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II. What Determines Prices: Supply and Demand

What determines individual prices? Why is the price of eggs, or horseshoes, or steel rails, or bread, whatever it is? Is the market determination of prices arbitrary, chaotic, or anarchic?

Much of the past two centuries of economic analysis, or what is now unfortunately termed microeconomics, has been devoted to analyzing and answering this question. The answer is that any given price is always determined by two fundamental, underlying forces: supply and demand, or the supply of that product and the intensity of demand to purchase it.

Let us say that we are analyzing the determination of the price of any product, say, coffee, at any given moment, or “day,” in time. At any time there is a stock of coffee, ready to be sold to the consumer. How that stock got there is not yet our concern. Let’s say that, at a certain place or in an entire country, there are 10 million pounds of coffee available for consumption. We can then construct a diagram, of which the horizontal axis is units of quantity, in this case, millions of pounds of coffee. If 10 million pounds are now available, the stock, or supply, of coffee available is the vertical line at 10 million pounds, the line to be labeled S for supply.

FIGURE 2.1 — THE SUPPLY LINE

The demand curve for coffee is not objectively measurable as is supply, but there are several things that we can definitely say about it. For one, if we construct a hypothetical demand schedule for the market, we can conclude that, at any given time, and all other things remaining the same, the higher the price of a product the less will be purchased. Conversely, the lower the price the more will be purchased. Suppose, for example, that for some bizarre reason, the price of coffee should suddenly leap to $1,000 a pound. Very few people will be able to buy and consume coffee, and they will be confined to a few extremely wealthy coffee fanatics. Everyone else will shift to cocoa, tea, or other beverages. So if the coffee price becomes extremely high, few pounds of coffee will be purchased.

On the other hand, suppose again that, by some fluke, coffee prices suddenly drop to 1 cent a pound. At that point, everyone will rush out to consume coffee in large quantities, and they will forsake tea, cocoa or whatever. A very low price, then, will induce a willingness to buy a very large number of pounds of coffee.

A very high price means only a few purchases; a very low price means a large number of purchases. Similarly we can generalize on the range between. In fact we can conclude: The lower the price of any product (other things being equal), the greater the quantities that buyers will be willing to purchase. And vice versa. For as the price of anything falls, it becomes less costly relative to the buyer’s stock of money and to other competing uses for the dollar; so that a fall in price will bring nonbuyers into the market and cause the expansion of purchases by existing buyers. Conversely, as the price of anything rises, the product becomes more costly relative to the buyers’ income and to other products, and the amount they will purchase will fall. Buyers will leave the market, and existing buyers will curtail their purchases.

FIGURE 2.2 — THE DEMAND CURVE1

The result is the “falling demand curve,” which graphically expresses this “law of demand” (Figure 2.2). We can see that the quantity buyers will purchase (“the quantity demanded”) varies inversely with the price of the product. This line is labeled D for demand. The vertical axis is P for price, in this case, dollars per pound of coffee.

Supply, for any good, is the objective fact of how many goods are available to the consumer. Demand is the result of the subjective values and demands of the individual buyers or consumers. S tells us how many pounds of coffee, or loaves of bread or whatever are available; D tells us how many loaves would be purchased at different hypothetical prices. We never know the actual demand curve: only that it is falling, in some way; with quantity purchased increasing as prices fall and vice versa.

We come now to how prices are determined on the free market. What we shall demonstrate is that the price of any good or service, at any given time, and on any given day, will tend to be the price at which the S and D curves intersect (Figure 2.3).

In our example, the S and D curves intersect at the price of $3 a pound, and therefore that will be the price on the market.

To see why the coffee price will be $3 a pound, let us suppose that, for some reason, the price is higher, say $5 (Figure 2.4). At that point, the quantity supplied (10 million pounds) will be greater than the quantity demanded, that is, the amount that consumers are willing to buy at that higher price. This leaves an unsold surplus of coffee, coffee sitting on the shelves that cannot be sold because no one will buy it.

FIGURE 2.3 — SUPPLY AND DEMAND

FIGURE 2.4 — SURPLUS

At a price of $5 for coffee, only 6 million pounds are purchased, leaving 4 million pounds of unsold surplus. The pressure of the surplus, and the consequent losses, will induce sellers to lower their price, and as the price falls, the quantity purchased will increase. This pressure continues until the intersection price of $3 is reached, at which point the market is cleared, that is, there is no more unsold surplus, and supply is just equal to demand. People want to buy just the amount of coffee available, no more and no less.

