In economic theory, the law of supply and demand is considered one of the fundamental principles governing an economy. It is described as the state where as supply increases the price will tend to drop or vice versa, and as demand increases the price will tend to increase or vice versa. Basically this is a principle that most people intuitively grasp regarding the relationship of goods and services against the demand for those goods and services.

When supply and demand are in balance, the economy is said to be in equilibrium between price and quantity.

This is a very simple principle but is it actually a “law” and is it completely true?

When we examine specific instances of goods and services against a particular demand, we see that this behavior seems to hold true and so where could there be a problem with this model?

Let’s examine the supply side first. This is the component that provides the goods and services, so effectively this is the element that brings things to “market” for which the consumer or demand side reacts. One of the big items considered on the supply side is the cost of labor.

“…as wages rise, the supply of goods and services is reduced, because wages are the input price of labor. Labor accounts for about two-thirds of all input costs, and thus wage increases create supply reductions …” (Introduction to Economic Analysis, McAfee)

No doubt, this all makes sense and probably sounds like a statement of the obvious. However, let’s examine the demand side of this relationship. What is it? Where is it? How does it manifest?

Here’s where we encounter the problem with this model. There is no independent demand side of the equation. Demand is based on the consumption of the goods and services provided by the supply side, but the means by which this demand is met requires trade in exchange for the item(s) involved. In modern times that trade is through the use of money (or credit).

So the obvious question becomes, where does the consumer or “demand side” acquire its money? The answer is; from the supply side. In other words, despite the statement above which indicates that labor accounts for about two-thirds of the input costs, in reality, what is happening is that the supply side (labor cost) is subsidizing and creating the consumer or demand side of the equation. There is no independent demand side.

The problem this creates is that when the supply side attempts to reduce its cost of products (by reducing the cost of labor), it is correspondingly reducing the money available to the demand side. In effect, it becomes a death spiral, while every attempt by the supply side to reduce its costs further, the demand side shrinks as the jobs and means of acting on the demand are reduced.

The problem is that supply and demand aren’t independent variables interacting, they represent a symbiotic relationship where each is absolutely dependent on the other. Disruption of one automatically disrupts the other.

This leads us to a second assumption in the “law of supply and demand” and that’s for the model to hold, it must be a closed system. So it is worth exploring what the bounds for such a closed system must be.

Generally, it is sufficient to consider the system along national boundaries, since there is a common currency, common regulations, and a relatively fixed base of individuals the system is modeling. Without this constraint, the model no longer produces valid results, since they are skewed by irregularities (i.e. different rules in various circumstances).

Suppose we consider a closed system as being the United States. We will ignore foreign trade, imports/exports, etc. for the time being. From this limited view, we would expect the law of supply and demand to function as predicted because in a closed system, the constraints that drive these metrics will work.

If there is a shortage of skills, then employers must pay higher wages to attract individuals to work. If there is a surplus of goods, then prices will fall, all in keeping with the “law of supply and demand”.

However, let’s consider what happens if we take labor out of the equation and allow the supply side to operate outside this system and obtain cheaper labor from a different source. Suddenly the demand side no longer has the “subsidy” needed in order to generate a demand, so as demand drops, the price of goods and services must drop to accommodate it. However, if demand drops to zero (i.e. no money), then there is no equilibrium point for the supply to drop to and the economy collapses. 

In effect, by moving the labor costs outside the system, the rules have been skewed so that supply and demand no longer holds. While it may be considered valid on a larger system (i.e. the world), this is an impractical model since there are no consistent rules with which to model any of the actors. In other words, the supply/demand relationship has been subverted by moving outside the system and rendering one of the driving economic forces impotent.

Continuing to use the example of the labor markets, while it is often stated that different groups compete with each other, this is an economic fallacy since they are not operating from the same system. Different governments, different laws, different standards of living, do not provide a means by which economic competition can be gauged, so what actually happens is that the supply/demand model is rendered inoperative.

So in practical terms, the “law of supply and demand” needs to be restated to indicate that it reflects the relationship between supply (goods and services) and demand (consumers) within a closed system. It is the closed system that ensures that the cost of labor in producing supply is recycled into the demand side of the equation so that goods and services can be consumed.

Please note that I’m not making any statements about how foreign trade should be conducted, nor am I discussing isolationist policies. I am simply describing the necessary conditions for the “law of supply and demand” to hold. Any variations from this will render this “law” moot.

This situation will be exacerbated when we have supply and demand side players that can operate from different rules whereby one uses a global basis of operation while the other is confined to local operations. In the next post, I will explore the effects on a national economy by global players.