I feel like I’ve been here before. Gas prices are rising, approaching $4 per gallon. American drivers are freaking out, demanding the government “does something” to halt rising fuel costs. The next thing you know, people start buying bikes and riding them to work. Just like that, Americans change their lifestyles, abandon their cars, and reinvent themselves as bike commuters!

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The economics of this phenomenon barely requires explanation, but since this is an Economics teacher’s blog, I suppose I should explain it. A major determinant of the demand for a product is the price of related goods. In the US right now, fuel and cars are related goods; in economics terms, they are complementary goods. “You can’t have one without the other”. As gas prices rise, demand for driving cars begins to fall, since it becomes more costly to drive. The other good related to cars in this picture is a substitute mode of transportation, bicycles. The more expensive it becomes to drive a car, the greater the demand for bicycles.

Now, allow me to take my econ teacher hat off and put my avid cyclist hat (or helmet?) on. Bikes are way more than just a substitute for cars. The fact that every time gas prices approach $4 per gallon bicycle sales start to spike is bewildering to me. Do consumers really not know that riding a bike is always cheaper than driving a car? Why does it take slightly more expensive gas to motivate consumers to think about buying a bike?!

Okay, economist had back on now: You see, operating a car involves monetary costs that far exceed the price of gas. When I last had a car in the US, I paid nearly $200 per month in insurance (young males always pay the most), far exceeding my expenditures on fuel. In addition, there’s the fixed cost of the car itself, which once spent is a “sunk cost”, so should not affect an individual’s decision to drive or not to drive when the price of gas changes.

In addition to these explicit, monetary costs, however, there are also external, invisible costs of operating cars that make them an even less perfect substitutes for bicycles. More traffic on the roads, more accidents, more air and noise pollution, greenhouse gas emissions, environmental impact of the production and ultimate disposal of the car itself: these external costs are not even born by the driver when he or she decides to drive to work every day, rather they are born by society, taxpayers, and the environment.

My point is, making the decision to switch to commuting by bicycle should not require a 25% spike in fuel prices. The cost of filling your tank is in fact the least significant cost associated with driving a car when you look at the whole picture, and include not only those explicit, monetary costs paid by the driver, but include the external, social and environmental costs born by society as a whole.

Maybe I’m just on a bike high right now, since I got my new 29 inch wheeled fully two weeks ago and have ridden the 30 km round trip to work nearly every day since! Then again, maybe it really would make more economic, environmental, physical, spiritual and social sense if more people would park their cars and hop on a bike tomorrow morning!

This article was originally published on May 12, 2008. It is being re-published since it relates to our current units in AP and IB Economics.

The Associated Press: Gas prices knock bicycle sales, repairs into higher gear

Greg Mankiw has an ongoing series of posts linking to articles illustrating the impact that rising gas prices have had on demand in markets other than that of the automobile.

One of the determinants of demand for goods and services is the price of related goods and services. As gas prices rise, drivers tend to switch from automobiles to alternative forms of transportation. A few days ago I blogged about the switch from tractors to camels in India, one illustration of the relationship between the price of one good and demand for its substitutes. Mankiw has so far linked to articles about the impact of high gas prices on demand for bicycles, small cars and mass transit.

These three “goods” are all substitutes for the most common form of transport among Americans, the private automobile (often times a gas-guzzler in “the bigger the better” America). When the price of a good like personal vehicular transport increases (in this case due to the price of an input required in private cars, gasoline), the demand for a substitute good will increase.

In the case of bicycles, evidence indicates that just such a change in demand is already underway in America today:

Bicycle shops across the country are reporting strong sales so far this year, and more people are bringing in bikes that have been idled for years, he said.

“People are riding bicycles a lot more often, and it’s due to a mixture of things but escalating gas prices is one of them,” said Bill Nesper, spokesman for the Washington. D.C.-based League of American Bicyclists.

“We’re seeing a spike in the number of calls we’re getting from people wanting tips on bicycle commuting,” he said.

Interestingly, the increase in demand for bicycle travel in response to high gas prices might be even more pronounced due to America’s sluggish growth, 4% inflation and rising unemployment. Real wages have seen little gain in the last couple of years as growth has fallen close to zero while prices have continued to rise. It may be possible that a fall in real incomes in America has spurred new demand for bicycle transportation, which could be considered an inferior good, meaning that as household incomes fall, consumers demand more bicycles for transportation.

