Where Does Economic Demand Come From?
Every modern microeconomic textbook starts with the demand curve, and even the media and politicians talk about aggregate demand following this analogy. This is strange, as to demand a good, one needs to first have another good, so where does the purchasing power generating this famed demand come from?
Of course, 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 of economics is a willingness to buy various quantities of Product X at various prices, nothing more.
The Law of Demand is then introduced to explain that the higher the price of a product, the lower the quantity that will be purchased. This is not bad as a rule of thumb, though it is less than a universal law. But what makes the demand theory really problematic is that the context of this “willingness” is not specified.
Classical economics, on the other hand, 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 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 modern economics uses 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 modern economics, Léon Walras, understood that this was a problem, but did not find a good solution.
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. In his theory, all 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 like the way Adam named all the creatures in the Bible. 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 whether 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 of 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 economic theory 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 the quantity produced and the price.
Flaws in Methodology
Modern economics prefers to tell the story backward, starting with all-powerful consumers. This is not all too surprising in our debt-driven and consumption-focused culture.
But there are not just ideological reasons for why modern economics refuses to tell the story in a sensible way. There are methodological objectives, too. I believe Walras and other founders of economics wanted to create a mathematical theory of price determination, which is one reason they wanted to ignore the producers’ power over price.
There is another very important reason. 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 that 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 fewer of them. But whether I buy more or fewer shoes will also depend on all the other products I might buy instead and their specific prices.
If I do not know these things, how is it 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 for making shoes are also known, so the only issue on pricing shoes would be the size of the shoemakers’ profit margin.
Since in modern economic theory the small producer isn’t allowed to make economic profit, 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 in the world of classical economics that economists try so hard to escape.
This entire process of reasoning is hopelessly circular, convoluted, and illogical, and the reason economists keep selling the theory of consumer sovereignty rather than the more obvious and plausible producer power is their knack for mathematics and their pro-consumption ideology.
James H. Nolt is a senior fellow at the World Policy Institute and author of “International Political Economy: The Business of War and Peace.” This article was first published by the World Policy Institute.