Tuesday, October 2, 2007

Ever Wonder Why Wealth Does Not Bring Happiness?

ENGEL’S LAW: As incomes rise the PERCENTAGE of total income spent on basic food and other necessities declines. Engel’s Law does not say the AMOUNT spent on necessities declines—5% of a $50,000 salary ($2,500) spent on food is more than 20% of a $5,000 salary ($1,000), or 40% of a $500 salary ($200). In poor countries people spend, on average, 35% to 40% of their very small incomes on food—mostly basic raw food items such as beans, potatoes, corn, rice, etc. In middle-income countries the average spent is about 10% to 15% of their somewhat higher income on basic raw food items. In rich countries basic food accounts for only 1% to 4% of total spending. [Obviously we spend much more than 1 to 4 % of our incomes at the grocery store and in restaurants, but most of that spending is for other than basic food items.] Of course, the 1% of the very high incomes in rich countries is much more in absolute terms than the 15% spent on food in middle-income countries, and many times greater than the 40% spent on food in poor countries.

Engel’s Law is LAW; it is true for all people, in all countries, at all times in the past, and will be true for everyone in the future. [Although rising incomes, or economic development, is a rather new phenomenon in the world, and is by no means happening in all countries, and at all times in any country, today.] Engel’s Law is true because it correctly describes human behavior. One cannot hold Engel’s law to be false, any more than one can suppose people would prefer to spend their money on things they don’t want rather than spend it on those things they do want. The elasticity of demand for food and other necessities is low relative to the elasticity of demand for manufactured products and services. As we increase our consumption of food, and those other commodities that we consider necessities, our desire for consuming even more declines rapidly—we say demand for those commodities is inelastic. In the early stages of development, people may shift their diet from corn and beans to meat and other more costly foods. But, even in this case they would be shifting from necessities that keep them alive, to luxury foods that they prefer. At some point people find it unnecessary to “improve” their diets, and prefer to spend most of their extra money on manufactured goods and services.

We can list commodities from those with extremely low elasticity of demand to those with very high elasticity. At the bottom are commodities such as salt (as a food additive). Even in the poorest countries most people consume all the salt they want. [Salt has not always been so cheap and available to all people. Salt was a prime luxury among most hunter-gatherer peoples, and was a major article of trade in early farm societies. The fact that almost all people are able to obtain all the salt they want is a testament to the improved status of people in even the poorest communities on earth.] As their incomes rise they will probably not increase their consumption of salt at all. Therefore, the elasticity of demand for salt (as a food additive) is 0—income increases 10% and the amount spent on salt increases 0% which yields an elasticity of demand of zero (0% / 10%. = 0). Obviously, production of salt as a food additive is not a growth industry; indeed, growth is largely limited to the rate of population growth.

Basic foods such as potatoes, beans, cassava, corn, wheat, etc., also have an elasticity of demand near zero in most countries—even the poorest people normally consume all the basic food commodities they want, hunger now being limited mostly to shortages created by natural disaster and war. Notice that people with high incomes may be willing to spend 5 dollars for a loaf of French bread, or spend 150 dollars for dinner in a fine restaurant. However, the increased cost is incurred by manufacturing and service activities, rather than an increase in the amount of wheat in the bread or beef and potatoes in the dinner. Only in those countries where people do not have enough to eat will they spend a large share of INCREASED income on basic food commodities, and even in those cases, a continued increase in income will lead to a reduction in the demand for basic food. Production of basic food commodities cannot be a growth industry, except to the extent that the population is growing and/or people find a new export market for food commodities and/or a large share of the population is malnourished and gaining access to additional income.