Since bicycles represent such a drastically cheaper method of transportation, high gas and food prices, a weak dollar, and falling real wages accompanying the economic slowdown have had a negative income effect on American consumers, leading to increases in demand for inferior goods such as bicycle transportation

That said, having worked in a bike shop myself for two years in college, I can say that most consumers looking at new bicycles are not doing so because of falling incomes. Quite the opposite, in fact, indicating that new bicycles are normal goods (those for which as income rises, demand rises). However, the article states that in addition to increases in new sales, “more people are bringing in bikes that have been idled for years”.

It may be that while new bicycles themselves are normal goods, bicycle transportation as a whole is an inferior good. The increase in demand for new bicycles could be explained by the substitution effect (as the price of motor vehicle transportation rises, its substitute, bicycle transport, becomes more attractive to consumers) and at the same time explained by the income effect too (as real incomes have fallen, demand for the bicycle transport has risen).

This phenomenon is an excellent illustration of how the income and substitution effects work in conjunction to explain the inverse relationship between price and quantity demanded for automobiles (the law of demand), as well as the concept of cross-price elasticity of demand between two substitute goods.

Discussion Questions:

1. Both the price of substitute goods and income affect demand for a particular product. How have both the prices of substitutes for bikes and the income of bike consumers influenced the demand for bicycles in different ways?
2. What is the definition of an “inferior good” in economics?Do you believe bicycle transportation is an “inferior good”?
3. Are all bikes the same? Do you think demand for some bicycles responds differently to changes in income than demand for other bicycles?

Chocolate Sales: A Sweet Spot in the Recession – TIME

Living in Switzerland, I find an article featuring a local business from the town my school is in irresistible, particularly when it appear in TIME magazine. Lindt chocolate, the company featured in this article, manufactures its delicate treats right down the hill from the ZIS campus, which means that when the wind is just right, you can just catch the scent of fresh, creamy chocolate wafting up the hillside while walking to campus.

Lindt, as well as its global competitors in the chocolate business, is enjoying surge in demand even while countless other industries are forced to cut back production, lay off workers, and close their factory doors. From TIME:

While the credit crisis has slowed down sales of everything from cars to organic groceries, people seem happy to keep shelling out for chocolate. Last year, as the global recession was gaining ground, Swiss chocolate makers bucked the trend with record sales — nearly 185,000 tons, an increase of 2% over 2007, sold domestically and in 140 export markets…

“Switzerland’s image sells well abroad, and nothing says ‘Switzerland’ more than chocolate,” says Stephane Garelli, director of the World Competitiveness Center at the Institute of Management Development (IMD) in Lausanne, predicting that this comfort food will continue to sweeten the sour economy for months to come…

“Now that people don’t have a new television or a new car,” he noted, “they eat a bit more chocolate.”

“Chocolate is one of the more recession-resilient food sectors,” says Dean Best, executive director of Just-Food, a U.K.-based news and information website for the global food industry. “With consumers eating out less and eating at home more, there is evidence that they are still allowing themselves the occasional indulgence — and chocolate is a relatively inexpensive indulgence.”

But the question of why there is no meltdown in the chocolate business may be more a matter of psychology than economics. “There is well-documented evidence going back to Freud, showing that in times of anxiety and uncertainty, when people need a boost, they turn to chocolate,” says Garelli of the IMD. “That’s why when the economy is bad, chocolate is still selling well.”

Which goes to show that chocolate is more than a candy treat — it’s real food for the soul.

So does this mean chocolate is an inferior good, or one for which demand increases as incomes fall? I doubt many Swiss chocolate producers would consider their product inferior, but perhaps it does fit the definition.

On the other hand, perhaps the reason demand for chocolate increases during a recession has more to do with the substitution effect than the income effect. As people eat out less, they consume fewer expensive deserts at restaurants and instead fill their shopping baskets with more affordable dessert options for the home. I can say from experience that this is the case for myself.

