Thursday, March 13, 2008

Against Supply And Demand

1.0 Introduction

(I will not be blogging for maybe a week after maybe tomorrow.)

The dominant economic theories during the classical period did not explain prices by the interaction of supply and demand. In particular, the leading economic theorists of the time rejected the following ideas:
  • Supply and demand explain not only market prices, that is, temporary deviations from natural prices, but natural prices themselves.
  • Supply and demand are schedules relating the quantity demanded or supplied as a function of price.
I point out some texts relevant to this thesis below.

I am not denying that precursors to marginalist economics can be found during the classical period. I conclude by pointing out some backsliding from the classical school.

1.0 Classical Economics

1.1 Adam Smith

The distinction between market and natural prices apparently goes back to William Petty. Adam Smith defines 'market price':
"The actual price at which any commodity is commonly sold is called its market price. It may either be above, or below, or exactly the same with its natural price.

The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market, and the demand of those who are willing to pay the natural price of the commodity, or the whole value of the rent, labour, and profit, which must be paid in order to bring it thither. Such people may be called the effectual demanders, and their demand the effectual demand..." -- Adam Smith, An Inquiry into the nature and Causes of the Wealth of Nations, Book I, Chap. VII: "Of the Natural and Market Price of Commodities"
Notice "proportion". I think it unnatural to read this passage as presuming supply and demand are described by schedules. It seems to me Smith is talking about the ratio between two quantities, the quantity available on the market and the level of effectual demand.

1.2 David Ricardo

I want to make use below of a distinction clearly stated by Ricardo:
"There are some commodities, the value of which is determined by their scarcity alone. No labour can increase the quantity of such goods, and therefore their value cannot be lowered by an increased supply. Some rare statues and pictures, scarce books and coins, wines of a peculiar quality, which can be made only from grapes grown on a particular soil, of which there is a very limited quantity, are all of this description. Their value is wholly independent of the quantity of labour originally necessary to produce them, and varies with the varying wealth and inclinations of those who are desirous to possess them.

These commodities, however, form a very small part of the mass of commodities daily exchanged in the market. By far the greatest part of those goods which are the objects of desire, are procured by labour; and they may be multiplied, not in one country alone, but in many, almost without any assignable limit, if we are disposed to bestow the labour necessary to obtain them.

In speaking then of commodities, of their exchangeable value, and of the laws which regulate their relative prices, we mean always such commodities only as can be increased in quantity by the exertion of human industry, and on the production of which competition operates without restraint." -- David Ricardo, On the Principles of Political Economy and Taxation (3rd edition), Chapter I: "On Value", Section 1
I think Ricardo is clear here that he does not think natural prices are determined or explained by supply and demand:
"It is the cost of production which must ultimately regulate the price of commodities, and not, as has been often said, the proportion between the supply and demand: the proportion between supply and demand may, indeed, for a time, affect the market value of a commodity, until it is supplied in greater or less abundance, according as the demand may have increased or diminished; but this effect will be only of temporary duration." -- David Ricardo, Principles (3rd edition), Chapter XXX: "On the Influence of Demand and Supply on Prices"

(Ricardo, in Chapter XXXI, "On Machinery", says that he thinks that persistent unemployment is consistent with his theory where some of "the population will become redundant, compared with the funds which are to employ it." This view is inconsistent with explaining wages and employment by supply and demand. By the way, Ricardo is not denying Say's law here. He doesn't expect unused capacity for production to be created or to persist.)

1.3 Karl Marx

Karl Marx makes many of the same points as Ricardo. Here he points out that supply and demand do not determine natural prices for commodities:
"Nothing is easier to understand than the disproportion between demand and supply, and the consequent divergences of market prices from market values... If demand and supply coincide, they cease to have any effect, and it is for this very reason that commodities are sold at their market value... If demand and supply cancel one another out, they cease to explain anything, have no effect on market value..." -- Karl Marx, Capital: A Critique of Political Economy (Trans. by David Fernbach), V. 3, Chapter 10: "The Equalization of the General Rate of Profit through Competition. Market Prices and Market Values. Surplus Profit."

1.4 Piero Sraffa

I thought about going into the diverse theories the classical economists and Marx had for natural prices. But this post is already too long. Instead, I will point out a modern economist taking over the distinction between market and natural prices:
"A less one-sided description than cost of production seems therefore required. Such classical terms as 'necessary price', 'natural price' or 'price of production' would meet the case but value and price have been preferred as being shorter and in the present context (which contains no reference to market prices) no more ambiguous." - Piero Sraffa, Production of Commodities by Means of Commodities p. 9

2.0 Vulgar Economics

2.1 Thomas Malthus

Thomas Malthus rejected the classical theory of value and distribution:
"The principle of demand and supply is the paramount regulator of the prices of labour as well as of commodities, not only temporarily but permanently; and the costs of production affect these prices only as they are the necessary condition of the permanent supply of labour, or of commodities." -- Thomas Malthus, Principles of Political Economy, Chapter IV: "Of the Wages of Labour", Section 1
I don't know whether Malthus regarded supply and demand as schedules.

