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.
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.
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.