Origin of Supply and Demand Model

You know the supply and demand model is the most basic instrument to understand market price mechanism. Whatever university you enroll in, you have to understand it in your first lesson.

But it was not popularized before 1890. Even big names in classical economics like Adam Smith, David Ricardo, Thomas Malthus, or John Stuart Mill didn’t mention it. They had every idea regarding important of demand and supply, but they neither described it as a model nor said anything about the law of supply and demand.

Alfred Marshall, a British economist, is considered the father of supply and demand model. Only when he published his principal work on economics “Principles of Economics,” in 1890, the model got the attention of the academics.

Before him, in 1877, Leon Walrus, a French economist, published “Elements of Pure Economics” and described main principles of general equilibrium theory. He built a system of simulation to demonstrate that price and quantity are determined separately for each commodity. He discussed demand and supply in a way that may be considered close to the model built by Alfred Marshall.

Alfred Marshall discussed not only supply and demand model but also elasticities, consumer behavior, elasticities of demand and supply, factors shifting demand and supply curve, factors affecting equilibrium, the role of governments, etc.

In fact, Alfred Marshall was the father of neo-economics. While defining economics, he says:

“Political Economy or Economics is a study of mankind in the ordinary business of life; it examines the part of the individual and social action which is most closely connected with the attainment and with the use of the material requisites of well being.”

A Few Observations of Alfred Marshall on Supply and Demand Model

Alfred Marshall has discussed his ideas on supply and demand model in his book at length. Most of his observations hold field even today. How price changes with demand and supply, Alfred Marshall says:

“An increase of normal demand for a commodity involves an increase in the price at which each several amounts can find purchasers; or, which is the same thing, an increase of the quantity which can find purchasers at any price. Similarly, an increase of normal supply means an increase of the amounts that can be supplied at each several prices and a diminution of the price at which each separate amount can be supplied.”

He further says on supply and demand model:

“When demand and supply are spoken of in relation to one another, it is, of course, necessary that the markets to which they refer should be the same.”

The basic supply and demand model can work in a competitive market. It fails in monopolies. Alfred Marshall says:

“…we assume that the forces of demand and supply have free play; that there is no close combination among dealers on either side, but each acts for himself, and there is much free competition; that is, buyers compete freely with buyers, and sellers compete freely with sellers. But though everyone acts for himself, his knowledge of what others are doing is supposed to be generally sufficient to prevent him from taking a lower or paying a higher price than others are doing. This is assumed provisionally to be true both of finished goods and of their factors of production, of the hire of labor and the borrowing of capital.”

Observations on the point of Equilibrium

On the point of equilibrium in supply and demand model, Alfred Marshall says:

“When the amount produced (in a unit of time) is such that the demand price is greater than the supply price, then sellers receive more than is sufficient to make it worth their while to bring goods to market to that amount; and there is at work an active force tending to increase the amount brought forward for sale. On the other hand, when the amount produced is such that the demand price is less than the supply price, sellers receive less than is sufficient to make it worth their while to bring goods to market on that scale; so that those who were just on the margin of doubt as to whether to go on producing are decided not to do so, and there is an active force at work tending to diminish the amount brought forward for sale. When the demand price is equal to the supply price, the amount produced has no tendency either to be increased or to be diminished; it is in equilibrium.”

He further says:

“It is true then that a position of equilibrium of demand and supply is a position of maximum satisfaction in this limited sense that the aggregate satisfaction of the two parties concerned increases until that position is reached; and that any production beyond the equilibrium amount could not be permanently maintained so long as buyers and sellers acted freely as individuals, each in his own interest.”

“When demand and supply are in equilibrium, the amount of the commodity which is being produced in a unit of time may be called the equilibrium-amount, and the price at which it is being sold may be called the equilibrium-price.”

Role of Government

What should be the role of government in a market mechanism? Alfred Marshall discusses it in his book:

“These conclusions, it will be observed, do not by themselves afford a valid ground for government interference. But they show that much remains to be done, by a careful collection of the statistics of demand and supply, and a scientific interpretation of their results, in order to discover what are the limits of the work that society can with advantage do towards turning the economic actions of individuals into those channels in which they will add the most to the sum total of happiness.”

Elasticities and Alfred Marshall

He was very much aware of elasticities of demand and supply. He observes:

“Here there is to be noted an important difference between demand and supply. A fall in the price, at which a commodity is offered, acts on demand always in one direction. The amount of the commodity demanded may increase much or little according to as the demand is elastic or inelastic: and a long or short time may be required for developing the new and extended uses of the commodity, which are rendered possible by the fall in price.”

“An increase in the price offered by purchasers does indeed always increase supply: and thus it is true that, if we have regard to short periods only, and especially to the transactions of a dealer's market, there is an "elasticity of supply" which corresponds closely to the elasticity of demand. That is to say, a given rise in price will cause a great or a small increase in the offers which sellers accept, according as they have large or small reserves in the background, and as they have formed low or high estimates of the level of prices at the next  market: and this rule applies nearly in the same way to things which in the long run have a tendency to diminishing return as to those which have a tendency to increasing return.”

On analyzing, we realize that most of the observations made by Alfred Marshall are as valid today as they were in the 1890s. Taking liberty on the modern economics, we may say that supply and demand model has not been changed very much from the day Marshall designed it. Most of the later developments are merely commentary or discussions on the exceptions of a model like an oligarchy, transaction cost, switching cost, embedded costs, etc.

What do you think?