UNIT 7

1	In standard economics, consumersf willingness to pay is considered an important factor in deciding market prices.  But research shows what consumers are willing to pay can be easily influenced.  Consumers donft in fact have a good control of their own preferences.  Here is an illustration of this idea.  Consider your current consumption of wine and milk.  Now imagine that two new tax laws will be introduced tomorrow.  One will cut the price of wine by 50 percent, and the other will increase the price of milk by 100 percent.  What do you think will happen?  These price changes will surely affect consumption, and many people will walk around slightly happier and with less calcium.  But now imagine this.  What if the prices change in the same way, but you donft remember what you paid for these two products in the past?
2	I suspect that the price changes would make a huge impact on demand if people remembered the previous prices and noticed the price increases; but I also suspect that without a memory for past prices, these price changes would have a trivial effect, if any, on demand.  If people had no memory of past prices, the consumption of wine and milk would remain essentially the same as if the prices had not changed.  In other words, the sensitivity we show to price changes might in fact be largely a result of our memory of the prices we paid in the past and our desire for coherence with our past decisions \\ not at all a reflection of our true preferences or our level of demand.
3	The same basic principle would also apply if the government one day decided to impose a tax that doubled the price of gasoline.  Under conventional economic theory, this should cut demand.  But would it?  Certainly, people would initially compare the new prices with the previous ones, would be shocked by the new prices, and so might pull back on their gasoline consumption and maybe even get a hybrid car.  But over the long run, and once consumers readjusted to the new price (just as we adjust to the price of Nike sneakers, bottled water, and everything else), our gasoline consumption, at the new price, might in fact get close to the pre-tax level.  Moreover, this process of readjustment could be accelerated if the price change were to be accompanied by other changes, such as a new grade of gas, or a new type of fuel (such as corn-based ethanol fuel).
4	I am not suggesting that doubling the price of gasoline would have no effect on consumer demand.  But I do believe that in the long term, it would have a much smaller influence on demand than would be assumed from just observing the short-term market reactions to price increases.