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ward-sloping demand curve (for which the value of g is negative), marginal revenue,
therefore, will be less than price by a quantity p/e (disregarding the sign of e). The
more elastic the demand curve, the nearer the marginal revenue curve will lie to the
demand curve.
8 From the formula in the preceding footnote, it follows immediately that at a point
where elasticity is unitary, marginal revenue is zero. A special case is where total reve-
nue is unchanged for all points on the demand curve. For such a "constant outlay
curve," marginal revenue is zero, and elasticity unitary, for all points on the curve.
1 00 MARKET THEORY AND THE PRICE SYSTEM


mand for the services of employment agencies that specialize in jobs for
high-school graduates? Clearly an increase is to be expected. The cross-
elasticity concept·ranks the various possible degrees of relationship between
prices of goods and demand for other goods.
Cross elasticity may thus be either positive or negative. Positive cross
elasticity exists between two goods when a change in the price of one, other
things remaining unchanged, causes the quantity bought of the other to
move in the same direction. This is likely to be the case when most of the
consumers consider the two goods as substitutes for one another. A rise in
the price of the one good would thus stimulate a switch to the other good.
Negative cross elasticity, on the other hand, exists between two goods when
a change in the price of one, other things remaining unchanged, causes the
quantity purchased of the other good to change in the opposite direction.
This is likely to exist where the two goods are regarded by the bulk of con-
sumers as complementary to one another. A rise in the price of one good
tends to raise the price of the group of complementary goods that are used
to satisfy some desire. This tends to reduce the quantity purchased of the
group as a whole and therefore also of each good in the group.
If the consumers relate the goods strongly to each other (that is, if they
are very close substitutes, or if they are almost invariably used together in
consumption), then the cross elasticities also will be of a high (positive or
negative) degree. (A measure of cross elasticity relates the percentage
change in the quantity bought of one commodity to a given percentage
change in the price of the other.) If the relation between the goods is weak,
then the cross elasticity between them will be very low. A price fall in
one good will cause only a slight shift of expenditure away from any one
other good (although the total shift may be considerable).

DEMAND AS A MARKET FORCE
It must be emphasized that consumer demand constitutes a vibrant,
active market force, with a powerful positive impact on resource allocation,
prices, and other market phenomena. We must not allow the formal pres-
entation of demand analysis to create an image of market demand as being
merely passive, responding to changes in market prices but without itself
exerting any active influence on the market. Nothing could misstate more
grossly the true operation of demand in the market place. While a more
complete understanding of the operation of demand forces in the market
must wait until we discuss the determination of market prices, our discus-
sion of demand cannot close without making clear the positive nature of
this market force.
Consumers are human beings acting purposefully to improve their
positions. At any one time they find themselves able to choose among a
MARKET DEMAND 1 01


number of alternatives. As acting men they are intent on making sure that
no more desirable alternative exists other than those that they see before
them. To this end consumers are constantly experimenting with new
goods, new brands, and different stores. In selecting from among the avail-
able alternatives those they deem most attractive, consumers are at the
same time rejecting the remaining alternatives. In making these selections
and rejections, consumers are making known to the market the choices the
producers have to choose from. Consumers in the market place are not
only aware of the choices available at current prices but are aware that by
offering producers more attractive prices, they may themselves be able to
secure even more desirable buying possibilities.
Moreover, the true power exerted by demand forces can only be appre-
ciated by mentally relaxing the ceteris paribus assumptions underlying the
demand curve of a given instant. In the ever-changing complex of real
world conditions, consumers continually revise their relative valuations of
available alternatives. Producers are subjected to a steady flow of informa-
tion that apprises them of the most recently expressed preferences of the
market and helps them gauge possible future preferences. As a conse-
quence of changing demand patterns, it happens continually that the bids
made today by consumers, on the basis of yesterday's prevailing prices, pre-
vent all the desired choices from being successfully completed. It becomes
continually apparent to consumers, that is, that they must revise their opin-
ions of the actual choices they are free to make selections and rejections
among. When we have studied the complex of factors that affect the de-
cisions of producers, we will be in a position to understand the constant agi-
tation by which the market seeks to adjust the mutually offered alternatives
of producers and consumers to the ever-changing conditions on both sides
of the market.
It must be stressed once again that market demand does not present
itself as a single homogeneous force. It is not simply a matter of a single
"market" bid being placed for a quantity of a commodity being sold at a
given price. The aggregation of individual demand schedules into a
market schedule, and its expression by the market demand curve must not
mislead one into forgetting that market demand for a given good is the
force felt by the bids of individual buyers. Some of the buyers of the good
are more "eager" than others; that is, some buyers will be more active in
offering producers more attractive alternatives or will be more likely to
accept an alternative that other buyers reject. This must be kept in mind
when interpreting a market curve. For each buyer individually, too, it
must not be forgotten that his "eagerness" to buy a particular commodity
is not homogeneous. The very law of diminishing marginal utility, which
as we found is responsible for the characteristic downward slope of the
individual demand curve, makes implicit in such a curve the fact that buyers
102 MARKET THEORY AND THE PRICE SYSTEM


