Equilibrium of normal demand and supply

Book 5, Chapter 3

§1. What determines supply in the market? An individual trader considers a  host of factors (p 281):

Dealers take account of the areas sown with each kind of grain, of the forwardness and weight of the crops, of the supply of things which can be used as substitutes for grain, and of the things for which grain can be used as a substitute… If it is thought that the growers of any kind of grain in any part of the world have been losing money, and are likely to sow a less area for a future harvest; it is argued that prices are likely to rise as soon as that harvest comes into sight, and its shortness is manifest to all. Anticipations of that rise exercise an influence on present sales for future delivery, and that in its turn influences cash prices.

From this, we can see how the market price depends on the mix of opinions from dealers, buyers and sellers, and how price volatility reflects differences in these opinions.

§2. The cost of producing a good depends on a mix of labor and capital costs (money paid), as well as their opportunity cost at the margin (money not paid). This formulation disagrees with Marx’s Labor Theory of Value because it evaluates capital costs not in terms of the embedded labor it took to produce that capital but in the capital’s alternative uses.

§3. The price for a good will depend on the cost of inputs needed to bring it to customers. Thus, a tree is cheap when it’s bought from the logger, but furniture made from that tree reflects the costs of transportation, transformation, design, retail rents, etc.

All market participants will change the mix of inputs as relative costs shift, to maximize profits. Thus Marshall introduces the Principle of Substitution.

§4. Most market participants watch each other, making it possible to assume a “single price” for a given good that changes with time and circumstances. The price will move up (or down) as demand exceeds (or trails) supply. Better run firms will expand faster (or contract slower) than worse run firms.

§5. The price of goods usually increases as quantity sold increases, due to the need to attract increasing quantities of inputs. Economies of scale (spending more capital to shift to larger machines) can lower costs at higher volumes, but that’s discussed later.

§6. Marshall describes “equilibrium” in price and quantity, before explaining how that equilibrium is moving more randomly than “a disturbed stone on a string returning to rest,” i.e.,

In an age of rapid change such as this, the equilibrium of normal demand and supply does not thus correspond to any distinct relation of a certain aggregate of pleasures got from the consumption of the commodity and an aggregate of efforts and sacrifices involved in producing it… We cannot foresee the future perfectly. The unexpected may happen; and the existing tendencies may be modified before they have had time to accomplish what appears now to be their full and complete work. The fact that the general conditions of life are not stationary is the source of many of the difficulties that are met with in applying economic doctrines to practical problems.

§7. Marshall gives one of his enduring metaphors for the relative importance of demand (value) versus supply (cost) in determining market equilibrium (p290):

We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens.

In the same way, when a thing already made has to be sold, the price which people will be willing to pay for it will be governed by their desire to have it, together with the amount they can afford to spend on it. Their desire to have it depends partly on the chance that, if they do not buy it, they will be able to get another thing like it at as low a price: this depends on the causes that govern the supply of it, and this again upon cost of production. But it may so happen that the stock to be sold is practically fixed. This, for instance, is the case with a fish market, in which the value of fish for the day is governed almost exclusively by the stock on the slabs in relation to the demand: and if a person chooses to take the stock for granted, and say that the price is governed by demand, his brevity may perhaps be excused so long as he does not claim strict accuracy.

…and with scissors and fish in hand, the chapter ends.

This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

Author: David Zetland

I'm a political-economist from California who now lives in Amsterdam.

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