The Invisible Hand: How Markets Work
4. How Do Markets Work?

A sports team needs courage to do well, a family needs love. But the market needs neither, it is said. Only incentives, prudence. Or so, we repeat, some economists like to say. The next time you buy a soft drink from a machine notice how little involved you are with the makers of the drink. Coins in, drink out. The market, as an economist once put it, "economizes on love." If markets were in fact like vending machines then the love would be zero.

Adam Smith wrote that a person seeking gain in a market "intends only his own gain" but is "led by an invisible hand to promote an end which was no part of his intention." Actually Smith did not believe that people were motivated by gain alone. He was arguing merely that even if you assumed such an extremely simple---and foolish---model of human behavior, things would nonetheless work out. Therefore, how much better things would work out, he was arguing, if people were in fact as they are, adding love and courage and justice and temperance to their virtue of simpleminded prudence.

But what is this "invisible hand"? Briefly it is the force of self-interest responding to incentives, the means by which markets solve the problem of coordination. The gasoline station "is led" by its pursuit of gain to have gasoline on hand, which makes life easier for Maria. And Maria, and hundreds like her, in turn, make life easier for the owners of the gasoline station, by showing up with predictable regularity to buy---predictable in the mass, though not person-by-person.

Smith in the phrase "the invisible hand" was alluding to divine intervention, as he often did. It was his way of persuading his contemporaries in the 18th century that they did not need to rely on the intervention of visible hands, such as the hands of kings and bureaucrats and soldiers. The market would take care of itself. God had arranged things so. Smith's analysis was a little vague, and in truth he did not put a great deal of emphasis on it. He used the phrase "the invisible hand" only once in The Wealth of Nations. Later economists were obsessed with what they came to call the "price mechanism," and the English economist Alfred Marshall (1824-1924) finally systematized the tools of "market analysis," and his heirs have triumphantly produced what they call "proofs" on blackboards of how great the price system is.

An Economist's Economist

Alfred Marshall (1824-1924) was in many ways the creator of modern economics, dominating the English-speaking part of economics from the 1880s to the 1920s. Like many English intellectuals of the nineteenth century, when he entered St. John's College at Cambridge University in the early 1860s he intended to become a priest in the Church of England. But he lost his faith, and pursued instead his interests in mathematics, physics, and economics. He began teaching economists, first at Cambridge, then elsewhere, until in 1884 he received a "chair," or "professorship," at Cambridge (the rank of "professor" is more powerful in Europe than in the United States or Canada), which he held until his retirement in 1908.

Marshall believed an economist should have a "warm heart and a cold head" - humanitarian feelings balanced by a willingness to engage in logical argument. Unfortunately among his warm-hearted ideas were convictions typical of his times about race and empire, and about employment for women. His wife, Mary Paley Marshall (1850-1944), was herself a gifted economist, who in fact co-authored with Alfred his first book. But Alfred and the society around him would not have for a moment have considered making her, like him, a "professor."

His major book, Principles of Economics (1890), was for decades the main economics text wherever economics was taught in English---in the United States and Australia, for example, as well as in Britain. It contained the first explicit supply and demand diagram in English- in a footnote, because Marshall did not want to distract his students with graphs or mathematics. In a letter to his prize student A. C. Pigou he wrote about how economists should use mathematics in their work: "(1) Use mathematics as shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life (5) Burn the mathematics. (6) If you can't succeed in 4, burn 3. This I do often." Economists have not followed Marshall's advice.

Marshall brought Smith's "invisible" hand out into the open. It's the going price, he declared, that reconciles the competing interests of buyers and sellers. If, to use our earlier example, the price of gasoline is too high, sellers are eager to sell but buyers are reluctant to buy. If the price is too low, it's the other way around. How do we know when the price is just right? When the price reaches the level at which the amount of gasoline sellers are willing and able to sell is just equal to the amount buyers are willing and able to buy.

The Marshallian graph: Buyers and sellers, prices and quantities

Crucial to this Marshallian analysis is a clear and explicit separation of buyers and sellers. It helps, therefore, to think of them as if they were operating on two separate islands:

Figure 3.1 The islands of supply and demand

Think of the suppliers and the demanders as living on two separate islands. The only information that travels between them is the price and the quality of the product that is being bought and sold - here, gasoline.