display less "eagerness" for successive single units of the commodity. The
determination of price, we shall discover, depends quite fundamentally on
this "discrete" character of demand, on the fact that bargains are made
not with consumers as a whole but with individual buyers contemplating
the wisdom of acquiring additional units of a commodity.
Finally, we must draw attention once again to the way consumers adjust
to changes in the availability of goods and the consequences of this pro-
pensity for the demand of particular commodities. Suppose a sudden stop-
page occurs in the availability of a particular commodity or service; for
example, a cessation of commuter service occasioned by a strike. Consumers
of this particular service now find themselves barred from a previously avail-
able alternative. This will have an immediate consequence upon the
demand for both related and unrelated goods. Income allocated to com-
muter service most likely will be allocated to services that are substitutes
for commuter service. Taxicab service and car-rental services will now be
patronized by consumers on a larger scale, even at the previous prices. (Of
course, this will tend to exert a pressure on these prices to rise; but there
will be more of this in later chapters.) On the other hand, goods and serv-
ices in someway complementary to commuter service will experience a de-
cline in the quantity purchased at given prices. Newsstand literature that
is particularly suited for commuter reading, perhaps, will suffer such a
decline. Even the demand for entirely unrelated goods may alter some-
what as a reshuffling of income initiates a tendency toward a quite different
pattern of consumer equilibrium.
These short-run effects can be expected to give way, if the strike persists
so long as to force the complete closing down of the line, let us say, to a
permanent readjustment of consumer demand, other things remaining the
same. The human race has shown remarkable ingenuity at discovering
"substitute" goods and services, especially when allowed a long period of
adjustment. In our example we can expect the closing down of a com-
muter line to increase the "long-run" demand by the erstwhile commuter
communities for automobiles, to decrease the demand for new residences in
these communities, to increase the demand for new residences in other
communities, and so on.
This type of ability to adjust has important implications for demand
analysis. The point is sometimes expressed by saying that in the long run
the demand for a particular commodity is likely to be considerably more
elastic than in the short run. This means that given price changes can be
expected to cause more drastic shifts of demand away from the goods that
have become relatively more expensive, toward those that have become
relatively cheaper, as a longer period of adjustment is contemplated. As
human beings acting to improve their positions, consumers adjust to a
MARKET DEMAND 103


worsening of the available alternatives by seeking new ones. The discovery
and effective utilization of new methods to satisfy wants takes time.

