Introduction: Armen Alchian and the Third Law of Demand
Armen Alchian (1914-2013) is one of the most well-known and consequential economists in American history. A microeconomic theorist, his contribution to economics is expansive, ranging from founding new institutional economics and developing economic precepts on property rights (Mulherin, 2017). Through his widely accepted text, ‘University Economics,’ Armen developed numerous economic theories and precepts, the most controversial of which is the Alchian and Allen Theorem, commonly flaunted as the ‘third Law of Demand.’ Although the theory appears legitimate on paper, the theory’s practical application does not seem to support the theory’s major precepts. This suggests the theoretical limitations of the theory is void of certain practical precepts, such as the impact of supply, other substitutes apart from the compared substitutes, influence from governments and authorities among others, which suggest this theory should be fixed and involve relationships among other aspects of the economy other than a limited number of substitutes and fixed costs for the theory to be practically applicable.
Basics of The Alchian and Allen Theorem
The third law of demand, developed by Alchian and Allen through University Economics, states that adding the same fixed cost on two substitutes (similar goods) causes a comparative increase in demand for the higher-priced substitute (Miljkovic & Gómez, 2019). In this regard, a higher quality item tends to perform better than a lower-quality item in case of fixed cost increases, such as transport costs, because the higher-priced substitute becomes relatively less expensive.
The Alchian and Allen Theorem can be illustrated via a hypothetical situation- a country making wine. The country can either make good (quality) wine at the cost of $10 per bottle and lower quality wine (mediocre) at half that cost ($5 a bottle). If transport costs beyond international borders are estimated to be $5 per bottle, the price of the low-quality wine would be $10 per bottle, while the higher quality wine would be $15 per bottle. The ratio of the country’s prices is 1:2 and 1:1.5 beyond the country’s borders. The higher quality wine is relatively less expensive in international markets, which means international consumers should consume more expensive wine than the cheaper wine.
Problems with the Alchian and Allen Theorem
The Alchian and Allen Theorem is hypothetically correct and forms the basis for international trade- most companies with non-fluctuating transport and other fixed costs tend to prioritize transporting higher quality products due to the perceived higher demand such as products. The theory has been the subject of a lot of controversy and criticism because of its limited application in specific situations. One of the practical examples and applications of the theory is prohibited drugs. When a drug, say, marijuana is outlawed, and increased fixed cost comes in the form of expected punishment if caught. This is thought to be the reason behind the comparative higher THC content in marijuana today as compared to when it was still legal. Similarly, people tend to drink either higher quality or highly concentrated alcohol in areas where they are prohibited.
Several studies have attempted to test the Alchian and Allen Theorem in normal economic situations. In 2006, a study was conducted to test the Alchian and Allen hypothesis based on consumer behaviors and responses to changes in gasoline prices in the market. The research was based on consumer data from daily sales at a gasoline station over a period of seven years when major changes in prices can cause noticeable consumer behavior and responses (Lawson & Raymer, 2006). According to the theory, consumers should gravitate towards higher-priced gasoline once the general price of gasoline rises. Therefore, companies that produce higher-quality gasoline at higher prices should experience a comparative increase in market share because of a noticeable increase in gasoline prices. However, the empirical results from the study do not show alignment with the theory. Most consumers responded to the changing prices by switching to a mid-grade fuel when faced with higher prices of premium grade gasoline (comparatively higher price) (Lawson & Raymer, 2006). Most consumers that frequented lower quality gasoline did not show a considerable shift to the comparatively less expensive but higher quality gasoline.
The research on the Alchian and Allen Theorem was based on the assumption that a commodity group only has two quality-differentiable versions. It fails to consider and acknowledge the effect of a wider variety of substitutes, with multiple quality-differential brands (Razzolini et al., 2003). This is among the major areas of the controversy of the third law of demand, limiting its prospective application to a hypothetical and theoretical case where there are only two possible attributes or when the fixed cost goes beyond just increased financial input (like punishment, as in the case of prohibited drugs).
Conclusion
The legitimacy of the Alchian and Allen Theorem should be the subject of further research inquiry in the contemporary economic environment. Although the theorem is applicable in various specific and unique situations, it is evident from studies such as Lawson & Raymer (2006) that the theorem needs further research which should consider contemporary economic issues such as supply patterns and supply chain management as well as government regulations apart from the already explored effect of more than two substitute options. In hindsight, these sources only complicate the theory.