Maria, our buyer of gasoline, lives on the demand island with millions of other drivers. BP, Royal Dutch Shell, and all the other suppliers of gasoline live on the supply island. Gasoline gets shipped from the supply island to the demand island. If the gasoline is of the same kind (let's say, "regular unleaded") then price is the only other link between the islands. Accordingly, buyers know the price that the sellers charge and sellers know the price that buyers want to pay for certain quantities of gasoline. They don't know anything else about each other.

It was Marshall's idea to draw a curve describing how sellers react to price and another curve describing how demanders react to price. Combined in one diagram they are like, as he said, "scissors," two blades working together. Figure 3.2 displays the famous diagram.

The vertical axis shows all possible prices of a gallon of gasoline, from $0.00 to $5.10. (Beginning at price equal $2.30, as you climb the vertical axis, each horizontal line is equivalent to an additional 30 cents a gallon.) The horizontal axis shows quantities of gasoline demanded or supplied, measured in thousands of gallons per day. ("Per hour" or "per year" would do just as well and would merely shrink or stretch the curves horizontally.)

The upward-sloping curve is the supply curve. It shows what the sellers of gasoline want to sell each day at various prices. Its upward slope indicates that suppliers will try to supply more when prices are high---since higher prices mean bigger profits---and less when prices are low. In this case, the specific numbers are as follows:

Price Quantity supplied (QS)
$2.30 300 million gallons per day
$2.90 340
$3.20 380
$3.50 400
$4.10 500
The downward-sloping curve is the demand curve. It shows what the buyers want to buy each day at various prices. Its downward slope tells you that buyers will try to buy more when prices are low and less when prices are high - exactly the opposite of suppliers. Think of your own demand for cars. If the price of a BMW, loaded, falls, you are more likely to buy. You become a buyer whereas before the fall in price you were on the sidelines. Think of your demand for cappuccinos. If the price were to fall by half, you'd buy more per week. The specific numbers used on our graph are:
Price Quantity demanded by all U.S. consumers of gasoline (QD)
$4.70 300 million gallons per day
$4.10 350
$3.50 400
$2.90 425
$2.30 470

Clearly the market price determines how much gasoline will be supplied and demanded in the U.S. Prices provide powerful incentives to buyers and sellers. Now, note well: the only price that will induce suppliers to supply just the amount of gasoline the demanders demand at that price is $3.50 per gallon. At this price, the quantity demanded (400 million gallons a day on the horizontal axis) is exactly equal to the quantity supplied (also 400 million on the horizontal axis). Any higher price will result in "excess supply"---suppliers want to sell more than demanders at that price want to buy. Any lower price will result in "excess demand"---demanders want to buy more at that price than suppliers want to sell.

Concept Check 2: In Figure 3.2, find the quantity of gasoline supplied at a price of $2.30. Also find the quantity demanded at a price of $2.30. What do you conclude?

Market supply

Now look at the supply curve and the demand curve separately. The supply curve reflects the decisions the sellers make on their "island" in response to a particular price. To draw the supply curve you ask all the potential suppliers how much gasoline they would want to supply per day given a price of $2.90, $3.00, $3.50, $3.80, and so on. You don't mention Maria's plan to drive to Pilsen, or anything else that is happening on the buyers' island. The only information you give to the suppliers are the prices.

At the higher prices you find that sellers are eager to supply greater quantities of gasoline. Why? Because sellers want profit; and higher prices usually means larger profits. Think of a oil company's income statement: profit = sales revenue - expenses. If the price of gasoline increases its sales revenue also increases, since each gallon it sells brings in more And therefore its profit bumps up. Lured by the prospect of higher profits, Amoco, Shell, Mobil, BP, and other oil drillers and refineries will want to produce more gasoline.

In conducting your survey, you're only asking hypothetical questions: "What would you do if the market price were such and such, assuming that all other profit-related factors remain the same?" It's an experiment in thought.

