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Preservation of Equilibrium Between Supply and Demand

( Originally Published Early 1900's )

LET US begin by supposing method of doing business quite different from that considered in the preceding chapters. If we visit a port in the East Indies, a trader will come on board with silks, cashmeres, and other products of the country for sale. The ship is then his market, and the passengers the buyers. But his price will not be fixed by any such considerations of the state of this market as enter into the calculations of the wholesale dealer ; his only object is to get the highest possible price from each individual passenger. If one passenger would be willing to give $100 for a shawl rather than go without it, another $60, and a third only $40, the trader would endeavor to get these separate sums for the same kind of a shawl from the three separate parties. In such a case, in the absence of any communication among the different passengers, the price would be merely the result of mutual guessing; the trader trying to guess how much the passenger would give, and the passenger to guess how little the trader would take. There would therefore be no definable law to regulate the price.

So far as the willingness and state of mind of buyer and seller are concerned, the same thing may be considered as holding true in all cases. There are in the community a certain number of people who would give $20, $30, or $40 a barrel for flour rather than go without it. If their flour-dealer could keep them ignorant of the market price, he might exact this extreme limit of price for his flour. But the state of things which exists in the wholesale markets of every civilized country prevents any such operation. The general rule is that goods must be sold at the same price to all comers. A trader who should exact a higher price because his customer chanced to be for the moment ignorant of the market price would soon lose his business standing. It is only in the case of retail and short-sighted shop-keepers that the attempt is now practised. The result is that if any commodity is offered at a certain price P, the buyers will comprise all those persons who are willing to pay either P or any higher price.

We now see from another point of view how it is that as price is lowered the demand increases. All the purchasers willing to give the higher price are retained at the lower price, and a certain number of additional ones are brought in.

Graduated Cost of Production. It has been shown that if the net cost of producing a commodity exceeds the price it will command in the market, its production must cease. Hence the price asked must be above the cost of production by an amount sufficient to make good all the expenses connected with the sale in the market. Since whenever the price sufficiently exceeds the cost of production to make the latter pay well, the production will be increased, it might seem to follow that the selling price could never exceed the cost of production and sale. But this conclusion does not follow as a matter of course, because it rests on the supposition that the cost of production is a fixed quantity, and that the amount produced can be increased indefinitely without increasing the cost per unit of the commodity. Were there no limit upon the quantity which could be produced at the lowest net cost, this would be true. But we have shown that monopolized elements enter, to a greater or less extent, into nearly every commodity. Since, by hypothesis, these elements are limited in supply, and are not at the command of every one, the effect of the monopoly will be with every addition to the quantity to increase the cost of each unit added.

In the case of monopolies of the raw materials of production which we have described in the last chapter, the general rule is this : A certain limited amount of the raw material can be obtained at a comparatively low net cost from some especially favored sources. If this quantity does not suffice for the supply, then it is to be sought for from less and less favored sources, and thus each unit will cost more. This is the mark of a graduated monopoly (23, 25, 27), which is the most common kind of monopoly. In such a case, the quantity made to sell at a price P is all that can be made at a net cost not exceeding P, just as the quantity sold has been shown to be all that could be sold at a price not below P. To illustrate this, let us see how it may be with the production of iron.

There may be in certain favored spots deposits of iron ore so rich in metal and so near the surface that pig-iron can be made from them at a net cost of $7 per ton. From other deposits or other portions of the same deposit the cost may be $8 per ton ; in the next class in order $9 ; and so on until we reach a cost above any limit we choose to set.

Suppose now the market price to be $9 per ton. It is evident that all those mines from which the iron can be made at a net cost less than $9 will pay for working them. If the price rises to $10 or $12, the less favorable mines will be sought out and opened. If it falls to $8 or $7, the less favorable furnaces will have to close, temporarily or permanently. The result then would be :

I. The higher the price which can be got for the commodity the greater the quantity which will be produced.

II. The price will be equal to the cost of production from the least favored mines.

We shall hereafter see that the second rule is not the most general one. But we need not consider the exceptions to it at present. The final result of both the law of demand and the law of supply is that the price will be so fixed that supply and demand shall be equal. To show how the point of equilibrium is reached, we have supposed a state of things set forth in the table on the next page.

In the table of demand the first column is a series of prices per ton which are chosen quite at pleasure, and from which we may suppose the wholesale dealers, or the manufacturers, to select at pleasure in order to try the effects of each separate price upon sales and production.

The second column gives the corresponding demand, that is, the number of thousand tons which it would be possible to sell at that price in a given state of the market during a given period. In order to avoid the use of large numbers we shall call 1000 tons the unit of quantity. We may suppose, to fix the ideas, that the market includes the whole United States, and that the period of time is one year. The first two columns then indicate that 50,000 tons can be sold in a year at $7 per ton, 48,000 at $8, and so on.

In the table of supply the first column gives a series of. the various costs of production per ton.


Tons. Ton. at that Cost

$7 50 $7 10 10 8 48 8 10 20 9 46 9 12 32 10 43 10 13 45 11 40 11 15 60 12 36 12 20 80 13 33 13 20 100 14 29 14 20 120

The second column gives the quantity which we may suppose can be produced at each particular cost. That is, we suppose that 10,000 tons can be produced annually from those few favored mines which yield the product at $7 per ton; 10,000 from the next class, at $8 per ton; and so on.

