Never Reason from a Price Change

In introductory microeconomics, professors introduce the concepts of substitute and complement goods. In my Econ 101 class at the University of Michigan, the professor stated the concept as:

If two goods are substitute goods, an increase in the price of one increases the demand of the other.

If two goods are complementary goods, an increase in the price of one decreases the demand of the other.

This might make sense in most situations, but my Sumnerian senses are tingling -- why are we reasoning from a price change? What is causing the price of one good to increase, and how does this change whether the demand of the other good to increase or decrease?

Let us first consider the case of substitute goods. If two goods are substitutes for each other, it seems logical to consider that if supply in the second good contracted, pushing prices up, then people would substitute out of that second good and increase demand for the first good. If cars become harder to produce and become more expensive, it's logical that the demand for bicycles will increase. However, does this hold up if the price change was because of a demand shock? If cars became more expensive because demand increased, it seems peculiar to think that the demand for bicycles also increases. Just because it's a price change doesn't mean it's the price change you were looking for.

A similar scenario plays out in the case of complement goods. If two goods are complements, it seems logical to consider that if the supply for one good increases, then the price decrease would increase the demand for the second good. If tortilla chips become easier to make, we can expect the demand for salsa to increase. But does the same hold true if it was a demand shock that caused the price change? If people start demanding more potato chips, pushing up the price, what do we expect will happen to the demand for chip dip?  We would expect it to increase -- directly contrary to what the definition suggests.

Reasoning from a price change fails because it neglects whether the price change in one good is from a change in production technologies or from a change in preferences. If it's a change in technology, the standard analysis applies. However, if it's a change in preferences, we need a more nuanced view that encompasses both modes of analysis.

If two goods are substitute goods, an increase in the equilibrium quantity of one decreases the demand of the other.

If two goods are complementary goods, an increase in the equilibrium quantity of one increases the demand of the other.

So in the market for cars and bicycles, if the equilibrium quantity of cars increases, whether from a supply expansion or a demand contraction, then the demand for bicycles will decrease. This is true regardless of what happens to the price of cars. Similarly, if the equilibrium quantity of potato chips increases, then the demand for chip dip increases -- regardless of where the price for potato chips go. This makes sense because it encompasses the lay person view of substitutes and complements. If I ride my bike more, I drive less. If I eat more chips, I buy more salsa.

The fact that this isn't taught on the first pass around is understandable -- you don't want to confuse the auditorium of 300+ students with a model of both supply and demand when you're introducing the demand curve. But it does pose a problem when there are exam questions such as "Does an increase in price of a complement good raise the demand of the original good?" To which I have to say, "it might". A possible solution is to ask "Holding the demand of a complement good constant, does raising its price raise the demand of the original good?" This would be more comprehensive, and those who understand can better answer the question, while those who don't understand can forget about the first clause and just answer the second question.

Nominal and Real GDP: A Barrier to a Statistical Approach

Scott Sumner regularly talks about how almost all discussions of inflation become much clearer in terms of NGDP. This is because people have a hard time differentiating between inflation as a result of more aggregate demand (demand-push) and inflation as a result of less aggregate supply (cost-pull). The difference is summarized in the textbook aggregate demand/aggregate supply diagrams below:

Aggregate demand expansion = Inflation

Aggregate supply contraction = inflation

The first kind of inflation changes NGDP, while the second has minimal impact. This way, when we are in a recession and demand more inflation, what we really mean is that we need more of the first kind of inflation because we need more NGDP. If we were in the second situation, we wouldn't be demanding more or less NGDP because the supply shock would have had minimal impact.

Another example in which NGDP makes explanations easier is in discussions of whether deflation is bad in an economy. Often times, liberal economists will point to the recent recession and say deflation is bad, while libertarians might point to the late 19th century, early 20th century and say that deflation is good. The more correct answer is that stable NGDP is best. So because the first kind of deflation reduced NGDP, it was bad, while the second type of deflation kept NGDP steady, and therefore was good.

While NGDP is simple, it makes it hard to statistically show NGDP boosts RGDP. You can't look at a graph and point to any correlation; a skeptic could just say that it's the RGDP that's driving the movements in NGDP, and not the other way around. In the end, to explain the relationship between nominal and real output in AD shocks, I have to find specific channels, such as nominal debt. On the other hand, inflation and output make much more sense in terms of trying to find statistical relationships. These concepts are far enough in people's minds that a relationship doesn't seem like a tautology. However, when you start directly talking about NGDP and RGDP, it's too easy for people to think the observed relationship between NGDP and RGDP is just because the second is a component of the first.