Supply and Demand

by Sir Hubert Douglas Henderson

Figure 2

In Fig. 2 we start as before with our demand curve, and supply curve, cutting one another at the point P. We then suppose that some alteration takes place in the conditions of demand; there has been a growth in the general taste for the commodity or service, and the demand, as we say, has increased accordingly. How is this fact to be represented in the diagram? Plainly not by taking another point on the curve, DD', at a further distance from OY. For this would merely indicate the larger amount that would be taken, if the conditions of demand had remained unaltered but the sellers had reduced their prices. The correct way of representing the change we have supposed is to construct a new demand curve (in the figure, the dotted curve dd'), lying at every point above the old demand curve. For this indicates that larger quantities will be purchased at the old prices, which is exactly what we want to represent. Similiarly if we wish to represent a change in the conditions of supply, such as might result, in the case of a commodity, from a tax imposed on its production, we must draw a new supply curve, ss', which in the case supposed, must lie everywhere above the old supply curve. On the other hand, the decrease or increase in demand or supply, resulting from a change in price, is represented simply by a shifting of the equilibrium from one point to another on the same curve. The striking pictorial contrast between a movement from one curve to another, and a movement along the same curve should help to make vivid to our minds the fundamental distinction between a change in the conditions of demand, arising from new tastes, enhanced purchasing power, etc.; and a mere change in the amount purchased resulting from an alteration in the price which the sellers ask. Words, as this necessarily cumbrous sentence shows, are a clumsy instrument for the expression of abstract relations; it is not very easy to see which words in a sentence are the significant, commanding ones, and which are performing, as it were, ordinary routine duties. A diagram is not exposed to similar ambiguities of emphasis.

The particular distinction, to which attention has been called, is important. The reader who has grasped it clearly will be able to perceive many instances of the confusion arising out of its neglect in the ordinary discussions of economic questions which take place in the press and on the platform. It is not uncommon, for instance, for an argument to run something like this: "The effect of a tax on this commodity might seem at first sight to be an advance in price. But an advance in price will diminish the demand; and a reduced demand will send the price down again. It is not certain, therefore, after all, that the tax will really raise the price." A glance at the diagram will keep us out of such a bog of sophistry and muddle. For if we suppose the amount of the tax per unit of the commodity to be represented by Ss, the curve ss' (drawn, as it is, roughly parallel to SS') will represent the new conditions of supply after the tax has been imposed. The new position of equilibrium will be given by the point P', where ss' cuts DD', the demand curve. Now P' lies to the left of P the old point of equilibrium; hence, since DD' must slope downwards from left to right, it is clear that, if, as it is fair here to assume, the conditions of demand have remained unaltered, the new price P'M', must be greater than the old.

§4. Reactions of Changes in Demand and Supply on Price. Having now made clear the meaning that must be attached to the terms, let us consider the question which naturally arises, whether we can lay down any general propositions or laws as to the effect upon price, of an increase or decrease in demand or supply. Another glance at the diagram suggests that we can. An increase in demand is represented in Fig. 2 by a movement from DD' to dd', which cuts the supply curve, SS', at p, to the right of P. Since the supply curve (drawn, as it is best to draw it, to represent the amount which will be supplied in response to a given price) must always slope upwards from left to right, the new price, pm, must be greater than the old, PM. Conversely a decrease in demand is represented by a movement from dd' to DD', and the new price is seen to be less than the old. We have already seen that a decrease in supply, which is represented by a movement from SS' to ss' results in a higher price; and it is the obvious converse that an increase in supply will have the opposite effect. It would seem then that we might lay down quite generally that an increase in demand or a decrease in supply will raise the price while a decrease in demand or an increase in supply will lower it.