SUMMARY
The market demand schedule lists the different quantities of a given
commodity that will be asked for by the market as a whole at given prices.
It is made up of the sums of the individual purchases that would be made
by market participants at the different prices. The graphic representation
of this market demand schedule is the market demand curve.
The shape of the market demand curve depends on the individual
curves and is thus characteristically downward sloping. The proportion
in which the quantity purchased increases with a given percentage fall in
price measures the elasticity of demand over the given price range. If a
fall in price is associated with so great an increase in quantity bought that
total revenue increases, we call the demand elastic; if total revenue remains
unchanged, the elasticity is unitary; if total revenue declines, the demand
is inelastic. A perfectly inelastic demand situation is associated with a
demand curve that is vertical over the relevant range; a perfectly elastic
situation is associated with a horizontal demand curve.
From the point of view of the individual firm, the demand for his
product depends also on the prices charged by the firm's competitors. If
there is very little difference, in the opinion of consumers, between the
products of the firm and those available elsewhere, demand will be highly
elastic with respect to the prices charged by the firm. If the firm monopo-
lizes the production of his product, the elasticity of demand is the same as
that of the entire market for this good.
Associated with a demand curve are several revenue concepts: (a) the
total revenue of a given output, (b) the average revenue or revenue per unit
of output, and (c) the marginal revenue of any contemplated change in out-
put level. These three concepts are related arithmetically and change, with
changing level of output, in a way that depends on the elasticity of the
demand curve.
The relationship between consumer demand for any two goods is ex-
pressed in the concept of cross elasticity of demand. This concept relates
to the degree in which the quantity demanded of one good changes as a
result of a given percentage change in the price of another good. Cross
elasticity may be either positive (between goods that consumers regard as
substitutes for one another) or negative (between goods regarded as comple-
mentary to one another).
Demand is an active market force that constantly forces producers to
revise their estimates of the alternatives they can choose from. Market de-
mand expresses itself in bids for particular quantities of commodities by
104 MARKET THEORY AND THE PRICE SYSTEM


particular individual buyers. Demand by consumers, where thwarted
from the attainment of particular objectives, adjusts by an increased demand
for substitute goods as part of a general reallocation of individual consumer
income. This adjustment takes time to become fully worked out, so that
the elasticity of demand for particular commodities tends frequently to be
higher as a longer period of adjustment is considered.


Suggested Readings
Marshall, A., Principles of Economics, 8th ed., The Macmillan Co., London, 1936,
Bk. 3, Ch. 4.
Stigler, G. J., The Theory of Price, rev. ed., The Macmillan Co., New York, 1952,
Ch. 3.
Stackelberg, H. v., The Theory of the Market Economy, Oxford University Press,
New York, 1952, pp. 164-171.
7

Market Process in a
Pure Exchange Economy



LJ NTIL NOW we have been concerned
with the way consumers make decisions when faced with the necessity of
choosing between alternatives given by the market. We assumed consumers
were faced with an array of products that could be bought at given prices.
We investigated the principles by which the consumer allocated his income
among the array of purchase possibilities, focusing attention in particular
on the kinds of changes in the data that could alter the consumer's alloca-
tion pattern.
This analysis, based as it was on the assumption of opportunities de-
termined externally, did not deal with the really essential elements of the
market process. We have been assuming that the facts governing the rele-
vant decision were presented in some definite but unexplained way by the
external world, as market data. Just as an individual is forced to adjust
himself passively to the physical laws governing his surroundings, so we also
assumed him to face the prices of the goods that he wished to buy as being
determined completely by impersonal and external forces. But the market
process is itself continually modifying, disrupting, and adjusting the market
phenomena that govern the decisions of the market participants. Our real
task is to understand this process.
A market process is the result of the interaction between the decisions
made by all the participants in a market. In a market system where
products are produced and sold to consumers by entrepreneurs who have
produced by combining resources purchased from resources owners, the
market process results from the impingement upon each other of the plans
made by consumers, entrepreneurs, and resource owners. Each of the par-
ticipants in the market, at any one time, makes his decisions on the basis
105
1 06 MARKET THEORY AND THE PRICE SYSTEM


