In the first blog of this series, we had a look at the hidden underpinnings of Adam Smith’s aptly named ‘invisible hand’ as they pertain to the supply side of the economy.  We discussed how investment decisions hinge critically on the world of unseen and unmeasured expectations.  In this blog, we will see how the logic of the invisible hand is equally applicable to the demand side, and how we – as consumers – can do our part to satisfy its implicit requirements.

Suppose for a moment that we lived in a world of healthy competition and accurate expectations on the supply side of the economy.  Every supplier in this fantasy world knows exactly what other producers are going to do, faces stiff competition in his market, and is keenly focussed on identifying and capitalizing upon the next profitable opportunity.  Suppose further that accurate information about consumers’ intended spending patterns flows freely to all suppliers, and that all markets are humming along.  From this initial position, what could happen on the demand side to mess things up?

Speaking as an economist, and abstracting from any type of government intervention (about which more later in this series), by ‘mess things up’ what I mean is ‘cause inefficiency’, where I will define inefficiency in this context as having produced goods whose costs of production exceed consumers’ willingness to pay for them.  For this to happen requires some type of ex ante uncertainty on the part of suppliers about demanders’ willingness to pay, which – once costs of production are subtracted – is commonly known as the available surplus that could be enjoyed through trade.  To understand what this means, we have to take a brief detour into the wild and wonderful world of surplus.

Surplus is one of those odd quantities in economics that in its natural state is denominated in different currencies, and only by eggheads like us gets translated into a common currency for analysis.  Supplier surplus is easy enough to recognize and quantify, as it is simply profits from trade (price by quantity minus cost of production), denominated in the money of the land.  Consumer trade surplus though is a trickier concept.  Its definition all comes down to how much we want things.  If I am so thirsty that I would pay $50 for a bottle of water, but can buy one at the store across the road for $3, then that purchase immediately produces $47 worth of consumer surplus that I get to enjoy when I buy and then drink that bottle of water.  If I am less thirsty, then that trade produces less consumer surplus.  The definition of efficiency that I give above hence implies a dependence on unspoken desires in the minds of consumers.  The stronger are your desires for the goods and services offered in the economy, then all else equal, the more surplus you enjoy and the more ‘efficient’ (by the above definition) are your economy’s trades.

Let’s think more deeply about other examples of desires, these invisible phenomena on the demand side that drive the economy.  In addition to food, drink, and shelter, what else are we willing to pay for?  What do we really want?  Imagine a typical modern young person’s budget.  A good chunk of his money goes towards social activities, like going to pubs.  He does not really need to consume six beers on a Saturday night, so why does he do it?  Because, an economist would be tempted to conclude, either pub-going is a means to a productive end, or it produces good feelings as an end in itself.  If it is in part the latter, where do those good feelings come from?  They cannot be merely a function of being together with his friends, since if so, they could simply hang out at a park or at someone’s house (or even on a university lawn!) far more cheaply.  He may go to pubs for a particular productive end, such as that he hopes to meet available young women there.  But again, why pubs, rather than some other place where young people are observed, like universities?  The reason is because other young people, including both his friends and young women he does not know, go to pubs too with similar purposes in mind.  If he were not to go, then not only would he be less likely to meet an available woman, but he would risk being seen as not as solidly part of his group of friends.  An implicit coordination on the demand side – one might even say another invisible hand – has resulted in pub-going being both a catalyst for sexual transactions and a signal of, for lack of a better word, coolness.  (For those wanting to Google-search this notion, it is about ‘social externalities’ produced by ‘status goods’.)

This example may seem tangential to the problem at hand, but in fact it is fundamental.  Why do people buy hair products claiming to make their hair shiny and bouncy, or clothing of certain styles, or iPhones?  The consumer surplus that they enjoy from these purchases arises not only as a result of the sheer usefulness of cleanliness, clothes, or communication, but because these products allow them to display signals of being in ‘cool’ groups.  Cool groups are generally those that are healthy, young, economically successful, and in all other ways considered desirable in our society.  Yet, by design, to be cool is to exclude the ‘uncool’ and thus there is a perennial race played out in our purchasing decisions in which the ‘inherently’ cool attempt to distance themselves from the ‘wannabees’ who are trying to be cool.

So, while our willingness to pay has something to do with our ‘basic’ (non-psychological and non-social) needs, it also has something to do with other needs that are defined by our social wishes.  This is a strength as well as a weakness:  our never-ending desire to be accepted is a perennial boost to the economy, yet if we try too hard to fit in and forget what is actually good for us, we can lead both ourselves and the economy over a cliff:  making and trading things whose value is so dependent upon the social mores of a particular place, time or subgroup that, once that place, time or subgroup have passed, those things become next to worthless, shocking the economy.

Armed with these thoughts, let’s now return to our original question.  What phenomena on the demand side could ‘mess up’ a well-functioning economy?  Losing all desires creates an obvious shock to the demand side: the Buddhist who has freed himself of all of his materialistic desires has stopped participating in the economy, from the point of view of suppliers!  Instead, an economist’s advice is to work hard and play hard, so as to nurture your natural desires for the things that money can buy.  Wanting what the cool people have can lead to another type of shock:  while the prudent consumer will ensure that the goods or services he buys do have some amount of value that is robust to a particular moment, the follower of fashion is a slave to the actions of the ‘inherently’ cool and can thus find himself out-of-date.  This kind of fashion cycle does not merely hold for shampoo, but can also relate to much bigger items, like housing.  Want to buy a house because that is what all the ‘cool’ people have just done is perilous:  you are likely to be too late, and will end up buying your house at a higher cost than pay-off.  From this comes the ex-post advice to would-be home-buyers at the height of the real-estate bubble in the U.S.:  don’t buy.  Finally, as was eluded to in the previous post in this series, don’t be passive or lazy:  if you are unsatisfied with a product or a price, then don’t just put up with it.  Vote with your dollar and be the first to do so, ensuing that your preferences are captured as an input into the economy

Finally, lest I leave you with the unstable feeling that your own desires are not really yours at all but merely the outcomes of the whims of fashion, being as they are highly socially mediated, it bears repeating that we are social animals and our desire for social status is as fundamental to our psychology as it is to the economy.  We should not be ashamed of these desires.  Consider the following excerpt from a poem called The Grumbling Hive by one Bernard Mandeville (1670-1733), who thought much like an economist – though he would undoubtedly not have used that word to describe himself.

The Root of evil Avarice,

That damn’d ill-natured baneful Vice,

Was Slave to Prodigality,

That Noble Sin; whilst Luxury

Employ’d a Million of the Poor.

And odious Pride a Million more.

Envy it self, and Vanity

Were Ministers of Industry;