At a price higher than the intersection, then, supply is greater than demand, and market forces will then impel a lowering of price until the unsold surplus is eliminated, and supply and demand are equilibrated. These market forces which lower the excessive price and clear the market are powerful and twofold: the desire of every businessman to increase profits and to avoid losses, and the free price system, which reflects economic changes and responds to underlying supply and demand changes. The profit motive and the free price system are the forces that equilibrate supply and demand, and make price responsive to underlying market forces.

On the other hand, suppose that the price, instead of being above the intersection, is below the intersection price. Suppose the price is at $1 a pound. In that case, the quantity demanded by consumers, the amount of coffee the consumers wish to purchase at that price, is much greater than the 10 million pounds that they would buy at $3. Suppose that quantity is 15 million pounds. But, since there are only 10 million pounds available to satisfy the 15 million pound demand at the low price, the coffee will then rapidly disappear from the shelves, and we would experience a shortage of coffee (shortage being present when something cannot be purchased at the existing price).

The coffee market would then be as shown in Figure 2.5.

Thus, at the price of $1, there is a shortage of 4 million pounds, that is, there are only 10 million pounds of coffee available to satisfy a demand for 14 million. Coffee will disappear quickly from the shelves, and then the retailers, emboldened by a desire for profit, will raise their prices. As the price rises, the shortage will begin to disappear, until it disappears completely when the price goes up to the intersection point of $3 a pound. Once again, free market action quickly eliminates shortages by raising prices to the point where the market is cleared, and demand and supply are again equilibrated.

FIGURE 2.5 — SHORTAGE

Clearly then, the profit-loss motive and the free price system produce a built-in “feedback” or governor mechanism by which the market price of any good moves so as to clear the market, and to eliminate quickly any surpluses or shortages. For at the intersection point, which tends always to be the market price, supply and demand are finely and precisely attuned, and neither shortage nor surplus can exist (Figure 2.6).

Economists call the intersection price, the price which tends to be the daily market price, the “equilibrium price,” for two reasons: (1) because this is the only price that equilibrates supply and demand, that equates the quantity available for sale with the quantity buyers wish to purchase; and (2) because, in an analogy with the physical sciences, the intersection price is the only price to which the market tends to move. And, if a price is displaced from equilibrium, it is quickly impelled by market forces to return to that point—just as an equilibrium point in physics is where something tends to stay and to return to if displaced.

FIGURE 2.6 — TOWARD EQUILIBRIUM

If the price of a product is determined by its supply and demand and if, according to our example, the equilibrium price, where the price will move and remain, is $3 for a pound of coffee, why does any price ever change? We know, of course, that prices of all products are changing all the time. The price of coffee does not remain contentedly at $3 or any other figure. How and why does any price change ever take place?

Clearly, for one of two (more strictly, three) reasons: either D changes, or S changes, or both change at the same time. Suppose, for example, that S falls, say because a large proportion of the coffee crop freezes in Brazil, as it seems to do every few years. A drop in S is depicted in Figure 2.7.

Beginning with an equilibrium price of $3, the quantity of coffee produced and ready for sale on the market drops from 10 million to 6 million pounds. S changes to S’, the new vertical supply line. But this means that at the new supply, S’, there is a shortage of coffee at the old price, amounting to 4 million pounds. The shortage impels coffee sellers to raise their prices, and, as they do so, the shortage begins to disappear, until the new equilibrium price is achieved at the $5 price.

FIGURE 2.7 — DECLINE IN SUPPLY

To put it another way, all products are scarce in relation to their possible use, which is the reason they command a price on the market at all. Price, on the free market, performs a necessary rationing function, in which the available pounds or bushels or other units of a good are allocated freely and voluntarily to those who are most willing to purchase the product. If coffee becomes scarcer, then the price rises to perform an increased rationing function: to allocate the smaller supply of the product to the most eager purchasers. When the price rises to reflect the smaller supply, consumers cut their purchases and shift to other hot drinks or stimulants until the quantity demanded is small enough to equal the lower supply.

On the other hand, let us see what happens when the supply increases, say, because of better weather conditions or increased productivity due to better methods of growing or manufacturing the product. Figure 2.8 shows the result of an increase in S:

FIGURE 2.8 — INCREASE OF SUPPLY

Supply increases from 10 to 14 million pounds or from S to S’. But this means that at the old equilibrium price, $3, there is now an excess of supply over demand, and 4 million pounds will remain unsold at the old price. In order to sell the increased product, sellers will have to cut their prices, and as they do so, the price of coffee will fall until the new equilibrium price is reached, here at $1 a pound. Or, to put it another way, businessmen will now have to cut prices in order to induce consumers to buy the increased product, and will do so until the new equilibrium is reached.

