Fundamental Theories of Supply and Demand - Essay Example

1 Introduction Supply and demand theory are fundamental to the entire study if economics and, indeed, may be understood as the foundations upon whichthe entire discipline is based upon. It is, thus, that theories of supply and demand consume so much space in economic literature, on the one hand, and command so much of the attention of economists, on the other. Marshall's theory of demand and consumer surplus is to be understood within this context, as are criticisms, or critiques, of it. To understand Marshall's conceptualization of the demand curve and consumer surplus, it is necessary to understand his theory of supply and demand and his classification of markets. Following an objective presentation of the Marshellian demand curve and consumer surplus, as presented in Marshall's Principles of Economics, this essay will present the critical analytical opinions which the aforementioned has generated. 2 Marshellian Demand Curve and Consumer Surplus Integral to the comprehension and evaluation of the Marshellian demand curve and consumer surplus theory is Marshall's understanding of the implications of value and his classification of markets. Accordingly, this section will commence with Marshall's understanding of both of the stated, if only because they directly inform his supply and demand theory. Marshall claims that the notion of value is intimately connected with that of wealth. After noting, however, that for Smith the term value has two uses (as use and exchange value), he, without apparent justification, contends that it is inaccurate to use the term "value" to express the utility of an object. Accordingly, he uses the term value to connote the exchange value of one thing in terms of another at any time and place, contending that it "is the amount of the second thing which can be got here and then in exchange for the first." Hence, insofar as Marshall is concerned, the term value "is relative and expresses the relation between two things at a particular place and time" (Marshall, p. 51). In explaining exchange value, Marshall considers demand and, ultimately, consumers' demand as important to the explanation. In the long run, as Marshall argues, the price which traders and manufacturers will pay for a thing depends on the price consumers will pay for it, or for the things made with the aid of it. Hence, the "ultimate regulator of all demand" is the consumers' demand" (p. 75). To explain demand, Marshall turns to utility. For him, utility is taken as a 'correlative" to desire or want. Desire, however, cannot be measured directly, only indirectly "by the outward phenomena to which they give rise" and, "in those cases, with which economics is chiefly concerned," the measure is "found in the price which a person is willing to pay for the fulfillment or satisfaction of his desire" (p. 79). In this respect, Marshall is evidently opting for a behavioralist conception of utility. Marshall proceeds to claim that there is a limit to each separate want, expressed as the "law of satiable wants or of diminishing utility:" The total utility of a thing to anyone (i.e., the total pleasure or other benefits it yields him) increases with every increase in his stock of it, but not as fast as his stock increases" (pp. 78-79). If the utility of his marginal purchase is the marginal utility, then the law just stated is, thus: "The marginal utility of a thing to anyone diminishes with every increase in the amount of it he already has" (p. 79). Marshall "translates" this "law of diminishing utility," following a behavioralist interpretation, in terms of price. If the price that a consumer is willing to pay for a good is called his demand price, then the law may be reworded as follows: The larger the amount of a thing that a person has the less, other things being equal (i.e., the purchasing power of money, and the amount of money at his command being equal), will be the price he will pay for a little more of it. In other words, his marginal demand price for it diminishes (p. 80) For Marshall, an individual's demand schedule shows how much a person would be willing to purchase at each of the prices he is willing to pay. The economist, however, has "little concern with particular incidents in the lives of individuals:" he studies, rather, the course of action that may be expected under certain conditions from members of the industrial group, in so far as the motives of that action are measurable by money price; and in these broad results, he claims that the variety and fickleness of individual action are merged in the comparatively regular aggregate of the action of the many" (Marshall, p. 83). "In large markets, then - where rich and poor, old and young, men and women, persons of all varieties of tastes, temperaments and occupations are mingled together - the peculiarities in the wants of individuals will compensate one another in a comparatively regular gradation of demand" (p. 83). The total demand in a particular place is reckoned as the sum of the demands of all the individuals there. As with other neoclassical economists, Marshall maintains that demand considerations must go hand in hand with supply considerations in the explanation of value. Marshall, at this stage of inquiry, suggests the use of mechanical analogies: We must first look at the simpler balancing of forces which corresponds to the mechanical equilibrium of a stone hanging by an elastic string, or