The Mystery of Banking

short-
age
of coffee (shortage being present when something cannot be
purchased at the existing price). 
The coffee market would then be as shown in Figure 2.5. 
Thus, at the price of $1, there is a shortage of 4 million
pounds, that is, there are only 10 million pounds of coffee avail-
able to satisfy a demand for 14 million. Coffee will disappear
quickly from the shelves, and then the retailers, emboldened by a 
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F
IGURE
2.5 — S
HORTAGE
desire for profit, will raise their prices. As the price rises, the
shortage will begin to disappear, until it disappears completely
when the price goes up to the intersection point of $3 a pound.
Once again, free market action quickly eliminates shortages by
raising prices to the point where the market is cleared, and
demand and supply are again equilibrated. 
Clearly then, the profit-loss motive and the free price system
produce a built-in “feedback” or governor mechanism by which
the market price of any good moves so as to clear the market, and
to eliminate quickly any surpluses or shortages. For at the inter-
section point, which tends always to be the market price, supply
and demand are finely and precisely attuned, and neither short-
age nor surplus can exist (Figure 2.6).
Economists call the intersection price, the price which tends
to be the daily market price, the “equilibrium price,” for two rea-
sons: (1) because this is the 
only
price that equilibrates supply and
demand, that equates the quantity available for sale with the
quantity buyers wish to purchase; and (2) because, in an analogy
with the physical sciences, the intersection price is the only price 
What Determines Prices: Supply and Demand
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F
IGURE
2.6 — T
OWARD
E
QUILIBRIUM
to which the market tends to move. And, if a price is displaced
from equilibrium, it is quickly impelled by market forces to return
to that point—just as an equilibrium point in physics is where
something tends to stay and to return to if displaced. 
If the price of a product is determined by its supply and
demand and if, according to our example, the equilibrium price,
where the price will move and remain, is $3 for a pound of cof-
fee, why does any price ever 
change
? We know, of course, that
prices of all products are changing all the time. The price of cof-
fee does not remain contentedly at $3 or any other figure. How
and why does any price change ever take place? 
Clearly, for one of two (more strictly, three) reasons: either D
changes, or S changes, or both change at the same time. Suppose,
for example, that S falls, say because a large proportion of the
coffee crop freezes in Brazil, as it seems to do every few years. A
drop in S is depicted in Figure 2.7.
Beginning with an equilibrium price of $3, the quantity of cof-
fee produced and ready for sale on the market drops from 10 mil-
lion to 6 million pounds. S changes to S
′
, the new vertical supply 
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F
IGURE
2.7 — D
ECLINE IN
S
UPPLY
line. But this means that at the new supply, S
′
, there is a shortage
of coffee at the old price, amounting to 4 million pounds. The
shortage impels coffee sellers to raise their prices, and, as they do
so, the shortage begins to disappear, until the new equilibrium
price is achieved at the $5 price. 
To put it another way, all products are scarce in relation to
their possible use, which is the reason they command a price on
the market at all. Price, on the free market, performs a necessary