1. What happens to wealth?
We have seen that the production of wealth uses three fundamental resources or factors, land, labor, and capital goods. The wealth is distributed to the owners of these factors, landowners receiving rent, laborers receiving wages, and the owners of capital goods receiving a capital yield. This is the first distribution of the wealth.
The wealth is then subject to two further possible distributions. The recipients may voluntary transfer some of their wealth to others, such as to their children, to some organization such as a church or charity, or to their heirs as an inheritance. These gifts make up the second distribution of wealth.
Wealth can also be transferred involuntarily, and forced transfers make up the third distribution of wealth. The third distribution is of two types: 1) theft, and 2) taxes. Theft, of course, is the forced transfer of wealth by private persons, while taxes are the forced transfer by a government. Note that government revenues can be obtained by the first two distributions as well. For example, user fees are a voluntary payment by persons for specific government services, just like paying a price for any other consumer goods. Governments may also earn revenue from their operations, such as running a subway system. Finally, the government can act as a collection agency for commonly owned property, receiving the rent and using it for its operations. In substance, the collection of land rent, is also a first distribution, rather than a tax, if we consider the rent to be commonly owned by the members of a community.
The second and third distributions are called "redistribution," since they distribute again the wealth that was already distributed the first time to the owners. Redistribution normally refers to forced transfers of wealth by government.
After the wealth has been distributed, it ends up in the hands of the final recipients as income, which is an increase in wealth or claims to wealth. People are usually paid in money, but as we have seen, this money is just a general ticket one can exchange for real wealth.
Then what happens to the income? It is spent in three possible ways. First, it can be used to buy consumer goods. These are goods which are acquired for immediate, personal consumption. To consume really means to "use up." You buy a banana, your eat it; you have "used up" the banana. It is consumed - no longer exists.
Secondly, you can save your income. This income is usually put in a bank or other financial institution, which then invests it in new capital goods or in the creation or improvement of an enterprise (usually, the institution loans the funds to borrowers who invest it). So savings are usually directly or indirectly put to use for investment; investments tend to equal savings. One can also directly invest one's wealth. Also, since consumption consists of using up wealth, if one buys a durable good, something like a car that lasts a long time, then it too is an investment. It gets consumed a bit at a time; or, as accountants say, it depreciates (as discussed in Chapter 4 on capital goods). Every year, it loses some value.
Since capital goods have a yield, if you invest your money, it gets a return. If your investment is more direct, such as buying a car, you are getting an implicit return. If you instead had to borrow a car, you would be paying the owner a periodic fee; so if you own your own car, you are paying it to yourself, just like if you own land, it has a rent regardless of whether any explicit or money payments are being made.
The third way of spending income is to waste it. Waste involves the use of resources in different ways than the owners would have wanted, and without benefit to them. If a vandal destroys your car, for example, this is not only your own loss, but a social loss as well, since this resource has been wasted. If the government builds a road in a forest that benefits only a few individuals (say, the owners of a lumber company), then the wealth of the original owners (from the first distribution) has been wasted, used in ways they would not desire and do not benefit from. This road is not a true investment, since its yield is less than what investors would get in a free market. Government subsidies, then, are usually wasteful, and costs imposed by government restrictions and taxes are also a social waste of resources, since they not only extract funds that people would want to spend in different ways, but also increase the price of goods, and this involuntary increase constitutes a waste.
2. Consumers' utility
What, then, determines how income is consumed? Let's go back to the foundational principles of economics. Proposition #8 states that human beings have ends, or goals, desires, and needs. Proposition #11 states that human values, and thus these ends, are subjective. Proposition #9 states that people are able to rank their ends into those of greater and lesser importance.
The theory of economic values was pioneered by the founder of the Austrian school of economic thought, Carl Menger (1871). He defined value as "the importance that individual goods or quantities of goods attain for us because we are conscious of being dependent on command of them for the satisfaction of our needs" (p. 115). Values are thus subjective, since each individual perceives the importance of goods from his own needs or desires, from his own feelings and thoughts. Value originates in the human mind rather than in things: "Value is thus nothing inherent in goods" (p. 120). We know from experience that what pleases one person will be detested by another person.
Goods have utility, or usefulness, because we value them. As Menger stated it, "Utility is the capacity of a thing to serve for the satisfaction of human needs" (p. 119). In ranking our subjective ends or desires, we also rank the desirability or utility of the various goods that have the capacity to satisfy these desires.