a number of balls resting against one another in a basin" (p. 269). In line with the preceding analogy, Marshall proposes as the appropriate apparatus for the study of markets, the use of the general relations of supply and demand. That is, those relations by which process are maintained in equilibrium and which Marshall considers, in a rather pragmatic mode to be not descriptive but, as "set(ting) out of the theoretical backbone of our knowledge of the causes which govern value" (pp. 269-70). Marshall characterizes markets spatially and temporarily and classifies them on the following bases: The difficulties of the problem depend chiefly on variations in the area of space, and the period of time over which the market in question extends; the influence of time being more fundamental than that of space" (Marshall, p. 411). On the basis of the first criterion, he observes that at one extreme are world markets in which "he observes that at one extreme are world markets in which "competition acts directly from all parts of the globe." At the other end are those "secluded markets in which all direct competition from afar are shut out, though indirect and transmitted competition may make itself felt even in these." Midway between the two extremes lie "the great majority of the markets which the economist and the businessman have to study" (Marshall, p. 274). More important for Marshall is his classification of markets with respect to periods of time which is allowed to take the forces of demand and supply to bring themselves to equilibrium with one another: The nature of equilibrium itself, and that of the causes by which it is determined, depend on the length of the period over which the market is taken to extend" (Marshall, p. 274). Marshall initially distinguished three periods. He claims that in "short periods" markets are "limited to the stores which happen to be at hand," while in "longer periods" supply will be "influenced, more or less, by the cost of producing the labour and the material things required for producing the commodity" (Marshall, pp. 274-75). Following his clarification of a distinction between market periods, Marshall considers as "temporary equilibrium" of supply and demand the case in which "supply" means the stock available at the time of sale in the market. Marshall claims that in this case, some price has "some claim to be called the true equilibrium price because of it were fixed at the beginning and adhered to throughout, it would exactly equate demand and supply" (p. 278). Within the parameters of Marshall's logic, temporary equilibrium refers to stocks offered for sale which are already in existence. In the case of "normal" demand and supply, however, Marshall contends that one must consider longer periods "than those for which the most far-sighted dealers in futures generally make their reckoning: we consider the volume of production adjusting itself to the conditions of the market, the normal price being thus determined at the position of stable equilibrium of normal demand and normal supply" (p. 282). That is, we "take account of the many different kinds of labor and use of capital in many forms which the production of a commodity generally requires": the "exertions" of all the different kinds of labor that are directly or indirectly involved in making it, together with the "abstinences" - "or rather" the "waitings" required for saving the capital used in making it (Marshall, p. 282). The preceding distinction between different periods of time means that different equilibria correspond to each, given the different periods of adjustment for the relevant processes defining the periods to work themselves out. The implication here is, and as is evident from the preceding, that Marshall speaks of equilibrium in their "most general form," as neglecting features "special to particular parts of economic science," "confining our attention to those broad relations which are common to nearly the whole of it." It is, thus, assumed that the forces of supply and demand have free play. Insofar as there is no combination on either side, with each acting for, and by himself, with buyers competing against buyers and sellers against other sellers, there is "sufficient knowledge" of what others are doing to prevent taking a lower or paying a higher price than others are doing" (Marshall, p. 284). Now, when the demand price is equal to the supply price, the amount produce exhibit neither tendency to increase nor decrease, and it is said to be in equilibrium (Marshall, p. 287). Marshall calls this the equilibrium stable if whenever the price is displaced a little from it, it will tend to return "as a pendulum oscillates about its lowest point." In this case, when the demand price is greater than the supply price, sellers get more than is sufficient to bring goods to the market and, therefore, amount produced tend to increase, just as they tend to decrease if the supply price is greater than the demand price. Hence, when demand and supply are in stable equilibrium, any deviation from the equilibrium position will "instantly" bring to play "forces tending to push it back to that position" (p. 288). Marshall further claims that the demand and supply schedule do not, in practice, remain unchanged for a long time together but, are constantly being changed, such that the equilibrium is altered as they are changed. Proceeding from the stated, Marshall maintains that the statical theory of the stable