Do We Ever Reach Equilibrium?

If were to ask a 1st year economics student what the first and most important idea of economics, they would probably mention equilibrium. Neo-classical economics is based upon the theory that the economy is in equilibrium. This literally means balance or stability, but is usually expanded to mean not just any balance between supply and demand, but that there is only one and it is the optimal position for the economy. From this comes most neo-classical arguments about the economy, in particular the idea that the government only distorts the market and any intervention is necessarily inefficient. But is it actually true? Does the economy ever reach equilibrium?

I would like to examine the evidence and data that is provided to substantiate the idea of equilibrium, but there isn’t any. That’s right; there are no real world examples of equilibrium given in textbooks. As a foundation for economics, it’s not a good start. There are a few throwaway remarks and imaginary calculations based on imaginary data to calculate consumer welfare, but this is more an excerise in imagination that an actual proof. With made up numbers you can prove anything.

Let’s examine the theory on its own grounds. Textbooks usually open with a diagram like this where demand and supply are in perfect balance with each other. (Some might ask what is the point on focusing on beginners economics, but this is what the vast majority of people know about economics, decision makers included. This simple theory is never removed and is the foundation for later ideas) But why? Why are products sold exactly where demand and supply meet? What is strange is that such an important concept is so poorly defended. Microeconomics is based on equilibrium of supply and demand, yet the main defence is hypothetical examples. It is claimed that if the price is too high, then both sides will benefit from a reduction. The consumer from lower prices and the business from increased sales. However, this is purely hypothetical and there is no guarantee that this is how things will actually work.

It is claimed that market forces push businesses to supply at this point. If the price is too high then there will be excess supply and there will be a surplus of unsold goods. Therefore businesses will drop their prices until they reach the equilibrium point.

Textbook example of excess supply

Textbook example of excess supply

However, it is clear that this is not how the world works. Any examination of how businesses actually operate will show that surpluses are not a disaster that requires price changes but rather the ordinary operating of a business. Most businesses order new supplies infrequently, on a weekly or monthly basis. Therefore they will naturally run a surplus in between orders. If they do have a surplus come delivery time, they will just order less. The above picture implies that the cost of supply goes up if price goes up, yet there is no reason why the supply costs should increase when you are selling less at a higher price. Nor can it be claimed that there are diminishing marginal returns as most businesses have either constant or increasing returns to scale. In fact they usually offer discounts for ordering in bulk, not price rises.

The only time that surpluses would be a problem is if you are dealing in perishable goods. For example if you have a stall of fresh fruit, then you want to sell all your goods by the end of the day before they rot. This was a relevant problem when the theory of equilibrium was first applied to economics (the 1800s) but it out of date now. Nowadays if you have a surplus of goods, you can easily wait and sell it later.

It is further claimed that if the price is too low then there will be excess demand and a shortage of goods sold as the diagram below shows.

Textbook example of excess demand

Textbook example of excess demand

The implicit suggestion is that your suppliers won’t be willing to sell to you at such a low price. However, businesses offer discounts for bulk buying and increasing sales so it would be daft for them to punish you for buying more of their goods. They also are likely to benefit from economies of scale where it is cheap for them to produce more, so the supply curve should be downward sloping.

But why would any sane business think that strong demand for their good is a problem that must be alleviated? Surely they would rejoice at their brisk custom rather than try to kill the goose that laid the golden egg? Some businesses deliberatively sell cheaply in order to create hype about their product (for example concert tickets are always judged on how quickly they sell out). If people are buying your goods then this makes it “popular” and we all know the power of peer pressure. Other businesses may sell cheaply just to get customers into their shop (this is called loss leading and is widely practiced by supermarkets). Why would this create a shortage? Surely if more people are buying it then you have stocks for it, the solution is to order more?

Even on its own grounds, the argument for equilibrium to naturally occur is flawed. The market forces that are supposed to push the price towards equilibrium and hold it there are either too weak or non-existent. But won’t a business that charges too much have too few customers? Won’t a business that sells too cheaply not be able to pay its costs? True, but this does not mean it will reach equilibrium. You see, not all costs are equal, rather they all run on separate time frames. Repaying your mortgage on the building is a fixed cost not related to production. Not all employees are directly productive (managers and security guards provide benefit but are not directly related to the production of goods). Therefore it is not as easy as simply equating supply and demand when it is such a variable cost. It is quite possible for a business to run a loss for quite some time and still remain in business.

Now I am not saying demand and supply are completely meaningless and prices are random. Obviously they hold at the extreme. So if I tried to sell a cup of coffee for $10, no one will buy it (unless it becomes a status symbol of conspicuous consumption) or if I sell it for 10 cent my costs will exceed the price and I’ll go bankrupt. However, just because there is some pressure pushing prices towards the middle, does not mean it is strong enough to push it to one single price or the optimal equilibrium point. It is best to think of market forces like a ceiling and a floor. They stop you from going too far low and far too high, but neo-classical economics makes the mistake of presuming that this means they will meet in the middle or close enough. However, in reality there is a large gap between the floor and the ceiling, and it is in this gap that we live.


Filed under Economics

17 responses to “Do We Ever Reach Equilibrium?

  1. Are you suggesting that the invisible hand has a few tricks up its sleeve or that it doesn’t have my back?

  2. In physics and chemistry, to even have a chance of reaching equilibrium, you have to have a closed system which an economy is not. It might masquerade as a near-equilibrium system having properties similar to an equilibrium system but it will not be a true equilibrium system if it is open (meaning the stuff of the system can flow in and out of the boundaries you set). The test of whether a system is such a system is whether it obeys LeChatelier’s Principle. You might want to consider this in your investigations.

