The Classical economists, like Adam Smith and David Ricardo, tended to focus their attention and analysis upon production. It was production, after all, that was the revolutionizing economic life. The factory system was emerging and new goods and methods of production were rapidly appearing. Naturally, production would be their focus: production and the means by which growth in output could be maximized. Adam Smith was aware of the role of demand in setting prices, and he knew that changes in the conditions of supply had their effect on price, too. He felt, however, like most Classical economists that variations in prices were "noise": temporary phenomena that merely hid the fact that products sold, in the longer run--and under normal circumstances--at a price that equaled the product's value. Because price variability was considered obvious, and because the real interest of Classical economists was in policies that would promote economic growth, Smith and his compatriots did not concern themselves with "supply and demand" and demand curves and supply curves. This focus had to wait for the emergence of a more complex and sophisticated economy, wherein the proper choice of goods to produce, the efficient use of resources and the proper distribution of finished goods across the population became more pressingly important. As economics evolved, economists were increasingly interested in proving that the market economy could yield "optimal" results: i.e. that the economy could maximize the material well being of the consumer and do so with complete efficiency. In fact, that's the focus of microeconomics even today. The central fact of modern economic analysis is choice. The fact that we make so much and have so many options means that we can't begin to have everything--instead we must choose from a vast array of things to assemble that menu of goods we actually will purchase and consume. Since we can't have everything that's available (we've limited incomes, you know) we face the fact that anything we choose means that we can't have the other contenders for that choice. If I buy the Whopper, right now, that means I can't buy anything else with that money--it's spent. How can we arrange our spending to assure that we get as much enjoyment from our limited incomes as possible? The measure of our enjoyment is called, by economists, utility. The term "utility" (as well as "maximization" and "minimization") comes to us from Jeremy Bentham. Bentham was fascinated with the idea of empirical measurement--we can, he thought, measure the benefits of any policy or program--and this benefit will be counted in "utils" of "utility". His vision was the production of the greatest possible good from the resources at hand. His conviction was that we could measure "utils" and objectively structure optimal policies. He was, of course, a lunatic. We can't measure human happiness. We can't measure "well being" like we measure liquids. Still, economists were happy to latch onto the idea of using "utility" as the proxy for "well being" which the economy was supposed to maximize. Utility had the advantage of not referring to "charged terms" such as "happiness" or (God forbid) "pleasure". This utility, or well being, that we're meant to be maximizing has some interesting properties. For example, economists postulate that "as we consume successive units of any good (or service) within a particular time period, we will eventually get smaller and smaller increments in utility (or enjoyment) from each successive e unite we consume. This is, actually, quite lucky for us. Were we to get the same amount of enjoyment from each unit consumed, we would tend to consume the product we've just chosen until all our income was exhaust ed--or, worse, until we had exploded from the pressure of the food in our stomach (this assumes that, perhaps, it is Whoppers we have chosen and we continue to eat them until we explode--assuming our money doesn't run out first). Were we to not get diminishing utility returns from successive units consumed, we'd tend toward "corner solutions" wherein only one thing is bought and bought until incomes are exhausted (or worse). Because enjoyment (utility) diminishes as successive unites are consumed, we need to be coaxed to buy more of any product. After all, buying that product means we've sacrificed all others we might have had with that money. We want a reward that justifies the sacrifice. As we contemplate consuming more units of the product in question (Whoppers, perhaps) we find that we get less enjoyment from each successive Whopper, and will require that the price of each successive Whopper be lower than the previous in order that the sacrifice diminishes apace with the rewards. Once we understand, in order to coax out more purchases, that prices must be lower because the enjoyment we get from additional purchases is lower, we understand the shape of the demand curve. The demand curve is really a kind of "utility" or "enjoyment " curve. In fact, it is a "marginal utility" curve. It shows us, in dollar terms, the amount of enjoyment consumers are getting from each successive purchase of a good. "Marginal" means "incremental" or a purchase "at the margin". "Marginal utility" is the enjoyment we get from each successive unit of a good that we consume. As we've been saying, incremental utility (marginal utility) diminishes as we consume more and more of a product. Hence, the downward slope to the right. To lure us into buying more, we must be asked to sacrifice less--since we're getting less. The demand curve does not allow us to determine a price in the market. To do that, we need to know how much will be supplied at every price. We need a "Supply Curve". The supply curve slopes upward to the right. That is, it costs more (per unit) to produce more. Even though the history of the industrial revolution (and beyond) has been the ability to produce vastly more at lower costs, we are always stuck in the present with today's equipment, technology and plant. Over the many years of industrial advancement, we've been able to adopt better and better technology and produce more things ever more cheaply. Still, at any time, we have the plant and equipment that we have. Given that we have to work with what we've got (not what me might have, someday) we find that--at some point--the cost of the next unit of output increases as we increase output. This is called "diminishing returns". Over the earlier phases of output form a given factory, the cost of each incremental unit of output falls. This is the range of output that approaches the "engineering" optimum output of the plant (that point where incremental output costs are the lowest). We assume that the producer can sell all the output he wants at the market price (we assume he's too small to influence the market price all by himself). The "marginal cost" of output (the cost of the next unit produced) falls at first and then rises. As long as the cost of the next unit of output is falling, (assuming the cost is below the price) the producer will clearly produce that unit of output because profit is getting bigger with each successive unit of output. Once the cost of the next unit begins to rise, the producer has to pay attention. If marginal costs are rising, he could easily get to a point where cost exceeds price. This must be avoided. To maximize his profits, the producer needs to make every unit that's profitable, but not go beyond that into the region where the cost of the next unit exceeds it's price. This is done by producing to the point where marginal cost equal price. By doing this, the producer makes each unit that is profitable, and none that are not. The intersection of a supply and demand curve yields the "equilibrium price". This is the price at which everyone involved is happy. Consumers can buy all they want to at this price and producers can sell all they want to produce at this price. There are no shortages or surpluses. The equilibrium price is the one the market will establish, left to itself. The price is optimal and it's stable. If, for example, the government tried to hold prices above the equilibrium level, producers would supply more that consumers want to buy at the above equilibrium price. Should the price support be eliminated, prices will fall to equilibrium as suppliers try to sell their excess output. As prices fall, producers supply less and consumers demand more until the amount demanded rises to meet the declining amount being supplied. The equilibrium price will be the point at which the price decline ends. Should government set a price below equilibrium, more will be demanded than producers are willing to provide. There will be shortages. If the price controls are removed, consumers will bid the price up in an effort to alleviate the shortage. Producers will supply more and demand will moderate as prices rise. Again, the equilibrium price will be the end of the adjustment process. The equilibrium price is a price at which the cost of the last unit produced exactly equals the enjoyment (measured in the dollar price) that consumers get from the product. This is optimal. If consumers got more enjoyment (utility) from the product than it cost to make it, total utility could be expanded by making more of this product. Resources would be well used in expanding output. Should it cost more to produce the product than peoples' enjoyment from it, this would be a waste of resources. As it happens, the price mechanism leads to the production of every product to the point that the dollar measure of enjoyment got from the last unit produced exactly equals the cost of producing that last unit. In this way, all products are produced to the optimal level.