Equilibrium of normal demand and supply, continued, with reference to long and short periods.

Book 5, Chapter 5

§1. “Normal” prices in markets for goods, services, labor, etc. can be pushed up or down to “abnormal” levels by technology, time, changes in season or tastes.

§2. Economists gain insights by via “ceteris paribus” (holding all other things equal) analysis that allows them to ignore complexities while focussing on the most important causal factors. Results are “cleaner” with more controls but less realistic. Marshall cautions against abuse (p 306):

But nothing of this [the world standing still] is true in the world in which we live. Here every economic force is constantly changing its action, under the influence of other forces which are acting around it. Here changes in the volume of production, in its methods, and in its cost are ever mutually modifying one another; they are always affecting and being affected by the character and the extent of demand. Further all these mutual influences take time to work themselves out, and, as a rule, no two influences move at equal pace. In this world therefore every plain and simple doctrine as to the relations between cost of production, demand and value is necessarily false: and the greater the appearance of lucidity which is given to it by skilful exposition, the more mischievous it is. A man is likely to be a better economist if he trusts to his common sense, and practical instincts, than if he professes to study the theory of value and is resolved to find it easy.

§3. Marshall recommends starting with a stationary state before introducing “partial perturbations,” which is now known as partial equilibrium analysis.

§4. He then explores how the prices of fish might vary in the short, medium and long terms. In the short term (day-to-day), prices rise and fall with weather, “meatless Fridays,” etc. When looking at the medium term (~2 years), these fluctuations might cancel out and they can be should be ignored while examining the impact of, e.g., a fall in demand for beef due to a multi-year plague that increases demand for fish. In such a case, prices will rise and stay there (should people permanently change their taste for beef) until long-term adjustments (e.g., more boats and fishermen) increase supply.

§5. Producers will consider time when responding to abnormal prices. In the short run, marginal producers will work harder to add more quantity to the market while incumbents enjoy excess profits from above-average prices. If abnormal prices look set to endure, then producers will alter their capital mix to fit the “new normal.”

§6. Producers will sell at a loss in the short run (e.g., when higher production costs cannot be recovered in prices), but not without considering impacts on the market, competition and their long-run (capital) costs. Marshall cautions: “he [the producer] regards an increase in his processes of production [VC and FC], rather than an individual parcel of his products [VC], as a unit in most of his transactions. And the analytical economist must follow suit, if he would keep in close touch with actual conditions” [p 312]. Economists should not let their theory stray too far from reality. In modern industrial organization, it’s “continue to produce while pq>c(q) — even if pq-c(q) < fc — but shut down if pq<c(q).”

§7. In the long run, investments in production capacity depend on the expectation of profits. Changes in those perceptions thus impact changes in long run supply, in terms of prices and quantities.

§8. Thus, Marshall concludes, short-run supply depends on current capacity whereas long-run supply allows for changes in capital and thus capacity. In both cases, prices also depend on changes in demand (tastes) as well as technology, which affects both supply (more efficient production) and demand (via the appearance of competing substitutes).

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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