The Relation of Price and Demand
( Originally Published Early 1900's )
THE laws which we have to consider in this chapter are so wide-reaching in their operation that they may be justly regarded as the fundamental ones of economic science. In accordance with a general principle of scientific method, we have to begin the study of these laws by showing how they operate in the simplest cases. What these cases are will be seen by recalling the principal industrial and commercial operations as they have already been described. These operations consist, in brief, in producing goods, taking them to market, and selling them to persons who want to use them. In the case of most products a number of sales are necessary, because nearly every person who makes anything has to buy the materials with which to make it, and after it is made it may pass through several owners before reaching the final consumer. The simplest case which will include all the elementary operations is that in which a commodity is made by some producer, brought to market, sold by the producer to a dealer, and by him to the person who is to consume the commodity. In this case there are two exchanges. The difference between the prices at which the two sales are made will represent the profits and expenses of the dealer.
Let us take the purchase and sale of flour as an example. In accordance with what has been said, we have three classes of people to deal with :
I. Producers of flour. These producers actually comprise farmers, millers, and dealers. But, to make our first consideration as simple as possible, we shall combine them all together in the persons of the one class who bring the flour to market and sell it.
II. The dealers who purchase the flour from the producers.
III. The consumers of flour, who purchase it from the dealers in order to make it into bread for consumption.
Still further to fix the ideas, we shall take the city of New York as an example of a market. In and near this city there is a population of some 2,000,000 to be supplied with flour. Then the classes of people above described will be, firstly, those who are bringing flour to New York for sale; secondly, the dealers who purchase it at wholesale ; thirdly, the two millions of people who are buying it from the dealers to eat.
There are in reality many grades of flour, and the prices of different grades will differ. But, to make our first example as simple as possible, we shall suppose but a single average grade.
Since the dealers are the owners of all the flour they sell, or act as agents of the owners, we may consider them at liberty to charge what price they please. But the quantity which they can sell depends upon the price they charge. The relation between the price and the sales may be called the law of price and demand, and is such that the higher the price the less the quantity which can be sold.
The reason of this law is that every rise in price will lead to economy and retrenchment on the part of consumers. The diminution in the amount sold arises in two ways :
Firstly, by leading consumers to be more economical in the use of flour, eating and wasting less bread.
Secondly, by leading them to employ substitutes for flour, such as corn-meal, oat-meal, or potatoes.
We readily see that the diminution in the consumption arising from an increase of the price will be different with different classes of consumers. The wealthy do not take any account of the price of flour in determining whether they shall or shall not eat bread. The lower we descend in the scale of wealth the more rigorous the economy which must be practised, and the greater the diminution in consumption which will be caused by a rise in price.
We now have the following definitions of certain words which will be in almost constant use.
By market is meant a place or region where one or more commodities are bought and sold on a large scale. Chicago and New York are great wheat markets. Many thousands of farmers in the Northwestern States send their wheat to the former city for sale, while American and European dealers purchase wheat or flour in New York. The essential feature of a market is that the price of the commodity is publicly known, so that everybody knows very nearly at what price other people are buying and selling.
By the supply of a commodity is meant the quantity of that commodity brought to any market for sale. For example, if we find that there are to-day 100,000 bushels of wheat in Chicago awaiting purchasers, we might say that the supply to-day is 100,000 bushels. But it is better to consider the supply as the total quantity brought to market for sale in the course of a year, or other unit of time, rather than as a stock on hand.
By the demand for a commodity is meant the quantity of that commodity which can be actually sold in any market at any given price during a year or other unit of time.
We must carefully distinguish between this economic signification of the term demand and the popular one, which merely implies desire to purchase. No amount of mere desire for a commodity is sufficient, in itself, to constitute a demand. The latter arises only when the person desiring has the means as well as the willingness to purchase. " There is no demand, economically speaking, in the hungry eyes of a penniless boy looking at tarts through a pastry-cook's window. Without pennies an unlimited longing and passion for their consumption would not permit that boy to contribute aught to the demand for tarts."
Introducing the word demand, the law of price and demand which we have already mentioned may be expressed as follows :
FIRST LAW: Other conditions being equal, demand varies with price in such a manner that as the price increases demand diminishes, and vice versa.
