Monday, October 21, 2013

Teaching Microeconomics: Complements and Substitutes

When teaching about factors that change demand, one of the items included in almost every introductory textbook is the price of a complement or substitute good.  Complements are used together like peanut butter and jelly or bicycle helmets and bicycles.  Substitutes are used instead of one another like Coke and Pepsi or driving and taking the bus.

We are taught the following:
1. When the price of a complement good rises, demand for the other good in the pair falls.  This is because a higher price of peanut butter will lead me to buy less peanut butter.  Therefore, I need less jelly to go with it.
2.  When the price of a substitute good rises, demand for the other good in the pair rises.  This is because a higher price of Coke leads me to buy less Coke.  Therefore, I need to drink more Pepsi to quench my thirst for soda.

The problem with the textbook presentation is:  The above stuff that we're taught assumes that the supply curve shifted to change the price (peanut butter got more expensive because there was a weak crop this year or Coke got more expensive because the price of high fructose corn syrup rose).  What if instead, peanut butter became more expensive because it was discovered that eating PB makes you live longer and that caused people to want more of it?  Wouldn't that lead to more PB&J sandwiches (therefore increasing demand for jelly)?  And what if Coke got more expensive because consumers decided that Pepsi is garbage and they'd rather drink "the real thing?"  That should lead to less Pepsi consumption.

What we should really be teaching students is to think about the changes in the quantity demanded. In fact, the story always told with the price change is that a higher price leads to lower quantity demanded.  This is only true when that higher price is caused by a supply curve shift.  Why aren't we instructing students to think about what matters?

I gave a homework assignment with the following question:  Metal knives and ceramic knives are substitutes.  Show what happens in both markets when advertising causes consumers to buy ceramic knives.  The instructions read "for each of the problems below, you will want to begin each market in equilibrium then draw how each is affected by the scenario described.  It is assumed that everything else not mentioned in the question is held constant...write how price and quantity [in each market] were affected."  The correct answer is that demand for ceramic knives increases, causing an increase in the quantity of ceramic knives.  Since ceramic knives and metal knives are substitutes (you don't wield one in each hand), you are using more ceramic knives which leads to less of a need for metal knives thus reducing demand for metal knives.  Price and quantity of ceramic knives rise; price and quantity of metal knives fall.

Note:  I give credit to N. Rosario for first bringing this idea to my attention by asking a question while enrolled as a student in my class.  He mentioned the demand curve shifting and I agreed with what he said.  I looked through numerous textbooks and always found that the textbook presentation dealt with supply curve shifters as the reason for the initial price change.