August 18, 2024

by Stephen Stofka

This week’s letter is about the effect of quantitative phenomena on our quality of life. Why do events impact people of the same socioeconomic circumstances differently? We are part of a group responding to the event, so we interact with the collective responses of the group around us. Our direct response to the event is a small part of the total impact on our quality of life. Imagine we are a rubber duckie in a group of rubber duckies on the ocean’s surface as a wave passes. As we rise with the water that displacement causes a lot of jostling by the duckies around us. Much of the effect we experience is not the wave but the reaction of the others around us to the wave. Yet we attribute the cause of our experience to the wave, not our fellow duckies.

One hundred years ago, Louis de Broglie introduced a wave theory of matter. A few years later Erwin Schrödinger proposed a wave equation of electron motion to explain the quantum world. Those two ideas are cornerstones of quantum mechanics, the most tested theory in physics and the foundation of our current electronic technology. As you read this on a computer or smart phone you are watching quantum mechanics at work. Not all wave are alike. Light and radio waves are electromagnetic waves that don’t need a medium to travel in. Even in the vacuum of space, the electromagnetic field they create acts as a type of medium. Some waves, called transverse waves, cause matter to move in a direction that is partly perpendicular to the force of a wave. A rubber duckie bobbing up and down in the water is an example.

We are hunters of cause. We are interested in the origin of phenomena, thinking that the origin of something will enhance our understanding of that thing. For that reason, some economists like to debate the origin of money. One morning a few weeks ago, our cat woke up, yawned and stretched out a paw on the bed. A claw caught in the quilt and slid it sideways so that it formed a tunnel. Like a wave through water, the direction of the paw was parallel to the quilt, but the quilt reacted in a direction perpendicular to that movement. Kitty pulled her paw back and the tunnel mostly collapsed. She then stretched out her paw again and the quilt rose up. Her hunter reasoning led her to believe that a mouse was the cause of the tunnel under the quilt, so she attacked. She pounced and pawed the quilt to find that imaginary mouse, then lost interest, jumped to the floor and left the room. How often do we search for the cause of a phenomena that is mostly a response to the collective action of a group?

When prices go up, we can look to our side for contributing factors, the decisions of many consumers and businesses. A quantitative change in prices affects the quality of our lives. Like a cat, we often judge quantitative phenomena with an instinctive appraisal. We notice the rise in prices more than we do the rise in our wages because we are more sensitive to loss than gains. The Bureau of Labor Statistics reports that the annual increase in average hourly wages and weekly earnings is now higher than inflation. A rise in the price of the goods we buy has a greater effect than a similar rise in our income because we perceive a rise in prices as a loss of our purchasing power. We are particularly loss averse, according to Daniel Kahneman, the author of Thinking Fast and Slow, who won a Nobel Prize for his research into the less than perfect reasoning we employ in our decision making. He and Amos Tversky proposed a concept called Prospect Theory to describe and model the mechanics of our decision making.

Elasticity is a term that economist John Marshall borrowed from physics to describe the reaction of consumers to changes in the prices of goods. The most common measure is called the Price Elasticity of Demand and businesses pay close attention to this metric. It is the change in the percentage of goods bought in response to a 1% change in price – a ratio of two percentage moves – the zig divided by the zag. If the price of butter goes up 1% and the amount of butter sold declines by 2%, then the ratio of percentages is 2 to 1 and butter is considered to be elastic. If the quantity of butter sold declines only 1%, then butter is said to be unit-elastic. If the quantity of butter barely changes, then it is inelastic. When businesses sense that consumer demand for their good or service is inelastic, they can charge higher prices with less effect on the quantity sold and make a higher profit. Businesses respond to consumer decisions and tastes.

The elasticity of economic goods is not constant because consumer demand responds to a changing economic environment, as well as tastes and culture. In some cases, consumer demand can change abruptly. Such was the case after the pandemic. The airline market is an example of two types of demand elasticities. Business travelers are much less sensitive to changes in price, with an elasticity far below 1, according to research done in the 2010s. Because of that airlines upcharge business customers. Leisure travelers, on the other hand,  have an elasticity of almost 2, meaning that they are sensitive to price hikes. The higher prices that airlines charge business customers effectively subsidizes leisure travelers. However, after the pandemic, the demand for leisure travel surged and airlines responded with higher prices. Average airline fares surged 20% annually in the summer of 2021 then rose sharply by 34% in the summer of 2022. In the first quarter of this year, prices stabilized to pre-pandemic levels. Vacation travel is a luxury good, but it can feel like a necessity when we feel stuck in a grind and stressed at work.

The effect is more frequent for necessities like food, lodging and utilities. That frequency affects the elasticity of our spirit the way a weight on a spring changes the spring’s elasticity over time. The relief checks sent during the pandemic helped some families build a small savings cushion, a relief from the burden of living paycheck to paycheck. In the past two years, families that have dipped into their savings to meet higher housing, grocery and childcare costs feel a sense of loss because their savings are smaller. Even if wage gains have kept up with inflation on average, wage gains are calculated based on gross income before taxes. We buy groceries and pay housing costs with after-tax dollars. The loss is real.

Like water, human society is the medium, transmitting and transmuting the force of thousands of decisions made by people we will never meet. Our circumstances and decisions affect the lives of strangers. There is no single cause because we are part of the cause. Even if we could identify a primary cause like rising prices and remove it with a magic wand, we cannot predict a satisfactory resolution. Yet politicians running for office hold out their magic policy wand and promise to end this or that problem, hoping that enough voters will buy what they are selling. “Here’s the problem,” they say. “I can do something about it.” We want to believe that complex processes have simple causes, and in the final months of this election year, candidates will tailor their message to our belief in that simplicity.

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Photo by Joey Huang on Unsplash

Keywords: prices, inflation, cause, effect, wave