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.