 Normal & Inferior Goods

Increases in people's incomes raise consumption of most products. These products are
called normal goods. There are some products, however, that people use less of as their
income increases; these products are called inferior goods. Public transportation is an
example--as people's incomes rise, they stop riding the bus and drive their own cars. Blue
jeans were once another example--people with higher incomes bought them less
frequently than people with lower incomes. It was because they were a symbol of
"working-class" clothes that they were adopted by the radical left in the 1960s, and from
there they moved into high fashion.

 The Great Depression

However, economists date the Depression somewhat differently. First, they usually make
a distinction between recession and depression, and they use the concept of recession
much more than they use the concept of depression. A recession is a period in which
economic activity is receding or falling, while a depression is a period in which it is
depressed below some level. In the picture below, which shows a path of economic
activity through time, the period from a to b is the period of recession. At time a the
economic activity is peaking, and there is a trough at time b. After b the economy is in a
recovery or expansion stage. Which period is best called a depression is less clear since
one must first decide which level provides the measure of normalcy. One could consider
the period from a to c the depression because after c the economy is above its previous
high point, but there are other options that make as much sense.

The period that is called the Great Depression contained two periods of recession. The
first began in August of 1929 (two months before the stock market crash) and ended in
March of 1933. (These dates have been chosen by the National Bureau of Economic
Research, a nonprofit organization that sponsors a great deal of economic research. They
are based on the analysis of a large number of economic time series, and do contain some
subjective elements.) In the first recession the value of goods and services that the
economy produced fell by about 42% (but only by 36% once the effects of price changes
are eliminated). The recovery in the four years that followed was slow and not completed
by the time the second recession began. In this recession lasting 13 months from May
1937 until June 1938, output fell by 9% (but only 6% when the effects of changes of
prices are eliminated).
 The Demand Curve
The relationship between price and the amount of a product people want to buy is what
economists call the demand curve. This relationship is inverse or indirect because as
price gets higher, people want less of a particular product. This inverse relationship is
almost always found in studies of particular products, and its very widespread occurrence
has given it a special name: the law of demand. The word "law" in this case does not
refer to a bill that the government has passed but to an observed regularity.1

There are various ways to express the relationship between price and the quantity that
people will buy. Mathematically, one can say that quantity demanded is a function of
price, with other factors held constant, or:

Qd = f(Price, other factors held constant)

A more elementary way to capture the relationship is in the form of a table. The numbers
in the table below are what one expects in a demand curve: as price goes up, the amount
people are willing to buy decreases. (A widget is an imaginary product that some
economist invented when he could not think of a real product to use in an example.)

A Demand Curve
Number of
Price of Widgets
Widgets People Want to
Buy
$1.00 100
$2.00 90
$3.00 70
$4.00 40

The same information can also be plotted on a graph, where it will look like the graph
below.2

If one of the factors being held constant becomes unstuck, changes, and then is held
constant again, the relationship between price and quantity will change. For example,
suppose the price of getwids, a substitute for widgets, falls. Then, people who previously
were buying widgets will reconsider their choices, and some may decide to switch to
getwids. This would be true at all possible prices for widgets. These changes in the way
people will behave at each price will change the demand curve to look like the table
below.

A Demand Curve Can

Shift
Number of
Price of Widgets
Widgets People Want to
Buy
[100] becomes
$1.00
80
$2.00 [90] becomes 70
$3.00 [70] becomes 50
$4.00 [40] becomes 10

These are the same changes shown in a graph.

A Business Cycle
Economic "crises" occurred throughout the 19th century. By the latter part of the century,
a number of observers had come to the conclusion that there was a regular, wavelike
pattern to crises, and they called this pattern the business cycle. A cycle with its regular
and periodic fluctuations needed an explanation. What caused the pattern? What forces
determined the length and amplitude of the waves? Could the cycle be eliminated?

Research on business cycles expanded rapidly early in the twentieth century, but receded
after the 1930s. Although the peak in study of the cycle has passed, many of the ideas
developed during the boom years of business-cycle research remain as major ideas in
macroeconomics.