Consumer durables such as refrigerators, washers & driers, and basic cars, also have a relatively low elasticity of demand in technologically advanced countries. The elasticity of demand for those commodities may be say 0.25; that is, if our incomes increase by 20% we may be willing to spend 5% more on those commodities (5% / 20% = 0.25). We may be willing to spend 100% of our increase in income on a BMW; but that is a luxury rather than basic transportation that we consider a necessity. People in poor countries have a very high elasticity of demand for refrigerators and cars because those items are luxuries they lack. Producers of consumer durables in rich countries need access to markets in poor countries if they expect to increase production much beyond the rate of population growth. [Producers of consumer durables can increase demand by coming up with new gadgets and looks for their products, which may cause consumers to junk old appliances and purchase new ones; but again, the demand is for a luxury item rather than a basic frig or stove.]

Luxuries have a very high elasticity of demand. In rich countries, travel and entertainment usually ranks near the top; people with incomes of $30,000 may spend only $3,000 or 10% on travel and entertainment, whereas people with incomes of $300,000 may spend $100,000 or 33% on those things. If income rises by 100% (say from $30,000 to $60,000), expenditures on travel and entertainment may increase by 150% (say from $3,000 to $7,500). Thus, elasticity of demand would be 1.5 (150% / 100% = 1.5). People engaged in travel and entertainment businesses can enjoy a rate of growth in demand that is much higher than the growth rate of the population, or even the growth rate of the economy as a whole, assuming of course that incomes are rising. On the other hand, people are fickle and fads change rapidly. In the US, the ski resort business, which has boomed over the past forty years, has apparently peaked and may decline as the huge baby-boom generation moves beyond the prime age for skiing. That helps to explain why snow-boarding, previously prohibited in many ski resorts, is now almost universally welcomed to entice a younger generation to the slopes. Other high cost recreational activities such as luxury cruises, sport fishing, golf, etc., are good businesses to be in as the very rich baby-boomers hit their late fifties and sixties.

Engel’s law also works in reverse. When incomes decline, say during periods of recession or depression, people are forced to reduce their spending. However, people find it difficult to reduce spending on necessities very much. We have to eat, but we can switch from steak to hamburger; we have to buy clothing, but not necessarily a new suit. Thus spending on necessities declines but there is a limit on how much savings we can achieve on those items. By contrast, spending on luxuries can be greatly reduced or eliminated—no vacation this year; and forget about buying jewelry and ski lift tickets! Because the amount of money spent on luxuries declines sharply, whereas the amount spent on necessities declines much less, the PERCENTAGE spent on luxuries declines whereas the PERCENTAGE spent on necessities increases (even if the amount spent on necessities declines somewhat). Ironically, spending on some items may increase in absolute terms when incomes decline. For example, McDonald’s and other fast food restaurants may increase sales during periods of recession as people who would have gone to upscale restaurants shift toward less expensive food and the normal fast food patron mostly continues to consume those products because there is no cheaper alternative (fast food has been reduced to a necessity).

Those commodities that are most essential to life are those with the lowest elasticity of demand, and items that have the highest elasticity of demand are those we could most easily do without. The great irony of increased income (and economic development) is that as our incomes increase we switch most of our consumption from necessities—things that are extremely important to us—to things we care much less for, and which people in real need would consider frivolous.

This explains why great wealth does not promote human happiness. The more money one has the more that money is used to purchase things that are lower on the list of real needs. The allure of wealth for those without it is easy to understand: What joy it would be to provide one’s family with good food, clothing, and shelter, and to be able to provide the children with a college education. Alas, wealth means you have no such needs. Rather, you are faced with the tiring thought of yet another Caribbean Cruise; the disappointing realization that the ‘07 model just acquired seems no different from the ’06 model owned previously and that the $23 thousand spent for new golf clubs and cart has not taken a single stroke off your score; that nagging feeling that the words of friends and family are designed to solicit a gift or bequeath, and that your death will be greeted by family and relatives with more joy than grief; and the sad fact that you will never be able to afford that $289 million dollar ranch in Wyoming, which (you have convinced yourself) has always been the only real dream in your life—(sigh) life has been such a disappointment!

No comments: