Introduction to Economic Reasoning - Chapter 4: Demand and Supply

Dr. Gordon now turns to the laws of demand and supply; the concepts people most often identify with economics.

Gordon begins simply. Two actors have what the other wants. The first actor has apples and wants an orange. The second actor has oranges and wants an apple. In such a situation, we can expect an exchange to take place. One cannot determine, however, the ratio of apples to oranges at which the exchange will take place. True, each actor prefers one good to the other good. Still, it does not follow that the exchange will take place at this ratio. An exchange could take place at a ratio of 1 apple for 2 oranges or 2 apples for 10 oranges. Such ratios are consistent with the preference of 1 apple to 1 orange. Just because an actor prefers one apple to an orange doesn’t mean he has to settle for one apple for an orange. The same applies to the other actor.

A ratio cannot be established without recognizing marginal utility. As an actor acquires more apples, each additional apple will be worth less to him. As he gives up more oranges, each orange he still has will be worth more to him (he prefers apples to oranges, but he still values oranges. They are not worthless to him). A given preference scale for each actor, in this case apples and oranges, helps establish a range of prices at which an exchange will take place.

For example assume the following preference scales:

You have 4 oranges. Your preference scale is 2 apples, 1 orange, 2 oranges, 1 apple
I have 4 apples. My preference scale is 2 oranges, 2 apples, 1 orange, 1 apple

Say you demand 2 apples for 1 orange. According to my preference scale, I value 2 apples more than 1 orange, so I would not trade apples for oranges at this price.

In essence, though an actor may prefer one good to another, one cannot determine the potential ratios of exchange at which the actor may trade until one knows how much the actor values the good vs. the other good. Even with knowing the preference scale of two actors, one may only know a range of ratios (prices) at which goods will trade for each other, not necessarily a single ratio (price).

Consider, now, when other actors enter the market. According to their preferences they may more readily trade their goods for other goods. As trading between these different actors occurs, exchange ratios become known to other actors, who will also trade depending on their preference scales. As such, a competition will develop between the actors for goods and eventually these goods will exchange at a single price. This process is known as the law of one price.

During this process certain actors may observe different prices established between different sets of other actors. They may take advantage of these different prices and buy from actors willing to sell at a lower price and sell to other actors who are willing to buy at a higher price. Such actors are able to secure what is called an arbitrage profit. As this activity becomes known to other actors these arbitrage profits become more difficult to secure. The activity of arbitrage actually tends to speed up the establishment of a single price.

Gordon next asks us to look at the determination of prices in more detail. In doing so, he will introduce us to supply and demand curves. Before he begins he reiterates two principles (1) we prefer more of a good to less of a good (2) as you acquire more units of a good, you will put them to less valuable uses (law of marginal utility).

Given a preference scale, one can determine how much of a good an actor wants at a given price. For example for 4 apples you want 1 orange. For 3 apples, you want 2 oranges. For 2 apples you want 1 orange. This is a demand schedule for oranges. Such demand schedules, even made up ones, are based on preference scales and must follow rules 1 and 2 above. For example, a demand schedule cannot imply that you would value oranges more and more as you give up more apples for them. For each additional orange you gain, you value oranges more, and for each additional apple you give up, you value apples less. Essentially, the more oranges you acquire under this demand schedule, the more apples you are willing to give up for them. This violates the law of marginal utility.

Dr. Gordon cautions, however, that inconsistent preferences (as opposed preference scales inconsistent with the law of marginal utility) at the same price are not logically contradictory. A person can prefer 5 oranges over 25 apples, but also prefer 16 apples over 5 oranges. Even so, inconsistent preferences are generally not, well, preferred.

The law of demand follows from the last two paragraphs. At a lower price, an actor will demand more of a good.

Typically, the law of demand is illustrated by a demand curve. Discrete points defined by the coordinates of price (on the vertical axis) and quantity (on the horizontal axis) are connected by a downward sloping curve. One must realize however, that there is not necessarily a relationship between quantity and price between the discrete points used to draw the lines. Though points on these lines imply it, one may not be able to determine from the graph the price someone would pay for an orange plus a very small amount of another orange.

The law of supply also follows from principles (1) and (2) above. The law of supply says that the higher the price, the greater the quantity supplied. If one is offered more apples for oranges, one will be willing to supply more oranges.

The law of supply is also typically illustrated with a curve. As opposed to the downward slope of the demand curve the supply curve has an upward slope. The same warning about what demand curves can tell one about prices also applies to supply curves.

Both demand and supply curves can indicate how responsive quantities are to prices. More vertical demand and supply curves are called elastic. They indicate that even large price changes have little effect on the quantity of goods supplied.

One can overlay the demand and supply curves on the same chart. Where they intersect establishes where the demand for the good equals the quantity supplied. At higher prices, suppliers supply more of a good than is demanded, and must lower their prices to sell their stock. At lower prices, more goods are demanded than are supplied, and demanders will bid up the price.

Where the curves intersect establishes the equilibrium or market clearing price.

The demand and supply curves discussed so far apply to individuals. These curves can be combined with others to establish demand and supply curves for a group. The intersection point of these curves is the result of the law of one price, discussed earlier. The law is actually the result of a competitive process, not a mysterious force. Because we know that prices will converge to ‘one price’ as established by the law, we can treat a group of individuals as a single buyer and seller with their corresponding demand curves. Note that there is no preference scales for the group as there are for individuals. The price established by the demand and supply curves of the group, however, will closely match that of the marginal buyer and seller.

On a final note, Dr. Gordon highlights a common fallacy to be avoided. If the quantity of a good supplied increases and prices fall, a change in the quantity demanded of a good has occurred and the price has moved along the demand curve. On the other hand, should the quantity of a good increase along with the price of the good, the demand curve has shifted. Do not confuse movement along a curve with a shift of the curve.

If you remember one thing from this chapter, remember that prices are subjective. Individuals determine the prices of goods.