Tuesday, April 29, 2014 No tags 0

One of the key ways I try to start young economists in writing a viable research question for an EE in economics is for them to find two or three seemingly random variables and see if we can link them to each other causally using economic theory. For example, might there be correlation (and thus possible causality – not the same thing!) between the price of tortillas and the price of oil? Yes, as it turns out; tortillas are made from maize (corn)…and maize is used to make ethanol… ethanol is a substitute for gasoline… petrol (gasoline) is distilled from oil. Thus, when the price of oil rose sharply in 2004 there was a knock-on effect whereby the search for petrol substitutes led to an increase in demand for maize which drove up the price of maize and ultimately led to a decrease in supply of maize for tortillas. In summa: increased demand for oil in China ultimately caused an increase in the price of tortillas in Mexico.

A recent article in on the BBC website (http://www.bbc.com/news/magazine-27057547) points out that there should be an inverse relationship between the price of houses and soap. Yeah, pretty far-fetched – not to mention weird. Yet there is a clear chain of causality between the two, linked by a) derived demand, and; b) joint supply.

Salt. Now some electricity….

I shall give you a chance to do what is my strongest recommendation to all students; look it up! Thus, here is the causal chain (below) and your job is simply to look up the “connecting nodes” – e.g. how on earth the market for insulation materials used in houses is linked to the market for chloride.

Δ↓ Demand for housing → Δ↓ demand for insulation material and plastic piping → Δ↓ demand for PVC (look it up!) → Δ↓ demand for chlorine → Δ↓ quantity supplied of chlorine and ↓supply of sodium → Δ↑ price of sodium → Δ↓ supply of soap and Δ↑ price of soap.

Did you look it up? Then you probably know the order of progression:

1. Demand for housing falls, whereby…
2. …the demand for insulation material and plastic piping decreases as these goods are derived from the demand for housing. When demand for insulation/piping falls…
3. …this causes a decrease in the derived demand for the raw materials used in the production of insulation and plastic piping.
4. Pipes and insulation are made from PVC (polyvinyl chloride) – and, no surprises, PVC uses large amounts of chlorine in its manufacture. In fact, more than a third of all chlorine produced is used in the production of PVC. More than 70% of all PVC goes to housing materials.
5. Now, chlorine is made from salt – or, using the proper chemical name; sodium chloride. Using a process called electrolysis (ask your chemistry teacher) which consumes huge amounts of electricity, the sodium chloride molecules are broken down into chlorine (gas), hydrogen (gas) and sodium (hydroxide).
6. Thus, leaving chemistry and returning to the comfort zone of economics; it is evident that chlorine and sodium are in very strong joint supply – i.e. where an increase in demand for one good causes an increase in supply of the other. (Classic example: a rise in the demand for beef causes an increase in the supply of leather.)
7. Sodium is a key ingredient in the manufacturing of soap and now we have the complete “string” of events: falling demand for housing leads via derived and joint supply connections with other intermediate goods to higher manufacturing costs for soap and thus a higher price of soap.

In summa: the demand for housing is indeed inversely related to the demand for housing.