Living in Switzerland, I find myself rarely going out to eat at restaurants, an activity reserved for special occasions in this country where a steak can set you back 75 dollars. Instead, I eat at home almost every night, and nothing is more appealing to me, especially during hard economic times, than a bar of delicious chocolate after a home cooked meal. Demand for chocolate may rise during recessions simply because the demand for one of its substitutes (restaurant desserts) falls.

Discussion questions:

1. Do you think chocolate is an inferior good or a normal good? What’s the difference? What types of goods do YOU consome more of when you find yourself faced with a tighter budget?
2. Does economics have a good explanation for the above situation? The article mentions Freud, a pioneer in  the field of psychology; do humans’ economic behavior always appear rational?
3. If chocolate were an inferior good, what would happen to chocolate sales when the global economy finally turns around and incomes start increasing? What do you think will happen to chocolate sales when the economy starts imrpoving? Explain.

TDeluxe: How Luxury Lost Its Luster – Dana Thomas – Books – Review – New York Times

Unit 2 in IB and AP Economics begins by examining the interaction of supply and demand in product markets, and the importance of these factors in determining the equilibrium price in any particular product market.

In the above article from the NY times, the author reviews a book that exposes the diminished quality and attention to detail among manufacturers of luxury goods (think Prada, Gucci, etc…) The era of globalization and off-shoring of manufacturing has aided luxury firms in their quest for profits, as they’ve been able to significantly cut costs while maintaining exorbitant prices for their product.

The author takes issue with the alleged demise in the luxury market of attention to detail and craftsmanship, as competition and profit seeking behavior have led to an industry where the back alley workshops of Milan and Paris have been replaced by the factory floors of China and Vietnam. Free trade has allowed European luxury brands to produce more of their products at lower costs, which leads the author to her current question: “Why is this stuff still so expensive even as the cost of producing it goes down?”

Despite her accusations of poor quality and greedy, profit seeking managers in the luxury goods industry, the author seem unable to resist the luxury goods she claims to despise:

When, I asked myself, did it become commonplace to charge several thousand dollars for a mass-produced handbag? How could the flimsy designer sundress I bought on sale (a “steal”, the saleswoman assured me) still wind up costing a whole month’s salary? Why is my favorite brand of lipstick more expensive than a nice bottle of Italian wine? When did these products’ values grow so distorted, and what is the would-be customer to make of it all?

The author continues…

…the luxury industry is a sham because its offerings in no way merit the high price tags they command. Yet once upon a time, they most certainly did. In the 19th and early 20th centuries, when many of luxury’s founding fathers first set up shop, paying more money meant getting something truly exceptional. Dresses from Christian Dior, luggage from Louis Vuitton, jewelry from Cartier: in the golden period of luxury, these items carried prestige because of their superior craftsmanship and design. True, only the very privileged could afford them, but it was this exclusivity that gave them their cachet. Although they may have “cared about making a profit” the merchants who served this pampered class aimed chiefly to produce the finest products possible.

It appears that the author never took an introductory economics course. If she had, she would clearly understand that price is not determined by the level of craftsmanship, the attention to detail, nor the level of exclusivity represented by a particular purse, shoe or dress. Rather, price is determined by the interaction of Demand AND Supply in the market for all goods, EVEN luxury goods!

When she claims that “the merchents who served this pampered class aimed chiefly ‘to produce the finest products possible’”, the reviewer is forgetting some of the basic teachings of capitalism’s founding father. Adam Smith himself could have corrected the NYT reviewer when he said,

Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer…

Smith knew as any economics student should know that exchanges in any market happen not because of a mutual appreciation for craftsmanship or artistry, rather because a producer (firm) wants to make a profit by charging as high a price possible to a consumer (household). In the case of luxury goods, Gucci and Prada never made high quality goods because they loved making high quality goods, rather they made them cause consumers demanded them and were willing to pay top dollar for them.

What the author is missing is a basic understanding of the determinants of Demand. The price a good commands in the market has little to do with how much it cost to produce or where it was produced, and everything to do with the level of demand relative to the level of supply.

Discussion questions:

1. Why do Prada, Gucci, Cartier and other luxury brands command such high prices relative to cheaper substitutes widely available to consumers?
2. As nothing else changes and the price of luxury goods goes up, how is demand affected? Explain.
3. What are some of the determinants of demand that have kept the price of luxury brand goods high even as the costs of production have been reduced due to cheap overseas manufacturing?

