The Mystery of Banking

rationing
function, in which the available pounds or bushels or
other units of a good are allocated freely and voluntarily to those
who are most willing to purchase the product. If coffee becomes
scarcer, then the price rises to perform an increased rationing
function: to allocate the smaller supply of the product to the most
eager purchasers. When the price rises to reflect the smaller sup-
ply, consumers cut their purchases and shift to other hot drinks or
stimulants until the quantity demanded is small enough to equal
the lower supply. 
On the other hand, let us see what happens when the supply
increases, say, because of better weather conditions or increased
What Determines Prices: Supply and Demand
23
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productivity due to better methods of growing or manufacturing
the product. Figure 2.8 shows the result of an increase in S: 
24
The Mystery of Banking
F
IGURE
2.8 — I
NCREASE OF
S
UPPLY
Supply increases from 10 to 14 million pounds or from S to
S
′
. But this means that at the old equilibrium price, $3, there is
now an excess of supply over demand, and 4 million pounds will
remain unsold at the old price. In order to sell the increased prod-
uct, sellers will have to cut their prices, and as they do so, the
price of coffee will fall until the new equilibrium price is reached,
here at $1 a pound. Or, to put it another way, businessmen will
now have to cut prices in order to induce consumers to buy the
increased product, and will do so until the new equilibrium is
reached. 
In short, price responds inversely to supply. If supply
increases, price will fall; if supply falls, price will rise. 
The other factor that can and does change and thereby alters
equilibrium price is demand. Demand can change for various rea-
sons. Given total consumer income, any increase in the demand
for one product necessarily reflects a fall in the demand for
another. For an increase in demand is defined as a willingness by
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buyers to spend more money on—that is, to buy more—of a
product at any given hypothetical price. In our diagrams, such an
“increase in demand” is reflected in a shift of the entire demand
curve upward and to the right. But given total income, if con-
sumers are spending more on Product A, they must necessarily be
spending less on Product B. The demand for Product B will
decrease, that is, consumers will be willing to spend less on the
product at any given hypothetical price. Graphically, the entire
demand curve for B will shift downward and to the left. Suppose
that we are now analyzing a shift in consumer tastes toward beef
and away from pork. In that case, the respective markets may be
analyzed as follows: 
We have postulated an increase in consumer preference for
beef, so that the demand curve for beef increases, that is, shifts
upward and to the right, from D to D
′
. But the result of the
increased demand is that there is now a shortage at the old equi-
librium price, 0X, so that producers raise their prices until the
shortage is eliminated and there is a new and higher equilibrium
price, 0Y. 
What Determines Prices: Supply and Demand
25
F
IGURE
2.9 — T
HE
B
EEF
M
ARKET
: I
NCREASE IN
D
EMAND
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On the other hand, suppose that there is a drop in preference,
and therefore a fall in the demand for pork. This means that the
demand curve for pork shifts downward and to the left, from D
to D
′
, as shown in Figure 2.10: