Friday, June 06, 2008

Walraisian General Equilibrium a Dead End

Edward Lotterman teaches and writes in St. Paul, Minn, and posts an interesting piece in the Idaho Statesman (here) (6 June):

Adjustments take time in a rapidly changing economy

For many products, prices and output overshoot, for both good and bad

If Leon Walras' auctioneer did his job, running a business would be easier. One might say the U.S. economy "is in a dynamic state" right now. (That's an old Vietnam War phrase for "nobody knows what heck is going on, but it ain't good.") Rapidly changing economic conditions force changes, but such adjustments seldom are instantaneous. That complicates life for people producing all sorts of products.

Walras was a French-born 19th-century economist. Going beyond Adam Smith's metaphor of "an invisible hand" in explaining how markets work, he suggested the mental image of an auctioneer.

In modern economies, everything links to everything else in a complex web. Food prices depend on grain prices that depend on fuel prices. Demand for bass boats depends on demand for overtime carpenters' labor that depends on demand for houses. Wal-Mart's profits, compared with ritzy department stores, vary with household optimism or pessimism. The cost of flying to Los Angeles or having something trucked to Paducah increases with fuel prices, and so on.

Walras' imaginary auctioneer illustrates how markets solve these complex interrelationships. All producers and consumers submit bids to the auctioneer listing what quantities of things they are willing to buy at which prices and what they are willing to sell. The auctioneer tabulates the bids and announces who gets to buy or sell how much of each item at what price. He then bangs his gavel, and the economy moves forward to a new round.

As a mental model, Walras' auctioneer is useful. The real world, however, seldom is so smooth. It is as if some bid slips fall to the floor while being handed to the podium or the auctioneer errs while totaling some column.

Right now, many important factors - energy costs, housing prices, interest rates and inflation - are changing quickly. Such changes affect myriad other variables - eventually.

Adjustments are inevitable but not necessarily to a new, stable equilibrium. For many products, prices and output tend to overshoot on both the upside and downside.
This pattern of delayed adjustment to changing prices creates familiar expansion-contraction cycles in many industries beyond livestock, trucking and construction. If only Walras' auctioneer were a little better and faster at his job.”


Comment
This is a ptetty good account of the Walrasian auctioneer, both illuminating what he is supposed to be doing and what actually happens, crowning the account with the futility of general equilibrium economics.

In fact, Lotterman brings out something very important for all economists truing to model real world economies – there ain’t no such thing as equilibrium. This is a futile quest that was initiated in the 1870s that helped to re-direct economics into the pursuit of mechanical perfections akin to how the physical universe was supposed to work, using 19th century mathematics under the auspices of turning economics into a ‘hard science’.

The habit of extracting conclusions from such models overcame the reality that changes in economic variables are not made with infinite velocity. The humans in the system do not switch on an off immediately. Change takes time and is not synchronous.

Read Lotterman’s full article (via the link) to see how he expresses this simple and immovable fact.

Indeed no economic state starts at equilibrium. The variables are already changing, probably unnoticed, because the people who make the changes are already under the influence of pressures not captured in the models, some responding positively and some negatively. Some are going out of business and others are joining the complex supply chains that affect with their outputs the inputs of many businesses.
The auctioneer model is a nice try. It still leads to a dead end, even if elegantly imaged as a general equilibrium equation.

Adam Smith used the metaphor of ‘an invisible hand’ (WN IV.ii.9: p 456) to explain the consequences of varying degrees of risk avoidance among some, but not all, trading merchants who decided, some totally, some partially and some not at all, to allocate their capitals between the foreign trade of consumption (mainly with the British colonies in North America under the protections of the trading monopoly of the Cromwellian Navigation Acts, as amended, but also to the East India Company) and their domestic markets close to their home domiciles.

His account of the making of the common labourer’s woollen coat showed the complexities, extent and multiple locations of the supply chain that made them in 18th century Scotland. The multiple opportunities for disequilibria even in this single supply chain makes it obvious that the economy as a whole was beyond being modelled in a state of general equilibrium without the most unrealistic prior assumptions and the necessary absence of people. Change in real time is not instantaneous. Speeding up the work of the Walrasian auctioneer will not solve the problem.

For a start, economic equilibrium does not exist in the real world and the real world does not change with infinite velocity. Adam Smith did not make this mistake and nor did he make the mistake that inexorably follows from it: he didn’t try to predict the future. He preferred to look backwards in time to try to explain what had happened, not what might happen in future.

Firms and governments that hire forecasters, supply them with powerful computers, add their research staff and administrators, simply waste the money that pays for them all, at some cost to their alternative uses. Worse, firms and governments that act on their forecasts are yet more prodigal with scarce resources, net of the purchases by deluded other users of the outputs, but gross of all the resources spent on following the ‘predictions’

1 Comments:

Blogger alex said...

Exactly!

Sadly, most students and profs are interested in learning general equilibrium (Walrasian) thinking it would help in understanding an economy.

1:52 pm  

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