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The Limits of Supply and Demand

Mises Daily: Tuesday, April 09, 2002 by

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The recent rebound in some key economic indicators has prompted many economists to suggest that the aggressive lowering of interest rates by the Fed is starting to "grow" the economy. Notwithstanding this success, they contend, the central bank must remain on guard in order to prevent inflation getting out of control.

Thus, St. Louis Federal Reserve Bank President William Poole said that last year's tax cuts and interest-rate reductions have provided an underpinning for a solid U.S. economic recovery that could see "upside surprises" ahead. However, he warned that the strength and duration of the U.S. economic expansion, which he believes began near the start of the year, ultimately depends on keeping inflation contained.

Furthermore, according to Poole, "success in maintaining low inflation will not come automatically--the Fed must not fall asleep at the switch." He added that the timing of any interest-rate increases would depend on future economic data and possible risks to price stability.

What is the framework of thinking that led to this conclusion? The supply-demand framework. One of the few things economists agree on is that prices are determined by supply and demand. This is summarized by means of supply and demand curves which describe the relationship between the prices and the quantity of goods supplied and demanded. 

As such, an increase in the price of a good is associated with a fall in its quantity demanded and an increase in its quantity supplied. Conversely, a decline in the price of a good is associated with an increase in its quantity demanded and in a decline in its quantity supplied. In short, the law of supply is depicted by an upward-sloping curve while the law of demand is presented by a downward-sloping curve.

The equilibrium price is established at the point where the two curves intersect. At this point, the quantity supplied and demanded is equal. At the equilibrium price, the market is said to be "cleared." The laws of supply and demand are impeachable true. The problem comes if we mistake the graphs for the real world of uncertainty, speculation, purposeful behavior, and change.

Graphs vs. reality

In the conventional supply-demand framework, consumers and producers confront a given price; that is, at a given price, consumers demand and producers supply a certain quantity of a good. Demand is not a particular quantity, such as 10 potatoes, but rather a full description of the quantity of potatoes the buyer would purchase at each and every price that might be charged. Likewise, supply is not a particular quantity but a complete description of the quantity that sellers would like to sell at each and every possible price. In short, at a given price, people will demand a certain quantity of a good while producers will supply a certain quantity.

Within this framework, neither consumers nor producers have anything to say as far as the origin of a good’s price is concerned. The price is just given. In short, both consumers and producers react to a given price. But who has given the price? Where has the price come from? 

The law of supply and demand as presented by mainstream economics doesn't originate from the facts of reality but rather from the imaginary construction of economists. In short, none of the figures that underpin the supply and demand curves have originated from the real world; they are purely conjectural.

The framework of supply-demand curves rests on the assumptions of unchanged consumer preferences and income and unchanged prices of other goods. In reality, however, consumer preferences are not frozen, and other things do not remain constant. Obviously, then, no one could have possibly observed these curves. According to Mises, "it is important to realize that we do not have any knowledge or experience concerning the shape of such curves."[1]

Yet, economists are heatedly debating the various properties of these unseen curves and their implications regarding government policies. 

The supply-demand graphic is contrary to the fact that human actions are conscious and purposeful. In the graphs, there are no entrepreneurs. Instead, the shift of curves is in response to various factors that set prices. For instance, it is held that a shift in the demand curve to the right for a given supply will lift the price of a good. The price will also increase if, for a given demand curve, the supply curve shifts to the left. In other words, the supply-demand framework doesn’t deal with human beings but with automatons that react to various factors. 

