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Monday, November 5, 2012

The Law of Demand

The law of demand is a simple principle with profound consequences and incredible explanatory power. The law is so simple, it can be expressed as haiku:

All else held constant

quantity demanded falls

when the price rises.

When tomato prices rise, people eat fewer tomatoes. When tomato prices fall, people eat more tomatoes. What is true of the tomato market is true of other markets as well. The law of demand applies to markets for goods like tomatoes and to markets for services like auto repair and landscaping.

The law of demand applies to more than just the goods and services we buy, however. We can think about having a “demand” for all sorts of things, like a demand for speed and comfort while driving. When fast driving becomes riskier, people do less of it. When fast driving becomes safer, people do more of it.

Consider something else that has been controversial recently: the demand for convenient communication. With the diffusion of cell phones (and smart phones especially), communicating via email, text messages, Facebook, Twitter, and other applications has never been easier. The siren song of email, the Internet, and text messages can be strong, even for people who are driving at the time. Let’s consider first how the law of demand helps us explain why people text while driving and second the implicit theory underlying laws against texting while driving.

First, consider something called the Peltzman Effect, named for the economist Sam Peltzman, who studied driving habits before and after seatbelt laws were passed. Mandatory seatbelt use makes driving safer, which effectively makes risky driving less dangerous, or reduces the “price” of risky driving. Indeed, Peltzman found that people were riskier drivers after seatbelt laws were passed. As Steven Landsburg summarizes Peltzman’s findings in The Armchair Economist, there were more accidents but fewer fatalities per accident. Those who truly suffered were pedestrians; their fatalities increased.

Not everyone has to respond this way for the law of demand to be applicable or useful. There are probably a lot of people who don’t really change their driving behavior just because they have a seatbelt, just as there are some people who aren’t going to increase their beer consumption just because the price has fallen. But just because you are a teetotaler who will not drink more beer when the price falls doesn’t mean that there isn’t someone who will. In the same way, someone is more likely to text or check Facebook while driving because he is behind the wheel of a safer car.

Authorities recognize that people respond to the changing costs and benefits of different courses of action. Bans on texting while driving—like the one that just went into effect in Alabama—are attempts to raise the price of reckless behavior and thereby reduce the degree to which people engage in it. It remains to be seen how these bans will affect overall safety as the resources that have to be dedicated to enforcing them must come from somewhere else. Police officers who are enforcing texting-while-driving bans are, by necessity, not solving crimes.

Ignoring Demand

Government policies sometimes ignore the law of demand outright. Consider minimum wages. When the government mandates a higher price for labor, employers reduce the quantity of labor they demand and search for substitutes. Employers might cut back on hiring. They might cut back on employees’ hours (and according to the law of supply, workers will be willing to supply more hours at the higher wage), or they might substitute capital for labor (such as self-checkouts at grocery stores). Other effects might be difficult to see, and the effect of a minimum wage may not show up in a higher unemployment rate. Firms that used to offer paid training may stop doing so. Firms that used to provide uniforms might start making employees pay for them. And so on. In response to a higher price, firms reduce the amount of labor they demand.

Governments also impose price controls on things like rental apartments. After natural disasters, nebulous laws against “price gouging” might go into effect that limit suppliers’ ability to raise prices during emergency conditions. In emergencies people want more ice, flashlights, batteries, plywood, bread, milk, and gasoline at any given price. If the price is allowed to increase, people will get the signal that they need to think twice about some of their purchases. In response to price controls, firms are not as willing to bring more ice, flashlights, batteries, and the rest to the market. People still pay higher prices for goods that are in short supply. They may not hand over much cash, but they will find themselves “paying” by standing in longer lines.

The law of demand is one of the most important ideas in the social sciences. It is a deceptively simple principle with a wide range of applications. It helps us understand markets for goods like tomatoes, services like plumbing and landscaping, and even things that aren’t straightforwardly “economic” like law enforcement and risk-taking. It is also a law that we ignore at our peril: By making policies that do not acknowledge the law of demand, politicians often enact political “cures,” like minimum-wage laws and price controls, that are worse than the problems they are intended to address.

  • Art Carden is a Professor of Economics, author, and co-editor of the Southern Economic Journal.