Incremental Substitution

Because economic resources are not only scarce but have alternative uses, the efficient use of these resources requires both consumers and producers to make trade-offs and substitutions. Prices provide the incentives for doing so.

When the price of oranges goes up, some consumers switch to tangerines.

When bacon becomes more expensive, some consumers switch to ham.

When the cost of a vacation at the beach rises, some people decide to go on a cruise instead. Note that what is happening here is not just substitution-it is incremental substitution. Not everybody stops eating oranges when they become more pricey. Some people continue to eat the same number of oranges they always ate, some cut back a little, some cut back a lot, and others forget about oranges completely and go on to some other fruit.

When the price of oranges rises, it is very likely because the number of oranges demanded at the existing price exceeds the number of oranges actually available. Something has to give. Incremental substitution, because of Price increases, causes the loss to be minimized by being borne more by those who are relatively indifferent as between oranges and other substitutes, rather than by those who are so devoted to oranges that they will simply pay the higher prices and continue to eat the same number of oranges as before, Cutting back somewhere else in their budget to offset the additional money spent on oranges.

Incremental substitutions take place in production as well as consumption. Petroleum, for example, can be used to make heating oil or gasoline, among many other things. More petroleum is turned into heating oil during the winter, when the demand for heating oil is greatest, and more into gasoline during the summer, when many people are doing more driving to recreational areas. This is not a total substitution, since some petroleum is turned into both products (and many others) throughout the year. It is incremental substitution-somewhat more of A at the cost of somewhat less of B. Prices facilitate this kind of substitution, as they reflect incrementally changing demands, leading to incremental changes in the amount supplied.

Trade-offs and substitution can take place either intentionally or systemically. An intentional trade-off has been made by LTV, a steel manufacturer in Cleveland, whose equipment has been set up to shift automatically from oil to natural gas when the price of oil rises above a given level. Automobiles have also been adjusted intentionally by becoming more fuel-efficient. Thus, the average American car drove 2,000 miles more in 1998 than in 1973, but used about 200 gallons less gasoline than a quarter if a century earlier. This was because of high-tech equipment added to engines, obviously at a cost, but with the cost of this technology substituting incrementally for the cost of gasoline.

A systemic trade-off occurs when the economy as a whole uses less oil because the composition of its output changes. As a higher proportion of the output of the American economy has over the years come to consist of services, rather than material goods, less fuel is needed in their production. It takes less fuel to create more advanced software than to manufacture steel or automobiles. Over all, the amount of fuel used per dollar of national output in the American economy has declined steadily since the early 1970s, when oil prices were raised dramatically by the international petroleum cartel.

As important as it is to understand the role of substitutions, it is also important to keep in mind that the efficient allocation of resources requires that these substitutions be incremental, not total. For example, one may believe that health is more important than amusements but, however reasonable that may sound as a general principle, no one really believes that having a twenty year's supply of Band-Aids in the closet is more important than having to give up all music in order to pay for it. A price-coordinated economy facilitates incremental substitution, but political decision-making tends toward categorical priorities-that is, declaring one thing absolutely more important than another and creating laws and policies accordingly.

When a political figure says that we need to "set national priorities" about one thing or another, what that amounts to is making A categorically more important than B. That is the opposite of incremental substitution, in which the value of each depends on how much of each we already have at the moment, and therefore on the changing amount of A that we are willing to give up in order to get more B.

Incremental substitution means that the relative values of each varies with how much of each we already have available. This variation can be so great as to convert something that is beneficial into something that is detrimental, and vice versa. For example, human beings cannot live without salt, fat, and cholesterol, but most Americans get so much of all three that their lifespan is reduced. Conversely, despite the many problems caused by alcohol, from fatal automobile accidents to deaths from cirrhosis of the liver, studies show that very modest amounts of alcohol have health benefits that can be lifesaving.4 It is not categorically good or bad.

Whenever there are two things that each have some value, one cannot be categorically more valuable than another: Enough pennies will be worth more than any diamond. That is why incremental trade-offs tend to produce better results than categorical priorities.

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