The whole idea that the price of a good is simply given produces the impression that the price is an attribute of a good--i.e., that it is part of the good itself. There is, however, no such thing as a price of a good in general. The prices of goods are established in a particular transaction at a particular place and at a given time. According to Ludwig von Mises,

A market price is a real historical phenomenon, the quantitative ratio at which at a definite place and at a definite date two individuals exchanged definite quantities of two definite goods. It refers to the special conditions of the concrete act of exchange. It is ultimately determined by the value judgments of the individuals involved. It is not derived from the general price structure or from the structure of the prices of a special class of commodities or services. What is called the price structure is an abstract notion derived from a multiplicity of individual concrete prices. The market does not generate prices of land or motorcars in general nor wage rates in general, but prices for a certain piece of land and for a certain car and wage rates for a performance of a certain kind.[2]

The value that an individual assigns to goods is the product of his mind judging the facts of reality. Individuals assess the usefulness of a good as a means to support their life and well-being. On this Carl Menger wrote,

Value is thus nothing inherent in goods, no property of them, nor an independent thing existing by itself. It is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well being. Hence value does not exist outside the consciousness of men. It is therefore, also quite erroneous to call a good that has value to economizing individuals a "value," or for economists to speak of "values" as of independent real things, and to objectify value in this way.[3]

Similarly Mises wrote,

It would be absurd to look upon a definite price as if it were an isolated object in itself. A price is expressive of the position which acting men attach to a thing under the present state of their efforts to remove uneasiness.[4]

Since prices are always in reference to a particular transaction, and since each transaction is unique, it is erroneous to homogenize these transactions by means of curves. 

How prices are determined

Contrary to the mainstream view, prices are not just given; they are set by somebody. This somebody is a producer. Whenever a producer sets a price for his product, it is in his interest to secure a price where the quantity that is produced can be sold at a profit. In setting this price, the producer/entrepreneur will have to consider how much money consumers are likely to spend on the product, the prices of various competitive products, and the cost of production.

Producers set the price, but consumers, by buying or abstaining from buying, are the final decision-makers as to whether the price set will lead to a profit. Producers in this regard are at the total mercy of consumers. If, at a set price, a producer cannot make a positive return on his investment because not enough people are willing to buy his product, the producer will be forced to lower the price to boost turnover. Obviously, by adjusting the price of the good, the entrepreneur must also adjust his costs in order to make a profit.

Consequently, a producer will secure a profit when, at the set price of a good, consumer buying will generate revenue that will exceed the cost plus interest. Profit is an indication that both producers and consumers have improved their well-being.

In short, by investing a given amount of money, producers have secured a greater amount of money. This, in turn, enables them to secure a greater amount of goods and services, which in turn promotes their lives and well-being. Likewise, consumers, by exchanging their money for goods that are on their highest-priority lists, have raised their living standards.

In actual fact, price-setting is never mechanistic and automatic. It is up to the producer/entrepreneur to assess whether it is a good or a bad idea to raise prices; after all, what matters for him is making a profit. When a good makes a profit at a particular price, then it is a signal to entrepreneurs that consumers are willing to support the product at the set price. Prices, therefore, are an important factor in establishing how producers/entrepreneurs employ their resources.

Observe, then, that what determines the amount of goods supplied is not some hypothetical demand schedule, but a producer's appraisal as to whether, at a given place and a given time, consumers will approve of the goods supplied. 

Also, no producer is engaged in hypothetical ideas regarding the amount he will supply at varying prices. He has to be as accurate as possible in setting the right price that will enable him to sell his supply at a profit.

Further fallacies

In the supply-demand framework, an increase in the cost of production will shift the supply curve to the left. For a given demand curve, this will raise the price of a good. In short, in the supply-demand framework, production cost is an important input in determining prices of goods.

We have already seen, however, that it is consumer buying or abstention from buying that is the sole determining factor for the prices of goods. No individual buyer is preoccupied with the cost of producing a particular good. The price that he will agree to pay for a good is in accordance with his particular priorities at a given point in time. The cost of production is of no relevance to him.

