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Demand from Where?

By James H. Nolt

This week, I continue my series on the problems on contemporary economics, particularly the standard textbook version now taught to millions of economics students worldwide. The way of teaching economics now is so full of propaganda and myth, it should certainly be taken with a grain of salt. One of the most egregious farces is where every microeconomic textbook starts, with the demand curve.

Don’t get me wrong, demand for products and services is a real thing, but the way standard textbooks explain it is nonsensical. What “demand” means in the textbook version is willingness to buy various quantities of Product X at various prices. The “demand curve,” usually the first diagram introduced in the microeconomic sections of every textbook, is a function (often shown as linear rather than a curve) relating the quantity of Product X that would be demanded at various prices.

The Law of Demand is then introduced to explain the assumed inverse relationship between quantity demanded and price. This “law” is that the higher the price, the less quantity of a product will be purchased. This is not bad as a rule of thumb, though it is less than a universal law for reasons we will put off until later. But what makes the demand curve problematic is that the context of this “willingness” is not specified. This turns out to have enormous implications that are rarely ever spelled out for students any more.

As I said previously, classical political economy started with production rather than demand. Logically, this makes more sense. You cannot have products to buy until something is already produced. Furthermore, you cannot have buying power enabling you to be willing to demand products if you do not have a job or some other income that ultimately comes from what is produced.

Therefore “willingness” to demand things must depend first on the income of everyone in an economy, which is itself a function of what and how much is collectively produced. Until I know my income, the products available, and their prices, how can I form any concrete ideas about what I might be willing to buy? But since economics will use the demand curve plus the supply curve to determine prices, the demand curve for everything must exist logically prior to the determination of price.

One of the founders of economics, Léon Walras, understood that this was a problem. So he imagined a magical market system wherein it would be possible to find equilibrium prices even before considering production and income. He just assumed that a set of products somehow exist, owned by sellers, without any prices attached. All the consumers have money to buy things that they got from somewhere unrelated to any ongoing process of production.

In the middle of this illogical mess stands a single auctioneer with infinite time on his hands. He calls out a list of prices for each good, sort of the way Adam named all the creatures in Genesis. There are, of course, a lot of prices, so it takes a long time to do this even once. When he is done, all of the potential consumers and suppliers, who naturally remember all the millions of prices just called out, state how much of each thing they will demand and supply at that set of prices, given their predetermined assets.

The auctioneer then tallies up the result and sees if there is any excess supply or demand for anything. Likely there is, since his price list was arbitrary. If there was excess demand for something, he raises the price. If there was excess supply, he lowers it. Then the process repeats. It keeps repeating until all the prices are perfect and there is no excess supply demand. Who knows how many thousands iterations would be required. Only after the entire process has established these perfect prices does the auctioneer give the green light for actual trading of products to commence. Walras was not a very practical man.

The much simpler idea from classical political economy is that products enter the market with prices already attached because producers simply tally up their costs of production and add a margin for profit. They may subsequently adjust their price or production levels up or down according to the results of their selling effort. This entirely reasonable and practical way of understanding prices is rejected by economists for the simple reason that it implies that producers, not consumers, have the power to set quantity produced and price.

Economics prefers to tell the story backwards, starting with all-powerful consumers and making numerous free market capitalists the mere servants of consumer’s whims. Does anybody else notice the propaganda here, or is it just me?

There are not just ideological reasons why economics refuses to tell the story in a sensible way. There are also methodological objectives too. Remember, I argued that Walras and other founders of economics wanted to create a mathematical theory of price determination, which is one reason they wanted to ignore private power over price. There is another very important reason too.

The Three Golden Pillars, that free market economies must be stable, efficient, and fair, cannot be proven unless all trades occur at free market prices that exactly maintain equilibrium between the quantity consumers are willing to demand and the quantity suppliers are willing to supply. That’s a tall order! Take away any piece and the entire enterprise collapses. No wonder theorists like Walras conjured up such bizarre stories!

Returning to the demand curve for a single Product X, how can we even imagine I can form a willingness to demand some quantity of Product X if I do not already know both my budget and the prices of everything else? Imagine I inherit $1,000. I can choose how much of it to spend on shoes. Depending on the price of shoes, I will buy more or less of them. But I will also buy more or less shoes depending on all the other products I might buy instead and their specific prices. If I do not know these things, how is sensible to imagine I have formed a very specific willingness to buy a certain number of shoes at each possible price of shoes? If the prices of everything else are already determined, then the prices of the inputs to making shoes are also known, so the only issue on pricing shoes would be how big will be the profit margin of the shoemakers.

But later, after students learn the demand curve, they learn that the cost curves by which free market producers form their willingness to supply disallow any profit by the rational small (powerless) producer. If the suppliers of shoes are thereby constrained against earning any net profit from selling them, then the price of shoes must already be determined, independent of consumer willingness to demand shoes, by the cost of the inputs used to produce them. With that, we’re right back into world of classical political economy that economists try so hard to escape.

When you start to realize this entire process of reasoning is hopelessly circular, convoluted, and illogical, you start to understand how desperately economists struggle to come up with some story, any story, that can support consumer sovereignty rather than the more obvious and plausible producer power. We will continue this thread next week.

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James H. Nolt is a senior fellow at the World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of Wikimedia Commons]

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