  3. Well, I’m sure Dr Pangloss would disagree.

  4. I never thought that the concept was meant to be taken as literally as what you’er describing. Even in first year economics, I just assumed the point of equilibrium was a hypothetical point that’s useful for certain purposes. It just seemed obvious to me that there are factors that are not in the diagram. Of course, I’m not a market fundamentalist, so I don’t expect that concept to justify my entire political philosophy.

    One factor that is not in the diagram, and which would exist even in the simplest made up example, is the matter of time. In fact, when you talk of a surplus, and you mention that perishable goods like food might conform more closely to that idea, you’re implying that time is a factor. I’ve worked for myself and also tried to start my own business once (The business failed but when I was self-employed it went well enough.) and this idea does not lack all utility. Most businesses can’t run an surplus indefininitely. How much of a surplus or for how long will vary. You’ve spent capital on the goods or the raw materials. At some point, you’re going to need to get some money. Not only do you not make a profit by hoarding, you’d be losing when you consider that you’d still have ongoing expenses. How are you paying for the warehouse where you’re storing those goods? Goods are produced with the intent to sell them at some point.

    I think one thing that isn’t obvious in the diagram is that, in reality, that hypothetical price where the market clears is arrived at through trial and error. For instance, when I was self-employed as a decorative painter and trompe l’oeil muralist, I had a great deal of difficulty determining what I should charge. At the time, I was living in New York City and had a fair amount of trouble paying my rent and I was paying for my own health insurance at the time. So the pressure to charge as much as the market would bear came from my own personal expenses. At first, I charged a very low amount because I needed to build up a portfolio and have a list of former clients I could call on for recomendations. Eventually, I found that I was booked about four months in advance, but I also found that clients wouldn’t wait four months. By the time I got around to calling them to set a date, they’d have found another painter. About two months was the length of time I found that most people would wait. I liked having a little bit of a wait list because that represented some security for me. Basically, I increased my prices incrementally until people started to say, “No thanks, I’ll find someone else.” Then I lowered them a tad. It took a couple of years to find that point where I would have a steady stream of clients. Also, that point is a moving target. Market conditions are constantly changing. Eventually, I found my standard of living was declining because I couldn’t charge more but my rent was increasing. I stopped doing it.

    However, saying that the market can set prices tells us nothing about government regulation, at least not the kind of regulations we tend to talk about in the U.S. In fact, I would say that that diagram could also be used to explain why we need regulations, but then I’d have to start explaining to you my interpretation of the world and this comment is already long enough to tax everyone’s patience.

  5. GM

    “From this comes most neo-classical arguments about the economy, in particular the idea that the government only distorts the market and any intervention is necessarily inefficient.”

    Who are you arguing against – which economists?

    • Specifically neo-classical economists. Do you want their names? This is not personal, but rather about the ideas as presented and taught in textbooks.

      Libertarians often fall into a similar trap of assuming the free market will naturally end up at the optimal equilibrium (there are exceptions, but most do)

      • GM

        It would help if you named names, because I don’t know of any mainstream textbook which tells us that “the government only distorts the market and any intervention is necessarily inefficient”.

        In case you’re not aware, this is the best-selling and almost certainly the most influential economics textbook of all time:

        Now if you think Paul Samuelson thought that there was absolutely no role for government intervention, then you’re just plain wrong. He wrote this in the 1989 edition (!):

        “The Soviet economy is proof that, contrary to what many sceptics had earlier believed, a socialist command economy can function and even thrive.”

        Taking over the mantle today is the highly influential Greg Mankiw, author of “Principles of Economics”, which has sold over a million copies according to Amazon. Yes, his views are considered despicable by those on the Left. But no, he could not be described as someone who has ever argued that “the government only distorts the market and any intervention is necessarily inefficient.” He argues for things like carbon taxes, and agrees with a form of Keynesian.

        So those are two of the most influential economics textbook authors of all time, and neither one of them would agree with anything close to the view which you ascribed to mainstream textbook authors. There is another very famous and successful textbook author, called Paul Krugman, whose statist credentials don’t even need to be commented on. It seems as if your claim couldn’t be more false.

        • My textbook is “Principles of Economics” by Ben Bernanke and Robert Frank and “Microeconomics” by Jeffrey Perloff. The theory of equilibrium is taught in all lectures and modules. However, there is a large gap between most economists theory and practice. n theory they acknowledge equilibrium and perfect competition whereas in practice there know that some government intervention is necessary. Krugman is a perfect example of this. His textbook is neo-classical whereas in public he is Keynesian.

          The way economics is taught to undergraduates is extremely pro-market. Perhaps the exceptions to the free market come later in post graduate. but I am discussing the economics as it is known to 90% of people.

  6. Market equilibriumists (?) should familiarize themselves with trading in illiquid markets, like, say, RMBS market a few years ago. They’ll quickly revise their theory.
    And on a different but relevant note: Arthur Laffer, the father of the “Laffer curve” never provided any actual numbers to his theory. His theory states that as tax rates grow it becomes detrimental to the economy, but he doesn’t state whether it’s 80% or 30% where the actual curve bends. Everyone is free to insert any number there . Great theory! Just like the equilibrium – only in theory.

  7. John Doe

    Classical economists never said the market would reach equillibrium. That is prepesterous, there are so many factors that cause prices to changes, virtually every second. It is a diagram for visual aid, and in no way tries to exactly mimick reality. Classical economists actually don’t relt on exact figures. They say the market will always tend to move towards equillibrium. Not that it will be exactly at equillibrium.

  8. Pingback: The World Is Run by Folk Theories | the HipCrime Vocab

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