Chapter 20: Supply and Demand
Updated: 4/13/20
Elisha said, “Hear the word of the Lord. This is what the Lord says: ‘Tomorrow about this time a measure of fine flour will be sold for a shekel, and two measures of barley for a shekel, in the gate of Samaria.” Then the captain on whose hand the king leaned answered the man of God, and said, ‘See, even if the Lord should make windows in heaven, can this thing happen?’ Elisha replied, ‘See, you will watch it happen with your own eyes, but you will not eat any of it’ (II Kings 7:1–2)
Ben Hadad, king of Aram, had besieged Samaria in the Northern Kingdom. The city was stricken with a famine. The price of food had become too expensive for most people to buy. “So there was a great famine in Samaria. Behold, they besieged it until a donkey's head was sold for eighty pieces of silver, and the fourth part of a kab of dove's dung for five pieces of silver” (II Kings 6:25). The prophet Elisha was in the city. He made a prediction regarding the price of food the next day. There was no question in anyone’s mind what this meant. The siege would be lifted. Large quantities of food would be brought into the city. Under the new conditions of supply and demand, the price of food would be reasonable. He was not simply predicting a fall in the price of food; he was predicting the defeat of the besieging army.
A military officer understood exactly what Elisha was predicting. He dismissed this prophecy as nonsense. Elisha promised him that what he had predicted would take place, and the price of food would fall, but the commander would not taste of any of it. This is exactly what transpired. During the night, the besieging army heard what appeared to be marching troops approaching. They fled in terror, leaving all of their food behind. Four lepers went out to the now-empty camp of the army. They collected some gold and silver for themselves, but then they felt guilty. They decided to tell people in the city that the food was available. People in the city went out to collect the food and bring it back. In the rush to get the food, the mob trampled the officer. He did not have an opportunity to eat.
This passage makes it clear that the law of supply and demand was fully understood in ancient Israel. The commander could put two and two together. There was only one scenario that would make possible this rapid decline in the price of food: a lifting of the siege. There would also have to be a vast increase in the supply of food. Because there was no visible way for Israel to defeat the invading army, and because there was also no large supply of food available in the immediate vicinity, the captain dismissed the prophecy as nonsense. He paid for this arrogance with his life (II Kings 7:20). [North, Historical Books, ch. 26]
I believe that the law of supply and demand is the best understood law of free market economic theory. It is understood around the world. It has been understood throughout recorded history. People understand that prices reflect the conditions of supply and demand. So, the phrase is widely recognized. It is generally accepted. When someone invokes the law of supply and demand in an argument, the listener probably goes along with it unless he has an interest in opposing open competition.
The phrase “supply and demand” applies to the market’s pricing process. It is understandable if you understand an auction. Most people do not oppose the idea of an auction; therefore, most people do not resist the concept of supply and demand. This is why economists who favor the free market have successfully used the phrase for over two centuries. As we marketers like to say, it is an easy sell.
There are four assumptions that undergird this famous law: specialization, marketplace, money, and negotiation. First, specialization. There are sellers of scarce goods and services. These sellers have specialized in production. They have a high degree of expertise in the production and distribution of a particular item. They have invested time and money in the production of this item. They did not produce the item in order to consume it. They produced it in order to exchange it for money, which they could then use to buy something that they did not produce. This description rests on the concept of the division of labor. It rests on the concept of specialization in production. The concept of specialization says that it pays producers to specialize in those areas of the marketplace in which they have unique advantages: knowledge, geography, reputation, styling, and so forth. The individual produces the item for exchange, not for personal consumption.
Second, marketplace. Someone else has an item that he has produced. He also wants to improve his circumstances. He wishes to exchange his item for some other item that he desires more intensely. This is an aspect of subjective imputation of economic value. Each of the participants in an exchange imputes greater value to what the other participant owns than to what he owns. Each of them believes that he can improve his circumstances by making an exchange. To do this, they need a marketplace. It need not be physical. It can be digital. It must be paid for. There are no free lunches. The marketplace must be reliable. Contracts must be honored by participants and by outsiders.
