Big Question: Equilibrium and Stability

My senior year of high school I took my first economics course. We did a business proposal for opening a new restaurant franchise, and we learned some theory. The theory seemed fairly inane and innocuous. All we did was draw X's, occasionally with a price floor or a price ceiling. What seemed so straightforward to me at the time is perhaps the major postulate of modern economics: the idea that markets help supply and demand meet in the middle, automatically. In this post I want to look a bit more closely at that idea and when and why it may be true.

One of the big ideas in economics is that in markets, supply and demand tend toward equilibrium. Equilibrium is the happy place where buyers and sellers, in aggregate, agree on a price that allows as many people to buy the goods as can be supplied by the sellers. If the amount people will pay for the good changes, or the amount it costs to produce the good changes, that side changes their offered price and then the quantity adjusts appropriately. If people want lots of tulips and are willing to pay more for them, then more people will grow them. Similarly, if clothes become cheaper to produce, suppliers will sell them more cheaply and more people will buy more clothes. We own a lot more t-shirts these days than they did 200 years ago.

This is all common sense; the interesting stuff begins when equilibrium doesn't happen.

Which we will come to in a second. First, it is worth mentioning that equilibrium can happen too much. That is, sometimes it is possible to have "multiple equilibria"--markets may have two (or more) price/quantity combinations that buyers and sellers could end up agreeing too. This happens when the demand or supply curve gets more complicated than the traditional X (for example). Another famous macroeconomic example of multiple equilibria is the (simplified Keynesian) explanation for the Great Depression, where a collapse in demand dragged supply down supply, and the economy stabilized below its potential. Multiple equilibria can happen in markets for individual products as well: think about an expensive hotel in an exclusive resort destination, and then a few years later when the everyone has heard about it and college kids go there for spring break. The product is the same (minus the exclusivity) but now supply and demand have come to rest at a lower price.

Multiple equilibria are important--as the Keynes example shows, they are a factor in justifying major fiscal or monetary stimulus programs--but they are only one issue with the concept of equilibrium. The very idea that an economic system will gravitate toward any price point because of supply and demand forces is often suspect. Economists get around this by exploring "static" snapshots of reality, but even this is difficult because the only data you have is one point on the graph, and it is difficult to extrapolate the entire X from one point: the lines of the X may have different slopes or not be straight lines at all. Economists end up relying on "shocks" that hopefully affect only one side of the demand/supply equation: if the supply side stays constant, for example, it may be possible to see how the demand side of the curve is formed.

Static pictures, however, may fail to capture important dynamics--how the system may change over time because of the way supply and demand interact. This is what claims of equilibrium mean: that supply and demand, sellers and buyers, eventually agree on a price that supplies as many goods or services as can be supplied at the price people can pay for it. And eventually the amount supplied and demanded goes toward this price.

In many markets equilibrium may be a realistic assumption. But in others it may not be. Let's break it down a bit. Why might equilibrium--any equilibrium at all--not be a realistic state of affairs in a market?

We can think of markets with two other types of equilibria: equilibria that are unreachable or that are unsustainable. Unreachable equilibria are blocked for some reason, such as regulation or monopolization. The classic textbook example of an unreachable equilibria is price controls, where laws keep prices from reaching the point at which demand is met by as much supply as can be sustainably produced. Rent controls are a price ceiling, and may result in too little housing being provided--the shortage of housing prevents an equilibrium from being reached.

The idea of unsustainable equilibria is more complicated, because it depends on how supply and demand change and react to each other over time. This process of change and interaction works differently in different markets. One common way that they may fail to interact in a way that creates a sustainable equilibrium is when there is poor information: if price signals function poorly or not at all, suppliers and demanders may not have any way of communicating how much they want. This can happen if buyers do not have a good way of knowing how much a good is worth. Education "markets" are a good example: people buying education know that a good education is valuable but have no realistic way of knowing how valuable it will be, because their future is simply too uncertain.

Another example of unsustainable equilibria is Keynes's well-known idea of "animal spirits". This is slightly different than an information problem because, in markets where animal spirits play a prominent role, supply and demand may be based entirely on irrational emotions and perceptions of economic actors. That is, the problem is not in the imperfect information people have, it is in the imperfect rationality of the people themselves (they may have imperfect information as well, but that is beside the point).

