Supply and demand: a law lacking jurisprudence.

In high school my economics teacher, suit and tie, used to pick up a piece of crayon and draw a large diagonal cross on the blackboard. A downward sloping demand curve, an upward sloping supply curve, and markets clear when demand equals supply. I considered it true and the first foundation on which all my future economic knowledge would rest was laid. I found that in economics the state of equilibrium condition is an integral part of most theories, a paradigm that underlies many discussions, a condition that is assumed to always hold. But can equilibrium theory really be called a law, a universal truth that holds, no matter the circumstance? Is our blind trust in the state of equilibrium justified?

The basic lemma of supply and demand that I described, as found in every economics textbook 101, is mainly a representation of the work of W.S.Jevons, who pioneered marginal economics. The figure we all know and love made its appearance in an essay by Fleeming Jenkin in 1870, and popularized by English economist Alfred Marshall, describing the theory of supply and demand in his 1890’s’ Principles of Economics. In the 19^th century Arrow and Debrieu proved that a market-clearing equilibrium exists, given strict conditions, like perfect competition. This means that equilibrium is reached only if there are no market distortions. That is a big if. Let’s sum up some the conditions necessary to obtain equilibrium: a large number of buyers and sellers, perfect information, a future market with future prices and no external effects. The million dollar question is to name a market that fulfills these conditions. I can’t. All markets are regulated in some way. Paradoxically, the market that comes closest to a perfect market, the financial market, is actually the most regulated of all. Let me introduce to you the law that never holds.

‘So what?’ I hear you think. It’s all about forces moving the economy away from equilibrium or back to equilibrium. If the latter prevails, I’d say the law is useful. But let me introduce the notion of unstable equilibriums. As Marshall nested himself into mainstream economics, a French economist was pushed into oblivion until recently. Leon Walras came up with the general equilibrium theory in 1874, which basically states that everything is connected. Perturbations in one market distort equilibrium in another. If the horsegate affair drops the demand for meat, not only does the price of meat drop, all other prices and quantities in the economy respond. Looking at how the housing crisis turned into a financial crisis, turning into a sovereign crisis and back, this sounds reasonable. If the equilibrium changes continuously, the law is of little use. Walras never really settled in mainstream economics, mainly because of computational limitations back in the days. Computable general equilibriums, although widely used by policy makers, is to academics something like Fernando Torres: expensive, but doesn’t score. 

In France, Walras was not forgotten. Edmond Malinvaud postulated that the stability of the equilibrium depends on the state of the economy. He assumed that the pricing mechanism is the driving force towards equilibrium, but the pricing mechanism does not always work equally well. In a boom prices are flexible and equilibrium is reached. In a crisis prices and wages are (downward) rigid and the price mechanism breaks down. This could lead to lengthy crises, without forces pushing the economy back to equilibrium.

Mathematician David Ordell convincingly argues in his book Economyths that the economy, and particularly a crisis, is better explained by agent-based models. Agent based models consist of persons connected to each other like nodes in a web. The best predictor of you buying an Ipad is not your age or income, it is the number of your connections that own Ipads. People do not make decisions independently, but are influenced by each other. Agent-based models are a popular side branch of mainstream economics, explaining crises, exchange rates and stock markets a little less incorrectly.

Lastly I’d like to point out the tipping points theory, as developed by Marten Scheffer in his book Critical transitions in nature and society. This theory states that small perturbations push the economy back to equilibrium, but large perturbations do not (a tipping point exists). Scheffer shows that major changing events are preceded by increasing perturbations. This empirical observation also holds in economics, and might predict crises the same way increased seismological activity predicts volcanic eruptions.

To conclude, the recent crisis casts doubt on the usefulness of equilibrium theory. Maybe it is time to look at the jurisprudence and demote the law of supply and demand to a simple notion. When it comes to equilibrium theory, one can only conclude with Confucius: “True wisdom is knowing what you do not know.”