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2. Direct Exchange

9. Continuing Markets and Changes in Price

How, then, may we sum up the analysis of our hypothetical horse-and-fish market? We began with a stock of eight horses in existence (and a certain stock of fish as well), and a situation where the relative positions of horses and fish on different people's value scales were such as to establish conditions for the exchange of the two goods. Of the original possessors, the “most capable sellers” sold their stock of horses, while among the original nonpossessors, the “most capable buyers” purchased units of the stock with their fish. The final price of their sale was the equilibrium price determined ultimately by their various value scales, which also determined the quantity of exchanges that took place at that price. The net result was a shift of the stock of each good into the hands of its most capable possessors in accordance with the relative rank of the good on their value scales. The exchanges having been completed, the relatively most capable possessors own the stock, and the market for this good has come to a close.

With arrival at equilibrium, the exchanges have shifted the goods to the most capable possessors, and there is no further motive for exchange. The market has ended, and there is no longer an active “ruling market price” for either good because there is no longer any motive for exchange. Yet in our experience the markets for almost all goods are being continually renewed.

The market can be renewed again only if there is a change in the relative position of the two goods under consideration on the value scales of at least two individuals, one of them a possessor of one good and the other a possessor of the second good. Exchanges will then take place in a quantity and at a final price determined by the intersection of the new combination of supply and demand schedules. This may set a different quantity of exchanges at the old equilibrium price or at a new price, depending on their specific content. Or it may happen that the new combination of schedules—in the new period of time—will be identical with the old and therefore set the same quantity of exchanges and the same price as on the old market.

The market is always tending quickly toward its equilibrium position, and the wider the market is, and the better the communication among its participants, the more quickly will this position be established for any set of schedules. Furthermore, a growth of specialized speculation will tend to improve the forecasts of the equilibrium point and hasten the arrival at equilibrium. However, in those cases where the market does not arrive at equilibrium before the supply or demand schedules themselves change, the market does not reach the equilibrium point. It becomes continuous, moving toward a new equilibrium position before the old one has been reached.29

The types of change introduced by a shift in the supply and/or the demand schedule may be depicted by the diagrams in Figure 24.

 

These four diagrams depict eight types of situations that may develop from changes in the supply and demand schedules. It must be noted that these diagrams may apply either to a market that has already reached equilibrium and is then renewed at some later date or to one continuous market that experiences a change in supply and/or demand conditions before reaching the old equilibrium point. Solid lines depict the old schedules, while broken lines depict the new ones.

In all these diagrams straight lines are assumed purely for convenience, since the lines may be of any shape, provided the aforementioned restrictions on the slope of the schedules are met (rightward-sloping demand schedules, etc.).

In diagram (a), the demand schedule of the individuals on the market increases. At each hypothetical price, people will wish to add more than before to their stock of the good—and it does not matter whether these individuals already possess some units of the good or not.

 The supply schedule remains the same. As a result, the new equilibrium price is higher than the old, and the quantity of exchanges made at the new equilibrium position is greater than at the old position.

In diagram (b), the supply schedule increases, while the demand schedule remains the same. At each hypothetical price, people will wish to dispose of more of their stock. The result is that the new equilibrium price is lower than the old, and the equilibrium quantity exchanged is greater.

Diagrams (a) and (b) also depict what will occur when the demand curve decreases and the supply curve decreases, the other schedule remaining the same. All we need do is think of the broken lines as the old schedules, and the solid lines as the new ones. On diagram (a) we see that a decrease in the demand schedule leads to a fall in price and a fall in the quantity exchanged. On diagram (b), we see that a decrease in the supply schedule leads to a rise in price and a fall in the quantity exchanged.

For diagrams (c) and (d), the restriction that one schedule must remain the same while the other one changes is removed. In diagram (c), the demand curve decreases and the supply curve increases. This will definitely lead to a fall in equilibrium price, although what will happen to the quantity exchanged depends on the relative proportion of change in the two schedules, and therefore this result cannot be predicted from the fact of an increase in the supply schedule and a decrease in the demand schedule. On the other hand, a decrease in the supply schedule plus an increase in the demand schedule will definitely lead to a rise in the equilibrium price.

Diagram (d) discloses that an increase in both demand and supply schedules will definitely lead to an increase in the quantity exchanged, although whether or not the price falls depends on the relative proportion of change. Also, a decrease in both supply and demand schedules will lead to a decline in the quantity exchanged. In diagram (c) what happens to the quantity, and in diagram (d) what happens to the price, depends on the specific shape and change of the curves in question.

The conclusions from these diagrams may be summarized in Table 5.