Moreover, the cost-of-production theory runs into trouble when attempting to explain prices of goods and services that have no cost because they are not produced--goods that are simply there, like undeveloped land. Likewise, the theory cannot explain the reason for the high prices of famous paintings. On this Murray Rothbard wrote,

Similarly, immaterial consumer services such as the prices of entertainment, concerts, physicians, domestic servants, etc., can scarcely be accounted for by costs embodied in a product.[5]

Using the supply-demand framework for a particular good, mainstream economists proceed further and introduce supply and demand curves for the whole economy. They hold, for example, that if the economy is underperforming, then what is needed is a bolstering of demand by means of fiscal or monetary policies. For a given supply curve, they contend, this will push the demand curve to the right, thereby lifting overall output. Needless to say, the supply-demand framework provides the rationale for government and central bank interference with businesses.

This framework, however, says absolutely nothing about how the increase in demand generates more output. Furthermore, it is silent regarding the funding required in order to raise output. Also, we have seen that, in reality, it is producers that initiate the introduction of new products. They set in motion increases in goods and services, and not consumers as such. Producers present new products, so to speak, to consumers who, in turn, by buying or abstaining from buying, determine the fate of products. Hence there is no such thing as an autonomous demand that somehow triggers supply. Moreover, one cannot demand something before offering something in return.

Supply-demand graphics also provide the justification for various imaginary monopolistic theories, which in turn provide the rationale for the government destruction of successful businesses. For instance, it is held that a company that forces the price above the competitive price level is engaged in monopolistic activities and therefore must be taken to task. 

Even if we were to accept this way of thinking as valid, however, there is no way to establish whether the price of a good is above the so-called competitive price level (monopoly price). By what criteria can one decide what is competitive price? On this Rothbard wrote, "There is no way to define 'monopoly price' because there is also no way of defining the 'competitive price' to which the former must refer."[6]

In the supply-demand framework for the economy, economists employ the quantity of output produced and its average price. However, neither the average price nor the total output can be logically defined. Thus it is not possible to establish an average for $10/shirt and $5/liter of wine. Likewise, it is not possible to add 10 shirts and 20 potatoes to establish the total output. Hence, the entire graphical framework of the supply and demand for the economy rests on misleading premises.

What’s more, the whole issue of so-called equilibrium is misleading in the way the supply-demand framework presents it. Equilibrium, in the context of conscious and purposeful behavior, has nothing to do with the intersection of supply and demand curves. Equilibrium is established when an individual’s ends are met. When a supplier is successful in selling his supply at a price that yields profit, he is said to have reached equilibrium. 

Similarly, consumers who bought this supply have done so in order to meet their goals. Therefore, government and central bank policies aimed at shifting imaginary curves toward so-called equilibrium in fact prevent both consumers and producers from attaining their goals and hence prevent true equilibrium. 

Conclusion

Despite its great appeal because of its simplicity, the supply-demand graphic as employed by mainstream economics is a tool that is detached from the facts of reality. The real-world economy is far too complex to be faithfully rendered on simple graphs that take no account of uncertainty, entrepreneurial speculation, and the ceaseless change of the market economy. 

By no means is this framework harmless, because government and the central bank decision-makers make use of this tool in forming various policies. This is why they are continually surprised when the real economy performs in a manner different from what their graphical analysis would seem to predict.


Frank Shostak, Ph.D., is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org.  Send him MAIL and see his outstanding Mises.org Articles Archive. Dr. Shostak expresses gratitude to Michael Ryan for helpful comments during the writing of this article.


[1] Ludwig von Mises, Human Action, ch. 16 (2), Valuation and Appraisement, p. 333.

[2] Ibid. ch. 16 (13), Prices and Income, p. 393.

[3] Carl Menger, Principles of Economics (New York, London: New York University Press), pp. 120-21.

[4] Mises, Human Action, chapter 16 (12), p. 392.

[5] Murray N. Rothbard, Economic Thought Before Adam Smith: An Austrian Perspective on the History of Economic Thought, vol. 1 (Edward Elgar), p. 452.

[6] Murray N. Rothbard, Man, Economy, and State (Nash Publishing), p. 607.