Menger then notes that "these differences in the importance of different satisfactions can be observed not only with the satisfaction of needs of different kinds but also with the more or less complete satisfaction of one and the same need" (pp. 123-4). For example, you not only desire food, but a different amounts for different reasons, such as for survival, health, or enjoyment. The highest rank might be for survival, then for health, and then for enjoyment, or perhaps some folks would rank enjoyment greater than health, as we often do some of the time. Hence, we rank food-value in terms of the decreasing importance of various amounts. In general, for any good, different amounts satisfy different types of needs or desires of different importance, so that as we consume ever more of it, ever decreasing desires are satisfied, until the amount is reached when, at some moment, "a more complete satisfaction of that particular need is a matter of indifference" (p. 125). Even more consumption would then become a burden.
So the utility derived from some good diminishes as you obtain more and more of it. Maybe the first small increments give increasing utility, but eventually the utility of increasing amounts diminishes. This is called "diminishing marginal utility."
The value you place on an extra amount of a good depends on the subjective importance or value of only that extra amount, regardless of the value of the previous amounts. So what you would be willing to pay for that amount depends only on that marginal or extra utility obtained, not on the utility of the previous amounts. And here is the kicker: when you buy a certain amount of a good, if all the units of the goods (like individual oranges in a bag) are priced identically, then the price you are willing to pay per unit depends on the utility of the last, the marginal, the least important unit. Otherwise, you would not buy that extra or last unit!
For example, if apples and oranges are each priced at 20 cents each, but you prefer oranges to apples, you would rather buy one orange than one apple. You value the second orange (at that moment) less than the first, but still greater than the apple. But now, having two oranges, you would rather have one apple than a third orange. If oranges are priced cheaply, you'll then take a fourth or fifth one. You don't want an extra apple because an extra orange is more important at the time. But if that day oranges are expensive, then you might only take two, plus one apple, since the first couple of oranges are more important and valued than the next few. So the price you are willing to pay for one orange or one apple depends on the value to you of that last apple or orange taken, rather than the first.
As Menger put it, "The value of a particular good ... is thus for [an individual] equal to the importance of the least important of the satisfactions assured by the whole quantity available" (p. 139).
Marginal utility explains why water is so cheap where it is in large supply, even though it is an important commodity overall. When lots of water is available, the last unit you buy will be put to a relatively unimportant use, like washing your car. The marginal value of water, then, is low, even though some of the water (the first amounts you would buy if it were scarcer) is very important.
3. The law of demand
"To "demand" in economics does not mean to boldly and angrily insist on getting something, but simply to both want something and be able to pay for it. A demand for a product means the amount that consumers are willing and able to obtain. The demand of an individual consumer for a product depends on his subjective value with regards to the good, the utility he perceives it to have for him. Because of diminishing marginal utility, people buy more of a good if the price is less, since they will be willing to satisfy less important desires if the price is lower.
The price of a good is not just the amount one has to pay for something, but also the foregone opportunities. If you spend $100 for a coat, you have lost the opportunity to spend that amount on something else. The real cost is therefore the foregone opportunities, not the $100, since that $100 will be spent on something. At a lower price, the foregone opportunities are fewer or less valuable. This concept of cost being a foregone opportunity is called "opportunity cost," another concept pioneered by the Austrian school, namely by Friedrich von Wieser.
Land has an opportunity cost for an individual, but for an economy as a whole, the land is already there, so there is no opportunity cost in its use overall (as opposed to use for a particular purpose). Labor does have an opportunity cost because the alternative is leisure. Land being dead, it doesn't care whether it is being utilized 24 hours per day. Because of the zero real cost of land, the rent not caused by the efforts of the site users can be considered a social surplus.
Thus, for any good, at different prices there are different opportunity costs, and the lower the price, the lower these costs, relative to the subjective value of another unit of a good. Hence, there is a relationship between different prices of a good and the amount one is willing to buy: the lower the price, the more one is willing to forego other opportunities and buy another unit of the good.
A demand function consists of the various quantities of a good one demands for each price of a good. We can concisely describe this function as Q=f(P), quantity bought is a function of price. The actual relationship for various values of the function can be written in a schedule or table, or in a graph. Such a graph has price along the vertical axis, the opposite from the normal mathematical convention of having the independent variable on the horizontal, thanks to Alfred Marshall (1842-1924), the economist who pioneered the analysis of supply and demand. Quantity is then on the horizontal axis, and we then draw points showing the quantities demanded for each of various possible prices. These points are then jointed together to form a "demand curve."
