It seems to be fairly simple, but it raises many questions. To start with: Did Adam Smith describe a law of economics akin to a natural law, or is the market mechanism only a model or idealization that describes an optimal way to produce and distribute goods and services?
When economists refer to price in a market, they try to keep considerations of fairness and justice out of the picture and, analyze price simply as an outcome of the forces of supply and demand. But what are these forces and what determines them? The following points describe the mechanism, a cornerstone of economic theory, as simply as possible.
- People sometimes refer to prices being “too high” or “too low” as a judgment about the way they think the world ought to be. This is like saying that the weather on a given day is “too cold” or “too hot.” Such judgments reveal something about the preferences of the person expressing the opinion, but they don’t tell you why the price (or the temperature) is actually at the level that it is.
- There is a difference between “use value” and “exchange value”. Adam Smith used the diamond-water paradox to describe this difference: Diamonds have high value in exchange, but little value in use. Water has little value in exchange but high value in use. For economists, prices are only about “exchange value”.
- Prices are nothing but a relation between supply and demand.
- In the market model above, demand and supply have quite specific meanings. Demand is a relationship between quantity demanded and any given price. Demand curves slope down, which shows that quantity demanded tends to fall as price rises. Demand is not the same as quantity demanded. The demand curve above only indicates the relationship between quantity demanded and the range of possible prices; quantity demanded refers to a specific amount demanded at a certain price. The same applies to the supply curve.
- Demand for a certain good can shift for a variety of reasons: changes in income, population, tastes, or prices of complement or substitute goods.
- Supply is the relationship between quantity supplied and any given price. Supply curves slope up, which means that quantity supplied tends to increase as price rises.
- Supply can shift for a variety of reasons, including changes in technology, weather, and prices of key ingredients.
- The equilibrium price is where quantity demanded is equal to quantity supplied. Demand and supply determine the equilibrium price, where quantity demanded is equal to quantity supplied. If the price is temporarily above equilibrium, then quantity supplied exceeds quantity demanded, which tends to drive the price down to equilibrium. If price is temporarily above equilibrium, then quantity demanded exceeds quantity supplied, which drives the price up to equilibrium.
- The equilibrium price and quantity create efficiency in the sense that extra quantities are not up on shelves, nor are buyers waiting in line.
- A shift in demand or supply will lead to a new point of equilibrium. In this way, shifts in demand and supply can explain movements in prices and quantities of goods observed in markets.
- The supply and demand model is intended as a framework for discussing how prices and quantities are determined in markets and why they change. The model argues that markets move towards equilibrium and thus efficiency; it does not argue that people are happy with the prices. Typically, buyers will prefer the price to be lower, while sellers would prefer the price to be higher.
- Most people don’t think in terms of the demand and supply model. But if consumers look for the goods they prefer at the lowest possible price and firms adjust their production in response to changes in price, then people and firms are acting in accordance with the model.
- The test of the supply and demand model is whether it works as a method of understanding the determination of prices and quantities. As a scientific model, it does work for all sorts of products, in markets all over the world, and at different times of history.