The vertical axis represents price for any commodity and the horizontal axis indicates quantity of that commodity. Within the chart there are two lines that cross, “S” for supply and “D” for demand. The supply curve indicates the amount of any commodity that producers are willing to supply at a given price, while the demand curve indicates the amount of that commodity that consumers are willing to buy at a given price. The point where the two lines cross, labeled “E” is called the equilibrium point, while “Q1” and “$1” represent the quantity and price at the equilibrium point. The chart is based on an intuitively obvious idea, namely that buyers want to spend as little as they can and suppliers want to get as much as they are able. Hence, the lower the price of something, the more consumers are willing to buy of that product, while the higher the price, the more suppliers are willing to produce. The equilibrium point represents the balance between supply and demand, the point where buyers are willing to buy the exact amount that producers are willing to supply at that price.
This deceptively simple chart is an extremely powerful tool, and economists put it through all sorts of permutations to arrive at all sorts of conclusions. None of that need concern us here; at this point we are mainly interested in understanding the idea of equilibrium, and how societies get to that point. . It is no exaggeration to say that the entire structure of modern, neoclassical economics is built on this chart. Therefore, some comments on the chart are in order. The first thing that we must note is that this is an idealized representation; it represents equilibrium in a static moment, but an actual economy is dynamic; prices change from day to day and even from hour to hour. Because it is an idealized portrait, it shows equilibrium as a precise and knowable point that is actually reached. In a real economy and for any real product, the equilibrium point is rarely known with any precision, but forms an attractor point around which prices and quantities fluctuate. And it should be noted that while we call them “supply” and “demand” curves, they are really both demand curves, since the supply curve represents the producers’ demand for the commodity known as “money.” This would be self-evident in a barter economy. If someone were trading shoes for fish, we would place fish on one axis (it doesn’t matter which one) and shoes on the other, and both parties would be simultaneously “demanders” and “suppliers.” It is only in a money economy, where goods and services are measured in terms of one special commodity that we can strictly separate “suppliers” from “demanders.” It is important to remember this, because in a money economy, most people become demanders only after first being suppliers, usually by supplying to the market the commodity known as labor.
The Demand Curve
Demand is affected by the consumer’s income level, his needs, tastes, and preferences, the prices of other goods, and his expectations of any changes in price levels. If a consumer’s income increases, some portion of the increase will contribute to an overall increase in demand. So, for example, an increase in the minimum wage might raise overall demand and affect the equilibrium point. What the equilibrium point really measures in not overall demand, but effective demand, by which we mean both the desire for the product and the ability to pay for it. Note that in a market system, the equilibrium point will always be less than total demand, usually substantially less. Hence, certain common goods, such as police or schools or roads are not normally provided as market goods (or some would receive none of them) but as socialized goods.
Needs, tastes, and preferences are often regarded as “individual choices”; however the truth is much more complex. While these always appear as personal actions, they are actually socially influenced. In fact, a lot of what we are has little to do with “individual choice.” For example, most readers of these words speak English not as an individual choice, but as a social gift; we were given the English language long before we realized that we might have some choice in the matter. Our preferences are heavily influenced by such things as fashion, advertising, work-place dress codes, and social conventions. Even those who wish to escape the conventional most often do so by substituting other conventions. For example, a teen-ager objecting to conventional styles may adopt “goth” styles, a social “sub-group.” Examples of a “pure” individual choice are hard to come by. Economists tend to model demand as the aggregate of purely individual choices, but this may not be the best model of what humans actually do.
Prices of other goods affect demand because we must make choices; to purchase a quantity of commodity A precludes us from using the same money to purchase B. Further, many products have substitutes. For example, if the price of beef increases relative to the price of pork, many people will substitute pork for beef in their diets. Hence a producer competes not only against others producing the same product, but against those producing products that can be substituted for his.
Another thing we may note about demand is its elasticity. Elasticity measures how much a change in price is required to change the volume purchased. Some products are highly elastic; a small change in price will lead to large increases or decreases in what is purchased. Other products are inelastic; it takes a large change in price to change buying behavior. For example, most of us must use a certain amount of gasoline to get to work, and have difficulty finding an alternate means of transportation. Therefore, we are likely to pay whatever the market demands for gas, making gas an inelastic commodity.
The idea that as a commodity's price falls people will tend to purchase more of that commodity is called The Law of Demand. However, it is not really a law in the way that gravity is a law, always and everywhere operative. Rather, it is a tendency, and as such there are many exceptions. Some products actually depend on the price being unreasonably high. A Ford will get you where you are going as well as will a Jaguar, but a Jaguar will display your wealth along the way. If the price of Jaguars were lowered to that of Fords, it is likely they would, after a time, sell less of them, not more. A more common example is athletic shoes. A $130 pair of Nike’s may or may not be any better than the $30 no-name pair that comes out of the same shoe factory in Vietnam. But by placing the “swoosh” on the shoe, the seller can get a large premium, a premium which contributes to the product’s image and exclusivity. Again if he lowered the price to $30, there would be nothing to distinguish it, and sales might actually fall. Nevertheless, and even with all these caveats, the law of demand is still a useful concept, even if it isn’t really a law.