Universal Applicability of the Law of Price and Demand. The law of diminished demand with increased price applies not only to goods bought and sold in market, but to every form of service for which people pay money. If hack-men charge too much for the use of their carriages, fewer people will employ them and more people will walk or take the street-cars. If a theatrical manager puts the price of his tickets too low, more people will apply for them than the theatre will hold ; if he sets the price too high, some of the seats will be empty. If bricklayers demand higher wages, fewer people can afford to build houses. By lowering their wages the number of people who can afford to employ them is in-creased. When a Washington newsboy finds the day passing away without his supply of New York papers being disposed of, he lowers the price from five to three or two cents, knowing that he may thus sell at a low price papers which he would otherwise have to lose entirely.
Sensitive and Insensitive Commodities. Let us next inquire whether we can make any approximate estimate of how much the demand will fall off with a given increase of price. First let us see why it falls off at all. The reason is that the income of people in general is limited. If, therefore, prices rise without any general increase of income, it will be impossible for individuals to purchase the same amount of everything as before. The fundamental question we have been considering is, How will demand vary with price, all other conditions being equal? Among the other conditions which, by hypothesis, remain equal are the incomes of the purchasers. Since, then, each man has an equal amount of money to spend whether the price be high or low, the sum total which he can purchase with his money will vary inversely as the price. For instance, if prices should all be doubled, the could purchase on the average only half as much as before. We may now reasonably suppose as an average rule that the result will be the same for each separate commodity that it is for things in general; that is, that the quantity sold or demanded will vary inversely as the price. For example, if it is a question of how many peaches a man will purchase for his table, we may suppose that each person will be willing in the course of the summer to reserve a certain definite amount of his income for buying peaches. Then if the price is one half the usual one, he will buy twice as many as before ; and if it is double, he will buy one half as many.
However sound this rule may be in its application to the general average of all the things exchanged, we cannot suppose it to be true of each commodity considered separately. For both as a matter of fact and by reason we know that the demand for some commodities will fall off much more than that for others in consequence of a given increase of price. We need words to express these differences, and therefore shall adopt the following definitions :
Sensitive commodities are those the demand for which falls off most when the price is raised.
Insensitive commodities are those the demand for which is but little changed by changes in price.
We readily see that those commodities will be insensitive on which consumers have the least ability or the least inducement to economize. A few examples will make this clear.
Pepper, mustard, and table condiments generally will be insensitive because their cost is insignificant. Tobacco is insensitive because a man who becomes addicted to it finds it so difficult to give it up that he would rather economize on something else if the price of tobacco rises. Nearly the same re-mark applies to wines and spirituous liquors, so far as their use as beverages is concerned.
Food considered as a whole is an insensitive commodity, be-cause it is most difficult for any one to go with much less than his accustomed quantity. But if the price of only one particular kind of food rises, it might prove to be sensitive, because some other kind would be substituted for it. For example, if the price of potatoes rises, bread can be eaten instead of potatoes, and vice versa. So one kind of bread or meal can be used instead of another. But if the prices of all sorts of food should rise in the same proportion, there would be no motive to substitute one for the other, and people would have to economize on something else.
On the other hand, clothing, especially fine clothing, is probably sensitive commodity. Most people could make their old clothes last a good deal longer than they do ; there is there-fore a strong inducement to buy fewer fine clothes, or no fine clothes at all, when the price rises. The same is true of those luxuries which people indulge in only as their means increase.
As we ascend in the scale of luxury we find that the demand for commodities depends more and more on the cost of things below them in that scale, and therefore proportionally less on their own cost. Hence we cannot strictly classify them as being, in themselves, sensitive or insensitive.
Investments and other forms of capital are a case in point. Many people save up a part of their annual income to be invested in bonds, stocks, and other interest-bearing securities. If then the price of anything which they deem necessary rises, they may stop saving and spend their surplus income in paying the increased price for the necessary articles of current consumption. This will tend to make the necessaries and small luxuries of life less sensitive than the average, because by economizing in investments and costly luxuries consumers will have more money to spend on other things.