of what he believes to be given market data. Out of the mutual interplay
of these numerous decisions, and of their influence upon subsequent deci-
sions, the market process of price and production determination emerges.
In the previous chapters we investigated the elements of the market
process that must be explained by consumer theory. In Chapters 8 and 9
we will investigate those elements that must be explained by the theory of
production. These elements are based on the assumption of data given by
the market that the individual consumer or producer must passively adjust
himself to. In Chapters 10 and 11 we take up the full analysis of the com-
plex market process emerging from the compounding in the market place of
all these separate elements. The analysis in the preceding chapters, and in
Chapters 8 and 9, is introduced not primarily for its own intrinsic impor-
tance but as an indispensable help to the understanding of the complex
strands of cause and effect making up the market process.
The present chapter is introduced at this point as a step toward the
understanding of the market process in its full complexity. In this chapter
we show how a market process could emerge in a market made up of con-
sumers only. We imagine an economy where no production is possible;
all commodities are obtained costlessly by natural endowment. Exchange
could and probably would take place in such a society. The actions of
individuals in such an exchange economy would be governed by the prin-
ciples analyzed in the preceding chapters. Market phenomena would be
derived purely from the interaction of the decisions of the consumer par-
ticipants. Although this kind of market is unlikely to correspond to any
real society, its thorough analysis will prove extremely valuable for the
analysis of the more complex market processes involving production activi-
ties. There are chains of logic that apply with equal validity to any kind of
market. They can be perceived with especial clarity in a simple market
such as we consider in this chapter. We will be drawing heavily upon this
chapter when we come to consider markets, in Chapters 10 and 11, involving
production as well as simply exchange and consumption.

THE NATURE OF COMPETITION
Any investigation of the process that determines prices and produc-
tion programs must take careful account of the competitive element inher-
ent in market activity. In the final analysis, the market process relies most
heavily upon this element. We may view the market process as the mecha-
nism that determines the opportunities that market participants find most
advantageous to offer other participants and that in this way also deter-
mines the particular opportunities that will be embraced in the market.
A market process may be defined as competitive when the opportunities
MARKET PROCESS IN A PURE EXCHANGE ECONOMY 107

that market participants feel constrained to offer to the market are only
those opportunities
that they believe to be more attractive (or at least no less attractive) to
the market than comparable opportunities being offered by others.
Each market participant is forced to act with the realization that the oppor-
tunities he would like to offer to the market (that is, those that, if accepted,
would yield him the greatest advantage) will be rejected by the market (that
is, they will yield no advantage at all) if they are considered less attractive
than those made available by his competitors.
In general, then, the competitive market process tends to ensure that
each participant will offer to the market those opportunities that, if em-
braced, will prove most advantageous to himself”not out of all possible
opportunities that he could offer”but out of those opportunities he is able
to offer that he believes at least not less attractive to the market than those
of others. This is a very general proposition that applies to both buyers
and sellers and is sufficient to narrowly delimit the range within which
exchange opportunities emerge and are embraced in the market place.
Our task in this chapter is to reduce this general proposition to more specific
statements that can be applied to particular conditions.

A SIMPLE CASE OF PRICE COMPETITION
The simplest possible case where we may observe and analyze the com-
petitive process at work is that of the market for a single homogeneous com-
modity, which cannot be produced by human action, but which is each day
obtained costlessly from nature by a large number of market participants.
The careful analysis of what can be expected to take place in this simplest
of cases will prove of great value in the analysis of the more complicated
cases to be taken up later.
Participating (at least potentially) in the market for our commodity
are all those individuals who, on the one hand, might be induced to buy
quantities of it if the price is low enough, and those who, on the other hand,
possess some units of the commodity and might be induced to sell quantities
of it if the price is high enough. Since we avert our eyes from everything
except the one commodity, competition can only take the form of offering
more attractive opportunities in terms of higher prices offered or lower
prices asked. The factor that determines the quantity of the commodity
a potential buyer might wish to buy at each of a series of different prices
(graphically expressed by his demand curve) is the marginal utility to him of
additional units of the commodity. Similarly, since production of further
units of the commodity is assumed to be impossible, the factor that de-
termines the quantity of the commodity its owner would be willing to sell
at given prices is the marginal utility to him of the units of the commodity
108 MARKET THEORY AND THE PRICE SYSTEM


