DEMAND, SUPPLY, AND MARKET PRICES

Chapter2providedabird’s-eyeviewof how producers respond to consumer demands in a private-enterprise, free-market economy. Now we need to examine this linkage in more detail, especially the role of the market place and market prices in connecting consumers and producers. If you thought economics was going to be about “supply and demand,” this is it.

THE ROLE OF THE MARKET AND MARKET PRICES

In a loose way, it is easy to see how consumer demands get the goods and services produced that consumers want. If consumers demand more red barn paint, the immediate result is increased sales for paint stores, and these stores order more paint from wholesalers to replenish their stocks. The wholesalers in turn order more paint from the manufacturers. And the manufacturers, with joyous hearts, turn out more red barn paint, since their profits depend on producing and selling paint. The linkage may be jerky and imperfect, but each participant has an incentive to do his part—the profit incentive.

Sometimes the linkage between consumer and producer is direct. An example is the local laundry that washes your shirts. More often, consumer demand has to pass through several links before it hits the ultimate producer. An example is consumer demand for steel nails, which goes through at least the local hardware store and a wholesaler before it gets to, say, the American Steel and Wire Company, which makes nails.

But this is only part of the picture. American Steel and Wire in turn has to obtain iron ore, coal, and the other ingredients of steel, to say nothing of steel-making machinery, buildings for its operations, adding machines for its cost clerks, and stationery for its typists. Yet nails are a relatively simple commodity.

Try thinking about automobiles, or new house construction, or air travel. If you chart the branching-out relationship that starts with consumer demand, you will soon find yourself rapidly running out of sheets of paper. The complex interdependence of the modern economic system surpasses the comprehension of even the most systematic human mind. Yet consumer demands must be relayed to producers through the intricate web if the system is really to turn out what consumers want to buy.

What ties all these myriad links together is a structure of markets and market prices. The grocer knows you want sugar when you walk into his store and buy 5 or 10 pounds at the prevailing price. Similarly, there is a market that links grocers to wholesalers; one that links wholesalers and sugar-refiners; one that links sugar-refiners and sugar-growers.

In each market, price acts as the adjuster between demand and supply. When you demand more, price tends to move up. When price rises, there is an increased incentive to produce more. It is this interaction between demand, supply, and price that is the core of the self-adjusting mechanism of the private-enterprise system.

The world is far too complex to understand if we try looking at all the details at once. Thus, it is useful to concentrate first on some very simple cases, or models, of markets. The problem of understanding the real world is, then, one of using these models to help understand the more complex markets of the real world. In many respects, markets differ widely. But they all boil down to pretty much the same central problem of interaction between demand, supply, and price. A good understanding of the much-cited “law of supply and demand” is a powerful tool indeed for understanding how the modern economy works. We turn now to the supply side of the picture.

SUPPLY

Supply is analogous to demand. Supply is a schedule of amounts that will be offered for sale at different prices during some time period, other factors remaining unchanged. Supply can also be plotted on a curve with amounts on the horizontal axis and prices on the vertical one. But it differs from demand when it is plotted, since the supply curve ordinarily slopes uphill whereas the demand curve ordinarily slopes downhill. The slope of the supply curve reflects the fact that usually more units will be offered for sale at high than at low prices, in contrast to the reverse demand relationship.

Upward-sloping supply curves may seem obvious to you. The higher the price, the greater will be the profit inducement to produce and sell more. Or they may seem anything but obvious. You may think of the economies of mass production, and suspect that more units will be produced when demand increases, without ~tny rise in price. This may, of course, be true under some circumstances, and sometimes—for example, in the automobile industry—to a significant extent.

The relation between firms’ costs and the supply curves for their products is a major subject in economics. It is analyzed in detail in the following chapters. For purposes of this chapter, take it on faith that most supply curves are flat or upward-sloping, with the reasons to be examined later. And even if supply curves should turn out to be downward-sloping in some cases, the type of interaction between supply, demand, and price described in the following pages would still be generally applicable and useful.

A simple example can show how supply curves work. Suppose there are three dairy farms nearby. At various milk prices each will produce and offer different amounts for sale, as in Table 21-1. For the moment, we merely assume that each farmer will produce and offer more milk as the price rises.

This supply schedule can be plotted on a graph just as the demand schedule was. Again putting price on the vertical axis and quantity on the horizontal one, we get the market supply curve shown in Figure 21-1.

FIG 21-1 The supply curve shows how many quarts will
be supplied each week at different prices.

It is important to remember some of the same warnings on supply that apply to demand: (1) Supply is a schedule, not a single amount. Thus, more output at a higher price may be merely a movement to a new point on the supply schedule, not an increase in supply. A change in supply is a change in the schedule (a shift of the curve). (2) Supply has meaning only with reference to some time period. The period should always be specified. (3) A supply schedule or curve is always drawn on the assumption of “other things equal.” Just what “other things” we hold constant will vary from case to case, depending partly on the time period involved. For a one-day period, the number of cows and the amount of mechanical equipment the farmer has must be taken as constants. If we’re talking about supply per year, obviously such matters become variables. This would lead you to suspect that the supply curve per year might look quite different from the supply curve per day—and it does, as we shall see presently.