Supply & Demand

Trade is mutually beneficial.  This means that both parties benefit from the exchange; what they receive from the exchange is, in their estimation, of higher value than that which they must give up.  In economic terms, the benefits are higher than the costs.  The theory of exchange I just laid out here has two implications which help get us to the Laws of Supply and Demand: 1) there exists a price* that is sufficiently high that will induce someone to enter the market as a seller and 2) there exists a price that is sufficiently low that will induce someone to enter the market as a buyer.**  Graphically, these implications give us the old standard supply and demand diagram:


Look at the sublime beauty of this hand-drawn graph.

Now, consider what is going on with the points where Supply are valued less (that is, the price suppliers are willing to supply at is lower than the price buyers are willing to pay), say at points A and B in the above graph.  Sellers value the quantity in question at Pa and consumers value it at Pb.  Since Pb>Pa, a trade will occur (the buyer values the good/service higher than its current owner) and the gain from trade is Pb-Pa.  (Nota bene: on the right-hand side of the graph, where the value of supply is greater than the value of demand, no trade will occur).

These gains of trade will be discussed in more detail in the next blog post.

*A quick note on price: We tend to think of prices in monetary terms, but they needn’t be.  A price is just whatever it costs to acquire something.  Prices represent opportunity costs.

**For a neat proof and thorough discussion of this point, see Investment, Interest, and Capital by Jack Hirshleifer, Chapter 1, especially pages 4-15

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