WHAT DETERMINES PRICES:SUPPLY AND DEMAND

What determines individual prices? Why is the price of
eggs, or horseshoes, or steel rails, or bread, whatever it
is? Is the market determination of prices arbitrary,
chaotic, or anarchic?
Much of the past two centuries of economic analysis, or what
is now unfortunately termed microeconomics, has been devoted
to analyzing and answering this question. The answer is that any
given price is always determined by two fundamental, underlying
forces: supply and demand, or the supply of that product and the
intensity of demand to purchase it.
Let us say that we are analyzing the determination of the price
of any product, say, coffee, at any given moment, or “day,” in
time. At any time there is a stock of coffee, ready to be sold to the
consumer. How that stock got there is not yet our concern. Let’s
say that, at a certain place or in an entire country, there are 10
million pounds of coffee available for consumption. We can then
construct a diagram, of which the horizontal axis is units of quantity,
in this case, millions of pounds of coffee. If 10 million
15
pounds are now available, the stock, or supply, of coffee available
is the vertical line at 10 million pounds, the line to be labeled S
for supply.
16 The Mystery of Banking
FIGURE 2.1 — THE SUPPLY LINE
The demand curve for coffee is not objectively measurable as
is supply, but there are several things that we can definitely say
about it. For one, if we construct a hypothetical demand schedule
for the market, we can conclude that, at any given time, and all
other things remaining the same, the higher the price of a product
the less will be purchased. Conversely, the lower the price the
more will be purchased. Suppose, for example, that for some
bizarre reason, the price of coffee should suddenly leap to $1,000
a pound. Very few people will be able to buy and consume coffee,
and they will be confined to a few extremely wealthy coffee fanatics.
Everyone else will shift to cocoa, tea, or other beverages. So
if the coffee price becomes extremely high, few pounds of coffee
will be purchased.
On the other hand, suppose again that, by some fluke, coffee
prices suddenly drop to 1 cent a pound. At that point, everyone
will rush out to consume coffee in large quantities, and they will
forsake tea, cocoa or whatever. A very low price, then, will induce
a willingness to buy a very large number of pounds of coffee.
A very high price means only a few purchases; a very low
price means a large number of purchases. Similarly we can generalize
on the range between. In fact we can conclude: The lower
What Determines Prices: Supply and Demand 17
1Conventionally, and for convenience, economists for the past four
decades have drawn the demand curves as falling straight lines. There is no
particular reason to suppose, however, that the demand curves are straight
lines, and no evidence to that effect. They might just as well be curved or
jagged or anything else. The only thing we know with assurance is that they
are falling, or negatively sloped. Unfortunately, economists have tended to
forget this home truth, and have begun to manipulate these lines as if they
actually existed in this shape. In that way, mathematical manipulation begins
to crowd out the facts of economic reality.