Suppliers may respond by asking, "What if my workers' wages are rising at the same time?, Would the supply curve remain the same?" The answer would be: "Assume everything else remains constant" or, as economists prefer to say in Latin, "ceteris paribus". The supply curve is what it is only if we assume that all profit-related conditions on their island except the market price of gasoline will remain absolutely unchanged. Wages, rent, the cost of ingredients, the rate of interest on loans - all will remain just as they are. "Ceteris paribus" is a simplifying assumption that we will often need.

Speaking economics: Ceteris paribus
The Latin phrase ceteris paribus is pronounced "KET-er-iss PAR-ih-buss." Ceteris means "other things". The Latin is the same as in the phrase "et cetera" (etc.), which means "and other things". The next word, paribus, means "equal," as in words like parity or (golfing) par. Together they mean "other things equal," that is, other things that might spoil the experiment held constant.

After compiling the results of your survey and studying the trends, you will come up with the law of supply:

Law of Supply: As the price of a product rises, ceteris paribus, more of it will be supplied.

The line in Figure 3.3 shows a supply curve you might draw based on your findings. Formally speaking, a supply curve is a curve that shows the amounts of a good that are supplied to the market at various prices over a certain period by all the suppliers taken together - as long as other factors remain constant. The upward slope of the supply curve is the geometric expression of the Law of Supply.

Figure 3.3 The supply curve illustrates the "law of supply"
As price rises the suppliers grow eager to supply more gasoline in the hope of earning more profits. Along the curve, the ceteris paribus condition applies: all other factors that may affect the suppliers' profits, such as the costs of production, are assumed to be constant. Whenever there's a change in one of these other (non-P) factors, the entire supply curve will shift.

Moving along vs. shifting a supply curve

The basic theory of supply assumes that the market quantity (the quantity supplied, QS) of any product depends on the expected profitability of production. The factors that influence suppliers' profitability are in fact usually changing. When these changes cause suppliers to anticipate larger profits, they will supply more. When these changes cause them to anticipate smaller profits, they will supply less. It's common sense. But the supply curve is an experiment in thought, also common sense, imagining the effect of a change in the one condition suppliers face, the market price.

Shift or Slide, Prof?

Whether you shift the whole curve or slide along an unmoving curve depends on the cause of change. Be careful with the graphs:

  • When suppliers' expected profits are changing because of a change in the market price (P), you show it by moving up or down along the supply curve (slide, no shift).
  • When suppliers' expected profits are changing because of a change in anything other than P, you show it by shifting the entire supply curve, either inward (left) or outward (right). For example, if the price of crude oil fell from $60 to $30 a barrel, the supply curve for refined gasoline would shift to the right. The new curve says that at the same price for gasoline the suppliers would be willing to supply more.

When the price changes, the "quantity supplied"to the market changes - that's what the supply curve tells you. Whenever the price changes, move your eye along the supply curve to find the quantity supplied at the new price. In Figure 3.3, as the price rises from Low to High, the quantity supplied also rises. In these situations we say loosely "supply is constant" even though the quantity supplied changes with each change in the price. It's not a good way of speaking. What we actually mean is that the supply curve sits where is was. When any of the ceteris paribus conditions change, the entire curve will shift either outward or inward, as shown in Figure 3.4.

Figure 3.4 Shifting a supply curve
When one of the ceteris paribus conditions changes, the entire supply curve shifts. If the change is bad news from the suppliers' point of view (causing them to expect smaller profits), the curve will shift inward - less will be supplied at each price level. But if it's good news for suppliers, the curve will shift outward, indicating larger QS at each price level.

If Quick Trip had to raise the wages of the clerks in its gasoline stations---because wages in the economy generally rose---its managers would lower their estimated quantity supplied at each price, because the higher wages would mean less profit per gallon sold. We might say loosely that "the supply of gasoline goes down." Bad talk again. Better: the whole supply curve would shift inward, that is, to the left, reflecting unwillingness of Quick Trip to continue supplying the same amount of gasoline at a price. In order to supply the same amount it would have to receive a higher price.

