Exchange and Demand Individuals engage in four fundamental activities which reduce the burden of scarcity: exchange, production, specialization, and entrepreneurial activity. Markets and prices facilitate these activities and these activities form the basis of market activity which we study using supply and demand analysis. We will examine voluntary exchange along with a detailed development of the demand curve. We will also, see exactly how pure exchange reduces the burden of scarcity. I. Introduction We will see that the demand curve is the result of individuals making choices constrained by scarcity. Individuals are assumed to be rational, that is, to make choices which maximize their utility, where utility is defined as the want-satisfying ability of the goods consumed. A rational individual chooses from among the possible combinations of goods, that particular combination which maximizes her utility—that which makes her as well-off as possible. The possible combinations from which the individual can choose are limited because of scarcity. In a market economy the individual confronts scarcity in the form of prices, the fact that time is scarce and in the form of limited quantities of goods he or she owns which can be sold to buy other goods. Prices here are the prices of the goods the individual buys and sells, and they include not just prices of consumption goods but also wages, interest, rents, and profits. For most of us the primary good we sell is our labor services, and since our time and abilities are constrained by scarcity the income we can hope to derive from the sale of our labor services is constrained by scarcity as well. Our other possible income sources including, interest, dividends or proprietor’s income form business profits, for example, are constrained as well. Furthermore, scarcity forces us to pay positive prices for the economic goods that we choose to buy—and, of course, the things we buy are just things that other people choose to sell. So we face scarcity in the form of a finite income, limited time and positive prices on the goods we buy. II. The Postulates of Human Behavior1 The postulates discussed in this section are the fundamental assumptions about human behavior from which the demand curve can be derived. These postulates are basic assumptions relating to individual choice constrained by scarcity that apply to all individuals making all choices. Before we discuss the postulates it is necessary to understand a basic methodological starting point in economics: the individual is the unit of analysis. Economics is the study of constrained decision making, and, since it is in the minds of individuals that decisions are made, it is necessary to focus on the individual as the unit of analysis. Specifically individuals make their choices by the subjective weighing of costs and benefits. Because of scarcity, decisions made by individuals, including the independent choices made by individuals in the markets, must be coordinated with each other. For example, if you decide to buy a loaf of bread, in order for your wish to be fulfilled someone must decide to bake that bread and sell it. 1 Much of the material in this section is derived from Armen A. Alchain and William R. Allen, Exchange and Production, 3rd Edition, Belmont, California: Wadsworth, 1983, chapter 2.2In a market economy the decisions of individuals are coordinated or aggregated by markets and prices, a process we will look at in a later chapter. Postulate 1 (we all confront scarcity) Every individual faces scarcity. This postulate means that each individual must make choices. If they want more of one good they must give up some of another. Postulate 2 (variety is the spice of life) Individuals desire variety in their consumption choices. Individuals will choose more then just a few different goods when making their consumption choices. Utility maximization results in individuals consuming several different goods. Postulate 3 (the “substitution postulate”) Individuals are willing to give up some of any economic good in exchange for some other good or goods. This postulate implies that for any good a person consumes there will be some other good or combination of goods that that person will willingly take in exchange for sacrificing some amount of the original good. If we pick any good that the individual is consuming, apples for example, there will be some quantity of another good, oranges perhaps, that the individual will take in exchange for a given number of apples. We do not require that the individual give up consuming the good entirely, only that she would give up some quantity of the good. We also do not require that the individual take any other good in exchange, only that we can find some other good that, if given to the individual in sufficient quantity, will induce her to give up some of the original good. The maximum amount of one good the individual is willing to give up to acquire an additional unit of another good is called the personal marginal value of the second good in terms of the first good. So, for example, the personal marginal value of beer in terms of tacos is the maximum number of tacos an individual will give up to acquire one more unit of beer. In general terms, MVX,Y is the individual’s personal marginal value of the good X in terms of the good Y. If the MVX,Y, = 3Y/X, then the maximum number of Ys the individual is willing to give up to be able to consume one more unit of X is three Ys. Postulate 4 (diminishing personal marginal value) The more of a good an individual consumes the greater the total personal satisfaction resulting from consumption of the good, and thus the higher the utility of the individual. However as the individual consumes more and more units of the good the additional satisfaction resulting from consuming an additional unit (the personal marginal value) will diminish. This postulate which is key to our understanding of why demand curves slope downward is discussed in detail below.3Postulate 5 (people are different) Individuals have different tastes and preferences. Even if two individuals have exactly the same amount of each good their personal marginal values for any specific good are likely to be different. Postulate 6 (people will strive to improve their lot in life) People are innovative and rational. Individuals will make their choices, including those involving the