Part VII NEW DEFINITIONS OF SUPPLY AND DEMAND

 

Part VII

NEW DEFINITIONS OF SUPPLY AND DEMAND

 by

M. Northrup Buechner

A series of essays based on Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

A preliminary step to saving the Law of Supply and Demand is to distinguish demand from desire, want, and need. (This is standard practice in economics, a practice with which I agree.) To demand a good, it is not enough to want a good. I want a Lamborghini, but I do not demand a Lamborghini. I am not part of the Lamborghini market. Demand is not just desire. The standard formulation is that demand requires desire plus means. In economic exchange, the means is money. For a man to demand a good, he must have the money and be ready to spend it on the product he wants. An individual’s demand is the quantity he wants to buy. This is a hard-hearted and hard-headed concept of demand. It makes demand a concept of this world and keeps economic theory in this world.

Now, to save the Law of Supply and Demand, we have to abandon the concepts of supply and demand as curves and define them the way all noneconomists think of them, as simple concrete quantities, such as two tons of steel a day, six feet of lumber an hour, and three million automobiles a year. Demand means the quantity demanded over some time period and supply means the quantity supplied over some time period. (A time period has to be specified to makethe quantity meaningful.) These concepts of supply and demand are meaningful across the whole economy. Every business has supply and demand in exactly this sense of simple quantities. (If there are exceptions, I would like to hear about them.)

Now, let us see how the Law of Supply and Demand works with these definitions. Supply is the quantity a businessman offers for sale. Usually this quantity is equal to the quantity his customers want to buy. The normal pattern (not the universal pattern) is that the businessman sets a price at which he expects to sell a quantity sufficient to maintain his business and make a profit. Then he sells all that his customers want to buy at that price. If they want to buy less than he expected, he offers less for sale. If he sells more than he expected, he offers more for sale to meet his customers’ demand. Thus, there is an ongoing tendency, motivated by the businessman’s self-interest, for the supply to equal the demand in all the product markets of the economy. Of course, supply and demand are not exactly equal at every moment. But if we allow time for businessmen to adjust their supply to variations in demand, demand will beapproximately equal to supply, on average, over one or two months. This is the Law of Supply and Demand with supply and demand conceived of as quantities, not curves. The Law says that over time, the quantity demanded of every good will tend to equal the quantity supplied.

Nevertheless, there are still all the exceptions identified in Part II of this series. How can we integrate those exceptions with the Law of Supply and Demand as I have defined it here? I will take up that problem in my next post.


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Part VI: NEW DEFINITIONS OF SUPPLY AND DEMAND

Part VI: NEW DEFINITIONS OF SUPPLY AND DEMAND by M. Northrup Buechner

A series of essays based on Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

I know that some of my readers have noticed that in this analysis of the Law of Supply and Demand, I have so far failed to define “supply” or “demand.” This is because the meanings of supply and demand that I depend on are common sense meanings—meanings that I think the reader will have assumed while reading the discussion so far. By contrast, the meanings of supply and demand that dominate modern economics would never be reached on a common sense basis and are held by no one other than economists

A short detour to indicate the meanings of supply and demand in modern economics will yield two benefits. First, my readers will be in a better position to grasp my definitions of supply and demand in contrast to their accepted meanings in economics. Second, the economic model of perfect competition described below is the implicit basis for the critique of my views that I projected in my last post (see the next to last paragraph below).

For about the last one hundred years, economists have defined supply as the quantity supplied at every price and demand as the quantity demanded at every price. The phrase “at every price” turns supply and demand into curves defined by mathematical equations that can be solved for a price. Many economists take this solution as a theory of price. But defined as curves, neither supply nor demand exist in the economy.

Modern economists agree that a supply curve makes sense only when the price is given to the businessman. This occurs only in the model they call perfect competition (millions of firms producing the same product). Farm markets are usually pointed to as the real world counterparts of perfect competition because boards of trade such as CBOT (the Chicago Board of Trade) give farmers the prices for which they can sell their products, and farmers are the only businesses in the economy who do not set their own price. (Such markets have nothing in common with the neighborhood “farm markets” found in many cities.)

