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You just read that demand represents the interests of the consumer, while supply represents the interests of the producer. Consumers will buy a greater quantity of products at a low price, while producers will make a greater quantity of products at a high price. The reality of any market is that neither buyers nor sellers can get exactly the price they want. Instead, it is only through compromise between the interests of buyers and sellers that a market price and quantity can be reached.

During the eighteenth and nineteenth centuries, economists explored how the forces of demand and supply affected the functioning of markets. In 1890 prominent British

PRIMARY DOCUMENT: Alfred Marshall Describes the Importance of Demand and Supply

We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value [the price of an item] is governed by utility [the demand side of the market] or cost of production [the supply side of the market]. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens.

In the same way, when a thing already made has to be sold, the price which people will be willing to pay for it will be governed by their desire to have it, together with the amount they can afford to spend on it. Their desire to have it depends partly on the chance that, if they do not buy it, they will be able to get another thing like it at as low a price: this depends on the causes that govern the supply of it, and this again upon the cost of production.

Principles of Economics, Alfred Marshall

economist and mathematician Alfred Marshall (1842–1924) published Principles of Economics, which expanded on the work of the earlier economists. Marshall brought earlier analyses of supply and demand together onto the same graph, noting that free markets balance the interests of suppliers of products and demanders of products at an equilibrium price and quantity. When asked whether supply or demand was the more dominant determinant of the good's price, Marshall compared supply and demand to the blades of scissors. Just as both blades are needed to cut a piece of paper, both supply and demand are needed to establish market equilibrium, as explained in the above passage.[1]

Market Clearing Price and Quantity

The market equilibrium for a product occurs at the point where the demand curve and supply curve intersect. Thus, the market equilibrium is the best compromise between the interests of consumers, represented by the demand curve, and producers, represented by the supply curve. At the market equilibrium, the product's price and quantity are determined. The market equilibrium is also called the market clearing price because at this compromise point, all of the output supplied by businesses is demanded by buyers. Figure 2.6 illustrates the demand and supply for product X. At a low price of $2, the quantity demanded is high, 10,000 items in this case. Producers, on the other hand, are only willing to produce 10,000 items if they can charge a high price of $10 per item.

The power of the free market is its ability to make the necessary compromises without decrees or coercion from the government. Figure 2.6 shows that at this moment in time, the equilibrium price for product X is $6 and its equilibrium quantity is 6,000 items. Note that the horizontal axis is now labeled “quantity,” rather than “quantity demanded” or “quantity supplied,” because both the demand curve and the supply curve are shown on the same graph.

Price Ceilings and Price Floors

While the forces of supply and demand are responsible for establishing most prices in the U.S. economy, the government sometimes overrides the compromises of the market

Market Equilibrium for Product X

Figure 2.6 Market Equilibrium for Product X

to set the price for a product or a resource. This type of government intervention in the economy typically occurs when government, at any level, feels a price is unfairly high for consumers or unfairly low for producers. There are two types of government price controls, price ceilings and price floors.

A price ceiling is a government-imposed maximum price that a seller may charge for a good or service. The main goal of a price ceiling is to make a product more affordable to consumers. A rent control on apartment units is one common type of price ceiling used in the United States. Some local governments limit rents for apartment units at a price below the true market equilibrium. In Figure 2.7, for example, the true equilibrium price for a rental unit is $500 per month, and the equilibrium quantity is 40,000 rental units. The government-imposed price ceiling, however, dictates that the apartment owners cannot charge more than $400 in monthly rent to people renting these apartments. This $400 appears as a horizontal line to show that no matter how many apartments are demanded or supplied, the price (rent) stays constant at $400. At this lower controlled price, the quantity demanded of rental units increases to 50,000, shown at point B. An unintended consequence of the lower rents, however, is that the quantity supplied of rental units decreases to 30,000, shown at point A. The result is a shortage of rental units because the quantity demanded (50,000 rental units) is now greater than the quantity supplied (30,000 rental units).

Price ceilings have been used sparingly in the U.S. economy. For example, during World War II the federal government imposed price ceilings on certain consumer goods to hold inflation in check. The government also imposed price ceilings on domestically produced oil during the mid-1970s in response to skyrocketing oil prices in U.S. and global markets. A price floor is a government-guaranteed minimum price for a product or a resource. In the product market, the main goal of a price floor is to provide higher revenues for suppliers

Price Ceilings and Shortages

Figure 2.7 Price Ceilings and Shortages

of certain goods. For example, the U.S. government has instituted price floors on a number of agricultural products to boost revenues for the country's farmers. In the factor market, the federal government's price floor on wages, called the minimum wage, sets a minimum price for the services of workers. A minimum wage creates the lowest wage that an employer can offer an employee. The Fair Labor Standards Act created the country's first minimum wage of $0.25 per hour in 1938. In 2013 the federal minimum stood at $7.25.[2]

