I’m teaching History of Economic Thought again this year and during my progression through the material this term what has struck me is the very long road over time –literally hundreds of years - to understanding markets and value as the simultaneous interaction both supply and demand side factors culminating in the standard diagram of price and quantity determination in a market. There was recognition of separate demand and supply side factors and even adjustment to some idea of equilibrium as far back as the medieval period but the concepts were like ships passing in the night when it came to price determination. However, what also struck me is how much of the theory of demand and supply was ultimately grasped nearly simultaneously in the nineteenth century by an assortment of economists working separately.
In terms of markets and commercial activity, much of medieval economic thought centered on the notion of the 'just price' of a transaction. Medieval thinkers felt goods had two prices - a selling price and a price based on value or worth or what was termed the “just price”. The idea that a 'just price' was based on value or worth suggests that Medieval thinkers believed it was all right to reward factors for their cost of production but speculative gains were not morally correct. However, value was also based on need as Thomas Aquinas himself argued that price varies with need or what he termed indigentia.
As Aquinas wrote: "...if the price exceeds the quantity of the value of the article, or the article exceeds the price, the equality of justice will be destroyed. And therefore, to sell a thing dearer or to buy it cheaper than it is worth is, in itself, unjust and illicit...The just price of things, however, is not determined to a precise point but consists of a certain estimate...The price of an article is changed according to difference in location, time, or risk to which one is exposed in carrying it from one place to another or in causing it to be carried. Neither purchase or sale according to this principle is unjust." (Ekelund and Hébert, p. 30)
Skipping forward to the 1600s, there is a demonstration of the law of demand by Gregory King (1648-1712) that was disseminated by Charles Davenant (1656-1714). He presented a relationship between the price of wheat and the harvest which illustrates the law of demand and elasticity. The results suggest that if the harvest falls by 50%, the price would rise by 500% (See Table 1). Again, this of course intertwines both the supply side and the demand side as a reduction in the harvest is a supply side shift.
Richard Cantillon (1680-1734) in Essai sur la nature du commerce en general. (Essay on the General Nature of Commerce) argued the price of a product was divided into a normal price, measuring the quantity and quality of the land and labour that were used in its production, and the market price. The normal price can deviate from the market price, which reflects changes in the market.
Table 1: Gregory King’s “Demand” Schedule
Reduction in Harvest Increase in Price of Wheat
(Source: Spiegal, 142)
It is left to Adam Smith (1723-1790) and the Wealth of Nations to tackle the problem using an adjustment mechanism that more closely resembles what we now teach in first year economics. Yet he also seems to separates demand and supply into separate actors with one determining price in the short run and the other in the long run. In Chapters 5-7 of the Wealth of Nations, Smith articulates a labour theory of value as well as the concepts of demand and supply and market adjustment. According to Smith, a good can have two prices: its market price and its natural price.
The value of a commodity, according to Smith, was the sum of the amounts payable to the factors used in making a good - that is, the cost of bringing a product to market. The constant adjustment of demand and supply produces the long run 'natural price' that just covers the cost of bringing the product to market. When a commodity is brought to market, it is demand that sets the price but in the long run, the final price is set solely by producer costs. That first price, in response to the increase in demand is the market price while the price after the supply adjustment is the natural price. Of course, there were no graphs.
John Stuart Mill (1806-1873)– the great synthesizer of the Classical School –finally brings demand and supply together in a theory of an equilibrium price using verbal analysis. He presents demand and supply as schedules showing the relation between price and quantity demanded and supplied, all other things given. This finally resolves the past inability to see value determined simultaneously by two separate sides. First, utility, which led to demand and then cost, which led to supply. Mill provides an explanation similar to the modern exposition of equilibrium price determination. As Mill writes:
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, let us suppose that the demand at some particular time exceeds the supply, that is, there are persons ready to buy, at the market value, a greater quantity than is offered for sale. Competition takes place on the side of the buyers and the value rises...At what point, then will the rise be arrested? At the point, whatever it be, which equalizes the demand and the supply: at the price which cuts off the extra third from the demand, or brings forward additional sellers sufficient to supply it. When in either of these ways, or by a combination of both, the demand becomes equal and no more than equal to the supply, the rise of value will stop.
The converse case is equally simple. Instead of a demand beyond the supply, let us suppose a supply exceeding the demand. The competition will now be on the side of the sellers: the extra quantity can only find a market by calling forth an additional demand equal to itself. This is accomplished by means of cheapness; the value falls, and brings the article within the reach of more numerous customers, or induces those who were already consumers to make increased purchases.... 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 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 fall continues until the demand and supply are again equal to one another. (Mill, 446-448)
It was left to Alfred Marshall (1842-1924) to provide a graphical illustration – or so it seems. In Principles of Economics (1890), price is determined by demand and supply, cut, as it were by 'both blades of the scissors.' He reconciled the demand and supply side explanations of value into a single analytical framework. Utility theory provided the formulation of the demand curve while costs determined the supply curve and the interaction of demand and supply - set price. In the short run, it was demand that set price but in the long run, supply adjusted so that a competitive economy in the long run would tend towards the lowest possible costs of production. I suppose this is what Adam Smith had in mind when talking about market and natural prices.
Economists usually see Alfred Marshall as the originator of standard demand and supply diagrams and their use in economic analysis including welfare applications and consumer surplus. However, it turns out that Marshall’s diagram was not the first use of demand and supply curves. Cournot originates a scissors type diagram to illustrate tax incidence in 1838 that has a demand and a supply curve with price on the horizontal axis and quantity on the vertical axis. Indeed, at least five economists used similar tools before Marshall published it – Antoine Cournot (1838), Karl Rau (1841), Jules Dupuit (1844), Hans Von Mangoldt (1863) and Fleeming Jenkin (1870). According to Humphrey (1992), these individuals were largely unaware of the others work.
According to Humphrey (1992), Cournot contributed the original curves while Rau and Mangoldt provided stability analysis. Mangoldt did the first comparative statics exercises and Jenkin applied the analysis of price determination to the long and the short runs. Cournot, Dupuit and Jenkin use the framework for tax incidence analysis while Jenkin devises the concept of producer surplus. To Humphrey’s knowledge, Marshall was probably aware of much of this work. One wonders if Marshall's placing of price on the vertical axis and quantity on the horizontal axis might have been done to differentiate his work from the others – Cournot has quantity on the vertical axis and price on the horizontal (but see Gordon 1982 for another explanation of why Marshall did it – to motivate the desire to use price as a money measurement of benefits and costs in measuring surplus and welfare). Humphrey (1992) asserts that Marshall nevertheless deserves some credit because he gave the diagram its most “complete, systematic and persuasive” statement but not because he was the first to invent it. So there you have it.
Blaug, Mark (1983) Economic Theory in Retrospect (Cambridge: Cambridge University Press)
Ekelund, Robert B. Jr. and Robert F. Hébert (1990) A History of Economic Theory and Method, 3rd Edition (New York: McGraw-Hill).
Gordon, Scott (1982) “Why Did Marshall Transpose the Axes?” Eastern Economic Journal, Vol. VIII, No. 1, January, 31-35.
Humphrey, T.M. (1992) “Marshallian Cross Diagrams and Their Uses Before Alfred Marshall: The Origins of Supply and Demand Geometry”, Economic Review, March/April, 3-23.
Mill, John Stuart (1848/1969) Principles of Political Economy (New York: Augustus M. Kelley)
Smith, Adam (1776/1982) The Wealth of Nations (New York: Penguin Books)
Spiegal, Henry W. (1983) The Growth of Economic Thought (Durham: Duke University Press)