can consume less of a good when the fall in its price effectively increases your real income.

The always negative subst.i.tution effect is the phenomenon economists are trying to isolate with the demand curve, to establish what they call the 'Law of Demand' that demand always increases when price falls. This 'law' is an essential element of the neocla.s.sical model of how prices are set, which says that in compet.i.tive markets, supply will equal demand at the equilibrium price. For this model to work, it's vital that there is only one price at which that happens, so it's vital for the model that demand always increases as price falls (and similarly that supply always rises as price rises).

However the income effect can get in the way.

Economists thus found it necessary to search for a way to divide the impact of any change in price into the income effect and the subst.i.tution effect. If the income effect could be subtracted from a price change, this would leave the subst.i.tution effect as the pure impact on consumption of a change in relative prices. The problem is, though, that neither the 'income effect' nor the 'subst.i.tution effect' is directly observable: all we actually see is a consumer's purchases changing as the price of a commodity changes.

Economists dreamt up a way of at least notionally subtracting the income effect from a price change, using indifference curves. The clue is that, with income fixed and price falling, the lower price lets a consumer enjoy a higher effective standard of living which in their model was manifested by the consumer reaching a higher indifference curve.

Since, to an economist, the real object of individual behavior is utility maximization, and since any point on a single indifference curve generates the same utility as any other point, then in utility terms the consumer's 'psychic income' is constant along this curve.

The subst.i.tution effect of a price fall could thus be isolated by 'holding the consumer's utility constant' by keeping him to the same indifference curve, and rotating the budget constraint to reflect the new relative price regime. This amounts to reducing the consumer's income until such time as he can achieve the same level of satisfaction as before, but with a different combination of biscuits and bananas. Then the budget constraint is moved out to restore the consumer's income to its actual level and, voila, we have separated the impact of a price change into the subst.i.tution and income effects.

3.10 Separating out the subst.i.tution effect from the income effect The demand curve derived from neutralizing the income effect is known as the 'Hicksian compensated demand curve,' after both the person who first dreamed it up (the English economist John Hicks) and the procedure used. It finally establishes the 'Law of Demand' for a single, isolated consumer: the demand for a commodity will rise if its price falls.

The dissident Australian economist Ted Wheelwright once described this hypothesized activity as 'tobogganing up and down your indifference curves until you disappear up your own abscissa,' and it's easy to see why.

Nonetheless, the end result is that desired by economists: increasing a product's price will reduce a consumer's demand for that product: an individual's demand curve slopes downwards. The 'Law of Demand' holds for a single consumer. There will be the odd commodity where a positive income effect outweighs the negative subst.i.tution effect, but these can be regarded as 'the exceptions that prove the rule' and safely ignored.

OK, take one more swig of coffee for the final tedious bit of detail how economists consider the impact of changes in income on demand.

How rising income affects demand.

As with all other issues, economic theory uses indifference curves to handle this topic. The relevant commodity is placed on the horizontal axis, all other commodities on the vertical, and the budget constraint is 'moved out' (Figure 3.11). This represents an increase in income with relative prices held constant unlike a pivot, which represents a change in relative prices with income held constant. Economists say that the resulting plot known as an 'Engel curve' shows a consumer maximizing his utility as his income rises.

One point that is essential to the approaching critique is that Engel curves can take almost any shape at all. The shapes show how demand for a given commodity changes as a function of income, and four broad cla.s.ses of commodities result: necessities or 'inferior goods,' which take up a diminishing share of spending as income grows; 'Giffen goods,' whose actual consumption declines as income rises; luxuries or 'superior goods,' whose consumption takes up an increasing share of income as it increases; and 'neutral' or 'h.o.m.othetic' goods, where their consumption remains a constant proportion of income as income rises.

Necessities include such things as, for example, toilet paper. Your purchases of toilet paper will fall as a percentage of your total spending as you get wealthier (though you may buy more expensive paper). Some products that are subst.i.tutes for better-quality products when you are very poor baked beans, perhaps will disappear altogether from your consumption as you get wealthier, and economists refer to these as Giffen goods. Luxuries range from, for example, tourism to original works of art. Spending on holidays rises as income rises, and artworks are definitely the province of the rich.

I can't provide an example of a 'neutral good,' because strictly speaking, there are none. Spending on such a commodity would const.i.tute the same percentage of income as a person rose from abject poverty to unimaginable wealth, and there is simply no commodity which occupies the same proportion of a homeless person's expenditure as it does of a billionaire's. But economists nonetheless have termed a word for someone whose preferences look like this: they call this pattern of consumption 'h.o.m.othetic' (I call it 'neutral' in Figure 3.11d).

3.11 Engel curves show how spending patterns change with increases in income Strictly speaking, no one could have h.o.m.othetic preferences, and society in general would not display 'h.o.m.othetic preferences' either: as income rose, the pattern of consumption of both individuals and society would change. Poor individuals and societies spend most of their money on staples (such as rice) while rich individuals and societies spend most of theirs on discretionary items (like the latest high-tech gadgets).

It may seem like explaining the obvious to say this, but the point is crucial to the approaching critique: as you age and as your income (hopefully) rises, your consumption pattern will change, as will the consumption pattern of a society as it gets richer. Thus any consumer is going to have lots of necessities and luxuries in his consumption, but no 'h.o.m.othetic' goods.

Two is a crowd.

The 'Law of Demand' has thus been proved but only for a single consumer. Is it possible to generalize it so that it applies at the level of the market as well? In a nutsh.e.l.l, the answer is no. In the first of the many 'aggregation fallacies' that plague neocla.s.sical economics, what applies when one consumer is isolated from all others does not apply when there is more than one consumer: what is true of Robinson Crusoe, so to speak, is not true of the society consisting of Robinson Crusoe and Man Friday.

With Crusoe alone on his island, the distribution of income doesn't matter. But when Man Friday turns up, the distribution of income does matter, in ways that completely undermine everything involved in deriving an individual's demand curve.

One condition for deriving an individual's 'Hicksian compensated' demand curve for bananas was that changing the price of bananas didn't directly alter that individual's income.9 That condition fails when you move from a one-person, two-commodity model to a two-person, two-commodity world let alone anything more complicated because changing the price of bananas (relative to biscuits) will alter the incomes of both individuals.

Unless they're clones of each other, one individual will earn more than the other from selling bananas so an increase in the price of bananas makes the banana producer let's call him Crusoe richer, while making Friday poorer. This means that Crusoe is capable of buying more biscuits when the price of bananas rises. It's no longer possible to change the price of bananas while keeping constant the number of biscuits that the consumer can buy.