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FT.com | The Economists’ Forum | Will Americans demand the cars that Congress wants the big three to build?

It’s been driving me nuts, this whole bailout debate. My frustrations are definitely appartent to my students, who have had to put up with my occasional rants about the insanity of the whole affair since the issue came to the media forefront over a month ago. Here are some of the issues that just don’t add up from the perspective of a high school economics teacher:

The three companies asking for a bridge-loan supposedly want the money so that hundreds of thousands (some reports say as many as 2.6 million) jobs can be saved. But how could Ford, Chrystler and GM possibly maintain their labor force in a time of a recession when nobody is buying new cars in the first place? In the parlance of AP or IB Economics, automobiles are normal goods, ones for which demand falls as incomes fall. By definition, a recession in the United States means falling incomes. A government loan may allow the Big Three to keep making cars for the time being, but WHY WOULD THEY KEEP MAKING CARS when falling incomes point to falling demand in the immediate future? Making cars that nobody will buy represents a gross misallocation of the nation’s productive resources, not to mention taxpayers’ money. What is required of these industries is precisely what the government loan will prevent them from doing, DOWNSIZING, meaning the shrinking of their labor force as well as the number of plants in operation.

The US recession can not be avoided by allocating the nation’s scarce resources towards a bailout of the auto industry. In fact, it will be worsened because the capacity of any nation to emerge from a cyclical downturn requires the flexibility of the country’s labor force to adapt to the structural changes the country is experiencing in the era of globalization and free trade. America’s future does not reside in labor-intensive manufactured goods, especially in the production of a very expensive durable good for which demand falls drastically during recessions; specifically, automobiles.

The Finanacial Times Economists Forum approaches the issue of long-term falling demand for automobiles from another perspective. One of the conditions of the Big Three accepting a loan from the federal government is the mandate that Detroit will begin producing more fuel efficient automobiles to assure Americans more affordable, more environmentally friendly alternatives to the gas-guzzling SUVs that have dominated the industry for the last two decades. But here’s the problem, gasoline has fallen to a price as low as it was when SUVs were at their peak popularity back in the early 2000s! As any high school economics student knows, gasoline and SUVs are what we call complementary goods, or two goods for which demand and price are inversely related. As gas prices fall to their 2000 levels, demand for SUVs promises to rise once again, while demand for fuel-efficient automobiles will likely decline, creating market pressures for the Big Three to make not more fuel-efficient cars, but more SUVs instead! From the Financial Times:

The basic problem is that Americans like to drive sport-utility vehicles, minivans and small trucks when gasoline costs $1.50 a gallon…

Consumers may have regretted their behaviour when gasoline prices soared above $4 a gallon, but as gas prices descend, there is no reason to believe that left unchecked they will not return to their gas-guzzling ways.

Indeed, there is a distinct possibility that if they really do increase their small car production, in a few years the big three will be back asking for more help, on the grounds that they are losing money by doing exactly what Congress asked.

The only reasonable solution to this dilemma? If Congress DOES begin mandating that Detroit increase its production of fuel-efficient cars and phase out its manufacture of SUVs, any such requirement should be accompanied by a government-set price floor on gasoline. Several months ago, my colleague and fellow blogger Steve Latter blogged about a proposed price floor of $4 per gallon on gasoline. Such a scheme would likely prove nearly impossible to initiate politcally, but may be exactly what’s necessary to add legitimacy to any government requiremens of Detroit to manufacture fuel efficient automobiles. The FT appears to support such a scheme:

Congress should put their mouths where their money is. They should make binding commitments to ensure higher US oil prices and thereby sufficient demand for fuel-efficient cars and trucks in the future.

Discussion Questions:

1. What message does falling demand in the auto market send from buyers to sellers, and what contradictory message does a subsidy from the government send to auto makers?
2. If the auto makers receive a low-interest bridge loan (subsidy) from the government, how will this actually undermine the efficient functioning of markets in America?
3. Why would a price floor on gasoline be needed to accompany a government requirement that the Big Three make more fuel efficient automobiles after receiving a government loan?