Technical workshop: Shifting a supply curve

Question: At the price of $3.50 in Figure 3.4, suppliers will supply 400 million gallons of gasoline per day. What would happen if the Federal government passed a new "living wage" law that requires gasoline stations to pay their clerks $9 per hour instead of $6?

Answer: The cost of labor is one of the ceteris paribus conditions. Whenever it changes, the whole supply curve shifts inward. If the price of gasoline remains at $3.50 the quantity supplied will decline to something less than 400 million gallons a day. A similar shift would occur at each other conceivable price level, as indicated by the shift in the supply curve.

Concept Check 3: What will happen if the price of crude oil drops?
Check that the supply curve will shift inward in all the following cases:
- the rent for business property increases; or
- gasoline taxes increase; or
- the price of wholesale gasoline is expected to increase tomorrow.

Market demand

So much for the suppliers of gasoline. Potential buyers behave quite differently. After all, they're paying for the gasoline, not making a profit from it. They're burning the stuff up, not selling it. For them a higher price is a bad thing. An increase in the market price from $1.90 to $3.40, as happened in 2006, gives them an incentive to economize on gasoline, to buy less and to search for cheaper alternatives.

To plot a demand curve for gasoline we could ask Maria and the other people on the buyers' island how many gallons they are planning to buy in the next day at various prices, ceteris paribus. We would ask them to assume that everything relevant to their gasoline consumption decisions will remain unchanged except for the price of gasoline. You will come up with the Law of Demand:

Law of Demand: As the price of a product rises, ceteris paribus, less of it will be demanded.

The law of demand says that the quantity demanded is sensitive to price. Not "extremely sensitive," necessarily, but in the long run "somewhat" sensitive. A higher price means a lower quantity demanded: it "chokes off the demand." Imagine how much you would drive if gasoline rose to $6.00 a gallon----which by the way is about what it is in Europe. The demand curve shows how much will be demanded at each price. The formal definition of a demand curve is strictly parallel to that of a supply curve: a demand curve shows the amounts of a good that are demanded at various prices over a certain period of time by all the demanders taken together. The downward slope is the geometric expression of the Law of Demand.

The Law of Demand, like the Law of Supply, is just common sense. Of course the number of students attending four-year colleges and universities will go down if the price of attending them goes up. Some people will still go ahead with their purchase. But others will turn to cheaper alternatives, such as community colleges (e.g., attend the community college for two years before applying to a four-year college). Of course people will buy less gasoline when the price doubles. Often they will claim, "No: I need the amount of gasoline I'm using right now to get to work. I can't cut my consumption." But when you check six months or a year after the doubling in price, you'll find that they are consuming less. For example, when gasoline prices shot up during in the dark days of 1973 and again in 1979, people at first continued to buy at the same level as before, and claimed loudly in surveys that they "needed" to buy exactly the same amount as before the high price, but the quantity demanded eventually went down.

Figure 3.5 The demand curve illustrates the "law of demand"
The law of demand says "the higher the price, the lower will be the quantity demanded." Going from Low Price to High Price, the curve says that the quantity demanded will go down. In other words, a change in price causes a movement along the demand curve.

Moving along vs. shifting a demand curve

The basic theory of demand assumes that the market quantity---the quantity demanded, QD--- of any product depends on its "value" in the eyes of consumers. If buyers start to see a product as a better deal than it used to be, they will of course buy more. On the other hand, if they see it as a worse deal than before, they will buy less.

Again though, be careful with the graphs:
- When buyers' perceptions of value are changing because of change in the market price (P), you show it by moving up or down along the demand curve (slide, no shift).
- When buyer' perceptions of value are changing because of a change in anything other than P, you show it by shifting the entire supply curve, either inward (left) or outward (right).

When the price changes, the quantity demanded by the market changes - that's what the demand curve tells you. When the price changes, just let your eye move along the demand curve to find the quantity demanded at the new price. In Figure 3.5, a rise in price (from Low to High) triggers a movement along the demand curve to the lower quantity that buyers are willing to buy at the new price. The quantity demanded falls, but the curve itself does not shift.

