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Thursday, August 12, 2010

Supply Depends on the Demand for (Often Unseen) Alternatives

Another path from here to there.

Spend some time with my good friend Pete Boettke and I guarantee that sooner or later he will get upset about some bit of economic nonsense he reads or hears about and respond with a loud, “Demand curves slope down!” — often punctuated with his fist smacking his hand and sometimes finished off with one of several unprintable nouns.

Pete’s quite correct to remind us that the most basic laws of economics hold no matter how hard we wish they didn’t.  And that particular law is one well worth remembering:  If we want less of something, make it more costly.  But it’s also important to understand that supply is just the flip side of demand and often gives us an alternative way to change the incentives people face.

Imagine an entrepreneur considering making tents out of canvas.  The price of canvas will be crucial to his ability to supply those tents.  But the price of canvas is in turn determined by the demand for other consumer goods made of canvas.  That is, the supply of tents depends on the demand for canvas sneakers, canvas drawing boards, and the like.  Should there be a public craze for canvas sneakers, driving up their price, sneaker producers will bid canvas away from alternative uses and increase the quantity of sneakers.  The higher price of canvas will in turn will reduce the supply of tents since our entrepreneur will face rising input costs.

Thus supply decisions are ultimately driven by demand for the alternative uses of the inputs.  Or to put it in more colloquial terms: If we want people to do more of something we like, we either have to increase the benefit of their doing so or increase the cost of alternatives that use the same inputs.  Because all supply is based on the demand for alternative uses of inputs, changing either the costs of one side or the benefits of the other will change the relative value of the two choices in the same direction, generating the same result.

Overlooked Strategy

People often overlook this point when trying to change the incentives facing others.  Even economists tend to think first and foremost of raising the costs of an observed bad behavior as a way to discourage it.  The problem is that sometimes raising other people’s costs also raises our own. In such situations we don’t think enough about how to increase the benefits of alternatives as a way to discourage the undesired behavior.  The problem is that what we dislike is in front of us, while the alternatives we’d like to reward require some imagination.

Consider a parenting example.  From the time my wife and I first started dating, we agreed that our children would never be like the out-of-control monsters we saw all too frequently in restaurants.  So how to make sure our kids behaved when we took them out to dinner?

One solution was to punish them for the misbehavior.  If they got out of their seats or made too much noise or threw things, we could reprimand them or, in the extreme, remove them from the restaurant.  This would certainly raise their costs, especially if it was connected with further punishment at home, such as taking away their favorite toys.  But this would be costly to us too, in terms of the scene it would make and the disruption of our dinner.  If one remembers, however, that supply is driven by the often unseen demand for alternatives, there is a solution.

Without a higher return alternative to misbehaving, that’s what we’d continue to get. But kids’ energy and time have alternative uses. So we would always bring a few of their favorite toys for them to play with while waiting for food.  (Restaurants understand this point: Many kid-friendly ones provide crayons and paper, though some kids might find those too boring.)  Bringing toys and engaging with them as they played increased the demand for good behavior and thereby reduced the supply of misbehavior.  Instead of just punishing the seen, we imagined an unseen alternative and rewarded it.

Pete Boettke is also fond of saying that all economics is the economics of relative prices.  It’s as true for kids in restaurants as it is for tents and sneakers.

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.