In short, price responds inversely to supply. If supply increases, price will fall; if supply falls, price will rise.

The other factor that can and does change and thereby alters equilibrium price is demand. Demand can change for various reasons. Given total consumer income, any increase in the demand for one product necessarily reflects a fall in the demand for another. For an increase in demand is defined as a willingness by buyers to spend more money on—that is, to buy more—of a product at any given hypothetical price. In our diagrams, such an “increase in demand” is reflected in a shift of the entire demand curve upward and to the right. But given total income, if consumers are spending more on product A, they must necessarily be spending less on product B. The demand for product B will decrease, that is, consumers will be willing to spend less on the product at any given hypothetical price. Graphically, the entire demand curve for B will shift downward and to the left. Suppose that we are now analyzing a shift in consumer tastes toward beef and away from pork. In that case, the respective markets may be analyzed as follows:

We have postulated an increase in consumer preference for beef, so that the demand curve for beef increases, that is, shifts upward and to the right, from D to D’. But the result of the increased demand is that there is now a shortage at the old equilibrium price, 0X, so that producers raise their prices until the shortage is eliminated and there is a new and higher equilibrium price, 0Y.

FIGURE 2.9 — THE BEEF MARKET: INCREASE IN DEMAND

On the other hand, suppose that there is a drop in preference, and therefore a fall in the demand for pork. This means that the demand curve for pork shifts downward and to the left, from D to D’, as shown in Figure 2.10:

FIGURE 2.10 — THE PORK MARKET: DECLINE IN DEMAND

Here, the fall in demand from D to D’ means that at the old equilibrium price for pork, 0X, there is now an unsold surplus because of the decline in demand. In order to sell the surplus, therefore, producers must cut the price until the surplus disappears and the market is cleared again, at the new equilibrium price 0Y.

In sum, price responds directly to changes in demand. If demand increases, price rises; if demand falls, the price drops.

We have been treating supply throughout as a given, which it always is at any one time. If, however, demand for a product increases, and that increase is perceived by the producers as lasting for a long period of time, future supply will increase. More beef, for example, will be grown in response to the greater demand and the higher price and profits. Similarly, producers will cut future supply if a fall in prices is thought to be permanent. Supply, therefore, will respond over time to future demand as anticipated by producers. It is this response by supply to changes in expected future demand that gives us the familiar forward-sloping, or rising supply curves of the economics textbooks.

FIGURE 2.11 — THE BEEF MARKET: RESPONSE OF SUPPLY

As shown in Figure 2.9, demand increases from D to D’. This raises the equilibrium price of beef from 0X to 0Y, given the initial S curve, the initial supply of beef. But if this new higher price 0Y is considered permanent by the beef producers, supply will increase over time, until it reaches the new higher supply S’’. Price will be driven back down by the increased supply to 0Z. In this way, higher demand pulls out more supply over time, which will lower the price.

To return to the original change in demand, on the free market a rise in the demand for and price of one product will necessarily be counterbalanced by a fall in the demand for another. The only way in which consumers, especially over a sustained period of time, can increase their demand for all products is if consumer incomes are increasing overall, that is, if consumers have more money in their pockets to spend on all products. But this can happen only if the stock or supply of money available increases; only in that case, with more money in consumer hands, can most or all demand curves rise, can shift upward and to the right, and prices can rise overall.

To put it another way: a continuing, sustained inflation—that is, a persistent rise in overall prices—can either be the result of a persistent, continuing fall in the supply of most or all goods and services, or of a continuing rise in the supply of money. Since we know that in today’s world the supply of most goods and services rises rather than falls each year, and since we know, also, that the money supply keeps rising substantially every year, then it should be crystal clear that increases in the supply of money, not any sort of problems from the supply side, are the fundamental cause of our chronic and accelerating problem of inflation. Despite the currently fashionable supply-side economists, inflation is a demand-side (more specifically monetary or money supply) rather than a supply-side problem. Prices are continually being pulled up by increases in the quantity of money and hence of the monetary demand for products.

  • 1. Conventionally, and for convenience, economists for the past four decades have drawn the demand curves as falling straight lines. There is no particular reason to suppose, however, that the demand curves are straight lines, and no evidence to that effect. They might just as well be curved or jagged or anything else. The only thing we know with assurance is that they are falling, or negatively sloped. Unfortunately, economists have tended to forget this home truth, and have begun to manipulate these lines as if they actually existed in this shape. In that way, mathematical manipulation begins to crowd out the facts of economic reality.
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