Disequilibrium economics is a logical impossibility

This is going to be super abstract, potentially infuriating and probably wrong.

I sometimes hear people talk about „disequilibrium economics“ and I think I know what they have in mind. Equilibrium is often associated with a system at rest. That’s the physicist’s notion of equilibrium: a ball sitting at the bottom of a bowl, a planet moving around the sun in a stable orbit, etc. Disequilibrium is something not at rest: you hit the ball and it jiggles around inside the bowl, a planet collides with another and flies off its orbit.

Economists have a different notion of equilibrium. Indeed, they have several different notions depending on the context. But basically, an economic equilibrium is a consistency condition imposed on a model by the economist. It follows that „disequilibrium economics“ is a logical impossibility.

Let me explain. Economists build models to explain certain real-world phenomena, say bank runs. Inside these models there are agents, e.g. savers, banks, firms, each described by their preferences, beliefs and constraints. For instance, a saver wants to keep her money in the bank as long as she believes she will get it back eventually. Whether she can get it back depends on the number of savers who demand their money back. As long as most of them don’t want to withdraw their money, everything is fine. However, if there is a critical mass of savers who want their money back, the bank needs to liquidate its assets prematurely at „fire-sale“ prices, which means it cannot repay all the savers’ deposits in full. You have two equilibria: one in which nobody runs on the banks, the banks carry their investments to maturity, everyone gets repaid; another one in which everyone runs, the banks liquidate their investments prematurely, people don’t get repaid in full.

Only the first of these equilibria can sensibly be characterized as „a system at rest“. In the second equilibrium, nothing is at rest: there is chaos in the streets, banks go bust and people get hurt.

What characterizes both equilibria are two conditions:

  1. Everyone is doing the right thing given their preferences, beliefs, and constraints. The saver who runs on the bank is doing the right thing: Given that everyone else runs, she should run, too, or else she will get nothing. This is called rational behavior, but it should really be called consistent behavior. It’s behavior that is consistent with an agent’s preferences, beliefs and constraints.
  2. Things need to add up. Or to put in fancier language: individual decisions need to be consistent with each other. The total value of deposits repaid cannot exceed the total value of assets held by the banks. If there are 10 cookies and I want to eat 8 and you want to eat 5, that’s not an equilibrium. It’s a „disequilibrium“. It’s a logical impossibility.

If you’re a behavioral economist, you may take issue with condition (1). You may argue that people often don’t do the right thing, they are confused about their beliefs and they don’t understand their constraints very well. That’s fine with me. Let agents do their behavioral thing and make mistakes. (Although you must be explicit about which mistake out of the approximately infinite number of mistakes they could make they actually do make.) But still, things need to add up. I may be mistaken to want 8 cookies and you may be confused to want 5, but there are still only 10 cookies. Behavioral economics still needs condition (2).

If you’re a first-year undergrad, you may think equilibrium means that markets clear. Then you learn about asymmetric information and realize that things like credit rationing can occur in equilibrium. And you learn about the search models. Adding up constraints may be inequality constraints.

Finally, you cannot „test for equilibrium“ with data. Equilibrium is that which your model predicts. If your prediction is contradicted by the data, it’s because your model is wrong, not because there is „disequilibrium“. I have heard econometricians talk about error correction models where they call the error correction term a measure of „disequilibrium“. What they mean by that is that their economic model can only explain the long-run relationship between variables (the cointegration part), from which there are unexplained short-run deviations. But that just means the model is wrong for these short-run movements.

Equilibrium means consistency at the individual and at the aggregate level. It doesn’t mean stable, it doesn’t mean perfect. In fact, it is completely devoid of empirical content in and of itself. It only becomes meaningful in the context of a concrete model. And without it, economic models wouldn’t make any sense.

7 thoughts on “Disequilibrium economics is a logical impossibility

  1. “If your prediction is contradicted by the data, it’s because your model is wrong, not because there is „disequilibrium“.” …and if the football team you bet on looses, it’s because your considerations were wrong, not because the other team was better. No, wait, what?
    If I got you right, your point is similar to what I am saying about utility functions. They are just a suitable way to mathematically depict preferences. When I doubt the implications derived with common utility functions – and I do so – I hardly critisze the use of utility functions in general, but just how those utility functions look like, what they incorporate, what they neglect, and moste of all how agents are assumed to be aware of them as well as deal with them.
    However, I see an important difference between may plea in favour of utility functions and your plea in favour of equilibrium economics. An utility function describes an assumption about an agent’s characteristic, something temporary given, the starting point. Stating an equilibrium already presumes something about the system’s state, something to be determined, the end point. The equilibrium as it used in economics simply is more than a consistency condition. It also is more than a helpful and highly relevant concept – which it is. It (also) is an outcome – bullheadedly expected, stated, and even presumed.
    In the end therefore I confirm that the term equlibrium as it is used by economists is much more ‘flexible’ than the interpretation than “something is at rest”. But your way of ‘flexible’ reminds me a bit of a student that, after they are corrected by the teacher, always says: “That’s what I meant.” I think the honest way of dealing with equilibrium approaches is to state: “They are an approximation. They are helpful to discuss a bunch of issues and we like them because they may be written as well as solved so beautifully in analytical terms. But yeah, it is time to complement them with some less restrictive stuff as well.” I hope you get my point as well 🙂

    • It’s a fair point.