Third, money. Most people understand that the law of supply and demand is most visible in today’s markets. These markets are based on exchanges for money. In this situation, the person who owns money is in a more competitive situation than the person who is selling a specialized good or service. Money is the most marketable commodity. Sellers want money. They are willing to offer whatever they have for sale in exchange for a certain amount of money. It does not take sales ability for a buyer to persuade a seller to provide what he wants if the buyer is willing to pay the seller’s price. This is why buyers, who are sellers of money, possess consumer’s authority. They possess greater authority in the marketplace than the seller does under most conditions. This is not generally understood by the public. The public generally assumes that the seller is in a stronger position. Most people think this: “The seller sets prices.” The seller does not set prices. He announces prices. If no one buys whatever he is selling at the prices he has announced, then he has to lower the prices or in some way alter his marketing plan. Buyers confirm prices or fail to confirm prices by either buying or refusing to buy. Buyers can do almost anything with the money they are willing to spend. They have lots of alternatives. In contrast, sellers can do almost nothing with their inventory of whatever they have to sell if buyers are unwilling to pay.
Fourth, negotiation. The implicit assumption is that buyers and sellers are in a position to negotiate. The seller wants more money. The buyer wants to pay less money or receive better value for the money he spends. There is ignorance on the part of both buyer and seller. Therefore, there is an opportunity for negotiation. The book of Proverbs describes this process: “‘Bad! Bad!’ says the buyer, but when he goes away he boasts” (20:14). [North, Proverbs, ch. 59] In a highly competitive market where there are lots of buyers and sellers, negotiation is less likely. Prices are publicly available. Buyers know what sellers are willing to sell for. Sellers know what recent buyers have been willing to pay. The more widespread the information regarding prices, the less likely there will be negotiation. Negotiation is the market process that prevails when there is reduced knowledge of prices.
People understand that if the supply of an item unexpectedly goes up, existing sellers will not be able to sell all of the items they have brought to market. They may have to take some items back home. More likely, they will have to lower their prices in order to reduce their inventory to zero. People also understand that if the demand for an item unexpectedly goes up, existing buyers will not be able to buy all of the items they had wanted to buy when they brought their money to market. They may not be able to take home the items they wanted to buy. Or they may have to pay more money to buy the items. Here is the law of the auction: “high bid wins.” If there are a lot of auctioneers selling similar items, the bids will be lower. If there are a lot of buyers wanting to buy the items, bids will be higher. Most people understand this. Most people accept this. This is the law of supply and demand in an imaginative setting that most people can understand.
It is not true that supply creates its own demand. It is also not true that demand creates its own supply. Here is what is true: buyers make forecasts about what they will be willing to pay for an item in the future. Sellers make forecasts about what they will be willing and able to charge for an item in the future. If members of either group make mistakes, they will have to adjust their behavior when the day of market exchange arrives. Production is future-oriented. So are plans for future consumption. Nobody is certain what others will be willing to pay in the future. It takes successful entrepreneurship, meaning accurate forecasting and planning, for a seller to make a profit. It takes successful entrepreneurship, meaning accurate forecasting and planning, for a buyer to get the best possible deal for his money: “consumer surplus.”
Free market economists have traditionally argued that the market will clear itself of excess supply . . . at some price. Their assumption is this: sellers will adjust their prices in order to gain at least some money from buyers who refuse to pay the asking prices of the goods and services that sellers brought to market. Here is the secondary assumption: something is better than nothing. Sellers would rather receive some money than no money. Some of them would rather sell at a price that they would have regarded as a loss when they first brought the goods to market. The new conditions have redefined what constitutes a profit and a loss. Under the old conditions, selling their inventory below the cost of production would have been understood as a loss. That is no longer the case under the new conditions. Under the new conditions, getting some money is better than getting no money, and then being forced to carry home the unsold inventory.
The same attitude governs buyers. If conditions have changed, and prices have risen above what buyers had expected to pay, some of them will pay a higher price. They would have regarded this as a loss under the previous conditions. But, under the new conditions, paying more money and taking home the product seems to be the best decision available to them.