FT.com / World – Air fares nosedive amid falling travel demand

Our IB and AP Econ classes here at Zurich International School have just begun our second unit of the year, where the concepts of Demand and Supply are introduced and the effect these have on prices is examined. The first assignment of the new unit was for each student to find an article discussing the demand for a particular good, service or resource, and post it to our Unit 2 wiki page.

If it’s ever unclear whether a change in demand for a good or a service can actually affect the price, the article linked here should make it perfectly clear that demand is a powerful market force. In an industry where it has seemed recently that prices only rise, a recent fall in market demand has driven prices downward, as firms have responded to consumer demand in order to sell their product, which in this case are seats on short and long-haul flights within and from Europe.

Falling demand for business and leisure travel is causing a marked decline in air fares, with UK fares to North America declining by nearly a half, according to American Express.

Air fares peaked earlier this year as a result of rising oil costs. But the slowing global economy has caused that to reverse.

The lowest economy class fares in Europe, the Middle East and Africa fell on average by 12.5 per cent in April to June compared with the first quarter, with long-haul fares down more than a quarter.

But UK fares suffered the sharpest falls, with the lowest economy fares down by an average of 20.2 per cent, including a 49 per cent fall in fares to North America and a 22 per cent decline in fares to Japan, Asia-Pacific and Australia.

Discussion questions:

1. What factors are driving demand for air travel down within, to and from Europe?
2. Why does the price of air travel fall as demand for air travel weakens?
3. Which other industries may have to lower their prices as fewer and fewer people travel between European countries and North America?

FT.com / Asia-Pacific / India – Camel demand soars in India

In a principles of economics course such as AP or IB Econ, we learn about the determinants of demand. I teach my students the acronym “TOEISS”, which stands for consumer tastes, other related goods’ prices, expectations, income, size of the market and special circumstances. A change in any of these determinants will shift the demand curve for a particular product.

“Other related goods” refers to the effect that a change in price for a substitute or a complement of one good will have on the demand for that good. An example might be the effect of an increase in the price of pork on demand for beef. Clearly, these two goods are substitutes in consumption, and if pork becomes pricey, consumers will demand more beef.

In an era of soaring gasoline prices, many consumers have made the switch from large, inefficient, gas-guzzling trucks and SUVs to smaller, more efficient hybrids and compact cars, a reasonable substitute for the average commuter. For some drivers, however, a hybrid just won’t meet their everyday needs.

In northern India, where farmers rely on tractors to till their arid fields, rising gas prices have made expensive tractors, dependent as they are on large inputs of fuel, less attractive to farmers. As gas prices have risen, demand patterns have shifted among farmers in the northern state of Rajasthan:

As the cost of running gas-guzzling tractors soars, even-toed ungulates are making a comeback, raising hopes that a fall in the population of the desert state’s signature animal can be reversed.

It’s excellent for the camel population if the price of oil continues to go up because demand for camels will also go up,” says Ilse Köhler-Rollefson of the League for Pastoral Peoples and Endogenous Livestock Development. “Two years ago, a camel cost little more than a goat, which is nothing. The price has since trebled…

”Market prices for these “ships of the desert”, which crashed with the growing affordability of motorised transport, are rising again as oil prices soar.

A sturdy male with a life expectancy of 60-80 years now fetches up to Rs40,000 ($973), compared to Rs5,000-Rs10,000 three years ago, according to Hanuwant Singh of the Lokhit Pashu-Palak Sansthan, a non-profit welfare organisation for livestock keepers. Entry-level tractors cost around $4,000.

Camels, the ultimate “alternative energy vehicle”. In fact, the only fuel these vehicles need is the occasional bite of grass and a weekly sip of water; talk about fuel economy!

While it may seem funny to those of us so used to the motor vehicle, animals represent a viable substitute for farm machinery in the developing world, and it is likely that as fuel costs continue to soar, more poor farmers will switch back to traditional means of tilling their soil. Water buffalo, cattle, camels, these are all substitutes for the gas powered tractor. Demand for these “alternative vehicles” will rise as fuel costs climb.

Discussion Questions:

Clinton thinks suspending the gas tax for the summer is good for Americans. She says that any revenue lost can be made up for by taxing the profits of oil companies.