16. Reaction of Demand on Price. In what precedes we have compared the effect of different scales of prices for a commodity when the general conditions which exist in the market remain unaltered. Our conclusion has been a law according to which a cause which changes the price of a commodity, without at the same time changing anything else, will change the demand. This limitation is expressed by the condition "other things being equal." Although other conditions are always equal for the time, yet as a matter of fact they do not remain equal from one time to another. That is to say, although it is certain that to-day, or any other day, more flour can be sold at $5 per barrel than at $5.10, yet it is possible that more can be sold at $5.10 tomorrow than can be sold at $5 to-day. Some new use may be found for flour, or it may suddenly be wanted to make up a failure of the crops in Eu-rope. Then there will be an increase of demand, even if the price should remain unaltered or should be raised. Since in this case a greater quantity can be sold at the old price, dealers will be able to increase the price, while at the same time selling a greater quantity than before. Self-interest will prompt them to do this. Hence we have a second general law :
Other conditions being equal, an increased demand for any commodity increases its market price.
Combining this law with the other, we see the nature of the mutual interaction between price and demand. Weak reasoners sometimes find it hard to see that increase of price causes diminished demand, and that diminished demand diminishes price. In reality this mutual interaction is necessary to equilibrium. If increase of price acted on demand so as to increase it also, we should have an increasing price causing an increased demand; this increased demand would again increase the price, and so the two would go on increasing without stopping. Evidently this can never be the case. But since the actual rule is, increasing price diminishes demand, this diminished demand tends to diminish the price; a state of equilibrium is reached between the opposing forces ; a rise of price is checked by the falling off of demand, and falling price is stopped by stimulating demand, which keeps it from falling without limit.
Our next inquiry is how the two preceding laws connecting price and demand are to be modified so as to apply to the actual way in which business is done. The case to which the laws apply without modification is that when the demand which we consider comes from the people who actually consume the products, and when the price which we consider is what those people have to pay. Of course this price is generally the retail price. Now, will the same law apply in the wholesale markets, and in those cases in which large purchases of goods are made, not for purposes of consumption by the producer, but for re-manufacture into other things ?
Granting that consumption and retail prices are connected by the laws already laid down, we remark that the retail and wholesale prices necessarily vary together, so that the consumption must indirectly depend upon the wholesale price. Now, although it is not always true that the retail price varies immediately with every change in the wholesale price, yet these two prices must in the long-run correspond to each other, at least in the case of the great staples of life. Suppose a grocer to purchase flour at $4 and to sell it at $4.25. It is certain that if the wholesale price is increased 25 cents, he cannot continue to sell at the same price as before. If the wholesale price falls, he will have to lower his price in a corresponding degree, or other dealers will undersell him and he will lose his customers. Thus, as a general rule, the profit in selling at re-tail will be the lowest which will permit the retail dealers to meet all the expenses of their business and compensate themselves for their labor and skill. The modifications to which this general rule is subject will be considered in future chapters. We therefore conclude that, as a general rule, the demand will increase as the wholesale price diminishes, and vice versa, because the wholesale and retail prices vary together.
Equilibrium of Supply and Demand. In a normal state of things the price will be so adjusted as to preserve an equilibrium between the supply and demand. To return to our illustration, suppose that, the price of flour being $5 per barrel, the dealers of New York find that the quantity which comes into their market is sold nearly as fast as it arrives; there will then be no occasion for a change in either the supply, the demand, or the price. Suppose then that there is an unusually good crop, or that from any cause whatever an increased supply is brought to market, the conditions of the market otherwise remaining the same. The result will be that so long as the price remains at $5 the increased supply will accumulate on their hands. In order to get rid of it they will be obliged to lower the price. This will cause an increased demand both at home and abroad, according to the first law. The normal equilibrium will be reached when the price is so fixed that the increased demand thus caused exactly balances the increased supply.
Suppose, secondly, that instead of an increased supply there is a diminution in the supply. Then the people who go to market offering $5 per barrel cannot all be supplied. To decide who shall be supplied, the dealers raise the price. This action will, by the first law, diminish the demand. The normal price will be that which brings the demand down to the supply.
To illustrate the second law, let us consider that the supply remains constant, but that the change occurs in the demand. Suppose that owing to a failure of the European crop there is an increased demand. The immediate result will be exactly the same as in the case of a diminished supply. The demand cannot be entirely satisfied and the price must be raised. The rise in price will have the double effect of increasing the sup-ply and diminishing the demand. When they are equalized equilibrium will be restored.