Yet another market attribute that can disrupt the sustainability of an equilibrium is market connectedness: markets rarely exist in isolation, and the supply or demand of one market is often influenced by the supply and demand of other markets. One market may affect another market, and this second market may then affect the first market, either directly or through similar effects in other markets. The use of coal could lead to cheaper power which made the production of coal cheaper, for example.

In some cases linked markets may simply be understood as one market: if the cheaper price of flip-flops drives down the price of shoes, it may make better sense to simply analyze the footwear market overall. But in other cases it makes less intuitive sense to link markets because they do not serve as substitutes or complements to each other--they are only related because there is a finite amount of money in the system and money is fungible. Stuart Ewen, in his excellent critique of the genesis of the modern advertising industry, Captains of Consciousness, gives an example from the early days of industrialization: the demand for consumer products causes people to move to the city and work in factories to produce goods, but some of the goods demanded are demanded because of the move toward urbanization. Ewen writes about the Alpine Sun Lamp, which makes people feel like they are outdoors in the sunshine, which they presumably would have been if they still worked on a farm.

In this case connected markets experienced a kind of feedback loop. However, the connections between markets, or between markets and other social realities (such as politics), may have other impacts that preclude the existence of any meaningful equilibria. One example is the current price of Greek public debt: there is certainly a market "equilibrium" that is reached daily based on daily buying and selling, but this equilibrium is based to such a large degree on political expectations that it has little economic significance. Any equilibrium here only appears to be determined by supply and demand because those are the closest proximate causes. In reality, non-market political occurrences are far more powerful causes of market prices. Another example could be if the prices in a grain market are driven up by speculators searching for safer investments in commodities instead of in volatile currency markets. In such an example equilibrium in a single market may be meaningless, but any attempt to find an equilibrium across multiple markets is simply too complex to make meaningful sense of either (see: how quickly international trade models get hairy).

When thinking about equilibria, we need to make sure we understand that there may be economic forces (that is, incentives for market participants) pushing supply and demand toward an equilibrium, or there may not be. Or those forces could be pushing in several ways depending on other criteria. Or there may be outside forces that completely overpower any intra-market forces. In the words of Polanyi, "in no case can we assume the functioning of market laws unless a self-regulating market is shown to exist."

All the King's Theories and All the King's Thoughts

On a fundamental level, a level so fundamental that it describes pretty much everything but is mostly meaningless and uninteresting, our brains are distinguishing machines.  Basically, when we think, we separate things from each other mentally. The easiest metaphor, which is not really a metaphor, is the Hollywood view of someone regaining consciousness. On the screen we see the world through their vision: they open their eyes, their sight gradually sharpens, and they begin to distinguish one thing from another. From the moment we are born--and even before--we are separating things from each other in our mind. You could say we are "de-conflating" things.

But thinking is also about understanding the connections between things--understanding how things are not separate. Just like our hands connect to our shoulders by way of our arms or the light switch connects to the light, things are related by more abstract relationships as well: the ground is connected to the sky by relationships of gravity, distance, and the air in between; people connect to other people by means of family or friendship or professional or other relationships, now connects to later by means of all of the causes and effects that occur in between.

Sorry if this is sounding all mystical and wishy-washy; it is going to get worse before it gets better.

Because I am going to to talk about Yin and Yang for a second. I know next to nothing about non-western philosophy and my understanding of the concept of Yin and Yang does not go far beyond the the first few paragraphs of the wikipedia entry. The article summarizes the concept as describing "how polar opposites or seemingly contrary forces are interconnected and interdependent... and how they give rise to each other in turn in relation to each other." I have heard this described plenty of times and it seemed like an important truth and perspective on things but it never really grabbed me.

But the other day it kind of did, because I started thinking about it more in terms I usually use to think about other things--in this case, the distinction/connection framework above. And I rephrased it for myself in a way that I could understand a bit better.

Economics and politics are enormously complex systems that are full of relationships we can only scratch the surface of understanding. In our scratching, we have an easy enough time distinguishing something--we can measure GDP and payrolls and sales data, or votes, or demographics easily enough. (other things are much harder to measure and therefore distinguish, but that's a topic for another day) But we have a much harder time putting things back together. Economics is about cause and effect, and it has all kinds of snazzy ways to try and pull them apart, but putting them back together meaningfully is an awful lot of work and awfully indeterminate.