equilibrium of supply and demand is, in fact, only an "introduction' to a more philosophical treatment of society as an organism (pp. 381-82). As he writes: The theory of stable equilibrium of moral demand and supply helps indeed to give definiteness to our idea; and in its elementary stages it does not diverge from the actual facts of life, so far as to prevent its giving a trustworthy picture of the chief methods of action of the strongest and most persistent group of economic forces. But when pushed to its most remote and intricate logical consequences, it slips away from the conditions of real life. In fact, we are here verging on the high theme of economic progress, and here, therefore, it is especially needful remember that economic problems are imperfectly presented when they are treated as problems of statical equilibrium and not of organic growth (pp. 381-82). Having presented a comprehensive overview of the Marshellian demand curve and theory of consumer surplus, alongside the identification of various relevant terms and their Marshellian interpretation (e.g. value), critiques and interpretations of the stated will now be reviewed. 3 Critiques Milton Friedman engages in a critical analysis of the implications of the Marshellian demand curve and consumer surplus from the perspective of Marshall's starting point of "other things the same" (cited in Friedman, p. 464). As Friedman contends, this particular phrase is extremely important as it serves to both ground Marshall's theory and outline the limitations of its applicability. It grounds it by defining the conditions under which is supply and demand theory hold true and, in the same way, outlines its limitations by specifying the conditions under which Marshall's conceptualizations are relevant (pp. 464-66). The question, however, lies in what precisely do "other things" comprise. The phrase is extremely loose and open to a wide variety of interpretations with its being necessary to identify the nature of those "other things" without "emasculating the concept" (p. 464). In defining or identifying those other things, Friedman proceeds to list all of the prices of all goods and services with the exception of the one in question; total expenditure on the other goods and services and "the quantity purchased of every other commodity " (p. 464). The importance of defining these "all other things" lies simply in the fact that, as Friedman points out, the demand curve for other commodities, when considering price, extent of consumer need, market surplus and utility, among others, is different (pp. 464-467). Therefore, because these other things culminate in the yielding of different results along the demand curve, it is imperative that the Marshellian demand curve and concept of consumer supply be understood from within the limits of what these other things mean or comprise. The problem with the Marshellian demand curve, as argued by Friedman, is that it is vulnerable to interpretations. While not precisely open to misinterpretation, the absence of a clear articulation of what these other things mean, implies that it is vulnerable to alternate interpretations (pp. 465-466). Within the context of the current dominant interpretation, Friedman explain that "other things" are afforded unique importance and that they are defined as consumer taste, the economic status of the relevant consumer segment and the "price of every other commodity" (p. 465). Even though Friedman does not engage in the contestation of the current interpretation, he does not believe it to be consistent with Marshall's intentions. Instead, of income, Friedman maintains that Marshall meant real income and, rather than the price of all other commodities, Friedman believes that Marshall meant "the price of every closely related commodity" (p. 465). These difference are only seemingly minor as, in actuality, they lead to different understandings and interpretations of the Marshellian demand curve and concept of consumer supply. Indeed, it need be noted that in his critique of the Marshellian demand curve and concept of consumer supply, Friedman's criticisms are confined to the current interpretation as opposed to his interpretation. The differences between the two lie in that on the one real income varies along the demand curve while in his interpretation it is content; added to that, in the current interpretation, weight is given to the individual price of all commodities while in Friedman's interpretation, the average price of related goods is considered (p. 487). Within the context of the stated, Friedman criticizes the interpretation and not the theory. Friedman contends that the traditional interpretation of the Marshellian demand curve and consumer surplus is erroneous and that his radically different interpretation is representative of Marshall's meaning and intentions. Stigler disagrees. Indeed, even though the interpretation he offers differs in part from the traditional one, it is more compatible with the traditional interpretation than it is with Friedman's. Situating Marshellian demand curve and consumer surplus theory within the economic history and, more specifically, the evolution of the theory of utility, Stigler identifies Marshall as a contemporary economist whose theories are not supported by contemporary economic practices and phenomenon (p. 327). From Stigler's interpretive perspective, the Marshellian demand curve derives from the theory of utility, maintains the measurability