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Where Do Prices Come From? : Russell Roberts
14 paragraphs found.
"Prices adjust. They're not fixed. Supply and demand helps us remember this."

Supply and demand. Buyers are competing with each other. Sellers are competing with each other.


The simple answer of supply and demand is a strange answer, for it presumes you can talk about a good of a particular quality. In the real world, every good has a unique mix of attributes. Even when two goods are physically identical, they almost always come bundled with differing levels of service attached to them.


The strangeness of supply and demand leads some to conclude that it only applies to special cases of a homogeneous good where there are a near-infinite number of sellers and where there is perfect information about the quality of the good and the alternatives and their prices. In this view supply and demand might apply to wheat. Maybe.


The alternative view is that supply and demand has to be unrealistic. Otherwise there's no way to make sense of the myriad transactions that are constantly taking place. A realistic portrait of what happens in the Washington, D.C. housing market would have to chronicle the uniqueness of every transaction. That would not only be impossible but uninformative. What is the relationship between all of these transactions?


Supply and demand is a way to see the relationship that strips away everything except the fact that what people are willing to pay and what they have to pay depends on the alternatives. Supply and demand is a way to organize our thinking about this peculiar thing economists call markets and competition. Let's put it to work without using a graph and see what we can see.


For an introduction to the standard graphs of supply and demand and how to use them, go to Supply and Demand and Applications of Supply and Demand, by Russ Roberts, 2004.

Both Blades of the Scissors

One of the most important virtues of supply and demand is that it forces you to remember what Alfred Marshall called both blades of the scissors. With few exceptions, both buyers and sellers play a role in determining prices. That's surprisingly easy to forget. When my son asked why convertibles are so expensive, his brother explained that people really like them, the demand side of the equation. But that can't be the whole story or even most of it. Surely there are many people in colder rainier climates or even too-hot climates where driving a convertible is unpleasant. So why are they expensive? They're more costly to make because of the mechanism that allows the convertible to retract the roof. Convertibles only exist if their price is greater than non-convertibles. If people liked cars without any kind of roof, they'd be cheaper, not more expensive, than cars with roofs.


From Principles of Economics, Book VI, Chapter II, by Alfred Marshall, par. VI.II.16:

Thus again we see that demand and supply exert coordinate influences on wages; neither has a claim to predominance; any more than has either blade of a pair of scissors, or either pier of an arch. Wages tend to equal the net product of labour; its marginal productivity rules the demand-price for it; and, on the other side, wages tend to retain a close though indirect and intricate relation with the cost of rearing, training and sustaining the energy of efficient labour. The various elements of the problem mutually determine (in the sense of governing) one another; and incidentally this secures that supply-price and demand-price tend to equality: wages are not governed by demand-price nor by supply-price, but by the whole set of causes which govern demand and supply.

Prices Adjust

Prices adjust. They're not fixed. Supply and demand helps us remember this.

Emergence is a different way of seeing

Finally, supply and demand helps us see things in a totally different way. How bizarre it is that partisans credit or blame the president for the average level of wages or inequality in the United States. If wages are rising, the president will brag about all the good jobs the economy is creating. If wages are falling, then the critics of the president fault the president. But the wage level in the United States isn't under the president's control. It's an emergent phenomenon that comes from the choices people make about how much education to get, how many hours to work, and the mix of monetary and non-monetary satisfaction that people choose in various jobs.

Available at a price

One of the simplest insights that comes from supply and demand is the availability of goods in the marketplace. When people want more of something, the crowd of more enthusiastic buyers rarely exhausts the supply. Prices adjust to equate how much people want to buy with how much people want to sell. So if people suddenly want more of something, it doesn't just disappear. The price rises inducing an increase in what is available. As Henry George pointed out:

Here is a difference between the animal and the man. Both the jay-hawk and the man eat chickens, but the more jay-hawks the fewer chickens, while the more men the more chickens. Both the seal and the man eat salmon, but when a seal takes a salmon there is a salmon the less, and were seals to increase past a certain point salmon must diminish; while by placing the spawn of the salmon under favorable conditions man can so increase the number of salmon as more than to make up for all he may take, and thus, no matter how much men may increase, their increase need never outrun the supply of salmon. [Progress and Poverty, Book II, Chapter 3, by Henry George, par. II.III.5.]

A Caveat

Not all prices are set in what the textbooks call perfectly competitive markets. Supply and demand is a poor tool for predicting precisely the exact level of a price. Any individual transaction may deviate from "the" price because of mistakes or emotions. In many markets, an unusually large seller or buyer can affect the market price in significant ways. But just because a market isn't a textbook example of perfect competition doesn't mean supply and demand can't capture enough of the competition that remains. To take an extreme example, the gasoline market in the United States is full of regulations and amounts of market power that exist in various parts of the supply chain. But there is still competition throughout that market, even if it does not conform to the textbook definitions. And price controls, as the supply and demand model predicts, leads to shortages, lines and reductions in quality. That full story is a topic for another time.


Supply and demand is a simple and powerful way to describe the ways that transactions across time and space are not independent of one another. It is a powerful way to organize our thinking about the complexity that emerges out of the propensity to truck, barter and exchange, a complexity that is the result of human action but not of human design.