And so we arrive at the point I have been dancing around: we separate a lot of things in our minds that cannot truly be separated. Yin-Yang is a specific classic example of this: dark cannot exist without the light, good without evil. But our minds do this in all kinds of less abstract ways as well: supply and demand, employer and employee, policy and politician, winners and losers. We end up with two (or more) parts of something we have separated for convenience or because we did not understand them as one single thing.

And I am arguing that this can be a problem. When we forget that businesses need workers but they also need good leaders. When we forget that every dollar I have is a dollar you do not (or at least it lowers your purchasing power). When we forget that laws need people who understand them and obey them and are incentivized to do so.

Any time we are talking about an economic concept, that concept is embedded within a vast network of other concepts. This conceptual network has in turn been assembled to describe a vastly complex real world. Much of the most dangerous economic ideas--and I don't mean dangerous here in a good way--are those that ignore the vast complexity of reality in favor of their own internal logic. This can happen both through elaborate models based on shaky assumptions, or through a certain ignorance of the status quo and the variety of causes that have brought us to it.

More fundamentally, the idea of economics itself does not stand alone. Politics and economics are two concepts we separate but, when separated, they achieve a certain degree of rarefied meaninglessness. Trade may exist outside of formal authority (two merchant ships swapping rum for ale on the high seas, for example) but is never divorced from relationships of power (the ship with the bigger guns may end up with a better deal). Moreover, actual markets, in the sense of buyers and sellers coming together and creating a price) may indeed require formal authority. Certainly nobody is arguing too loudly that they do not; e.g. libertarians are arguing that markets require a very limited and specific amount of formal authority. Dean Baker describes the connection better than I can.

Our tendency to cut thing up is useful, but it can limit our ability to see the bigger picture. The complexity of political economy makes it difficult to answer many big questions conclusively, but in dividing and conquering we may find our separate territories less firmly in our grasp than we had believed. How do we avoid these pitfalls, particularly when specificity is a prerequisite to truth? When we try to connect the pieces back together, will we have a useful model or a two-dimensional picture of a three-dimensional world? How can we know a complex system in a relevant way?

One way to start is to acknowledge the complexity, particularly where economic ideas intersect with policy and the everyday life of non-economists. The political relevance of economics pushes it toward simplicity--politicians need clear numbers and talking points, not lengthy explanations without conclusions. This is a difficult tendency to counteract, but a possible attempt could be through better economics education. Economics is taught like a hard science, giving new students a toolbox of concepts and uncritical assumptions. These teachings percolate unhelpfully into popular discourse, lacking nuance and serving in the interest of polemics; teaching more of the controversy and the relevance could give students a far better appreciation of the role of economics in our world.

Everyone has, at one point or another, had a feeling of revelation. Some revelations are extremely mundane, others are esoteric--I don't necessarily mean some kind of transcendental religious enlightenment, perhaps just understanding a new mathematical idea or realizing why your friend was acting strangely. Sometimes revelations involve connecting ideas that had existed independently in your mind, sometimes they are new ways of cutting ideas up. But they cause us to think differently about things we already knew, or thought we knew.

The social sciences are endlessly revealing of the world we know or think we know, and the ways they break apart and reassemble the human relationships we thought we understood can be both immensely useful when juxtaposed against our own. But our recreated understanding is not necessarily any more "true" than whatever understanding we had previously, and we stand to lose something in our careful scientific analysis, because the real world is not an equation. Yin and Yang resist being broken apart, the analysis destroys the subject.

Alright--we probably don't need to be so melodramatic about it. But we should at least be wary of the the limits of abstraction.

Understanding Opportunity

In a recent post I did some thinking about opportunity and how we tend to confuse opportunity for one person with opportunity for everyone, overlooking the way systemic effects may overpower individual effects. This post looks more into the nature of opportunity itself; it is less about power and systems and games and more about what opportunity means to us and how it functions in our lives and political ideas.

Merriam-Webster defines opportunity as "a good chance for advancement or progress", but this definition does a poor job of capturing the word's political-economic implications. When we talk about opportunity, I would argue instead that we are talking about "the ability to succeed." But beyond this broad definition there is not a lot of agreement between different political persuasions.

There are several questions that can help us figure out what we are talking about when we talk about opportunity and "the ability to succeed." I start off asking, what is success and who do we see as successful people? Then I explore how likely we are to succeed. Finally, I examine what it takes to get there: how is success achieved? And how do we enourage it as a society?