      Maybe we should stop calling everything an equilibrium and reserve the term for what it used to be in the Old Days, namely supply = demand. But if so, half of economics already is “disequilibrium” economics.

      • I indeed prefer a more restrictive and straight forward notion approaching the one of physics or say system sciences, while the most common used notions like “supply equals demand” as well as “no incentive for unilateral deviation” satisfy this idea. We have the vocabulary to differentiate if needed as we exemplary do when we discuss steady states in constrast to stationary states.

  2. I very much like two of the above observations. 1) Equilibrium does not necessarily mean things are great. And indeed sometimes an equilibrium may not feel very restful. 2) There are often also simply technological constraints that just have to be obeyed. The total number of some product sold must be the total number of products bought, for instance. [This is not saying that demand equals supply.]
    So, yes, in equilibrium any technological constraints have to be satisfied. But, in my books, equilibrium is more narrowly defined than requiring that “Everyone is doing the right thing given their preferences, beliefs, and constraints.” Suppose I go to Japan and rent a car. Suppose I have the – erroneous – belief that people in Japan drive on the right side of the road. If I now drive on the right side of the road I am doing the right thing given my preferences (to avoid accidents), my beliefs (unfortunately wrong here), and constraints (not so important here). So one could potentially imagine a Japan in which a quarter of the population drives on the right side of the road because they believe that that’s what everyone does and the remaining three quarters derive on the left because they believe that that’s what everyone does. I would not want to call this an equilibrium. Crucially definitions of equilibrium usually entail the condition that beliefs are aligned. One could argue that this is actually what makes an equilibrium an equilibrium.
    In the driving example we imagine that such an equilibrium would be quickly established. There are examples, however, of non-equilibrium behavior. While I do not know of any well-documented example of non-equilibrium behavior in important economic interactions between humans (but I am sure there are some), there are many examples of non-equilibrium behavior in laboratory experiments. I think public good provision games with learning demonstrate that behavior in early rounds of this game is not in equilibrium.
    But I do know one very nice example of non-equilibrium behavior from the animal world. Apparently there are three types of male side-blotched lizards (https://en.wikipedia.org/wiki/Common_side-blotched_lizard#Mating) and they appear in ever changing frequencies. Their reproductive success is supposedly well-described by a kind of rock-paper-scissors game. The three types of males are as follows. There are harem types, who try to hold a largish harem of females but cannot at all times know what the females in their harem are up to; highly protective monogamist types who completely control every move of the single female they have paired up with; and so-called “sneakers” who try to mate with any females they can get access to. Arguably, harem types are easily infiltrated by sneakers, who in turn do not do so well against monogamist, who in turn do not do well against harem types. An equilibrium, as game theorists define it – requiring a common belief about how the game is played – would require that there be a fixed proportion of the three types. One has to realize that lizards are not very forward looking – so repeated game strategies are out. The reality of the situation, however, is that the frequencies of the different types of males vary substantially over time. This supposedly happens somewhat in loose agreement with the so-called “replicator dynamics”.

    • Interesting. As I said in the beginning of my post, I’m probably wrong, and I can see that my title was too strong a statement. Although I can’t help but notice that the two examples of disequilibrium you picked are about a hypothetical problem with driving in Japan (I’m not sure if car crashes due to people being confused about which side of the road to drive are a real thing there) and a rare lizard species.

      I still stand by my view that economists have stretched the concept of equilibrium to an extent that it has no empirical content. I am pretty sure that a clever PhD student in game theory could build a model in which car crashes in Japan (or the fluctuations in mating types among side-blotched lizards) occur as an equilibrium phenomenon with some suitable definition of equilibrium.

      I think the history of economics can be seen as extending the set of things that can be explained as equilibrium outcomes. People used to think unemployment is disequilibrium, then you get search models. People used to think bank runs are disequilibrium, then came Diamond-Dybvig. People used to think marriage and crime and addiction are beyond the scope of rational-choice equilibrium analysis, then came Gary Becker. And so on. But this was only possible by inventing new equilibrium concepts.

    • “The total number of some product sold must be the total number of products bought, for instance.” …as above I mentioned that the vocubalary of economists allow to differentiate, I have to add here, that this is what I would rather address with the term ‘stock-flow-consistency’ — which does not necessarily imply an ‘equilibrium’.

Leave a Reply to maxgoedl Cancel reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s