Although a large number of people once believed that a business cycle existed, they
agreed on little else. The literature is notable for the wide variety of contradictory ideas it
harbors and for the lack of commonly accepted terms to describe basic ideas. Also, many
writers were ambiguous and unclear in what they wrote, and there is sometimes a
tendency to read more into what they wrote than they may have meant. Two very good
summaries of the literature are Gottfried Haberler's (Geneva: League of Nations, 1941)
and Robert A. Gordon's (New York: Harper, 1952). They form an interesting contrast not
only because they group theories differently, but also because their conclusions about
what was valuable and what was nonsense in the literature are very different.

The picture below illustrates a framework in which business-cycle theories were often
constructed. Starting at point A, the economy grew very rapidly in a self-feeding growth.
Because of this "self-feeding" process, the economy would develop momentum. Once
started, growth would continue until the system hit a limit or boundary that would stop it.
The economy would then turn around and enter a contraction that was also self-feeding.
This downswing would continue until a lower boundary was encountered, which would
stop the contraction and start a new upswing. Notice that in this view the economy is
never in equilibrium, but perpetually adjusting.

Although many business-cycle theorists accepted this basic picture, they differed on what
provided the upper and lower bounds and why the self-feeding process would take place.
Sometimes their differences were matters of emphasis. What one took as part of the
institutional structure or as a "given," another would emphasize as the central causal
force. To use an analogy, suppose two people are trying to explain why a windmill is
turning. One argues that it is the wind that causes everything and the other argues that the
rotation depends entirely on the pitch of the blades. This disagreement would be more
apparent than real. They differ in what factors should be taken as given and which to
consider as causal. One person takes the wind as given and then examines the structure of
the machine, while the other accepts the machine as given and looks instead at outside
forces.
In the business-cycle framework illustrated above, lines of causation are difficult to test
because of feedback. To see this, consider a simple cycle, the temperature in a house
heated by hot-water radiators. When it is cold outside, the rooms lose heat. Eventually the
house reaches a temperature so that the thermostat lights the boiler and starts water
circulating to the radiators. This does not immediately stop the decline in temperature
because it takes time for the heat to be transferred from the fire to the water to the
radiator to the air near the thermostat. Nor does the furnace shut off once the decline has
stopped. Rather it continues to heat water until the temperature of the air at the thermostat
has reached a shut-off level. After the furnace has shut off, the temperature in the house
will continue to rise for a while because at the time of shut off the water in the radiators
had been heated to its highest value.

It is clear that the behavior of the furnace determines the temperature in the house. It is
equally clear that the temperature in the house determines the behavior of the furnace.
Systems in which variable A determines variable B, but in turn variable B determines
variable A contain feedback. Systems with feedback can be difficult to explain if only
their outcomes are available. For example, suppose someone who had no idea of how
heating systems worked was given a chart of temperatures in the house and the times
when the furnace was on. Perhaps the most obvious relationship in these data would be
that when the house was coldest, the furnace was on. A person with no knowledge of the
system might conclude that the furnace made the house cold, and turning it off heated the
house. Unless one knows what to look for, or when one looks for the wrong things,
strange conclusions can emerge from studies of complex systems.

Not all economists working in the late 19th and early 20th centuries accepted the
business-cycle framework, and some business-cycle theories do not fit it is an example of
an economist who had a theory of business fluctuations, but had serious reservations
about cycles. Although he agreed with many of the ideas mentioned above, he stressed
the differences of each episode, and did not believe a regular, periodic cycle existed.
Other economists, such as, had much more elaborate frameworks. Schumpeter thought
there were three cycles within the economy: a long, 60-year cycle, a moderately long, 10-
year cycle, and a short, 40-month cycle.

The best examples of theories of business cycles that do not fit the above framework are
theories relying on sunspots or other astronomical phenomena. Several prominent
economists developed these theories in the 19th and early 20th centuries. According to
sunspot theories, changes in sunspots caused changes in harvests, which in turn affected
the overall performance of the economy. Perhaps the weirdest of these theories was that
of Henry L. Moore, an American economist who was an early user of mathematics.
Moore, after considerable statistical work, concluded that there was an eight-year cycle
and attributed it to the planet Venus that every eight years passes directly between the
earth and the sun. None of these theories involved feedback, and they did not have self-
feeding processes that some boundary stopped. All have predicted so poorly that today
they are as as economic ideas ever get.