But here it is necessary to be cautious. All conclusions as to the effects of causes are necessarily based, implicitly, if not explicitly, upon the assumption "other things being equal." This method of reasoning, which some people appear to find so irritating in the economic sphere, and as they say so "theoretical" and "unreal," is one which they adopt readily enough in every other department of life. No one, for instance, objects to the statement that the sun, when it comes out, makes a room warmer, although it may very well happen, if a fire is dying at the same time, that the room grows colder in point of fact. For in our general statement we assume implicitly that "other things" such as fires, are unchanged. But assumptions of this kind are legitimate only when there is no reason to suppose that the cause, the effects of which are being studied, will itself produce a change in the "other things." If (as I have often been told; I really do not know if it is true) the rays of the sun help to put a fire out, the statement made above would be the better for some qualification.

Now we can only say that an increase in demand raises price if we assume the conditions of supply (as represented by the supply curve) to remain unchanged. But in practice, an increase in demand may cause a change in the conditions of supply. An increase, for instance, in the demand for a commodity may give rise to a revolution in the methods of production, to the introduction of labor-saving machinery and so forth, which will eventually result in the commodity being produced more cheaply. It will certainly take a considerable time before reactions of this kind can exert an appreciable influence; and we can, therefore, feel reasonably sure that over a short period an increase in demand will raise the price. But we cannot be sure what the ultimate effect will be. A similar alteration in the condition of demand is less likely to result from an increase or decrease in supply; but it may conceivably occur. We must, therefore, be careful to qualify any general propositions which we lay down in this connection, by explicit reference to a short period of time. We can add the following to our body of laws:—

IV. An increase in demand, or a decrease in supply will tend to raise the price for a short period at least. Conversely a decrease in demand, or an increase in supply will tend to lower the price for a short period at least.

This law, like the others, applies to commodities, services, capital, to anything which can be said, literally, or by analogy, to have a price. "A short period" is, however, a vague expression and, since precision is the hallmark of an important law, we must accord to this one a status inferior to that which the preceding three can rightly claim.

§5. Some paradoxical reactions of price changes on supply. Let us turn, though, once more to these earlier laws, and with a heightened critical sense let us submit them to the test of the whole gamut of our experience, and see if in any of them we can find the smallest flaw. The first of them will pass through the ordeal—let each reader prove it for himself—unscathed. The second will emerge with a few hairs, as it were, singed. It tells us, for instance, that a rise in price will tend to augment the supply. Now there are some things the supply of which cannot possibly be augmented; these are the capital resources of nature, of which land is the most important for our present purpose. Land is bought and sold, it commands a price. In a certain sense, it may be said to be possible to increase the supply of land, in response to a rise in price, by drainage and reclamation schemes; and it will certainly happen that a rise in the price which land can command for any particular purpose will increase the amount which is devoted to that purpose. But, speaking broadly, the supply of land available for purposes of every kind is a fixed unvarying factor, with an inertia which the cajolery of price-changes is powerless to disturb. This is a most important fact, and it gives rise to some peculiar features of the price and rent of land, which we shall have to consider later as a separate problem. It constitutes a limiting case rather than an exception to the general law. But we have not yet done with the reactions of price upon supply. In the case of capital, the nature of those reactions has been much discussed as a highly controversial question. That a rise in the rate of interest will cause some people to save more than before, is generally admitted; but it is pointed out that the effect upon others may be the exact opposite, because it means that they do not need to save so much to acquire the same future annual income. It is unwise to say dogmatically that the former tendency outweighs the latter; though upon the whole it seems highly probable that it does. We cannot, therefore, in this case feel confident that a change in price will react upon supply in the manner which our law indicates. Similarly it is possible to argue that a rise in the general level of real wages may reduce the supply of labor, even, or some might say particularly, if the term is used to denote not the number of workpeople, but the quantity of work done. For there may be a tendency for workpeople, when more comfortably off, to work less regularly or less hard. Here again we cannot be sure. In none of these cases, however, including that of land, is there any reason to doubt that a rise in price will diminish demand, or conversely that a fall will increase it. Since, therefore, in the reasoning by which we deduced the third law, the conclusion will hold good, even if the effects of price-changes on supply are of the above paradoxical kind, provided that they do not continually outweigh the effects upon demand, there is no reason to cast doubt on the solidity of Law III, which, indeed, as we suggested before, commends itself directly to experience. But Law II seems now, perhaps, somewhat the worse for wear.