Thursday, January 07, 2010

The Dead-End of General Equilibrium in Practice

Dr Madsen Pirie of the Adam Smith Institute writes Here
which is part of his series on “Philosophical Observations on Economics.”:

“There is no equilibrium position in economic activity”

“Economists used to talk, and some still do, of the equilibrium position at which supply meets demand. Demand generally decreases as price rises, while more suppliers will tend to enter the market as prices rise. The equilibrium price is supposed to the price at which the supply exactly matches the demand. People use this (and other) 'equilibrium' notions to derive equations which aim to describe how an economy behaves.

The problem is that equilibria are entirely theoretical abstractions and do not occur in real economies. The real economy is characterized by motion. There never is a point at which supply meets demand. Demand changes from moment to moment, and so does supply. There are countless economic actions taking place every moment as potential consumers change their positions on whether they are in the market for particular items, and potential producers decide whether or not to put more produce on sale. Even further back, producers are deciding whether to commit resources now to augment production in a few months time, in anticipation of what demand might be.”

[Follow the link for the rest of the article]

To which I offered a comment:

“Congratulations, Dr Pirie. You have observed reality and not accepted that we can model it accurately with equations seeking to 'prove' equilibrium in markets. Beyond first year economics, equilibrium notions are misleading. The pursuit of scientific credentials from the 1870s - while rooting them by assertion in ancestral Smithian economics - has led to illusions of predictability and imaginary theorems, more poetic than real.

Smith never made predictions (except that the former colonies in North America would become the most powerful economy in the world by the 1870s) because given the multiple distortions and wrong-headed mercantile political economy myths in his day he knew enough about human interactions to know how easy it was to be wrong about the present.”

[Disclosure: I am a Fellow of the Adam Smith Society.]



Blogger Gevin Shaw said...

There are attempts to make these equilibria real, or at least to follow the minute changes more closely.

Just in time supply chains, coupled with historic demand data, are an expression of a belief in such an equilibrium and our ability to predict it, but make it more difficult to respond to unanticipated spikes and drops in demand and to disruptions in supply than a warehouse full of inventory (or available to store excess supply). I wonder whether the greater vulnerability of these global supply chains timed to the hour make our economy more…vulnerable…or mean we are less likely to go to war (actual or metaphoric) in order to protect the supply.

I have heard of tests (or maybe it's just the desire) to change retail prices at the register on an hourly basis to take advantage of peak shopping (demand) times. This, of course, just takes advantage of most shoppers' inability to change when they shop—at lunch, on the way home from work—rather than of some theoretical equilibrium.

7:16 pm  
Blogger Gavin Kennedy said...

Hi Gevin

Just-in-time supply chains model only one chain for which they have data – the economy consists of innumerable supply chains (and has done so since Smith discussed the woollen-coat example in Wealth Of Nations: WN I.ii.). Since, of course, the complexity of the chains has grown many-fold. Linking them all – even just for coats – is a formidable ambition – and because they work on ‘Not Just-in-Time invariably, the complexity becomes astronomical.


8:32 pm  
Blogger Brian Woods said...

Prof Kennedy,

Can't access you via e-mail?? Irish Times Business This Week (Jan 8th, p4), article on Cantillon + Smith by Antoine Murphy.

Brian Woods

10:26 am  
Blogger Gavin Kennedy said...

Hi Brian

Have you used gavinatnegwebdotcome?

1:56 pm  
Blogger Gavin Kennedy said...

That should be dotcom [!]

1:57 pm  
Blogger Ian B said...

I am reminded of a point in Hazlitt's glorious demolition of Keynes ("The Failure of the New Economics") at which he upbraids Keynes for the very thing of basing his calculation on supply and demand curves which are treated as static; I can't be bothered to look up the exact quote now :) but Hazlitt says something to the effect that, "if we could actually see these curves they'd be constantly changing and snapping around like snakes". He makes it quite clear that such curves are a mathematical fiction. So, we can say that at least some old-fashined classical economists (well, one at least) wasn't tempted by the myth of a "static" economy in equilibrium.

But I think the point is that markets are constantly seeking an equilibrium, even though they cannot reach it. That is, they follow a moving target. Command economies attempt to impose an equilibrium, with disastrous consequences.

I'd think though that in simple, primitive economies- the kind in which life is much the same from one century to the next- a general equilibrium, or something very close to it, could be achieved. People would plant the same quantity of grain and raise the same number of cattle every year, and so on. Of course, such economies are very vulnerable to external disturbance, e.g. the rains not coming as expected.

3:48 pm  
Blogger Gavin Kennedy said...

Ian B
Well said. I like the Hazlit quote of which I was unaware.


5:19 pm  
Blogger Ian B said...

Gavin, I found my pdf of the book and dug up the quote I was referring to-

"In short, we can draw all the beautiful supply and de-mand curves we like and cross them at the points that please us most. We can thus help to clarify ideas for college freshmen and even for ourselves. But we constantly run the danger of deceiving ourselves by our own diagrams; of giving ourselves the illusion that we know what we in fact
do not know. For these supply and demand curves are merely analogies, metaphors, visual aids to thought, which should never be confused with realities...

A typical supply-and-
demand-curve exposition tacitly assumes, say, that a demand curve remains fixed while a supply curve moves up and down and crosses it at different points, which constitute
the changing prices. But the truth is that the level and shape of the supply curve, and more particularly of the demand curve, are themselves constantly changing from hour to hour. If they could really be discovered, and put on a motion-picture film, we might find them writhing, vibrating, and jumping in a way to discourage even the cockiest mathematical economist."

5:38 pm  
Blogger Gavin Kennedy said...

Ian B
Well done.

8:27 pm  

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