Further, economists agree that demand curves cannot be defined when firms compete. The only industries in the economy with no competitors are government monopolies such as public utilities (gas, water, electricity) and, again, farmers. Farmers do not compete because millions of them produce identical products (such as winter wheat) for which they are all given the same price. Since each farmer can sell all he wants at the market price, there is no competition for sales. Since the products are identical, there is no competition for quality.

Thus, demand curves and supply curves are meaningful only for agricultural markets, and the Law of Supply and Demand, conceived as intersecting curves, applies only to farmers (which does not mean that the modern conception of the law is valid even here). In the standard measure of total economic output, agricultural output accounts for about one percent. Thus modern economists have succeeded in restricting the Law of Supply and Demand to one percent of the economy, while they have no theory of price for the rest of the economy. A disgrace is the mildest word that can be used to describe this performance.

The assumption of millions of producers on the supply side facing millions of consumers on the demand side with the price somehow set by no one is the perfectly competitive model, and the assumption underlying Part V of this series.

In my next blog, we will see how demand and supply can be defined to make the Law of Supply and Demand applicable to one hundred percent of the economy.

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Part V:  THE MODERN ECONOMISTS’ ANSWER

 

Part V:  THE MODERN ECONOMISTS’ ANSWER
By
M. Northrup Buechner

A series of essays based on Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

In Parts II through IV of this series, I have argued that, as interpreted in modern economics, the Law of Supply and Demand is largely untrue. There are many important exceptions to the idea that the quantity demanded always equals the quantity supplied at the market price (Part II), and it is not true that changes in price are caused by changes in demand and supply, i.e., increases in demand and decreases in supply raise price while decreases in demand and increases in supply reduce price (Parts III and IV).

Modern economists will object that my analysis ignores that the law of supply and demand is a law of markets. It depends on large numbers of buyers on the demand side and large numbers of sellers on the supply side. Prices in the context in which the law of supply and demand applies are not set by individual businessmen. With millions of people bidding prices they want to pay and more millions asking prices they want to receive, the price settles where the quantity demanded equals the quantity supplied. The individual businessman and his customers have no influence on the price. Their individual goals and values are nullified by the impersonal forces of the market. The prices they receive and pay are given to them by the forces of supply and demand. They must adjust to those prices; they cannot set or change them.

Likewise, an increase in demand that takes the form of an increase in the quantity demanded by millions of buyers will raise the price, not increase output; and a decrease in demand embodied in a decrease in the quantity demanded by millions of customers will lower the price, not reduce output. The same argument applies to increases in supply and decreases in supply that reflect change in the output of millions of producers.

There are many things one could say about this argument. An explanation of why anyone would believe it would be illuminating. But that would take us too deeply into the details of modern economic thought (see Appendix A of Objective Economics). Suffice to say that the entire construct presented above is a fantasy that corresponds to nothing in reality. Note the evasion contained in the phrase “the price settles” in the fourth sentence of the second paragraph. “Settles” implies a change from one price to another. Who makes that change? Who settles the price? If the answer is “no one,” how does it happen? In fact, there is no answer to these questions, because there are no prices in reality that originate in this way. Every price is set by someone. If we hold on to that simple idea, we will avoid many dead ends and pitfalls.

Next time I will show how the law of supply and demand can be reformulated so that it is valid across the economy.
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THE LAW OF SUPPLY AND DEMAND Part IV

THE LAW OF SUPPLY AND DEMAND

Part IV

A series of essays based on Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by M. Northrup Buechner.

Modern economists interpret the Law of Supply and Demand to mean that increases in demand raise price while decreases in demand reduce price; and increases in supply reduce price while decreases in supply raise price. In Part III of this series, I explained why these effects of demand on price are far from a law and that when an increase in demand raises price, that is probably an exception to the general rule.

Now let us take up the effect of changes in supply on price. The first thing to note about supply is that, unlike demand, supply is in the hands of the businessman. Nothing can force him to increase supply or reduce supply. That is his choice. When might he chose to increase supply?