If these are the effects of changes in the demand and supply schedules from one period of time to another, the next problem is to explain the causes of these changes themselves. A change in the demand schedule is due purely to a change in the relative utility-rankings of the two goods (the purchase-good and the sale-good) on the value scales of the individual buyers on the market. An increase in the demand schedule, for example, signifies a general rise in the purchase-good on the value scales of the buyers. This may be due to either (a) a rise in the direct use-value of the good; (b) poorer opportunities to exchange the sale-good for some other good—as a result, say, of a higher price of cows in terms of fish; or (c) a decline in speculative waiting for the price of the good to fall further. The last case has been discussed in detail and has been shown to be self-correcting, impelling the market more quickly towards the true equilibrium. We can therefore omit this case now and conclude that an increase in the demand schedule is due either to an increase in the direct use-value of the good or to a higher price of other potential purchase-goods in terms of the sale-good that buyers offer in exchange.

A decrease in demand schedules is due precisely to the converse cases—a fall in the value in direct use or greater opportunities to buy other purchase-goods for this sale-good. The latter would mean a greater exchange-value—of fish, for example—in other fields of exchange. Changes in opportunities for other types of exchange may be a result of higher or lower prices for the other purchase-goods, or they may be the result of the fact that new types of goods are being offered for fish on the market. The sudden appearance of cows being offered for fish where none had been offered before is a widening of exchange opportunities for fish and will result in a general decline of the demand curve for horses in terms of fish.

A change in the market supply curve is, of course, also the result of a change in the relative rankings of utility on the sellers’ value scales. This curve, however, may be broken down into the amount of physical stock and the reservation-demand schedule of the sellers. If we assume that the amount of physical stock is constant in the two periods under comparison, then a shift in supply curves is purely the result of a change in reservation-demand curves. A decrease in the supply curve caused by an increase in reservation demand for the stock may be due to either (a) an increase in the direct use-value of the good for the sellers; (b) greater opportunities for making exchanges for other purchase-goods; or (c) a greater speculative anticipation of a higher price in the future. We may here omit the last case for the same reason we omitted it from our discussion of the demand curve. Conversely, a fall in the reservation-demand schedule may be due to either (a) a decrease in the direct use-value of the good to the sellers, or (b) a dwindling of exchange opportunities for other purchase-goods.

Thus, with the total stock constant, changes in both supply and demand curves are due solely to changes in the demand to hold the good by either sellers or buyers, which in turn are due to shifts in the relative utility of the two goods. Thus, in both diagrams A and B above, the increase in the demand schedule and a decrease in the supply schedule from S′S′to SS are a result of increased total demand to hold.

In one case the increased total demand to hold is on the part of the buyers, in the other case of the sellers. The relevant diagram is shown in Figure 25. In both cases of an increase in the total demand-to-hold schedule, say from TD to T′D′, the equilibrium price increases. On the contrary, when the demand schedule declines, and/or when the supply schedule increases, these signify a general decrease in the total demand-to-hold schedule and consequently a fall in equilibrium price.

A total demand-stock diagram can convey no information about the quantity exchanged, but only about the equilibrium price. Thus, in diagram (c), the broken lines both represent a fall in demand to hold, and we could consequently be sure that the total demand to hold declined, and that therefore price declined. (The opposite would be the case for a shift from the broken to the solid lines.) In diagram (d), however, since an increase in the supply schedule represented a fall in demand to hold, and an increase in demand was a rise in the demand to hold, we could not always be sure of the net effect on the total demand to hold and hence on the equilibrium price.

From the beginning of the supply-demand analysis up to this point we have been assuming the existence of a constant physical stock. Thus, we have been assuming the existence of eight horses and have been considering the principles on which this stock will go into the hands of different possessors. The analysis above applies to all goods—to all cases where an existing stock is being exchanged for the stock of another good. For some goods this point is as far as analysis can be pursued. This applies to those goods of which the stock is fixed and cannot be increased through production. They are either once produced by man or given by nature, but the stock cannot be increased by human action. Such a good, for example, is a Rembrandt painting after the death of Rembrandt. Such a painting would rank high enough on individual value scales to command a high price in exchange for other goods. The stock can never be increased, however, and its exchange and pricing is solely in terms of the previously analyzed exchange of existing stock, determined by the relative rankings of these and other goods on numerous value scales. Or assume that a certain quantity of diamonds has been produced, and no more diamonds are available anywhere. Again, the problem would be solely one of exchanging the existing stock. In these cases, there is no further problem of production—of deciding how much of a stock should be produced in a certain period of time. For most goods, however, the problem of deciding how much to produce is a crucial one. Much of the remainder of this volume, in fact, is devoted to an analysis of the problem of production.

