Supply and Demand

Central part of economics
Central part of economics

An old story says that if you want an “educated economist,” all you have to do is get a parrot and train the bird to squawk “supply and demand” in response to every question about the economy!

Not smart enough, but…

It’s true that the theory of supply and demand is a central part of economics.

It is widely applicable, and also is a model of the way economists try to think most problems through.

The theory of supply and demand is a theory of price and output in competitive markets.

Adam Smith (1723 – 1790) had argued that each good or service has a “natural price.”

If the price (of bread, for example), is above the natural price, then more resources will be attracted into the trade (bakeries, in the example), and the price will return to its “natural” level.

We may think of demand as a force tending to increase the price of a good, and of supply as a force tending to reduce the price.

When the two forces balance one another, the price would neither rise nor fall, but would be stable.

This stability leads us to think of an “equilibrium” price.

This “equilibrium” exists when the price is just high enough so that the quantity supplied just equals the quantity demanded.

At equilibrium, there is no competition either to buy or to sell, because everyone can buy or sell however much they may wish, at the going price.

Supply and Demand

But whenever the market is away from equilibrium, competition will arise and tend to force it back.

Alfred Marshall (1842 – 1924) compared the supply and demand sides to the two blades of scissors.

One won”t cut by itself. You have to have both!

One of the key words in economics is “allocation.”

To allocate resources is to determine who gets the use of what resources.

An obvious case of allocation of resources is when market processes of bidding, buying and selling determines who gets the use of what resources.

That is, in effect, markets can allocate resources.

Accordingly, economics is centrally concerned with the workings of markets, and with the question, how do markets allocate resources?

One answer to that question is expressed in the familiar phrase, “Supply and Demand.”

The allocation of resources through markets is a complex process.

There are several models of resource allocation through markets…

But the model of “Supply and Demand” is the best known and most widely used model!