Book IV, Chapter V

The Law of Supply and Demand

The zone within the limits of which the struggle of competition forces the formation of price is, as we have seen, characterised as lying between the subjective valuations of the marginal pairs, and on this characteristic feature we have formulated our law of price. But this zone has a second characteristic feature: it is that in which exactly as many commodities are offered for sale as are wanted to purchase;^*19 or, to use the common expressions, in which supply and demand are quantitatively in equilibrium. In our scheme, at a price which did not rise to £21 more horses were demanded than were offered; at a price which rose above £21:10s. more horses were offered than were demanded; while in the zone indicated by our law of marginal pairs—that between £21 and £21:10s.—the position requisite to end the competition was reached, and at that price exactly as many horses were asked as were offered.

Now, if it should be thought preferable, the formulation of the law of price may be based on this second characteristic feature, and it will then take the following shape: The market price is found in that zone in which supply and demand quantitatively balance each other. This formula is as correct as the other. It indicates the same zone in another way. But it is less expressive (1) in so far as it only points to the level of the determining zone in a roundabout way, while, by our formula, the limits of this zone are directly and positively indicated; (2) as it has to contend to some extent with the difficulty of having to use the expressions Supply and Demand,—for the protean ambiguity of these terms is sure to bring innumerable errors and misconceptions in their train, just as it has brought the terms themselves into thoroughly bad repute with many,^*20 Still, these drawbacks may very well be overcome by critical attention; and there is no objection, in my opinion, to treat the theory of price under the good old catchwords Supply and Demand, if care is only taken to avoid the errors and misunderstandings which so plentifully surround them, and to inform the old forms and formulas with new and clear knowledge.^*21

In one special case this second formulation of our law of price is even the more exact of the two. In the vast majority of cases, the zone within which supply and demand just balance each other exactly coincides with the zone whose limits are marked out by the valuations of the marginal pairs. But there is one quite definite coincidence of circumstances in which it may happen that the equilibrium between supply and demand does not make its appearance within the whole of the last-mentioned zone, but only within a distinctly narrower part of that zone; and, in such cases, the price is always fixed within these narrower limits. The very peculiar coincidence of circumstances which produces this result occurs very rarely indeed in economic life, but, among the cases where it does occur, there is one that is very important for the theoretical explanation of interest, and for that reason, in spite of its somewhat "exotic" character, I must devote a few words to it.

The casuistical conditions of this case are the following. First, there must be considerable latitude between the valuations of the marginal pairs. This condition is most thoroughly fulfilled where all the competing exchangers come to terms (there being, therefore, no excluded competitors), and when, at the same time, the buyers, as a body, value the commodity considerably higher than the sellers do. If there are, for instance, ten buyers who each value the commodity at £10, and ten sellers who each value it, subjectively, at £1, obviously all the ten pairs can come to terms, and the zone which lies between the valuations of the last buyer and the last seller represents the wide latitude between £1 and £10. Secondly, that this latitude should be narrowed down, the further circumstance must be present, that the desire of the buyers is directed to an unlimited number of goods, while, at the same time, the total amount of means of purchase must be strictly limited, and the buyers must be determined to spend the whole of this sum in purchase of the commodities in question—in the purchase of fewer goods if the price be high, in the purchase of a proportionately larger number of goods if the price be low. To put it in terms of our illustration. Say that each of the ten buyers is resolved to spend the sum of £100 in buying cotton goods; that is to say, at any price under £10 he will buy as many pieces as he can obtain for £100. And suppose that against this total competing demand of £1000 there is a supply of 200 goods, which their owners are inclined to let go at any price above £l. It is easy to see that the price must be fixed at £5 the piece. For if the price were to be less, say £4, the 200 pieces offered would be purchased for £800, and £200 of the available means of purchase would remain unemployed. Here the owners, acting on the motto "rather a small gain than no exchange," will continue bidding up against each other, and so raise the price to £5, at which figure the whole capital of £1000 finds employment. If, on the other hand, the price were to be put still higher, say £8, only 125 pieces of cotton goods could be bought with the £1000 available, and 75 would remain unsold. Now, obviously, no seller (considering that the price remains profitable to him till it is brought down as low as £1) would willingly forego taking part in the exchange, and thus the sellers, in fear of being shut out, would offer below each other, and the price would be pressed down to the equilibrium point of £5. Inside the wider zone, then, of £1 to £10—that determined by the valuations of the marginal pairs—the necessity for equilibrium between supply and demand determines the price with much more exactitude, and fixes it at £5, that being the point at which, if the competitors follow their own interests without let or hindrance, the market price must be fixed.

As we have already said, the extremely peculiar coincidence of circumstances necessary to this result occurs very seldom, but, as it happens, the cases where it does occur are very notable. One of these is the formation of the price of Money—which, however, does not concern us here.^*22 A second is the formation of price in the Labour market, and this is the case which we shall have to take up later on, on account of its close connection with the origin and height of Interest. It should, however, be carefully noted that, even in these two cases, the conditions under which this special form of the law of price appears are seldom met with in economic life in entire isolation. Thus the practical importance of such cases is still further diminished, and, if the recognition of them cannot well be ignored in the course of any theoretical exposition, still, as regards the infinite majority of cases, the first formulation of the law of price—that which determines the height of price by the subjective valuations of the marginal pairs—may be relied on with perfect confidence. This formulation is always correct, and, for the infinite majority of cases, is sufficiently exact. Moreover, without losing its practical usefulness in the majority of cases, it permits of being still further simplified. Before going on to this, however, some other explanations are necessary.