Posts Tagged 'Demand Curves'

Demand Curves Always Slope Downward

Last month marked 30 years since I received my MBA. This anniversary has made me think critically about what I learned in business school and to judge what proved helpful and what did not. I will be the first to admit I have a good, yet sometimes selective memory for these things.

I had many outstanding business professors. They were far superior to the teachers I encountered as an undergraduate. There was one professor in particular I will always remember. I took an economics course from him and later took a business law course from him. I had little interest in business law and took the course solely because he was such a great lecturer.

He devoted the final lecture of his business law course to a topic that had nothing to do with law. He stated that there was a simple tenet we should always keep in mind. If we learned nothing else from our time in the program it should be this: demand curves always slope downward.

He then predicted that during our careers we will encounter many situations where people will try to convince us otherwise. We will see things in the business and popular press that ignore this basic concept. But, unlike the others, we will never fall for it because it is the one mistake he was on a crusade to ensure that none of his students would ever get wrong.

Demand curves always slope downward.

What does this mean? It is a simple concept most kindergartners can explain: If the cost of something goes up, fewer people will want it and less of it will be sold. Simple, huh?

My professor was prescient. In the past 30 years, I have encountered dozens, perhaps hundreds of cases where somebody was convinced that a cost change won’t have an effect on volume.

I’ve seen it a lot in business planning. I worked for a consumer goods firm for a short time. One year, a product manager decided to take a price increase. The business plan she created showed that in the current year we had sold 1 million units at $3 for a revenue of $3 million. Her planning assumed a 10 percent price increase would increase revenue by $300K. Not! If the price goes to $3.30 the only guarantee I can think of is that we would sell less than 1 million units. Nevertheless, her plan got through.

I’ve seen public policy makers forget this simple concept as well. They will propose tax changes and then assume that the change won’t affect consumer behavior.

The error is most commonly made when people only consider price and not “cost” in a broader since. Cost involves price but is also comprised of other things, such as the value of your time, the inconvenience of traveling to make a purchase, etc. As Adam Smith said, the real price of something is the “toil and trouble of acquiring it.”

A good example of this happened earlier this year in the county I live in. Our county legislature decided against raising the legal smoking age from 18 to 21. A quote from my representative indicated that because surrounding counties sell tobacco to those 18 and older, raising the age to 21 in our county would not change smoking behavior because young smokers will simply drive elsewhere.

Wrong! Demand curves slope downward. Raising the age to 21 in our county most certainly will decrease tobacco use because we have raised the cost of obtaining cigarettes by making it more inconvenient. 18-21-year olds would now have to drive further to get tobacco. They might have to bug someone of legal age to buy them for them. They may need to risk buying while underage. This all increases the cost to them and they will buy less. It is okay if you are against raising the legal age but it is not okay to use flawed logic to get there.

It is fine to argue that raising the age won’t have a large effect, but arguing that it won’t have any effect at all ignores a basic economic tenet. Demand curves slope downward. Thinking otherwise would sort of be like trying to convince a physicist that gravity only exists in some cases.

To illustrate this point, look to CVS. In 2014, CVS decided to stop selling tobacco products. This increased the cost of buying cigarettes because it became a bit less convenient to find them. Although many felt that this wouldn’t do anything to overall smoking behavior (thus ignoring that demand curves slope downward), a recent study by CVS concluded that 95 million fewer packs of cigarettes were bought by smokers in an 8-month period studied. If we pro-rate that over the 5 years since CVS has stopped selling cigarettes, the implication is that as a result of CVS’s decision, about 3 billion fewer cigarettes have been smoked per year.

Without wading too deeply into a one of the hottest of hot-button political issues, I do hear things from the pro-gun lobby that clearly shows they don’t recognize that demand curves slope downward. I think it is legitimate to be against gun restrictions from a philosophical viewpoint (e.g. gun ownership is a citizen right, guaranteed in the constitution, etc.). But the pro-gun lobby often claims that restricting which weapons that can be sold, taxing them, making it more onerous to register them, etc. will have no effect on “bad guys” getting guns.

Of course it will. Raise the cost of something and people will do it less. I have no idea how to resolve the gun debate in the US, but I am 100% confident that if we make guns harder to obtain fewer guns will be obtained. By good guys and bad guys. Whether that is a good or bad thing depends on which side of the debate you are on.

This concept can influence behavior in unexpected ways. There are studies that show how frequently employees interact varies inversely with the geographic distance their desks are from one another. I noticed this first-hand. At one point, my office was moved literally about 30 feet down a hallway, further away from where the bulk of the people on my team sat. I noticed right away that I conversed with them about half as often as a result. Why? Because the cost for us to interact increased and our behavior changed. It became a bit more inconvenient to interact with them.

“Demand curves slope downward” can have a converse affect: lower the cost of something and people will buy more. The rise of online retail demonstrates this. Shopping online is so convenient and easy that consumers have moved to it quickly – because their cost of shopping has come down. However, in my experience you don’t see people making mistakes on this side of the argument. People seem to know that lowering cost increases volume. It is more that they often fail to see that increasing costs lowers volume.

So, 30 years later, I am going to send a link to this post to my former professor. He will be pleased that at least one of his students remembered his advice.

NOTE: Economic geeks will note that there are some cases where demand curves don’t slope downward. There are “Giffen goods” – items where consumers will buy more of when price goes up. In reality, it is rare to ever see a discussion of this outside of an Economics class.


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