We shall now proceed to cases in which the existing stock of a good changes from one period to another. A stock may increase from one period to the next because an amount of the good has been newly produced in the meantime. This amount of new production constitutes an addition to the stock. Thus, three days after the beginning of the horse market referred to above, two new horses might be produced and added to the existing stock. If the demand schedule of buyers and the reservation demand schedule of sellers remain the same, what will occur can be represented as in Figure 26.

The increased stock will lower the price of the good. At the old equilibrium price, individuals find that their stock is in excess of the total demand to hold, and the consequence is an underbidding to sell that lowers the price to the new equilibrium.

In terms of supply and demand curves, an increase in stock, with demand and reservation-demand schedules remaining the same, is equivalent to a uniform increase in the supply schedule by the amount of the increased stock—in this case by two horses. The amount supplied would be the former total plus the added two. Possessors with an excess of stock at the old equilibrium price must underbid each other in order to sell the increased stock. If we refer back to Table 2, we find that an increase in the supply schedule by two lowers the equilibrium price to 88, where the demand is six and the new supply is six.

Diagrammatically, the situation may be depicted as in Figure 27.

The increased stock is reflected in a uniform increase in the supply curve, and a consequent fall in price and an increase in the quantity exchanged.

Of course, there is no reason to assume that, in reality, an increased stock will necessarily be accompanied by an unchanged reservation-demand curve. But in order to study the various causal factors that interact to form the actual historical result, it is necessary to isolate each one and consider what would be its effect if the others remained unchanged. Thus, if an increased stock were at the same time absorbed by an equivalent increase in the reservation-demand schedule, the supply curve would not increase at all, and the price and quantity exchanged would remain unchanged. (On the total demand-stock schedule, this situation would be reflected in an increase in stock, accompanied by an offsetting rise in the total-demand curve, leaving the price at the original level.)

A decrease in stock from one period to another may result from the using up of the stock. Thus, if we consider only consumers’ goods, a part of the stock may be consumed. Since goods are generally used up in the process of consumption, if there is not sufficient production during the time considered, the total stock in existence may decline. Thus, one new horse may be produced, but two may die, from one point of time to the next, and the result may be a market with one less horse in existence. A decline in stock, with demand remaining the same, has the exactly reverse effect, as we may see on the diagrams by moving from the broken to the solid lines. At the old equilibrium price, there is an excess demand to hold compared to the stock available, and the result is an upbidding of prices to the new equilibrium. The supply schedule uniformly decreases by the decrease in stock, and the result is a higher price and a smaller quantity of goods exchanged.

We may summarize the relation between stock, production, and time, by stating that the stock at one period (assuming that a period of time is defined as one during which the stock remains unchanged) is related to the stock at a previous period as follows:

If:

St equals stock at a certain period (t)

St– n equals stock at an earlier period (t – n) which is n units of time before period (t) Pn equals production of the good over the period n

Un equals amount of the good used up over the period n

Then:

St = St n + Pn – Un

Thus, in the case just mentioned, if the original stock is eight horses, and one new horse is produced while two die, the new stock of the good is 8 + 1 – 2 = 7 horses.

It is important to be on one's guard here against a common confusion over such a term as “an increase in demand.” Whenever this phrase is used by itself in this work, it always signifies an increase in the demand schedule, i.e., an increase in the amounts that will be demanded at each hypothetical price. This “shift of the demand schedule to the right” always tends to cause an increase in price. It must never be confused with the “increase in quantity demanded” that takes place, for example, in response to an increased supply. An increased supply schedule, by lowering price, induces the market to demand the larger quantity offered. This, however, is not an increase in the demand schedule, but an extension along the same demand schedule. It is a larger quantity demanded in response to a more attractive price offer. This simple movement along the same schedule must not be confused with an increase in the demand schedule at each possible price. The diagrams in Figure 28 highlight the difference.

Diagram I depicts an increase in the demand schedule, while diagram II depicts an extension of quantity demanded along the same schedule as a result of an increase in the supply offered. In both cases, the value scales of the various individuals determine the final result, but great confusion can ensue if the concepts are not clearly distinguished when such terms as “increase” or “decrease” in demand are being used.

 

  • 29. This situation is not likely to arise in the case of the market equilibria described above. Generally, a market tends to “clear itself” quickly by establishing its equilibrium price, after which a certain number of exchanges take place, leading toward what has been termed the plain state of rest—the condition after the various exchanges have taken place. These equilibrium market prices, however (as will be seen in later chapters), in turn tend to move toward certain long-run equilibria, in accordance with the demand schedule and the effect on the size of stock produced. The supply curve involved in this final state of rest involves the ultimate decisions in producing a commodity and differs from the market supply curve. In the movements toward this “final state,” conditions, such as the demand curve, always change in the interim, thus setting a new final state as the goal of market prices. The final state is never reached. See Mises, Human Action, pp. 245 ff.
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