What is it that always pushes markets back to equilibrium? “Market forces”.
This refers to the interaction between the demand from consumers for some product on one side and the willingness to supply that product on the other. What brings demand and supply into balance is the “price mechanism” – the price keeps changing until demand and supply are equal and the price is stable.
Say there’s some shock that causes the quantity demanded to exceed the supply available. This will cause the market price to rise, and the rise will send a “price signal” to both buyers and sellers.
The signal to buyers is: buy less. Be less wasteful in your use of the product, or look for similar products that are cheaper. The signal to sellers is the reverse: sell more. Now the product has become more profitable, produce more of it.
So, the price mechanism has caused a fall in the demand for the product and a rise in its supply. This will push the price back down until demand and supply are equal again. The market will have “cleared,” leaving nothing unsold, and the price will be back to about where it was before the shock. Equilibrium will have been restored.
Simple, eh? Neat, eh? And that’s a big part of the reason the economists’ way of thinking about how markets and market-based economies work hasn’t changed much in 150 years.
You see, too, why economists believe that prices – particularly changes in them – are the great incentive for people to change their behaviour. You want to decarbonise the economy? Put a price on carbon emissions.
Wait for market forces to stop global warming, and you’ll wait forever, decimating the economy in the process.
Another instance of the equilibrating effect of prices is the existence of “arbitrage”, particularly in the markets for shares and other securities. Any difference in the price of the same security in different markets won’t last because the actions of people seeking to profit by buying in the cheaper market and then selling in the dearer market will soon eliminate the discrepancy. Economists call this “the law of one price”.
Putting all this another way, economists have long understood that markets and market economies are, in the modern idiom, “interactive”. Any new action always leads to a reaction, as the people affected change their behaviour to cope with the new development.
This understanding is why economists don’t worry about some developments as much as normal people do. Normal people say: look what’s just happened – it’s terrible. Economists say: yes, but then what happens? They call this the “second-round effect” and their model is supposed to predict what it will be.
For example, economists have never been impressed by all those reports warning that, by 2030, there’ll be a massive national shortage of teachers/nurses/other skilled occupation as all the baby boomers retire. No, there won’t. Why not? Because employers will take evasive action and other employees will take advantage of the opportunities presented.
Despite panic buying at the start of lockdowns, AMP Capital chief economist Shane Oliver says the economy has already taken a $17 billion hit.Credit:Tertius Pickard
But the notion of equilibrium can be taken too far. The doctrine of “laissez-faire” (leave it alone) – which lurks just below the surface of what lefty academics call neo-liberalism, but I prefer to call market fundamentalism – says that, since market economies have an inherent ability to return themselves to equilibrium after any shock, government intervention to correct the problem will only make things worse.
This is the old case of taking an element of truth and raising it to the status of a magic answer. The economists’ theory of how markets work is grossly oversimplified. In the real world there are lots of problems can’t be solved just by leaving it to market forces.
Wait for market forces to stop global warming, and you’ll wait forever, decimating the economy in the process.
Or cases where waiting for the market to solve the problem would take too long or extract an unacceptable price in human suffering. Do nothing about the pandemic and waiting for all of us to get the virus and thus achieve herd immunity would cost too many lives.
The econometric models that economists use to forecast the macroeconomy or predict the effects of some policy proposal rely heavily on the assumption that, over the (unspecified) long term, the economy always returns to where it would otherwise have been. Yeah, sure.
The opposing theory to certain return to equilibrium – which comes from the physical sciences – is “path dependence”. That where you end up after equilibrium is disturbed depends on what else happens to the economy while it’s supposed to be on its way back to where it was. It could be knocked off course and never return to the previous path it was following.
The notion of equilibrium contains a lot of truth. Trouble is, so does the notion of path dependence. As always, the whole truth is somewhere in the middle.