Taking all these things together, we note that the deceptively simple supply curve encodes a tremendous amount of information. Any change in the factors making up the supply curve can have large consequences on the shape of the curve and hence on the equilibrium point. Moreover, this encoded information is largely social. Our actions are influenced by others and, in turn, influence others. For example, when we choose to buy a giant Hummer, we increase the demand for gasoline, and thus affect the price that everyone else pays for it, even those who have no interest in monster-sized cars.
The Supply Curve
As complex as the demand curve is, the supply curve presents even more challenges. In the standard, neoclassical theory of economics, it is relatively straightforward: firms supply product to the market until marginal revenue equals marginal costs; this is called marginal cost pricing. “Marginal” here means the cost or revenue for the last unit produced. Marginal revenue is simply the price of the product. Marginal cost, however, is highly complex. In general, we know that with a given amount of equipment and labor, we can produce one more unit of a product for a low additional cost, up to a point. Beyond that point, costs per unit will actually start to rise. It will cost more to make the last unit than the product actually sells for; hence there is no reason to produce past this point. Firms will produce product up to the point that marginal costs equal marginal revenues. Under conditions of perfect competition, this will provide the greatest possible amount of goods to the market at the lowest practical price. Society will benefit, and the firm will make a reasonable, but not outrageous, profit.
The theory is sound; however, actual practice diverges from this theory more often than not. In the first place, knowing the “marginal revenue” means knowing what the demand curve will be, and this is generally just a guess, for all the reasons we have already mentioned. But it is the marginal cost that is most problematic. When an economist thinks of costs, he thinks of all the resources that were consumed in making the product. The businessman, however, only thinks of the costs he actually has to pay. Other costs may be externalized, that is, placed upon thirdparties who are not necessarily purchasers of the product. For example, the owners may get the government to build them roads, finance their facilities, pay part of their work force (with food stamps or housing vouchers, for example), give them tax rebates, etc. The most obvious example of an externalized cost is pollution. A manufacturing process may dump highly toxic chemicals into the air, the land, or the water, causing health problems for everybody else. This is a real cost, but one that does not show up in the business owner's calculations. But even considering just internal costs, these turn out to be complex and difficult to measure, and few companies actually undertake such an analysis. Rather, they depend on strategies other than marginal cost pricing.
If a company has a patent on a product for which there are no substitutes, it may engage in monopoly pricing. This is especially the case in the drug industry, where patent protection allows the drug companies to charge $10’s or $100’s of dollars for a pill that may cost pennies to manufacture, even considering research costs. If there are a few companies in the same business, they may engage in a similar practice, oligopoly pricing. They may use package pricing, relying on the reputation or packaging of the product to obtain a higher price, as in the
Having drawn all of these caveats around the supply and demand curves, have we not then shown that the “Magic Chart” is not really valid? Well, perhaps, but I don’t think so. All we have shown is that the standard tools of neoclassical analysis may not be the best way to understand equilibrium. The theoretical model may be insufficiently “scientific,” that is, not really well-related to the way things really work. The truth is that all successful economies reach equilibrium, more or less. But the problem (and the analytical challenge) comes in the fact that they reach it through both economic and non-economic means. It is the means by which equilibrium is reached that must be correctly analyzed.
When people come together in families or firms to produce things, they add wealth to the economy; in fact, this is the only economic way to add wealth. If they get an equitable share of the output, or the wealth they create, there will be enough purchasing power in the economy to buy all the things they produce. This is the much-maligned “Say’s Law of markets,” which states that “supply creates its own demand.” When there is an excess of goods supplied to the economy, we have a recession, or worse. Say’s Law is much criticized because if you examine it closely, it says that recessions are impossible; there will always be enough purchasing power to clear the markets. Clearly, we purchase things in terms of other things. If, for example, you are a fisherman and you want some shoes, you catch some fish and trade them with the cobbler (in a barter economy). The total number of things created equals the total number of things that can be used for purchasing the other things. The two quantities are in fact the same quantity, so that there can never be a shortage of purchasing power in the economy. Granted, there may be a temporary disequilibrium in any particular market. The fisherman may catch more fish than people really want to eat; the cobbler may make too few shoes. But such a situation will normally not persist. A fisherman who cannot sell all of his fish will cut back on the time spent fishing and devote himself to other things. Perhaps leisure, or perhaps he will take up cobbling, thereby adding to the supply of shoes. But in any case, a recession in these circumstances cannot be of long duration or great importance. And yet, recessions do happen, quite obviously. Long ones. Deep ones. Serious ones. So what is wrong with Say’s “Law”?
To understand the problem, we have to look at the sources of demand in a money economy. And these sources are two: wages, and interest or profit. Wages are, of course, the rewards of labor, and profit the reward of capital. In another sense, however, these are the same rewards since capital is merely “stored-up” labor, or things produced in one period to be used to continue production in the next period. For example, if a farmer wishes to have a crop next year, he must save some seed-corn from this year’s crop. Now, the corn he consumes and the corn he saves are the same corn from the same crop. But by saving some corn for seed, it becomes “capital.” Hence, the return on this capital is really a return on his prior-period labor, just as his wages are a return to current-period labor. Clearly the returns to capital and labor, interest and wages, spring from the same source (labor). Capital, then, ought to have roughly the same rewards as labor, plus some premium for saving. Or, to put it in “eco-speak,” the returns to capital and labor should be “normalized” to each other. This normalization of incomes from capital and labor is the condition of equity in an economy. That is, the same kind and quality of labor, whether in its original or “stored-up” form of capital, should produce roughly the same return.