We saw in Part III that this is likely to occur when there is an increase in demand for his product. In that case, the business sells more out of its stock of goods than it adds to that stock, and the stock (inventory) shrinks. If the business is making an acceptable profit at the current price, he is happy to increase output to meet the increased demand without raising price.

But, suppose a businessman has been making high profits and consequently has added to his capacity in order to produce and market additional output. The process of adding plant and equipment takes time, but at some point, the new capacity comes on line and the businessman has more output to sell. This is an increase in supply and the businessman has to cut his price in order to sell it. The cause is one of the most important laws in all of economics, the law of demand.

The law of demand says that there is an inverse relation between price and quantity, that when the price goes up, customers want to buy less and when the price falls, they want to buy more. In a subsequent posting, I will explain why the law of demand is a law, but for now, everyone can confirm its truth by their own personal experience: shopping for lower prices, looking for sales, refusing to buy a product whose price has risen, buying extra because the price is less than expected, and so forth. The businessman with additional quantity to sell will be able to sell it only by lowering his price. Thus, an increase in supply lowers price because the seller has to cut price in order to sell the additional quantity. (Obviously, this is true only if the additional products produced by the additional capacity are the same as the original products.)

What about a reduction in supply? If a businessman is selling at a price that yields a profit, it would be irrational to reduce his output—unless the demand by his customers declined. In that case, however, he would reduce supply to meet the reduced demand—the case discussed in Part III. But, suppose the businessman is losing money. If he raises his price, he knows he will sell less, but if the quantity decreases by less than the price increases, he will increase his profit. In this case (which is unusual), the businessman would raise his price and simultaneously begin to reduce his supply to meet the lower demand he expects. The higher price does not cause a decrease in supply, and neither does the decrease in supply cause a higher price. Both changes are created by the businessman’s choice. Once again, the standard interpretation fails to describe the facts.

In the next post, I will take up the argument that I think modern economists would raise against the analysis I have presented here.
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THE LAW OF SUPPLY AND DEMAND Part III

THE LAW OF SUPPLY AND DEMAND Part III

A series of essays based on Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by M. Northrup Buechner

In Part II of this series, I explained what is wrong with the standard interpretation of the law of supply and demand in economics—that at every free market price, the quantity demanded always equals the quantity supplied. A second interpretation of the law is also universal in economics. This interpretation uses the law to predict the effect on price of changes in supply and demand.

Every beginning economics student learns this doctrine: increases in demand raise price while decreases in demand reduce price; and increases in supply reduce price while decreases in supply raise price. On its face, this idea is false, and less obviously, it represents a misapprehension of the concepts of supply and demand.

When a businessman sets or changes a price, at a minimum, he intends to survive and continue in business at that price. Usually, though certainly not always, he expects to make a profit. Economists assume “profit maximization” as the standard of every business action. However one might interpret that standard, it is not a meaningful idea in the context in which businessmen normally choose a price.

Whether or not a particular price succeeds in reaching the businessman’s goals of survival and profit depends on the number of sales. Businessmen do not directly control the purchases by their customers; the only thing they directly control is the price. The quantity a businessman can sell is in the hands of his customers.

Consequently, the common pattern of business functioning is this: First the businessman chooses a price; then, if he is a manufacturer, he produces and sells the quantity his customers want to buy at that price. If he is not a manufacturer, he acquires the quantity he needs from his suppliers. If the quantity demanded by his customers increases, he does not raise the price; he increases his supply. If the quantity he can sell goes down, he reduces his supply. In general, businessmen do not raise price when the demand for their products increase and they do not reduce price when their customers want to buy less. I say “in general.” This is not a law. There are cases when sellers raise price when demand increases (for example, high-end fashion goods that “get hot”). The point is that those cases are not the norm, and certainly are not instances of a universal law—the law implied by the interpretation of the law of supply and demand in the second paragraph above.

I will take up the effect on price of changes in supply in my next post.
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