People buying vegetables from a vegetable market, Municipal Market, Panaji, North Goa, India: Exotica/Alamy Stock photo
People buying vegetables from a vegetable market, Municipal Market, Panaji, North Goa, India.

Unit 8 Supply and demand: Markets with many buyers and sellers

How markets work in competitive equilibrium, when all buyers and sellers act as price-takers

Before you start

This unit builds on the concepts and examples introduced in Unit 7. You should work through Unit 7 before beginning work on this unit.

8.1 How the American Civil War rocked global cotton prices

Students of American history learn that the defeat of the southern Confederate states in the American Civil War ended slavery in the production of cotton and other crops in that region. There is also an economics lesson in this story.

When war broke out on 12 April 1861, President Abraham Lincoln ordered the US Navy to blockade the ports of the Confederate states, which had declared themselves independent of the US to preserve the institution of slavery.

The blockade brought the export of US-grown raw cotton to the textile mills of Lancashire in England to a virtual halt. Sailing at night, a few blockade-running ships evaded Lincoln’s patrols, but 1,500 were destroyed or captured.

excess demand
A situation in which the quantity of a good demanded is greater than the quantity supplied at the current price. See also: excess supply.

This unit will show how the market price of a good like raw cotton is determined by the interaction of supply and demand. The tiny quantities reaching England through the blockade were a dramatic reduction in supply, causing large excess demand—that is to say, the quantity of raw cotton demanded at the prevailing price exceeded the available supply. As a result, some sellers realised they could profit by raising the price. Eventually, cotton was sold at prices six times higher than before the war, keeping the lucky blockade-runners in business. Consumption of cotton fell to half the pre-war level, throwing hundreds of thousands of people who worked in cotton mills out of work.

Mill owners responded. For them, the price rise was an increase in costs. Some firms failed and left the industry. Others switched to India for an alternative to US cotton, greatly increasing demand there. Excess demand for Indian cotton gave sellers an opportunity to profit by raising prices: prices of Indian cotton quickly rose almost to match the price of US cotton.

Responding to the higher income now obtainable from cotton, Indian farmers abandoned other crops and grew cotton instead. The same occurred in Brazil. It also happened in Egypt, where farmers who rushed to expand the production of cotton began using enslaved workers, captured in sub-Saharan Africa (like the enslaved people Lincoln was fighting to free).

There was a problem. The only source of cotton that could come close to making up the shortfall from the US was in India. But Indian cotton differed from American cotton, and required an entirely different kind of processing. Within months of the shift to Indian cotton, new machinery was developed to process it.

As demand for the new equipment soared, firms like Dobson and Barlow, who made textile machinery, saw profits take off. (We know about this firm because detailed sales records have survived.) It responded by increasing production of the new machines. No mill could afford to be left behind in the rush to retool to use the new raw materials. The result was, in the words of Douglas Farnie, who studied the history of cotton production, ‘such an extensive investment of capital that it amounted almost to the creation of a new industry’.

The lesson for economists: Lincoln ordered the blockade but in what followed, the farmers and sellers who increased the price of cotton were not responding to orders. Neither were the mill owners who cut back the output of textiles and laid off the mill workers, nor the mill owners desperately searching for new sources of raw material and setting off a boom in investment and new jobs.

All of these decisions were made over a matter of months by millions of people, most of whom were total strangers to one another, each seeking to make the best of a new economic situation. American cotton was now scarcer, and people responded, from the cotton fields of Maharashtra in India to the Nile delta, Brazil, and the Lancashire mills.

To understand how the change in the price of cotton transformed the global cotton and textile production system, think about the prices determined by markets as messages. The increase in the price of US cotton shouted: ‘Find other sources, and find new technologies appropriate for their use.’ Similarly, when the price of petrol rises, the message to the car driver is: ‘Take the train,’ which is passed on to the railway operator: ‘There are profits to be made by running more train services.’ When the price of electricity goes up, the firm or the family is being told: ‘Think about installing photovoltaic cells on the roof.’

In many cases—like the chain of events that began at Lincoln’s desk on 12 April 1861—the change in behaviour resulting from the price change is motivated by the individual’s self-interest, but it also leads to an improvement in the way that societies’ resources are used: if something has become more expensive, then it is likely that more people are demanding it, or the cost of producing it has risen, or both. By finding an alternative, the individual is saving money and conserving society’s resources. This is because, in some conditions, prices provide an accurate measure of the scarcity of a good or service.1

In centrally planned economies, like those in the Soviet Union and central and eastern Europe before the 1990s (Unit 1), messages about what should be produced are sent deliberately by government experts. The same is true inside large firms like Walmart, where (as discussed in Section 6.2) managers, rather than prices, determine who does what.

The amazing thing about prices determined by markets is that individuals do not send the messages, but rather the anonymous interaction of sometimes millions of people. For the economist Friedrich Hayek, this was the key to understanding markets.

Great economists Friedrich Hayek

Portrait of Friedrich Hayek

The Great Depression of the 1930s ravaged the capitalist economies of Europe and North America, throwing a quarter of the labour force out of work in the US. During the same period, the centrally planned economy of the Soviet Union continued to grow rapidly under a succession of five-year plans. Even the arch-opponent of socialism, Joseph Schumpeter, conceded: ‘Can socialism work? Of course it can … There is nothing wrong with the pure theory of socialism.’

Friedrich Hayek (1899–1992) disagreed. Born in Vienna, he was an Austrian (later British) economist and philosopher, who believed that the government should play a minimal role in the running of society. He was against any efforts to redistribute income in the name of social justice. He was also an opponent of the policies advocated by John Maynard Keynes designed to moderate the instability of the economy and the insecurity of employment.

central planning
In a centrally-planned economy, decisions about what to produce and how are taken by the government, rather than by firms responding to market prices.

Hayek’s book The Road to Serfdom was written against the backdrop of the Second World War, when central planning was being used by German and Japanese fascist governments, by Soviet communist authorities, and by British and American governments. He argued that well-intentioned planning would inevitably lead to a totalitarian outcome.2

His key idea about economics revolutionized how economists think about markets. It was that prices are messages. They convey valuable information about how scarce a good is, but information that is available only if prices are free to be determined by supply and demand, rather than by the decisions of planners. Hayek even wrote a comic book, which was distributed by General Motors, to explain how this mechanism was superior to planning.

The advantage of capitalism, to Hayek, is that it provides the right information to the right people. In 1945, he wrote:

Which of these systems (central planning or market competition) is likely to be more efficient depends mainly on the question under which of them we can expect to make fuller use of existing knowledge. This, in turn, depends on whether we are more likely to succeed in putting at the disposal of a single central authority all the knowledge which ought to be used but which is initially dispersed among many different individuals, or in conveying to the individuals such additional knowledge as they need in order to enable them to dovetail their plans with those of others. (The Use of Knowledge in Society, 1945)

Hayek’s challenging ideas and their application are still relevant, and fiercely debated, today.3

  1. Paul Seabright. 2010. ‘Who’s in Charge?’ in The Company of Strangers: A Natural History of Economic Life (Revised Edition). Princeton, NJ: Princeton University Press. 

  2. Friedrich A. Hayek. 1994. The Road to Serfdom. Chicago, Il: University of Chicago Press. 

  3. The Economist. 2014. ‘Keynes and Hayek: Prophets for Today’. Updated 14 March 2014.