The determining factor is price. It is the determining factor for sellers, and it is the determining factor for buyers. I am not speaking of all sellers and all buyers. I am speaking of what market economists call marginal sellers and marginal buyers. These are the buyers and sellers who are willing to make a transaction at a price different from what they had expected. These are the sellers who sell at prices lower than they had expected to receive. These are the buyers who purchase at prices higher than they had expected to pay. Their transaction prices set the prices for comparable transactions. The prices paid by marginal buyers and sellers are regarded as the best available prices in the market, and other buyers and sellers will imitate the selling prices of the marginal buyers and sellers. The transaction prices of the marginal buyers and sellers send signals to all other buyers and sellers in the marketplace who are aware of the transaction prices of the marginal buyers and sellers. Sellers do not want to accept less, and buyers do not want to pay more.
The great transformation in economic theory began in 1936 with the publication of John Maynard Keynes’ book, The General Theory of Employment, Interest, and Money. The world had been in a depression for about six years. While Austrian economists had an answer for this, as seen in the book by Mises’ disciple Lionel Robbins, The Great Depression (1934), the vast majority of free market economists seemed unable to explain why the depression did not end. This made free market economists vulnerable to the accusation that their theories no longer worked. (Robbins decades later disavowed the book.)
There were valid reasons for the economic stagnation that these economists ignored. Governments had indulged in huge deficit spending campaigns as a way to put people back to work. Every government had gone off the gold standard by 1934. Monetary policy of central banks was no longer predictable. Businessmen were wary for good reason regarding the next piece of legislation. Germany and Italy had adopted central economic planning in the form of fascism. Property rights were no longer respected by these major governments. In the United States, the national government interfered in the economy as never before in peace time. Free market theory says that prices should have adjusted to clear the market of unsold goods. But governments had passed legislation that made it difficult for retailers to sell their goods at a market price and also hire laborers at a market wage. The depression dragged on.
It was then that Keynes offered a criticism of the traditional free market approach regarding supply and demand. His target was a French economist of the early nineteenth century, J. B. Say. Either Keynes had no understanding of what Say had written, or else he was deliberately deceiving his readers. He devoted only three sentences to Say’s writings. Here is what he wrote. “From the time of Say and Ricardo the classical economists have taught that supply creates its own demand—meaning by this in some significant, but not clearly defined, sense that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product” (p. 18). “Thus Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile” (p. 26). Keynes’ phrase has been cited by Keynesian economists ever since: “supply creates its own demand.” Obviously, in 1936, supply had not created its own demand. So, it looked as though Say and Ricardo were economic ignoramuses.
The problem is this: Say never said any such thing. Here is what he wrote regarding pricing. This is from his Treatise on Political Economy (1803). The passage is a defense of price flexibility in the marketplace. It is a defense of economic negotiation as a way to clear the market of unsold inventories. In short, it is a defense of market-clearing prices.
The prospect of an abundant vintage will lower the price of all the wine on hand, even before a single pipe of the expected vintage has been brought to market; for the supply is brisker, and the sale duller, in consequence of the anticipation. The dealers are anxious to dispose of their stock in hand, in fear of the competition of the new vintage; while the consumers, on the other hand, retard their fresh purchases, in the expectation of gaining in price by the delay. A large arrival and immediate sale of foreign articles all at once, lowers their price, by the relative excess of supply above demand. On the contrary, the expectation of a bad vintage, or the loss of many cargoes on the voyage, will raise prices above the cost of production. . . .This is the meaning of the assertion, that, at a given time and place, the price of a commodity rises in proportion to the increase of the demand and the decrease of the supply, and vice versâ; or in other words, that the rise of price is in direct ratio to the demand, and inverse ratio to the supply (I:II, p. 290).In each country the wants of the consumer determine the quality of the product. The product most wanted is most in demand; and that which is most in demand yields the largest profit to industry, capital, and land, which are therefore employed in raising this particular product in preference; and, vice versâ, when a product becomes less in demand, there is a less profit to be got by its production; it is, therefore, no longer produced. All the stock on hand falls in price; the low price encourages the consumption, which soon absorbs the stock on hand (III:I, p. 390).