of utility, affirms the law of negatively sloping demand and upholds "diminishing utility only if the utility function is additive" (p. 326). Although, as Stigler contends, Marshall was later to revise some aspects of his theory, especially as pertains to consumer surplus and negatively sloping demand, inconsistencies between practice and theory remained (p. 327). The implication here is that revisions to both his demand curve and consumer surplus theories have not rendered Marshellian theory compatible with economic reality. Interestingly, this perspective us at extreme variance to Friedman's who, not only maintained the validity of Marshellian demand curve and consumer surplus but did not believe that Marshall modified either. Writing some three decades after Friedman and Stigler, Dooley similarly focuses on criticisms of the Marshellian demand curve. In direct contrast to Friedman and Stigler, however, rather than critique the concept of consumer surplus from his perspective as an economist, he focuses on the critical literature on the topic (pp. 26-27). As he notes, criticism, a large body of which contested the validity of the Marshellian demand curve, falls into four main categories (p. 26): An additive utility cannot function as a satisfactory explanation of consumer behavior; The marginal utility of money is not constant; The quantity demand of a product cannot, alone, be treated as a function of its price; The validity of interpersonal comparisons is not a given. Marshall and his supporters, as Dooley argues throughout his article, never admitted to the potential validity of any of the many criticisms directed against him and, indeed, expended tremendous time and effort in responding to the above summarized criticisms. The refusal to concede to the aforementioned was not an outcome of the undisputed economic logic which informed Marshall's theory of consumer supply since critical analysis very effectively indicates that it has its logical shortcomings (pp. 34-36). More accurately, it is consequent to the fact that Marshall and his supporters interpret his concept of consumer surplus in a way that differs to his critics' interpretations. Accordingly, it is a question of conception versus misconception which partially accounts for the debate. It is important to note, however, that even as he explains the aforementioned source of controversy, Dooley ultimately voices his own objections to Marshall's theory of consumer surplus: "Marshall's victory over his critics is a curiosity and may have more to do with the sociology of economics than the force of its logic" (p. 36). As is apparent from the preceding review of Friedman, Stigler and Dooley's articles on the Marshellian demand curve and consumer surplus, the controversy tends to center on interpretations. Alford confirms the stated by drawing attention to the fact that there are varying interpretations of Marshall's conceptualizations, the most popular being the traditional interpretation and those forwarded by Stigler and Friedman (p. 23). Through his review of these two economists' critique of Marshall's work, Alford expresses his own reservations about the Marshellian demand curve and consumer surplus theory (p. 42). Identifying Marshall as a conservative economist who erred in his use and interpretation of cases and examples (p. 42) Alford tends towards support of Stigler rather than Friedman. Indeed, Alford maintains that Friedman imposes his interpretation upon Marshall's work and that, indeed, there is nothing in his Principles to support Friedman's reading. Accordingly, not only does Alford uphold the traditional interpretation but he maintains that Stigler's criticisms and objections are valid (pp. 47-48). Schlee and Ekuland do not focus on a critique of marshall's demand curve and conceptualization of consumer surplus per se but, like Dooley and, to a degree, Alford, turn their attention to the controversy itself. The fact is that Marshall's interpretation of demand and consumer surplus, or his reworking of either has led to debate among economists. This debate, according to both Schlee and Ekuland is more of an outcome of misunderstandings of Marshall's theory than it is san outcome of an objective reading of the theory. For example, much of the criticism is a result of the belief that Marshall upset the traditional theory of demand and, indeed, sought to redefine and re-conceptualize value. This is not true. Marshall was not offering an alternative demand curve nor was he presenting a radically different interpretation of consumer surplus. Instead, as both Schlee and Ekuland maintain, he maintained consistency with economic history and did not attempt to dispute but to build upon traditional theory. Misunderstanding of this is where the roots of the debate lie. 4 Conclusion On the basis of the foregoing analysis, two observations may be made. The first is that much of the literature reviewed tended towards the disputation of the Marshellian demand curve and consumer surplus theory. The second is that, apart from Friedman who seeks the validation of Marshall's theory through the imposition of his reading upon it, some economists believe that the Marshellian demand curve and consumer surplus incited controversy because they were erroneously interpreted as an attempt to replace historic economic demand theory. To believe that this is not true is to believe that Marshall's theory is consistent with contemporary economic reality. Read More