The impact of a minimum wage on some low-wage labor markets might resemble that shown in Figure 2.8. Note that the equilibrium wage in this labor market occurs where the supply curve and demand curve for labor intersect, in this case an hourly wage rate of

$4 and a quantity of 5,000 employed workers. Suppose a minimum wage of $7 was applied to this labor market, as shown in Figure 2.8. This $7 per hour wage appears as a horizontal line to show that no matter how many workers are demanded or supplied, the price of labor (wage rate) stays constant at $7 per hour. The result is a drop in the number of workers that firms demand from 5,000 to just 2,000, as shown on the demand curve. At the same time, the number of workers willing to work at this higher wage rises from 5,000 to 8,000, as shown on the supply curve. Hence, a labor surplus of 6,000 workers is created because the quantity supplied (8,000) is greater than the quantity demanded (2,000) at the new government-imposed wage rate. This theoretical model overstates the job loss that would occur due to an increase in the minimum wage but illustrates the potential for unemployment when the government intervenes in certain markets.

Price System

A market economy is a type of economy that relies on the private sector—individuals and business firms—to answer the basic economic questions of what to produce, how to produce, and for whom to produce. In practice, this means that people can own and control private property and exercise a variety of freedoms in the marketplace.

Impact of the Minimum Wage on a Certain Labor Market

Figure 2.8 Impact of the Minimum Wage on a Certain Labor Market

The Hong Kong Special Administrative Region (SAR) is the freest economy in the world

The Hong Kong Special Administrative Region (SAR) is the freest economy in the world.

ECONOMICS IN HISTORY: The Case of Hong Kong and Economic Freedom

Over the past few decades the former British colony of Hong Kong has been among the freest market economies in the world. Established as a free port by the British in the early 1840s, Hong Kong attracted foreign trade and investment during the nineteenth and twentieth centuries. The influx of aspiring entrepreneurs and foreign capital accelerated during the early twentieth century as people fled the chaos of war and revolution in neighboring China, including the devastating civil war between the Nationalists and the Communists—a conflict that raged until the victorious Communists created the People’s Republic of China in 1949.

British policies encouraged free markets and profit incentives in Hong Kong. By design, there were few government regulations on business activity. The British also invested heavily in the development of a modern infrastructure, including an electrified railroad, a subway system, and an international airport. In 1997 Hong Kong was made a special administrative region of the People’s Republic of China. Today, this region is called the Hong Kong SAR. The present government of the Hong Kong SAR has a strong commitment to free markets and lives by the principle of “Big Market, Small Government.”[3] It retains a privileged position within China, however. The Hong Kong SAR enjoyed the most economic freedom of any economy in the world in 2010, according to Economic Freedom of the World: 2012 Annual Report.[4]

The price system coordinates most production and consumption decisions in a market system, largely through invisible “signals” to market participants—consumers, producers, workers, and others. Many of these signals are price signals. Recall from Chapter 1 that one of the basic principles of economics is that people respond to price incentives. That is, price incentives, rather than government authorities, allocate resources.

What are some of these price signals? Consumers enjoy the freedom of choice—the ability to consider the prices of goods when they spend their money. First, a lower price on a certain item signals consumers to purchase more of the lower-priced item and less of the higher-priced substitute goods. Second, consumer spending signals producers about what goods and services to produce—producers produce only what consumers will buy.

Producers, in turn, have the freedom of enterprise, which allows firms to consider the price of resources when they produce goods. Producers shop around for low-priced resources to make goods and services. The use of less expensive resources enables producers to remain competitive with other firms and to earn higher profits. Economists summarize the functions of the price system as follows:

Allocation function. the price system encourages firms to make efficient use of resources, to lower production costs, and to produce goods that people are willing to buy; and

Rationing function. the price system signals which products people can or cannot afford to buy at a moment in time.

  • [1] Alfred Marshall, Principles of Economics. Abridged. Amherst, NY: Prometheus, 1997, Book V, Chapter III, Section 27–28.
  • [2] U.S. Department of Labor (DOL), “History of Federal Minimum Wage Rates under the Fair Labor Standards Act, 1938–2009,”; DOL, “Changes in Basic Minimum Wages in Non-Farm Employment under State Law: Selected Years, 1968 to 2013,”
  • [3] Hong Kong Special Administrative Region, Hong Kong: The Facts (Hong Kong, China: Information Services Department, Hong Kong SAR, January), 2012
  • [4] James Gwartney, Robert A. Lawson, and Joshua C. Hall, “Exhibit 1.2: Summary Economic Freedom Ratings for 2010,” Economic Freedom of the World: 2012 Annual Report (Canada: Fraser Institute), 2012, 10
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