Obama thinks it will cause more harm than good to the economy. He says the $9 billion of government revenue foregone could have done more good for the economy through job creation and road maintenance than the $25 each American driver will save with a suspension of the gas tax.

They’re both using their positions on the gas tax to garner more support among Democratic voters in Indiana and North Carolina, where next week’s key primaries will be held.

Greg Mankiw, Harvard economist, has this to say about Hillary’s plan:

I don’t know any prominent economist who favors this McCain-Clinton proposal. More common is the reaction of a friend of mine (a veteran of the Clinton administration) who calls the idea “ludicrous.”

Sometimes a candidate’s position on one particular issue, even a relatively minor one like a federal gas tax that most Americans probably didn’t even know they were paying when they filled up their tanks, draws clear lines around a candidate’s values.

Clinton’s ‘Trouble’ ad

Obama Takes On Clinton and McCain on Gas Tax Holiday

It should be noted that while Obama is probably right that a gas tax suspension will only save drivers a pittance, his economics is slightly flawed. Here’s Tim Haab of Environmental Economics blog responding to Obama’s claim that a gas tax holiday could actually increase demand for gas thus raise gas prices:

Wrong, wrong, wrong: A lower gas price causes quantity demanded to increase as consumers move down the demand curve. The only things that cause gas demand to change are changes in income, prices of substitutes and complements, tastes and preferences and expectations… I demand a retraction.

Who are these “some economists” that Obama is talking about? Did they get their degrees from an SEC school or something? Name names so that we can have an econoblogosphere beatdown! Out these blasphemers!

Note: I think Obama got the $25 to $30 number correct.

Mr. Haab is technically correct when it comes to basic economic theory. Repealing the gas tax should shift supply out, not demand, as taxes are a determinant of supply. Rather than demand changing, quantity demanded by drivers will increase, in response to the increased supply and lower prices.

What I do think could happen, however, is that expectations of future price increases might incentivize drivers to increase their demand for gas over the summer. This Mr. Haab seems to oversee. When August roles around and drivers know that come Labor day the gas tax will kick in again, they may chose to take a family road trip that they otherwise would have postponed, shifting overall demand for gas out, driving prices up.

In the case of a temporary suspension of an excise tax on any good, there is always the expectation that the price will increase again in the future. This could lead to hoarding or stockpiling of the good, increasing overall demand and driving the price up before the tax has even returned.

Holiday weekend retail sees big crowds, but no splurging – Nov. 25, 2007

Black Friday; a most interesting phenomenon of American culture. A day when consumer demand in retail product markets is at its strongest, the day after Thanksgiving when, still lightheaded from excess tryptophan and mashed potato intakes and an NFL overdose from the previous day, millions of Americans stumble full-bellied from their beds and flock to the malls and big box retail outlets of suburban America to give thanks to the gods of consumerism: Wal-mart, Target, JCPenny, Nordstroms, Macey’s… all the holy temples of our sacred religion open their golden gates to the hoards of consumption-crazed pilgrims, all hoping to pay tribute to their beloved deities with their almighty dollars.

Although deep discounts brought out much bigger crowds of holiday bargain hunters, a major retail trade group said Sunday that shoppers actually spent less money this year over the crucial Thanksgiving weekend.

The National Retail Foundation’s (NRF’s) 2007 Black Friday Weekend Survey said more than 147 million shoppers hit the stores over the Black Friday weekend, up 4.8 percent from last year.

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by Annie Sung and Kristie Chung

Which do you prefer, the Wii? the XBox 360? the PS3? How about other video game consoles? Can you even think of any other video games consoles? Hmm… let’s see… how about the Sega? Wait, no, haven’t seen any of those in a while… what about the Atari? Oh, shoot, nope! Oh yeah, don’t forget the Caleco Vision (for the record, Mr. Welker’s earliest video game memory was of playing Smurfs on a Caleco Vision).

The fact is, today, the market for video game consoles has shrunk to three dominant firms: Nintendo, Microsoft and Sony. This podcast will investigate the video game console market, examine its characteristics, including the elasticity of demand for the different consoles, and conclude whether it exhibits the features of an oligopoly.