Since a greater quantity is demanded at a lower price, a demand curve slopes down, diagonally to the right. This is called the "law of demand," a fundamental principle of economics. As we have seen, the law of demand is derived from the diminishing marginal utility for increasing amounts of consumer goods. Demand curves can also be horizontal (where the price is always the same) or vertical (where the quantity is always the same).
The quantity of goods demanded can be of two types. For flows, goods in continuous production and consumption, the quantity is an amount per unit of time. For example, the demand for oranges is a certain amount per week or month. The quantity axis is then Q/T, quantity per time interval.
The other type of good is a stock, a certain quantity at one moment of time. For example, the demand for a certain rare stamp is that of a stock. No more of these stamps are being produced; there is no flow of product. Instead, collectors bid already-existing stamps from one another, competing for a fixed stock. At any moment in time, there will be bids and offers for stamps, and an exchange takes place when a bid and offer match in price. The demand for the stamps are therefore the number of bids at any particular moment in time at some price. At a higher price, fewer collectors are willing to bid for a stamp. So the demand curve for stocks of goods also slopes down, but the quantity axis is for bids at a certain moment. The market for land is such a market, since people bid for existing parcels, buying from a previous owner rather than for newly manufactured or imported land!
The demand for consumer goods depends of many variables, such as subjective preferences (or tastes), income and wealth, and alternative goods and prices.
The demand curve for a good for an entire economy is simply the addition of all the demand curves of the individuals.
4. Shifts in demand
If someone says "demand has gone up," the correct response from an economist is, "what demand do you mean?" This language is ambiguous because it can mean two different things. First, it can refer to an increase in quantity demanded when the price goes up, which would be a movement along the demand curve or schedule. Secondly, it can refer to a shift of the entire demand curve, when consumers want more of the good at all price levels. When an economist talks about an "increase in demand," the meaning is that there has been a shift in the demand curve towards greater quantities at all prices.
5. Elasticity or responsiveness
An entrepreneur wishes to know how much more of his product will be bought if he lowers or increases the price. What he wants to know is called the "price elasticity of demand." We can blame Alfred Marshall for this confusing terminology, just as he is to blame for switching the demand-curve axes. A better term for elasticity would be "responsiveness." The price elasticity is the responsiveness of the quantity demanded to a small change in the price of a good. It is measured as the proportionate (or percentage) change in quantity divided by the proportionate change in price. The technical calculation is as follows:
Demand is said to be elastic if the price elasticity (quantity responsiveness) is high. This means a small change in price leads to a relatively large change in quantity demanded. By convention, demand is calculated as elastic if its value is greater than one, which means the proportionate change in quantity is greater than in price.
The opposite is an inelastic demand, if the quantity responsiveness is low, less than 1. If it is exactly 1, then it has "unitary elasticity." These elasticities are important in applied economics, since enterprises want to know the effects of price changes, and they experiment to see what the quantity responsiveness is. So an education in economics needs to include these concepts and terms.
There are two other elasticities relevant to demand. One is (again confusingly called) the "income elasticity of demand," which would be better called the "quantity responsiveness to income." Here, we measure the change in quantity demanded when there is a change in income. This is calculated as the percentage change in quantity divided by a percentage change in income - this time with no minus sign. Again, there is a practical application, since if we expect incomes to rise, an enterprise wants to know how the demand curve for his product will shift.
The third type is the "cross elasticity of demand," which means, in English, the responsiveness of the quantity demanded of one good when the price of another good changes. It is calculated as the percentage change in quantity for one good divided by the percentage change in price for another good. This cross-price elasticity is important in being able to tell which goods are substitutes and which are complements.
A good is a substitute for another if one can switch from one to the other without much loss in utility. For example, if you don't much care whether your pencil is colored yellow or blue on the outside, they are close substitutes. We can measure this with the cross-price elasticity. If it is positive, the goods are substitutes, because it means an increase in the price of one good (blue pencils) induce an increase in quantity demanded in another good (yellow pencils). A big increase in the price of green apples would likely lead to people buying less of them and more of its substitute, red apples.
If the cross elasticity is negative, the goods are complements. A complement is a good that is used together with another one. For example, your left shoe is a complement to your right one. Suppose they were sold separately, and the price of right shoes went way up. You would not only buy fewer right shoes, but also fewer left ones, since you want both together. The cross price elasticity would be negative, since an increase in the price of left shoes leads to a decrease in quantity bought of right shoes.
If the cross price elasticity is zero, then there is no relationship between the two goods.
