Economists Do It With Models

It seems like such a simple concept: demand curves slope downwards. Here’s a visual for you:

When the price of the item goes up from P1 to P2, the quantity of the item that people demand decreases from Q1 to Q2. Put in real people terms, when something gets more expensive, fewer people want it. (Or the same number of people want less of it, or some combination of the two concepts.) This makes sense if for no other reason than demanding something involves being ready, willing and able to pay for it, and fewer people can afford an item when it gets more expensive.

But economists apparently like to make everything complicated, so they point out that it is mathematically possible to have a demand curve that slopes upward. Well, at least two economists have pointed out this possibility. Sir Robert Giffen pointed out that a good could be so inferior (meaning that people consume more of it when their incomes decrease and vice versa) that people actually consume more of it when its price goes up…and thus the Giffen good was born. The logic is that a price increase means that consumers are effectively poorer, since they can’t buy as much stuff as they did before. So if we’re poorer, we both substitute away from the goods that got more expensive and move toward inferior goods. Giffen goods are inferior goods where there aren’t really cheaper options to substitute to, so the latter effect dominates the former and the price increase actually leads to an increase in consumption.

Don’t worry, I find the logic a bit challenging as well. I also have never heard of an example of a Giffen good other than potatoes in Ireland. I feel like even that is a stretch, and I’m not quite sure why the example is limited to Ireland other than because of potato famine stereotypes.

On the other hand, we can theoretically have an upward-sloping demand curve for luxury goods as well. This concept was codified by Thorstein Veblen and the goods are appropriately called Veblen goods. (Sidenote: I love the pictures on that Wikipedia page.) His rationale is that conspicuous consumption and status considerations make some goods more attractive as a direct function of their prices. This increase in attractiveness can theoretically overcome the fact that the goods become less affordable, and the net result is that we see an increase in the quantity of these things demanded when the price increases (at least over some price ranges).

Okay, so I’ve got two models for why I might see an upward-sloping demand curve, but little empirical evidence for either concept. The end result of this is that I have become the nerdy economist equivalent of the people who go around searching for Bigfoot. Worse yet, since I write about this sort of thing, I’m actually more like the people who not only go around searching for Bigfoot but also set up museums and the like dedicated to this potentially nonexistent creature. (Yes, they do exist, and a guy I know does a whole comedy bit about the one located here.)

Luckily, I have people who are supportive in my quest and provide me with footage of these supposed upward-sloping demand curve sightings. For example, reader Brit pointed me towards an article in the Miami Herald that described how high tolls lure drivers to I-95’s pay lanes:

When Victoria Perkovich sees a high toll on the illuminated Interstate 95 Express signs, she steers into the toll lanes.

“I think the traffic must be pretty bad,” says Perkovich, a college student and frequent commuter. “I’d rather pay $4 than spend two hours sitting in traffic.”

Her behavior helps explain the traffic growth on the I-95 Express Lanes — and a classic misunderstanding of commuter psychology.

Traffic engineers assumed high tolls would deter drivers from using express lanes. Wrong.

Many drivers, like Perkovich, assume high tolls mean the toll-free lanes are clogged. Could be true, but the tolls rise mainly due to the number of drivers willing to pay a toll.

Fascinating. It seems like the idea here was to have some sort of congestion pricing scheme where drivers have to pay more to avoid the traffic when traffic is heavier. This makes sense, since the value proposition that an open lane presents is higher when the rest of the road is a parking lot. However, instead of using some objective method of traffic reporting to determine prices, the system sets prices as a function of how many people are going through the toll booth.

Could this work as an efficient congestion pricing system? Yes, if people were doing their own homework regarding traffic conditions and using that information to determine whether the toll was worth it. Given objective information about road conditions, if the toll is “too low” for the amount of traffic congestion, the system would see a high volume of traffic into the paid lanes and would raise prices. Once the traffic subsided, people would stop choosing the pay lanes and the prices would decrease. Does it work? No, since rather than checking the traffic reports, people are using the price itself as a signal of the traffic level. So what seems to be happening is something like the following: A few dudes who are really in a hurry choose the pay lane, just to be on the safe side. This raises the toll, and then other drivers see the toll increase and think “wait, what do these other guys know that I don’t?” and also choose the toll lane. This further increases the toll rate, at which point people think that traffic ahead must be REALLY bad, so even more choose the toll lane, even though there was no real traffic congestion to speak of in the first place. The behavior of people in this system is essentially crating a bubble in toll prices…and a lot of pissed off people who pay a $7 toll only to find out that their lane is more crowded than the free lanes.

This is not the only context in which people use prices as a signal of quality, but it’s one that shows the potential pitfalls from doing so particularly well. I find it especially interesting that the article specifically mentions the fact that people were educated on how the system works, so in a way they should know better. On the other hand, people have limited time and attention so perhaps either they didn’t pay attention or didn’t understand the system properly. In this setup, it seems like the only way to achieve an efficient outcome is to have a more objective pricing function- a simple fix would perhaps be to put the vehicle counters on the free lanes as opposed to the pay lanes. Gee, it sounds so simple put that way…

But back to the question at hand- is this really an example of an upward-sloping demand curve? The toll is certainly not an inferior good, so if anything it falls into Veblen good territory.

One of the important points about the demand curve is that it assumes that all factors other than price that affect demand are held constant. In most cases, this doesn’t really introduce a lot of confusion. However, in this case, the price is actually changing people’s tastes for the item because of the information that the price supposedly conveys. so are we really seeing this?

I argue that we aren’t, and that we are instead seeing something more like this:

This setup is consistent with the evidence that we see in the article- when the price goes up from P1 to P2, the quantity demanded goes up from Q1 to Q2. But this is because the price increase served to increase people’s taste for the toll lanes, which shifted demand to the right. To a certain degree, this is a question of semantics that exists with the explanation of Veblen goods in general- how direct is the price effect on quantity? In this sense, the latter model seems more appropriate in one important way- let’s say that you could communicate the information that the price increase supposedly conveys here without actually changing the price. What would happen to demand in this case? Logically speaking, it should be higher than with that same information conveyed through a price increase. In the diagram above, this point is labeled as Q3, and is in fact higher than point Q2. In the upward-sloping demand curve model, we would be stuck at quantity Q1 in the absence of a price increase.

To summarize: My economic Bigfoot, despite being a great example of one of the biases present in consumer decision-making, was really a dude in a gorilla suit that had been dragged through some mud and leaves. And my quest continues…