The third column shows the total quantity produced at each cost or at less. It is formed by adding all the prices beside and above it in the preceding column. For example, $7 being the lowest price of all, it shows all that can be produced at that cost. Opposite $8 we have the 10 units which can be produced at the cost of $8, and also the 10 which can be produced at $7, making a sum total of 20,000 tons at $8 or less. 12,000 tons can be produced at the cost of $9, which added to the preceding makes 32,000 tons which can be produced at the rate of $9 or less; and so to the end of the table.

Note particularly that these tables show, not what actually is done, but what can be done under certain assumed conditions, and by fixing certain arbitrary prices for iron. To see what actually would be done, suppose the selling price were fixed at $9 per ton. The dealers would then be able to dispose of their stock at the rate of 46,000 tons per annum. But since they could not afford to pay the full price at which they sold, but perhaps 10 cents less, the producers would supply them only with the 20 units which could be produced at a cost less than $9 per ton. Buying only 20 units and selling 46, the stock on hand would diminish at the rate of 26 units per annum, and the dealers would of course raise the price. At $10 per ton they would sell at the rate of 43 units per annum. But this rise of $1 would only add to the supply the 12 units which can be produced at $9 per ton, so that the supply would now be 32 units per annum and the equilibrium would not yet be restored. At $11 per ton the sales would be reduced to the rate of 40 units per annum, while the supply would be 45, the 13 units which can be produced at $10 per ton being now added. The supply would then slightly exceed the demand, so that the price under the conditions shown by the tables would be between $10 and $11 per ton.

Modifications. This is an example of the law of equilibrium in its simplest form. By comparing it with the actual case the student will readily see what modifications are to be made in it to correspond to what actually takes place. The following are the principal modifications

I. Neither of the two tables is to be considered as invariable from year to year. The demand at a given price will be greater in some seasons than in others, owing to the greater or less want of iron for railways or manufacturing purposes. In one year 46 units might be salable at $8 per ton, as supposed in the table, while in another year the sales at that price might be 50 units. But in any case we could make a table of the same kind as that given above which would hold good until there was a change in the demand. Every three months or every year we should need a new table.

II. The cost of production from each mine may vary in the same way with variations in the price of labor and the cost of machinery. Moreover, the quantity which can be produced at any one price is not fixed as we have supposed it, because the managers of the furnaces can to a certain extent increase or diminish their production at pleasure. If the price of iron were only $7.50 per ton, the most favored producer would have no great stimulus to manufacture for so small a profit, and therefore might make less than ten units per annum. But when the price went up to $12 per ton the large profit would stimulate him to enlarge his works and employ more labor, so that he would produce at the rate of more than ten units per annum.

On the other hand, this tendency is checked by the fact that any sudden change in the quantity produced is disadvantageous. A manager would rather run at a loss for a short time than discharge his workmen, and when the prices went up he might be unable to make any material increase of production without investing additional capital, and might not deem it worth while to make this additional investment. However these two opposing causes might operate against each other, the result would be in any case a relation of the saine general character as that shown in the table. We therefore need a new table of supply as well as of demand every few months or every year. But in every state of the market there is always a possible table of the kind shown which expresses that state.

IV. In many cases there may be no dealers at all, the producers of the pig iron selling direct to the manufacturers who use it. But this does not change the relation of things shown in the table. The functions of the dealers are then performed by the producers themselves, and since the prices are publicly known, the laws governing them are the same as when dealers fix them.

V. The modifications in the tables in case of no monopoly can readily be made. Suppose, for example, we could make a ton of pig iron at a cost of $9 in labor, capital, and supervision; that none could be produced at a less cost, and that any required quantity could be produced at that cost. The selling price would then be between $9 and $10 no matter what the demand. The only exception to this would be that in case of a sudden increase in the demand, the price would be temporarily raised, owing to the difficulty of suddenly increasing the supply to correspond to the new state of the market, while the reverse would be true when the demand diminished.

Suppose next that the quantity were an insensitive one for which the demand varied very little from 43 units per annum, regardless of the price. The result would be that the first four orders of mines shown in the tables would be worked continually. The total amount produced would then be 45 units per annum ; the selling price would be between $9 and $10 per ton, because if we place it at $9 or less the fourth class of producers would drop out, and the demand could no longer be supplied. On the other hand, if the price exceeded $10 per ton, the fifth order of producers would enter in and the total production would be 60 units per annum, or 17 units more than could be sold. Since it would be impossible to sell the entire product, some one would have to stop, and of course it would be the unwise man of the fifth class.

Combinations. In the case last supposed a combination might be made between the five classes of producers to charge $11.50 per ton and thus make it pay for the fifth man to continue the manufacture. But unless this combination included an agreement to diminish the total product pro rata, so, as to reduce the whole amount produced to the 43 units demanded, there would be a continual accumulation on the hands of the producers. The first four orders of men would soon find it pay better to "freeze out" number five by lowering the price than to continue the combination.

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