6. Amount of goods demanded
We can now determine that amount of each good that a consumer will buy in a market economy. Foundational principle #12 states that people economize. Henry George (p. 170) stated that this principle "is to political economy what the attraction of gravity is to physics - that men will seek to gratify their desires with the least exertion." Economizing implies too that people will want to maximize their utility or wealth for any given cost.
Consumers will then want to buy that basket of goods that gives them the most satisfaction. Since for each good there is diminishing marginal utility, to maximize utility,the last amount of each good bought needs to be equal in utility to the last amount of every other good bought, relative to their prices. For example, if oranges and apples each cost 20 cents, then you will buy 4 oranges and 2 apples if the 4th orange provides as much marginal utility as the 2nd apple. If the 5th orange provided more utility, then instead you would buy it instead of the 2nd apple. If tomatoes are 10 cents each, and you like two tomatoes as much as one apple for all quantities, then you would buy twice as many as apples since they cost half the price.
In general, the basket of goods that gives you as much utility as possible is that in which for each good, the marginal utility of each good is proportional to its price. The marginal utility of each good, divided by its price, equals the marginal utilitity divided by price of all other goods. In that case, the last dollars or pounds spent on all goods give the same amount of utility, and you can't do any better.
7. Consumer demand and the factors of production
In our model in Chapter 3 on rent, we had only one crop, corn, and the rent and wages were calculated in terms of corn. But in a complex economy with many goods, which goods determine the value of wages and rent?
We again turn to Menger (who is a good complement to George!). We have seen that the values of consumer goods are subjective. As you recall from chapter 4, capital goods are called by Menger "goods of higher order" than consumer goods. As Menger put it, "the value of goods of higher order is always and without exception determined by the prospective value of the goods of lower order in whose production they serve" (p. 150). In other words, if consumers value corn highly relative to other goods, then the goods of higher order used to produce those of lower order will have value. Land and labor used in growing corn have value because corn has value, or is expected to have value. The value of corn is not due to the costs of growing it; on the contrary, the resources used in growing it have value because the product has value. If you worked all day making mud pies, your labor would have a value of nill, since no one would want that product (unless your mother bought some).
As Menger recognized, the determination of the factors land and labor from the expected value of their final products is consistent with the law of rent, as analyzed in Chapter 3: "The existence of the special characteristics that land and the services of land ... exhibit is by no means denied. In any country, land is usually available only in quantities that cannot be easily increased; it is fixed as to situation; and it has an extraordinary variety of grades" (p. 169). Menger's theory deepens our insight into why land and labor have value at all. It was because the corn had value that the differential rent appeared in the first place and that the wages paid in corn had any value. But it is not the value of corn alone that would determine the rent of a particular lot of land.
As Menger wrote (p. 169), a factor of production will also have a greater value if complementary factors have a smaller value. Suppose that we need irrigation in order to use a particular area of land. If this water is cheap, then land rent will be higher than if the irrigation is more expensive. So the value of a capital good is determined by the relative physical productivity of the good, the expected value of the consumer good it helps to produce, and the cost of complementary factors.
8. Cost-influenced choice
Building upon the theory of subjective values, James Buchanan (1969), a pioneer of public choice theory which uses economics to analyze government, developed the theory of choices by private versus public agents. If you are choosing among goods with your own money, your choice will be "cost influenced," since each choice has an opportunity cost of foregone alternatives.
However, if your are a government official choosing among different goods for government spending, you do not personally bear the cost. The cost is borne by the taxpayers. Thus, this choice is not cost-influenced.
Recall in the beginning of the chapter that we had three categories of spending, consumption, investment, and waste. Consumption is a cost-influenced choice. Some government spending is also consumption and investment, since the taxpayers would, if given a direct choice over their funds, want to buy some of the things government buys, such as perhaps highways and wildlife conservation. But much of government spending will not have been so chosen, and it constitutes waste.
An individual may choose to buy an item he later regrets having bought. In retrospect, it was a waste. But since he did not know this beforehand, the spending is consumption. The key is whether the choice is cost-influenced. If at the moment of choice, you bear the cost and make a free choice, then the item bought is in the category of consumption or investment. The relevant utility of an item is that which is made at the very moment of choice. The fact that you might then have buyers remorse is irrelevant so far as the consumption is concerned. It's too late. The spending is now a sunk cost. Economics looks forwards to the future. Prices are always based on the expected utilities, not on the actual utility once a choice has been made. The past is important in influencing the future. A bad product will not be bought much in the future, if the word gets around. The past guides our future, but our expectations about the future determine our utilities and therefore the prices of goods.