Interest (or profit) and labor constitute the economic sources of demand, and if they are normalized to each other, economic recessions are unlikely. There will be enough purchasing power distributed equitably to clear the markets. In capitalist economies, the vast majority of men are not capitalists; that is, they do not have sufficient capital to make their own livings, either alone or in cooperation with their neighbors, but must work for wages in order to live. And since the vast majority of men and women work for wages, then the vast majority of goods will have to be distributed through wages. In conditions of equity, this will not be a problem; so long as there is equity, there is likely to be equilibrium, and periods of disequilibrium are likely to be brief. But it may happen, and quite often does, that interest and wages are not normalized to each other. In almost all cases (although there are exceptions), this means that capital gets an inordinate share of the rewards of production. This, in turn, means that the vast majority of men and women will not have sufficient purchasing power to clear the markets, and the result will be a disequilibrium condition, that is, a recession. When this happens, governments and societies often look to non-economic ways of restoring equilibrium.
The major non-economic means of restoring equilibrium are charity, welfare and government spending, and consumer credit (usury). Each of these methods transfers purchasing power from one group, which presumably has an excess, to another which has a deficit. The first method, charity, will always be necessary to some degree. This is because even in the most equitable and well-run economies, there will always be people who are incapable of making a decent living, perhaps because of mental impairment, moral deficiency, or physical handicap. One hopes that there is enough generosity and benevolence in society to voluntarily cover the needs of these people. However, when low wages become widespread, and when self-interest becomes the dominant motivation in society, it is likely that charity will be insufficient, and other means must be used.
The second non-economic means is welfare and government spending in general. By these means, the government seeks to re-establish equilibrium conditions either by supplementing the income of some portion of the population, or simply by increasing its spending to create more jobs and thus add more purchasing power to the economy. This strategy is at the heart of Keynesian economics. The “market” economy is allowed to continue to produce inequitable (and therefore disequilibrium) conditions, but the government will tax and redistribute the excess incomes in an amount sufficient to restore equilibrium. For a while, this method worked fairly well. However, it created some problems. In the first place, it created entitlements. Unlike charity, which depends on the benevolence of the donors and may evoke gratitude on the part of the recipients, welfare depends on the police powers of government and is more likely to evoke resentment on the part of both the recipients and the “donors.” Further, these re-distributions require increasingly intrusive bureaucracies to collect and disburse the funds. The recipients, no less than the donors, find that every aspect of their life is subject to government review and control, and this is never a comfortable feeling for either.
Despite the fact that Keynesian transfers now consume a huge portion of the federal and state budgets, these transfers have been, for some years now, insufficient to balance supply and demand, and for some time now the economy has depended chiefly on the third method, usury or consumer credit. Here we must distinguish between lending for investment and usury. Investment means giving money to firms and entrepreneurs in order to expand production and increase the wealth of society. In this case, interest is merely the investor’s participation in the profits; it is the “wage” of the capital supplied, and the one who supplies it is entitled in justice to that wage. Usury, on the other hand, is lending money at interest to increase consumption. Nothing is added to the wealth of society, however much may be added to the wealth of the lender. Since nothing is produced, there is no valid claim to profit; interest payments in this case merely constitute a transfer of wealth from the borrower to the lender, but no net increase in the social stock of wealth. In fact, wealth is actually “used up” in this process without making a contribution to production, hence the name “usury.”
This is the plastic economy, an economy based on credit cards. And to the extent than an economy depends on consumer credit, it is, quite literally, a house of cards, and will be as unstable as those structures usually are. In fact, usury is the most destructive way of increasing demand. Usury actually delays the problem, postpones the crisis to a future period. This is because a borrowed dollar used to increase demand today must be paid back tomorrow and hence decrease demand in a future period by that same dollar—plus interest. This requires more borrowing, which of course only makes the problem worse. Eventually, the system falls of its own weight, as credit is extended to an increasingly weakened consumer, and a credit crisis results.
Non-economic equilibrium provides us with a measure of just how well an economy is doing in economic terms. If the economy has a high dependence on non-economic means, we may assume that there are serious problems in the economy itself. This is an important point. Those who wish to scale back the extent of government involvement in the economy must first analyze the failures in the economy that make heavy government involvement necessary. Those who would effect a cure, must first analyze the cause. And the cause is always and everywhere the same: a lack of justice.
 There are non-economic ways to add wealth to a nation, such as plundering other countries.
 There is actually a third source of income, economic rent, or an amount paid beyond what it takes to keep an asset in productive use. Economic rent introduces some serious complications, and will be dealt with in a later chapter.
 However, there may be “non-economic” or “exogenous” causes for a particular recession, such as flood, famine, or plague.