[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

CONSENSUS ON THE
DETERMINATION OF PRICES
The law of supply and demand plays such a prominent role in economics that there
is a joke about teaching a parrot to be an economist simply by training it to say
“supply and demand.” That prices are determined by the law of supply and demand
is one of the most long-standing and widely accepted ideas of economists. In competitive
markets, prices are determined by the law of supply and demand. Shifts in the
demand and supply curves lead to changes in the equilibrium price. Similar principles
apply to the labor and capital markets. The price for labor is the wage, and the price for
capital is the interest rate; thus in later chapters we can use the same principles of demand
and supply developed in this chapter to study labor and capital markets.
FUNDAMENTALS OF DEMAND, SUPPLY, AND PRICE 3
THE MARKET CLEARS AT
THE EQUILIBRIUM PRICE
The price at which the quantity demanded and the quantity supplied are equal is
the equilibrium price. At the equilibrium price, consumers are able to obtain the
quantity they wish to purchase and firms are able to sell the quantity they wish to
produce. When the market clears, there are no shortages or surpluses. The law of
supply and demand allows us to predict how price and quantity will change in
response to shifts in the demand and supply curves.
Price, Value, and Cost
To an economist, price is what is given in exchange for a good or service. Price, in this
sense, is determined by the forces of supply and demand. Adam Smith, often thought
of as the founder of modern economics, called our notion of price “value in exchange,”
and contrasted it to the notion of “value in use”:
The things which have the greatest value in use have frequently little or no value in
exchange; and on the contrary, those which have the greatest value in exchange have
frequently little or no value in use. Nothing is more useful than water: but it will
purchase scarce any thing; scarce any thing can be had in exchange for it. A diamond,
on the contrary, has scarce any value in use; but a very great quantity of other goods
may frequently be had in exchange for it. 2
The law of supply and demand can help to explain the diamond-water paradox
and many similar examples where “value in use” is very different from “value in
2 The Wealth of Nations (1776), Book One, Chapter IV.
70 ∂ CHAPTER 3 DEMAND, SUPPLY, AND PRICE