Supply and Demand

by Sir Hubert Douglas Henderson

III. Price tends to the level at which demand is equal to supply.

These three laws are the cornerstone of economic theory. They are the framework into which all analysis of special, detailed problems must be fitted. Their scope is very wide. I have purposely refrained from introducing into my statement of them any reference to commodities; for they extend far beyond commodities. Subject to an important qualification, they apply to capital, the price paid for the use of capital being what we call the rate of interest. They apply hardly less to "services," to the remuneration of labor of every kind and grade. People sometimes protest warmly against the idea of treating labor "like a commodity." If this indignation expresses no more than a belief that in matters concerning conditions of work, and relations between employees and the management, the sensibilities of human nature should be taken into due account, it is based on elementary decency and commonsense. But if, as sometimes appears, it is directed against the fact that the remuneration of labor is controlled by the laws of supply and demand, it is a mere baying at the moon, with singularly little provocation. For these laws are in no way peculiar to commodities, and it is no one's fault that they include commodities too within their scope.

But let us go back to the laws themselves, and probe them and dissect them, and turn them this way and that, so that we may perceive their full content, and grasp it firmly in our minds. The third law implies a prevailing tendency for demand to be equal to supply. This tendency, as was suggested in Chapter I, can be verified by anyone from his experience and observation (provided he is a reasonable person, and not the tiresome kind who would dispute the law of gravitation because he sees that a feather falls to the ground more slowly than a stone). But it can also be deduced as a corollary from the two preceding laws; and to regard it in this way will help us to appreciate its significance. Start, for instance, by supposing that demand is in excess of supply. Then the price will tend to rise. After the price has risen, the supply will become larger, while the demand will fall away. The excess of demand with which we started will thus clearly be diminished. But if there remains any portion of this excess, the same reactions will continue; the price will rise further, and for the same reason; demand will be further checked and supply further stimulated. In other words, these forces must persist until the entire excess of demand over supply is eliminated. If we start by supposing supply to exceed demand, the converse chain of sequences will operate. Now these very simple steps of reasoning illuminate the nature of the normal equilibrium of demand and supply. They reveal that the equilibrium is established and maintained by the agency of changes in price, and they enable us to lay it down as perhaps the most important thing that can be said about the price of anything that it will tend to be such as will equate demand and supply. But that is not all that they reveal. They reveal also the extreme dependence of both demand and supply upon price. Now this is a fact which it is most important to realize vividly. It is apt to be obscured by customary modes of speech. In ordinary times the prices of most commodities and services do not change by very much, unless indeed over a long period of years; the amounts demanded and supplied may therefore seem to maintain a fairly constant level; and we may be tempted to speak of Great Britain producing so many million tons of coal, or America consuming so many millions of motor-cars per annum, almost as though these quantities were independent of price considerations. But we should never forget that there is no service or commodity produced by man, however essential it may seem, the demand for or the supply of which might not be reduced to nothing, if the price were sufficiently raised on the one hand, or lowered on the other. How easy it is sometimes to forget this simple truth may be seen from the mistake so commonly made of supposing, because the peoples of Central Europe were left, on the cessation of the war, starving and destitute of the means of life and the materials of work, that they must necessarily become heavy purchasers of imported goods; without pausing to consider whether the prices were such as they could afford to pay.

§2. Diagrams and their Uses. It will help to prevent mistakes like this and more generally to make sharp and clear the fundamental relations which exist between demand, supply and price, if we exhibit them pictorially in the form of a diagram. Such diagrams are of great service in many parts of economic theory, not because they can prove anything which could not be proved otherwise, but because, being really a simpler medium of expression than words, they enable the mind to grasp more readily and to retain more vividly the essential facts of complex relations.

Figure 1

In Fig. 1 the curve DD' represents the conditions of demand. It is supposed to be drawn in such a way that if any point, Q, be taken on the curve, and the perpendicular QN be drawn to meet the base line, or axis OX, then ON will represent the amount that will be demanded at a price represented by QN (or Ol). In other words, distances measured along OY represent prices, and distances measured along OX represent quantities of the commodity, or service, or whatever it may be. Clearly, then, the demand curve, DD', must slope downwards from left to right, since the lower the price asked, the greater will be the amount demanded. Similarly the curve SS' represents the conditions of supply. It is supposed to be so drawn that if any point q be taken upon it, and the perpendicular qN be drawn to meet OX, then ON will represent the amount that will be supplied at a price represented by qN (or Ok). Equally clearly this supply curve must slope upwards from left to right, since the higher the price obtainable, the greater will be the quantity offered. Take the point P where the two curves meet, and draw the perpendicular PM to meet OX. Then the third law enunciated at the beginning of this chapter corresponds to the statement that PM or Om will represent the price at which the commodity or service will be exchanged.

It can readily be seen that no other price could be maintained. For suppose the price to be less than Om, suppose it to be Ok, then, at this price, ON (or kq) will be the amount supplied, and kr the amount demanded. The demand will thus exceed the supply, and the price will tend to rise, i.e. to move upwards towards Om. Similarly if we suppose the price to be Ol, which is larger than Om, the supply (lR) will exceed the demand (lQ) and the price will fall downwards towards Om. Thus, again, we have deduced Law III from Laws I and II with the form and precision of a proposition in Euclid. Now, when once the eye has become familiar with this diagram, it ought to be impossible for the mind to lose even momentarily its grip on the fact that demand and supply are both dependent upon price. For these curves do not represent any particular amounts; they represent a series of relations between amount and price; if the price is QN the amount demanded is ON, and so forth. The terms demand and supply in the sense, in which I have been using them, of the respective amounts demanded and supplied are, indeed, strictly meaningless without reference to some particular price. The reference may sometimes be implicit; but, whenever there is a chance of ambiguity, it should be explicitly made.

§3. Ambiguities of the Expressions, "Increase in Demand," etc. It is the more important to be precise upon this point, in that there is a further possible confusion which we have now to consider. Demand and supply, as we have seen, are dependent upon price; but equally clearly they are dependent upon other things as well. Demand depends upon the needs, tastes and habits of the people, as well as upon the length of their purse; supply depends upon such things as the cost of production in the case of commodities. None of these things are constant factors, all of them are liable to change, and it may well happen that we shall want to consider in some concrete problem the probable consequences of such a change. Now the most usual and natural way of describing such changes in the medium of words is to use the expression "increase" or "decrease in demand," and "increase" or "decrease in supply," the same expressions, which we employed before to describe the consequences of a change in price. This identity of language conceals a fundamental distinction between the phenomena described; and to make this distinction plain we cannot do better than revert to our diagrammatic presentation of the laws.