Whenever any of the relevant ceteris paribus conditions change, the demand curve will shift to a new position, as is shown in Figure 3.6. When ceteris paribus conditions worsen from the buyers' point of view, the curve will shift inward - the quantity demanded at each price level drops.

For example, the demand curve for gasoline would shift inward if:
- bus fares dropped (fewer people buy gasoline for their own cars); or
- peoples' incomes drop (fewer people buy cars, or those who buy them are inclined to buy fuel-efficient cars; either way, less gasoline is bought); or
- car prices increase (fewer people buy cars and less gasoline is demanded); or
- gasoline prices are rumored to drop tomorrow.

Conversely, if buyers' incomes rise, they will demand a larger quantity at every price - an outward shift. Figure 3.6 shows both possibilities.

Figure 3.6 Shifting a demand curve

Technical workshop: Shifting a demand curve

Start at the price of $3.50 in Figure 3.6. The demanders will want to buy 400 million gallons a day. Now suppose their income drops sharply, a major recession. What happens? If the price stays at $3.50, the quantity demanded will go down to, say, 300 million gallons a day.

Now check to see that in each of the following changes, the demand curve for gasoline will shift outward (with the quantity demanded rising at each price):
- bus fares rise
- bad weather
- vacation time
- incomes rise
- car prices fall

Substitutes and complements

When bus fares go up, the demand curve for gasoline shifts outward. And when the price of cars goes up, the demand curve for gasoline shifts inward. The relationship between gasoline and bus travel is different from the relationship between gasoline and cars. The reason is that one is a substitute for gasoline and the other is a complement. A bus trip is a substitute for gasoline: Maria could buy a bus ticket instead of buying gasoline for her trip to the Pilsen neighborhood of Chicago. An increase in the price of a substitute is an improvement in the ceteris paribus conditions for the price of gasoline.

For two products, X and Y, we call Y a substitute for X if it satisfies the same consumer desire as X. If the price of a substitute falls, the demand curve for X will shift inward.

A car, on the other hand, is a complement to gasoline. A complement is a commodity that is regularly used in conjunction with some other commodity. There's little point in having gasoline without a car, or having a car without gasoline. A decline in the price of a complement is an improvement of the ceteris paribus conditions and will cause the demand curve to shift outward.

For two products, X and Y, we call Y a complement to X if it is typically purchased or consumed with X. If the price of a complement falls, the demand curve for X will shift outward.

Concept Check 4: Gasoline supplied by BP (British Petroleum) is a substitute for gasoline supplied by Texaco. If the price of BP gasoline goes down, what will happen to the quantity demanded for BP gas? For Texaco gas?
Concept Check 5: Which are the substitutes and which are the complements among the following: gasoline at BP, gasoline at the Mobil Station, a bicycle, car tires, service on the car, a car stereo, gasoline tomorrow, walking to Pilsen.

Maria: It's hard to remember all of the things that will shift the demand curve. Bus fares, weather, consumer income.

McCloskey: There's no need to. Just remember that everything except current price goes into the ceteris paribus category, including the income of gasoline buyers and whether or not there's an eclipse of the sun. Income is a special one: remember that. But other goods you can work out one-by-one, and by common sense. Bus-rides---a substitute, obviously. Car prices, a complement, obviously.

Maria: It seems strange to put everything into other-things-equal.

McCloskey: Not literally: the current price is what we're focusing on by using ceteris paribus. What it does is let us take things up one at a time. To decide what's likely to shift the demand curve, all you have to do is ask, "Is such-and-such likely to have much effect on the quantity demanded of gasoline?"

Maria: And an eclipse of the sun is not likely to have as much of an effect as a big change in the income of car owners, right?

McCloskey: Right. So in the case of gasoline demand, consumer income and the price of obvious substitutes and complements are worth paying attention to.

Market equilibrium

Now go back to the main focus of this chapter: the competitive interactions among and between buyers and sellers, and the "invisible hand" that turns the potential chaos of such self-interested actions into orderly social cooperation.

Paul: Before we do that, can you briefly explain the relationship between "comparative advantage" and the supply curve? I'm trying to make the link, but I'm not sure I've got it.