What is success?

Success is a complex concept, but we can think of it terms of a number of handy ethe (I had to look that plural up): I'll call them White Picket Fence, Zuckerberg, Horatio, and Beating the Joneses. These ideas of success are from a purely economic standpoint; there are other, critically important factors that I do not consider here at all.

White Picket Fence is the idea that everyone who works hard is entitled to a decent middle class life. It's a common formulation of The American Dream. Success here is defined as reaching an acceptable median standard of income and achieving an acceptable quality of life. Part of the idea is that it's available to anyone and everyone--it's your door prize for being American, working hard, and playing by the rules.

Zuckerberg is the idea that you can not just succeed but... succeed. That you can blow everything else out of the water, because nothing is holding you back. The key to the Zuckerberg conception of success is that there are no limits, and that individuals are free to compete and to win, in ways that have never been known before, because it's better for society if they do. Not everyone will succeed, but that's ok--either because the winning ends up benefiting others (e.g. through new inventions) or the chance of being astronomically rich provides a crucial incentive for everyone.

Horatio is the idea that succeeding means doing better than your parents or your current situation. It's most closely aligned with the dictionary definition of opportunity--the idea of improvement and advancement. It measures your success relative to your past success--how you have advanced over time. It also has the most to do with the idea of a meritocracy, which will be discussed more below.

Beating the Joneses is the idea success means doing better than other people. It defines success as being above average, it's it's a relative measure it depends more than anything on the success of everyone around you. Of these models of success, it's at once the most social, small-minded, and maybe the most realistic in terms of what really motivates us. It may have implicit meritocratic assumptions ("I drive a bigger car because I'm smarter and do a better job at work.") or it may not ("I drive a bigger car because my parents were rich.").

While these visions of success are limited to economics (meaning they are only concerned with money and "stuff") they are nevertheless revealing. They can get us started thinking about what our goals are for our society. When we argue that having a large middle class is good for a country, we are arguing for the White Picket Fence idea of success. When we argue that tax rates on the rich are too high, we are arguing in favor the Zuckerberg idea. When we support first-generation college student subsidies, we support Horatio.

There are countless policies, laws, and economic forces that help shape what kind of vision of success is ultimately realized, and for whom. On an individual level, we can think of these things as affecting our chances of success.

How likely are we to succeed?

We often think of opportunity, and whether it exists in a society, in a sort of binary mindset: either on or off, nothing in between. Either you can lift yourself up by your bootstraps or you can't. Either you can get rich or you can't. Either a black man can go to Harvard and become President of the United States or he can't. The ability to do something is an important concern. But it can be a gross oversimplification.

Success is much better understood as a probability. It makes a big difference whether your probability of success is 10% or 100%, whether your chance of getting a job is 3% or 30%, or your chance of getting into a top school is 5% or 50%. If it is 50%, you are competing in with one other person; if it's 5% you are competing with 19. Do we want to live in a country where one person gets to be rich, one person gets to be middle class, and the other 8 people are poor?

As I wrote about in my recent post, we cannot ignore the structural aspects of success. School is a good example because there are clearly a limited set of outcomes (admittance) that qualify as a certain level of success (to a top school). It is important that anyone in the USA can go to a top school, but it is probably more important that everyone in the USA cannot go. If you dismiss the aggregate aspect, you miss out on a critical determinant of what success is and what it means for a society. Thinking of success in terms of probability can help us see those systemic effects in individual terms--it helps us see some of the implicit difference between Zuckerberg and White Picket Fence, for example.

Of course, the probability of success is not the same for everyone, and we need to better understand which aspects of success are structural and which are individually based. While there may be a limited number of admittance slots, some students are clearly more likely than others to get into the most prestigious schools. Some people are clearly more qualified for certain jobs. Merit and ability and a million other factors also play a role in success. But how much and in what way?

What does it take to get there?

The idea of success implies an attempt, an achievement arrived at through some means or another. You do not just wake up one morning and find yourself successful--it has identifiable causes.

One of those causes is luck, of course, but other causes of success are more determinate. You might be a brilliant, risk-taking entrepreneur and design something very useful that everyone wants, and in exchange they might give you enough of their money for you to be successful. You might study hard and work hard and provide a good deal of value for your employer. You might have a well-to-do family that made sure you did your homework and had tutors and got into the best college and got you in the door for an interview at a prestigious firm.