Say fully understood what Adam Smith had understood, namely, that sellers of goods that were not in high demand would then lower their prices in order to sell their inventory. These low prices would encourage consumption: “the low price encourages the consumption, which soon absorbs the stock on hand.” Say did not teach that supply creates its own demand. He taught what should have been obvious, namely, that if someone has not supplied something worth buying at the price he is asking, he will not earn any money. If he does not earn any money, he will be unable to register demand in the market place. But, at some low price, he will sell his inventory. Thus, total (aggregate) production will create demand at some price. So, it is quite possible for a producer to bring to market an item for which there is no demand at the price he expected to receive and is asking. In such circumstances, he must lower his price if he wishes to make any money. In other words, is a matter of supply and demand. Say even used this phrase: “the relative excess of supply above demand.”
Anyone who understood the law of supply and demand in 1936 should have begun searching for causes of the inability of sellers to sell their inventories. The world economy had not adjusted to the new conditions of supply and demand. Why not? In July, 1930, the United States government hiked tariffs. Other nations retaliated. The international division of labor contracted. In May, 1931, a large Austrian bank, Credit Anstalt, declared bankruptcy. In September, 1931, England went off the gold standard. The United States followed in March, 1933. Governments ran massive deficits. Investors and businesses could no longer expect governments to cut taxes and spending. In 1963, Murray Rothbard’s book was published: America’s Great Depression. He discussed in detail the economic policies of President Hoover’s administration (1929–33), policies that were greatly expanded by President Franklin Roosevelt’s New Deal (1933–41). These policies restricted the ability of producers to lower their prices. They also restricted the right of employers to offer market-clearing wages to workers, thereby putting them back to work. The New Deal, beginning in 1933, launched the government-enforced trade union movement in the United States.
Keynesian economics rests on this premise: the law of supply and demand does not work predictably to solve the problems of recession and depression. Keynesian economists reject the suggestion that the law ever did work effectively. They conclude that government intervention in the form of large government deficits and central bank expansion of money are necessary to restore economic growth. They do not believe that reducing government taxation and intervention will lead to permanent economic expansion. They also believe in the welfare state.
In a world of scarcity, everyone would like to own more than he possesses. There are limits to his resources. Everyone faces monetary limits on his ability to bid for goods and services on a free market.
The only way for someone to register demand in the free market is through the results of his production or the production of somebody who gave him his money. This production must be marketable. If someone does not wish to buy whatever a producer has produced, the producer has wasted time, money, resources, and dreams. Just because he worked hard to produce something does not mean that buyers will be willing to pay him the money he asks in exchange for his output. He may have to ask less. Therefore, supply and demand are not autonomous forces. They are part of the market process.
Supply and demand are meaningful only in the context of prices. Prices must be flexible, upward and downward, in order for supplies of goods and services to find buyers. People must be allowed to negotiate with each other as a way to make exchanges. Civil law should allow owners to sell or rent their property. They should be allowed to transfer to others the responsibilities associated with owning specific goods. Other people may want the benefits and the associated responsibilities of owning these goods.
Price flexibility leads to the concept of the market-clearing price. This is not the same as an equilibrium price. There is no such thing as equilibrium; therefore, there is no such thing as an equilibrium price. The concept of equilibrium rests on a silly assumption: the theoretical usefulness of the concept of human omniscience. In contrast, a market-clearing price is the price at which everyone who has an item to sell can find a buyer for this item. Simultaneously, everyone who wants to buy this item can find a seller. Lots of people might like to buy it. Lots of people might like to sell theirs. But liking is not the same as doing. The key phrase is this: at some price. At a market-clearing price, all of those people who want to buy at a particular price make exchanges with all of those who wish to sell at that price. No one is left out in the cold with a desire either to buy or sell at that price. The unified concept of supply and demand implicitly has as its presupposition the possibility of a market-clearing price. Economic theory brings this to the forefront of the discussion what is usually only implicit. This price is not known in advance by either buyers or sellers. It is the product of negotiation, guesswork, and the providence of God.
Humanists prefer to substitute the word luck for the phrase providence of God. Their worldview is governed by the concept of chance, as I argued in Chapter 6 of the Student’s Edition. Chance is point one of their covenant model: the doctrine of origins. Obviously, I reject their attempted substitution.
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