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.