Adam Smith

T
he most basic laws in economics are the law of supply and the law of
demand. Indeed, almost every economic event or phenomenon is the

product of the interaction of these two laws. The law of supply states that
the quantity of a good supplied (i.e., the amount owners or producers offer
for sale) rises as the market price rises, and falls as the price falls.
Conversely, the law of demand (see DEMAND) says that the quantity of a
good demanded falls as the price rises, and vice versa. (Economists do not
really have a law of supply, though they talk and write as though they do.)
One function of markets is to find equilibrium prices that balance the supplies of
and demands for goods and services. An equilibrium price (also known as a
market-clearing price) is one at which each producer can sell all he wants to
produce and each consumer can buy all he demands. Naturally, producers always
would like to charge higher prices. But even if they have no competitors, they are
limited by the law of demand: if producers insist on a higher price, consumers will
buy fewer units. The law of supply puts a similar limit on consumers. They always
would prefer to pay a lower price than the current one. But if they successfully
insist on paying less (say, through PRICE CONTROLS), suppliers will produce less and
some demand will go unsatisfied.
Economists often talk of demand curves and supply curves. A demand curve
traces the quantity of a good that consumers will buy at various prices. As the price
rises, the number of units demanded declines. That is because everyones resources
are finite; as the price of one good rises, consumers buy less of that and,
sometimes, more of other goods that now are relatively cheaper. Similarly, a supply
curve traces the quantity of a good that sellers will produce at various prices. As the
price falls, so does the number of units supplied. Equilibrium is the point at which
the demand and supply curves intersectthe single price at which the quantity
demanded and the quantity supplied are the same.
Markets in which prices can move freely are always in equilibrium or moving toward
it. For example, if the market for a good is already in equilibrium and producers
raise prices, consumers will buy fewer units than they did in equilibrium, and fewer
units than producers have available for sale. In that case producers have two
choices. They can reduce price until supply and demand return to the old
equilibrium, or they can cut production until the quantity supplied falls to the lower
number of units demanded at the higher price. But they cannot keep the price high
and sell as many units as they did before.
Why does the quantity supplied rise as the price rises and fall as the price falls? The
reasons really are quite logical. First, consider the case of a company that makes a
consumer product. Acting rationally, the company will buy the cheapest materials
(not the lowest quality, but the lowest cost for any given level of quality). As
production (supply) increases, the company has to buy progressively more
expensive (i.e., less efficient) materials or labor, and its costs increase. It charges a
higher price to offset its rising unit costs.
Are there any examples of supply curves for which a higher price does not lead to a
higher quantity supplied? Economists believe that there is one main possible
example, the so-called backward-bending supply curve of labor. Imagine a graph in
which the wage rate is on the vertical axis and the quantity of labor supplied is on
the horizontal axis. It makes sense that the higher the wage rate, the higher the
quantity of labor supplied, because it makes sense that people will be willing to
work more when they are paid more. But workers might reach a point at which a
higher wage rate causes them to work less because the higher wage makes them
wealthier and they use some of that wealth to buy more leisurethat is, to work
less. Recent evidence suggests that even for labor, a higher wage leads to more
hours worked.1
Or consider the case of a good whose supply is fixed, such as apartments in a
condominium. If prospective buyers suddenly begin offering higher prices for
apartments, more owners will be willing to sell and the supply of available
apartments will rise. But if buyers offer lower prices, some owners will take their
apartments off the market and the number of available units will drop.
History has witnessed considerable controversy over the prices of goods whose
supply is fixed in the short run. Critics of market prices have argued that rising
prices for these types of goods serve no economic purpose because they cannot
bring forth additional supply, and thus serve merely to enrich the owners of the
goods at the expense of the rest of society. This has been the main argument for
fixing prices, as the United States did with the price of domestic oil in the 1970s
and as New York City has done with apartment rents since World War II (see RENT
CONTROL).
Economists call the portion of a price that does not influence the amount of a good
in existence in the short run an economic quasi-rent. The vast majority of
economists believe that economic rents do serve a useful purpose. Most important,
they allocate goods to their highest-valued use. If price is not used to allocate
goods among competing claimants, some other device becomes necessary, such as
the rationing cards that the U.S. government used to allocate gasoline and other
goods during World War II. Economists generally believe that fixing prices will
actually reduce both the quantity and the quality of the good in question. In
addition, economic rents serve as a signal to bring forth additional supplies in the
future and as an incentive for other producers to devise substitutes for the good in
question.
http://www.econlib.org/library/Enc/Supply.html

Adam Smith

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T

demand. Indeed, almost every economic event or phenomenon is the

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