Opportunity as conceived of today in America is intimately connected to the idea of merit. The idea of a meritocracy, though originally intended as a distopian satire, has caught on as a sincere ideal precisely because it is a good thing when capable, motivated people can succeed in a society. Otherwise, why would anybody care about being motivated or capable? Although few people would probably turn down a winning lottery ticket, the visions of success listed above turn on deserved reward, not arbitrary benefit. This is a good thing, and I think it is much better than holding comparatively undeserved respect for an aristocracy.

But Young's original critique of the idea of meritocracy (previous link) still stands. Young argued that we could end up with a solidified ruling class built on arbitrary definitions of merit that are hardly fairer than divine right: a new aristocracy based on whose kids went to the best prep schools, or based on whose kids did not grow up raised by absentee fathers and gangs on the street corner.

Young argues (as I understand from his article; I haven't read Rise of the Meritocracy) that we need to have a broad, accessible vision of success. That even if we can conceive of a completely fair selection process for success, it is dangerously possible to have outcomes of such a system that are anything but fair. If we have an economy where everyone takes a test and the top 10% of people get great jobs and the other 90% of people end up working work fast food, fairness does not get us very far. We would have built a system that fails to incentivize the majority of people.

You may counter that fairness be damned, society still needs some kind of selection process. We would not watch much pro basketball if NBA teams were required to give anybody who tried out a spot on their starting lineup. We prefer our leaders to be competent and hardworking and our scientists to have a clue. We can't just give jobs to whoever wants them--many of them require smart, capable people.

Of course we need a selection process. But the current process is problematic it is in many ways not set up to incentivize people for absolute success--and absolute success is what matters more for society. Businesses want people with certain definable skills, not just someone who is better than somebody else. We want leaders with integrity and competence, not simply a leader who is not as bad as some other guy. Relative comparisons do matter, but not nearly as much. Selection can be fair without it doing a good job of incentivizing real achievement, because our chances are based on relative criteria: if I know I have to be the best to succeed, I might be less motivated than if I instead have to have a high level of competence.

Looking at society more broadly, it seems to make sense to structure an economic system so that individual success is achieved by the creation of public value both now and in the future. This is the whole idea behind the invisible hand. However, a given individual's relative success matters little to the society as a whole--the absolute level of success, as measured by education and skill and competence and motivation is far more important. If we want to have an economic system with opportunity, we need individual freedom and meritocratic individual incentives, but we also need a system that rewards people for absolute performance and achievement and not only relative achievement.

Labor Day Grab Bag

Well folks, it is Labor Day again here in the USA. One of the most interesting things about Labor Day, in case you were not already aware of it, is that the rest of the world celebrates labor day on May 1st. But they celebrate it then as a memorial to a labor dispute (and subsequent sham trial) that occurred in the United States. President Cleveland chose the September holiday because the government was worried about encouraging links with international communist and anarchist movements.

I did not have the foresight to write up a long thoughtful post for all of you, so I'll try to redirect you to some long thoughtful writings elsewhere. Here are some of the most interesting things I've read lately related to labor.

For starters, I was recently reading an article in which (fairly prominent) labor economist Richard Freeman discusses his recommended reads about the labor movement, and was surprised to find one a pithy and coherent economic defense of unions in the comments section, of all places. I followed the commenter's link to his short-lived blog and found another good free-market defense of unions there. I will definitely be writing more about this in the future.

The next link is an in-depth look at the dynamics of power within the workplace, in the context of refuting libertarian simplifications about power. This is long but highly recommended; it has definitely been influential in my thought process lately (if you can't tell from some of my posts).

If you have been wasting any time online this past few days you have likely seen and already read Matt Taibbi's brutal article about Romney and Bain Capital. Taibbi is really taking issue with much more than Romney, however: he is arguing against a corporate-raider style, short-term profit oriented capitalist system. Because such a system ends up benefiting almost no-one. This is a disputable point, of course. The question is how tenable companies that failed (or shed workers) after a Bain takeover were before the takeover--whether Bain was simply hastening what would have happened anyway. Regardless, it is easy to see how this style of capitalism has impacted worker welfare.

Finally, more in the spirit of May 1 than September 3, here are two articles about the labor movement in China. Our economies are intimately linked and it is not really possible to understand labor issues from a purely domestic standpoint.