2.2 John Stuart Mill

I think Schumpeter described Mill as being a half-way house between classical and marginalist economics. Mill noted his predecessors did not regard supply and demand as schedules, and he thinks they should be so regarded:
"Meaning, by the word demand, the quantity demanded, and remembering that this is not a fixed quantity, but in general varies according to the value... The demand, therefore, partly depends on the value...

Thus we see that the idea of a ratio, as between demand and supply, is out of place, and has no concern in the matter: the proper mathematical analogy is that of an equation. Demand and supply, the quantity demanded and the quantity supplied will be made equal. If unequal at any moment, competition equalizes them, and the manner in which this is done is by an adjustment of the value. If the demand increases, the value rises; if the demand diminishes, the value falls: again, if the supply falls off , the value rises; and falls if the supply is increased. The rise or the fall continues until the demand and supply are again equal to one another: and the value which a commodity will bring in any market is no other than the value which, in that market, gives a demand just sufficient to carry off the existing or expected supply.

This, then, is the Law of Value, with respect to all commodities not susceptible of being multiplied at pleasure. Such commodities, no doubt, are exceptions. There is another law for that much larger class of things, which admit of indefinite multiplication. But it is not the less necessary to conceive distinctly and grasp firmly the theory of this exceptional case. In the first place, it will be found to be of great assistance in rendering the more common case intelligible. And in the next place, the principle of the exception stretches wider, and embraces more cases, than might at first be supposed." - John Stuart Mill, Principles of Political Economy with Some of their Applications to Social Philosophy, Book III, Chapter II: "On Demand and Supply in their Relation to Value", Section 4.
Notice that Mill uses supply and demand to explain the prices of only those commodities that cannot be (re)produced - here is where that distinction stated by Ricardo comes in. But Mill stretches this exceptional case further than others had.


YouNotSneaky! said...

"The distinction between market and natural prices apparently goes back to William Petty"

If you include the interest rate in prices then I'm sure this goes back to at least St. Thomas Aquinas.

Robert Vienneau said...

Based on secondary literature, I doubt it. Just prices and natural prices are distinct concepts.

Gabriel said...


Fair enough, but I think we now better know under which conditions relative prices are determined by constant returns and finite quantities supplied under competition alone. (I.e. what price vectors are consistent with no (excess) profit.) --

Some people do happen to think that the restrictions required for these results make them irrelevant to the analysis of contemporary economies. You think the same of neoclassical models. How can we settle this?

Btw, what do you think of Samuelson's Sraffa's Other Leg which deals largely with the subject of this post?

Robert Vienneau said...

The classical theory of value makes no assumptions on returns to scale. Nobody can state assumptions or restrictions on tastes, technology, or endowments - the data of multigood neoclassical models - that rule out Sraffa effects.

I don't think what Gabriel says I think.

Gabriel said...

My comment was strictly related to the conditions under which supply alone determined prices. (E.g. the non-substitution theorem.)

This is precisely why I was curious about your views on Samuelson's article, which discusses head-on these particular cases of cost-determined price, if that's the right thing to call it.

The labor theory of value need not enter the discussion.

I have no interest in "Sraffa effects" at this point, unless these are causing the result in question.

Robert Vienneau said...

In the classical theory of value, "supply" alone does not determine prices. Natural prices are determined for a level of effectual demand. (See the Adam Smith quote in the original post.)

One might claim that for "neoclassical models" to be relevant "to the analysis of contemporary economies", they must exclude Sraffa effects. "Sraffa effects" is a generic term to include reswitching, reverse capital deepening, price Wicksell effects that go in a direction counter to outdated neoclassical intuition, etc. I took Gabriel to be saying I doubt the restrictions or assumptions needed to rule out Sraffa effects. But I do not think so, since no such assumptions have been stated.

I am away from my library and will not comment on Samuelson here.

Gabriel said...

Oh, I understand what you mean now, (I think!). Thanks!

The emphasis I was missing was on "natural". Oh, well, back to square 1.

Btw, regarding Samuelson, beyond the Leg paper, there's his 59 paper referenced there. Your comments on both of them would be most interesting! (I see there are quite a few replies to the 59 paper, I forget its name.)