Ziliak: By Zeus, I think we've got an economist in the making. Great question! Everywhere on the supply curve-and especially at the beginning of a supply curve, where supply just meets the price axis-one finds crucial information about comparative advantage. The companies with the greatest comparative advantage are the companies with the lowest cost of production, able to offer the lowest sale price to their consumers. One expects to find their supplies disproportionately clustered around the bottom of the supply curve, at the lowest prices. As prices get higher more and more of the less comparatively gifted companies get into the business.

The balance of forces at equilibrium

What will happen in the market for gasoline when there is free trade from one island to the other? You would expect that sometimes the price would be too high (good for sellers, bad for buyers), while at other times the price would be too low (bad for sellers, good for buyers). Sooner or later you'd expect the offers and bids, rejected and accepted, of buyers and sellers would create a workable compromise: a price that's just right. They do, where the total quantity demanded equals the total quantity supplied (see Figure 3.7). Economists call a price inducing exact equality between amounts supplied and amounts demanded the equilibrium price.

The equilibrium price is the price at which quantity supplied equals quantity demanded.

Speaking economics: The balance of forces in equilibrium

Economists in the nineteenth century borrowed the word equilibrium from chemists and physicists. It comes from the Latin phrase aequa libra, which means "balanced scales." When the forces pushing price up and the forces pushing price down are equal, the scales are balanced and the market is in equilibrium.

An apple at the bottom of a bowl, for example, is "in equilibrium."

Apple-in-bowl diagram: The apple has a tendency to roll away from the point labeled "not equilibrium," if a hand had pushed it there to start with. But after it has found---buy rolling around back and forth---at the point labeled "equilibrium," the apple has no tendency to move - unless it is pushed by an outside force (i.e., a change in ceteris paribus conditions).

Figure 3.7 The "equilibrium point" is where demand and supply intersect

The big idea: Market competition is unintended social cooperation

We've seen that whenever a market is out of balance (in disequilibrium), buyers and sellers will find a reason to change the market price. In the case of excess demand, the price will be pushed up; in the case of excess supply, the price will be pushed down. In turn, these price changes will induce buyers and sellers to adjust their QD and QS until the original imbalance has been eliminated. In short: equilibrium is re-established through a price-guided process of unintended social cooperation.

We say "unintended" because no one in the market is consciously trying to help the market achieve equilibrium. Buyers and sellers are just minding their own business, looking for the best deals. Yet their competitive interactions lead them to work together, without realizing it, toward the "goal" of equilibrium. Quite unintentionally, buyers and sellers are adjusting their actions to the actions of others.

Think of the checkout lines at a grocery store. Why does the number of people in each line tend to be roughly the same, despite the fact that no one is "in charge" (telling people which line to join)?
- Each individual looks for the best deal they can get (the shortest or fastest line).
- Each individual's choice unintentionally influences the choices of others (e.g., when one person switches to a shorter line, it reduces the length of a longer line and lengthens one of the shorter lines).
- The end result is a spontaneous coordination of people's choices: equalizing the length of the checkout lines and creating a more efficient flow of people through the lines, as if people were being guided by an invisible hand.

Bayla: Or "longest line," if "standing in line at a hip restaurant" is your thing.

McCloskey: You're catching on! In that case the long line serves to signal "this is a cool restaurant." Nothing in the grocery-store line corresponds to such a signal. In the Communist economies of old when you saw a long line you joined it, regardless: the line said "something is for sale at the low, controlled price." Rock concerts are often hard to get into, with long lines. Why don't the promoters just jack up the price?

Bayla: Hmm. Maybe because the long lines send the signal, "This is a cool rock group: buy our records"?

McCloskey: Sounds reasonable to me. But at the drive-in bank there's no CD to buy. As though by an invisible hand, people join the shortest line, so the three lines end up being about the same length.

Concept Check 7: Lines form outside a fashionable restaurant every night. People wait in line an hour and a half to get in. What's going on, in terms of supply and demand curves? Why doesn't the fashionable restaurant raise its prices to "clear the market"?