Substitutes

Economics concept #12

A quick review before moving forward...we know that people want things (utility). We know that people have to give up some things they want to get others (opportunity cost). We know that one of the ways to do this is trade, and that when people trade, they have economic surplus because they wanted what they got more than what they gave up. And we know that modern trade is done with money, for a wide variety of reasons.

Putting all that together, let’s say someone goes to the grocery store and buys some steaks for $9 a pound. Obviously the steaks are worth that much or more to them. And the steaks, seasoned and cooked, are worth more to them than that $9 a pound plus the value of whatever spices and marinade they may use plus the value of the time and effort they expect to use preparing them. We can’t numerically measure all of that, but we know it’s true based on our shopper’s decisions.

What is it about a steak that makes it worth the cost and effort? Steak is a source of protein and other nutrients, but so are a lot of other foods. Many of them are less expensive than steak. The answer is probably obvious if we think of people as people, and not as the “homo economicus” from the previous article. The taste, the smell, the texture – these benefits can’t be quantified any more than the non-monetary costs in the previous paragraph, but they’re just as real to us and just as important in our decision making. People buy steak for $9 instead of chicken for $3 because their economic surplus from the first trade is more than their economic surplus from the second trade.

But suddenly the price of steak increases (for now, we won’t worry about how or why). The next week, our shopper and many others go back to the store to find that the same steak is now $13 a pound. Some of them will still buy it if they like steak so much that the economic surplus from buying it is still more than other protein sources. The ones whose indifference point was somewhere between $9 and $13, who now get no economic surplus from a steak purchase, won’t. They still need protein, though.

This is where substitutes become important. If a good that fulfills important needs and wants isn’t available at a price you’re willing to pay, you will generally get one that’s similar. It doesn’t have as much utility for you as your first choice, of course – otherwise your first choice wouldn’t be your first choice. But if the price of your first choice is high enough, and/or the price of your second choice is low enough, you may get more economic surplus from your second choice.

As a result, a large increase in the price of one good can cause increases in the prices of its substitutes. If the price of steak increases, the people who are no longer willing to buy it at the higher price will instead want to buy other high-protein foods – that is, the demand for those goods will increase, which causes the equilibrium price to be higher. The market price will increase until it’s roughly equal to the equilibrium (or until the equilibrium shifts again for whatever reason).

But hang on. How long will it take for the market price to change? And how do the sellers know when and how much to change it? And why do they change it at all, can’t they just charge less? And if they want to, can’t they charge more than the equilibrium?

All good questions. We’ll look at them next time.

Narrator: “but he did not look at them next time, at least not all of them.”