Discounting the .Market. The sale of goods at retail for consumption generally goes on at a very regular rate. But in the wholesale market the changes may be sudden to any ex-tent, the exchanges being determined not merely by the present price, but by the judgment of men as to what the price or the supply is going to be in the future. If, in the opinion of a wholesale dealer, the price of wheat is going to rise five per cent within the next three months, he will at once proceed to purchase a large stock. If it is going to fall, he will make no more purchases than are necessary for his present business, but will rather make contracts to sell wheat three months hence which he has not yet bought, but which he intends to buy at the lower price. Since all the wholesale dealers proceed on the same system, it follows that the prospect of a future rise in price will cause a present rise. If reports show the probability of a short crop, then, although a year may elapse before the scarcity will be felt, an immediate rise of price will result. This will be true even if the short crop is that of some foreign country, because then that country will demand more wheat from us. The act of purchasing according to an expected price is called discounting the market. The effect of this cause is to make prices more steady than they would be if no account were taken of the future supply and demand. The wholesale dealers in the great markets adjust their price, not to the supply and demand of to-day, but to the probable supply and demand of the future. They make the adjustment so that in the long-run the consumption shall as nearly as possible balance the production.
Speculative Transactions. In the regular course of trade all commodities may be considered as passing from hand to hand only in one direction. If A sells wheat to B, it ought to be because A is in nearer communication with the producer than B is, while B is in nearer communication with the consumer. If A sold to B and B sold back to A again, there would have been two sales with no net result. So, also, if the wheat passed from A to C through the hands of B, when C could just as well have purchased from A, B's labor would be wasted. Hence when all transactions are conducted in the most economical manner there will be no more exchanges than are necessary to the proper care of the wheat while it is passing from the farm to the mill.
But there is one occasional exception to the rule. A and B may have different opinions on the subject of the future price of wheat, the one thinking that it is going to fall, the other that it is going to rise. Then B may purchase the wheat, not to send to some other market, but to keep in order to resell it in the future at a higher price. Perhaps he will sell it back to the very man from whom he bought it, in which case the latter will suffer for his want of judgment. This operation of selling merely to take advantage of a prospective rise in price is called speculation. Its economic effects are greatly exaggerated in the popular mind. It amounts to little more than betting on the future price of the article speculated in.
Prices in Diferent Markets. It is obvious that there can-not be two prices for the same commodity in the saine market at the same time. Thus the price of wheat in Chicago is telegraphed over the country from day to day with as much exactness as we know the height of the barometer. The same is true of the great cotton markets in Charleston and Liverpool, and of the silver market in London.
It is also evident that in two different markets the price cannot differ by more than the cost of transportation from one market to another. If it costs fifteen cents to transport a bushel of wheat from Chicago to New York, it is certain that the price in New York cannot differ by more than fifteen cents from that in Chicago. For, if there were a greater difference, dealers would purchase in the other market and trans-port it, thus saving money. If the demand in New York is such that it is necessary to transport wheat from Chicago to meet it, then the price in New York must be higher than that in Chicago by the cost of transportation.
Is the rise of price consequent on increase of demand temporary or permanent? It does not follow that because increased demand raises the price the rise will be permanent. The first effect of such a change will be that the wholesale dealers will try to purchase more of the commodity and pay higher prices to the producers. If there is any prospect that the increased demand will be permanent, production will be stimulated ; manufacturers will enlarge their facilities and employ more men, and new factories will be started. As the ultimate result of this, one or the other of two opposite effects may follow. We have shown in Book II. that commodities can frequently be made more cheaply on a large scale. If then the increased demand is such as to lead to more economical production, the ultimate result will be to lower the price. For example, the price at which axes and hatchets are sold is very much below what they would cost if very few people wanted them.
On the other hand, it may happen that an article cannot be produced on a large scale with advantage owing to the limited supply of something necessary to its production. A rise of price due to increased demand may then be permanent, as will be shown in the next chapter.
The Law of Value applied to Money. When money and goods are exchanged for each other we may consider the act of exchange to consist in the buying of the money with the goods, and the latter will then be the price paid for the money. In this case increasing the supply of money has the same effect as increasing the supply of a commodity; that is, the value of the money relative to the goods it exchanges for falls. This is the same as saying that a larger amount of money will be required to purchase a given commodity ; that is, there will be a rise of prices. The law under which this occurs will be fully explained hereafter. At present we need only state the result, which is : If the volume of currency be increased, all other things being equal, money will be cheaper relatively to goods, and thus the scale of prices will be increased in the same proportion.