45 Demand
45.1 Theory
The way the economy works, the extraction limit is really an affordability issue. If the cost of extraction rises too high, relative to what people around the world have for spendable income, production will stop because demand (in terms of what people can afford) will drop too low. People will tend to cut back on discretionary spending, such as vacation travel and meals in restaurants, cutting back on demand for fossil fuels.
[d] How “demand” works is poorly understood. Very often, researchers and the general public assume that demand for energy products will automatically remain high.
A surprisingly large share of demand is tied to the need for food, water, and basic services such as schools, roads, and bus service. Poor people require these basics just as much as rich people do. There are literally billions of poor people in the world. If the wages of poor people fall too low relative to the wages of rich people, the system cannot work. Poor people find that they must spend nearly all their income on food, water and housing. As a result, they have little left to pay taxes to support basic governmental services. Without adequate demand from poor people, the prices of commodities tend to fall too low to encourage reinvestment.
The majority of fossil fuel use is by commercial and industrial users. For example, natural gas is often used in making nitrogen fertilizer. If the price of natural gas is high, the price of fertilizer will rise higher than farmers are willing to pay for the fertilizer. Farmers will cut back on fertilizer use, reducing yields for their crops. The farmers’ own costs will be lower, but there will be less of the desired crops grown, perhaps indirectly raising overall food prices. This is not a connection that economic modelers build into their models.
The lockdowns of 2020 show that governments can indeed ramp up demand (and thus prices) for energy products by sending out checks to citizens. We are now seeing that the approach seems to produce inflation rather than more energy production. Also, countries without energy resources of their own may see their currencies fall with respect to the US dollar.
Tverberg (2022) Why No Politician Is Willing to Tell Us the Real Energy Story
45.2 Human Needs
I remember being fascinated when I discovered Manfred Max-Neef’s matrix of human needs. It’s such a rich description of the human animal that defies reduction to a single dimension. It puts homo economicus to shame. (Blair Fix)
45.3 Aggregate Demand Function
Since 1976, Robert Lucas—he of the confidence that the “problem of depression prevention has been solved”—has dominated the development of mainstream macroeconomics with the proposition that good macroeconomic theory could only be developed from microeconomic foundations. Arguing that “the structure of an econometric model consists of optimal decision rules of economic agents” (Lucas, 1976, p. 13), Lucas insisted that to be valid, a macroeconomic model had to be derived from the microeconomic theory of the behaviour of utility-maximizing consumers and profit-maximizing firms.
In fact, Lucas’s methodological precept—that macro level phenomena can and in fact must be derived from micro-level foundations—had been invalidated before he stated it. As long ago as 1953 (Gorman, 1953), mathematical economists posed the question of whether what microeconomic theory predicted about the behaviour of an isolated consumer applied at the level of the market. They concluded, reluctantly, that it did not:
Market demand functions need not satisfy in any way the classical restrictions which characterize consumer demand functions… The importance of the above results is clear: strong restrictions are needed in order to justify the hypothesis that a market demand function has the characteristics of a consumer demand function. Only in special cases can an economy be expected to act as an ‘idealized consumer’. The utility hypothesis tells us nothing about market demand unless it is augmented by additional requirements.’ (Shafer and Sonnenschein, 1993, p. 671-72)
What they showed was that if you took two or more consumers with different tastes and different income sources, consuming two or more goods whose relative consumption levels changed as incomes rose (because some goods are luxuries and others are necessities), then the resulting market demand curves could have almost any shape at all. They didn’t have to slope downwards, as economics textbooks asserted they did.
This doesn’t mean that demand for an actual commodity in an actual economy will fall if its price falls, rather than rise. It means instead that this empirical regularity must be due to features that the model of a single consumer’s behaviour omits. The obvious candidate for the key missing feature is the distribution of income between consumers, which will change when prices change.
The individual demand curve is derived by assuming that relative prices can change without affecting the consumer’s income. This assumption can’t be made when you consider all of society—which you must do when aggregating individual demand to derive a market demand curve—because changing relative prices will change relative incomes as well.
Since changes in relative prices change the distribution of income, and therefore the distribution of demand between different markets, demand for a good may fall when its price falls, because the price fall reduces the income of its customers more than the lower relative price boosts demand.
The sensible reaction to this discovery is that individual demand functions can be grouped only if changing relative prices won’t substantially change income distribution within the group.
Alan Kirman proposed such a response almost 3 decades ago:
If we are to progress further we may well be forced to theories in terms of groups who have collectively coherent behavior. Thus demand and expenditure functions if they are to be set against reality must be defined at some reasonably high level of aggregation. The idea that we should start at the level of the isolated individual is one which we may well have to abandon. (Kirman, 1989, p. 138)Unfortunately, the reaction of the mainstream was less enlightened: rather than accepting this discovery, they looked for conditions under which it could be ignored. These conditions are absurd—they amount to assuming that all individuals and all commodities are identical. But the desire to maintain the mainstream methodology of constructing macro-level models by simply extrapolating from individual level models won out over realism.
Macroeconomics cannot be derived from microeconomics.