under consideration. (This can easily be seen by observing that what an
owner o£ the commodity does not sell, he is keeping for himself. Clearly
the quantity of the commodity he wishes to keep for himself depends on the
marginal utility of the relevant units of commodity as compared with what
can be obtained by selling them.) Our discussion in earlier chapters of the
significance of the law of diminishing utility will lead us generally to ex-
pect that at higher prices, all market participants will wish to hold less of
the commodity. The higher the price of the commodity, the less attractive
it generally becomes to hold a unit of it instead of what its value in money
could buy of other commodities. Fewer non-owners (and owners) of the
commodity will be willing to buy quantities of it, while more owners of the
commodity will be willing to sell it. On the other hand, the lower the price
of the commodity, the more attractive it generally becomes to hold a unit
of it instead of its value in other commodities. More non-owners of the
commodity will be willing to buy, while fewer owners will be willing to
sell (more of them, in fact, joining the non-owners in being prepared to add
to their holdings). If we assume an appropriate discrepancy between the
marginal utility of the product for some holders of it and that for others in
the market, we have a situation where conditions for mutually profitable
exchange exist. The problem is to explain the terms exchange will take
place upon.
The competitive process of price determination in a market such as
this can be grasped most easily by first imagining a quite impossible situa-
tion”where each market participant is fully aware of the quantities that the
rest of the market would wish to buy and sell at each possible price. This
"perfect knowledge" implies that each buyer and seller knows both what
sellers would be prepared to sell at each possible price (if it could be ob-
tained), and also what can be sold at each of these prices. In other words
each buyer and seller knows the limiting price above which a given quantity
of the commodity cannot be sold, as determined by the willingness to buy of
the most eager buyers; each participant also knows, for any given quantity
of the commodity, the limiting price below which it cannot be bought, as
determined by the willingness to sell of the most eager sellers.
In this situation it is easy to describe the outcome. The knowledge
possessed by the buyers and sellers will ensure that the prices asked for by
sellers will be similar to those offered by buyers, and will be within a nar-
row range”the limits of this range being easy to define. Our assumption
of perfect knowledge on the part of each buyer and seller means that he
knows the best offers available to him, as well as the best offers available to
others and against which he must compete. Each potential buyer knows
(a) the lowest price it is not necessary to bid above in order to induce each
given seller to sell given quantities, and (b) the highest price it is necessary
to bid above in order to ensure (if it proves desirable to do so) that given
MARKET PROCESS IN A PURE EXCHANGE ECONOMY 1 09


quantities of the commodity are not bought by less eager buyers than him-
self. Similarly, each potential seller knows (a) the highest price it is not
necessary to go below in order to induce each buyer to buy given quantities,
and (b) the lowest price it is necessary to offer to sell below in order to
ensure (if it proves desirable to do so) that given quantities of product are
not sold by less eager sellers than himself.
It follows that the range of possible prices that may emerge in our
market must necessarily include only
those prices at w¬iich the quantity of the commodity that buyers would
be willing to buy (at these prices) is no greater and no less than the
quantity that sellers would be willing to sell (at these prices).
No exchange could take place at higher prices; buyers would not offer such
higher prices (nor, in fact, would sellers waste their time in asking these
prices).1 No buyer would offer such higher prices because he knows that
the lower price is quite sufficiently high to induce the more eager sellers
to supply all that buyers would ask at that lower price. (No seller would
waste time in asking such higher prices because he knows that buyers can
find an adequate number of sellers sufficiently eager to supply all the
units of product that would be asked for at the lower price.) On the
other hand, no exchange could take place at prices below the range specified
above: no sellers would accept lower prices. He would not do so because
he knows that the higher price is quite sufficiently low to attract all the
buyers necessary to buy what the sellers would offer at that higher price.
With perfect knowledge assumed, this definite outcome will emerge
immediately without haggling, or exploratory, "mistaken" acts of exchange
at "wrong" prices. Perfect knowledge would ensure that each participant
resign himself immediately to what he correctly believes to be the best
opportunity he can obtain. He knows that he cannot obtain a superior
opportunity because he knows that everybody else has the same perfect
knowledge that he does, thus even those who might otherwise be prepared
to provide superior opportunities know perfectly well it is unnecessary
for them to do so. (No seller, as we saw, would waste his time asking prices

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