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.

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Economics on the beach IV: welfare optimal pricing – a model

This post builds on the previous two, economics on the beach II and economics on the beach III. I have started this, so I need to finish this now. In this post I will finally try to build a small model in which it is true that “charging a perhaps even substantial price for beach access would be welfare improving for all potential beach goers”.

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Economics on the beach III: towards discussing welfare optimal pricing – first steps in building a model

I will try and build a small model in which it is true that “charging a perhaps even substantial price for beach access would be welfare improving for all potential beach goers”, a claim I made in my last post. In this post I will take a first few steps in this direction, first only demonstrating my claim that beaches potentially suffer from the “tragedy of the commons” before I will tackle the main question in the next post.

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Economics on the beach II: the tragedy of the commons

There are things you want to do only with lots of other people. Go see a football game, for instance, or a pop concert. You would feel rather silly being the only one clapping and cheering. You might also prefer not to be the only couple in a restaurant. Aside from the growing feeling that you are probably in the wrong place, you miss the background chatter, the gentle clashing of dishes, the constant moving around of busy waiters. You would miss atmosphere.

But the beach, for me at least, could do with fewer people.

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Me, Myself and Economics: Unknowns, Trials and Errors

Maybe some remember the moment during their study, when they gradually left their textbooks behind and came in touch with journals and papers instead. While it probably felt like a step further towards the scientific process or even into the scientific sphere, one of the first obvious differences probably was the countless citations authors had stuffed in their introductions in order to impressively show how well their work is embedded in the state of the art as well as in the history of the discipline. I admired those authors for their comprehensive knowledge. Facing the extent of the literature I seemingly could have known already that the obvious question was and always will be: should I even know it?

In contrast to personal matters, knowing always seems to be preferable to ignoring when it comes to science. However, it is not that easy. For example, if I know the conclusions derived in a model or based on a study, while at the same time I do not know the underlying assumptions or the characteristics of the test persons, there is a high chance of misinterpretation and even misapplication of the conclusion I know. Especially in our discipline a lot of particles of information are taught which in the packed form crucially lack general validity. This is one reason why I took a little extra time in order to stick with textbook-knowledge. As I am critical of the fundamentals I probably have to step in at a fundamental level.

At the same time, new knowledge is generated day by day. While complete knowledge is utopic anyway, even specialization does not guarantee sufficient knowledge with regard to the issues you are investigating. Facing over two hundred years of economics, meanwhile hundreds of journals with economic background, and our restriction in time, it leaves the quest of acquiring the ‘right’ and ‘necessary’ knowledge with quite a load of uncertainty. For me science therefore always will partly – probably even to large parts – be about trial and error. That is the second reason for why I probably invested less time in catching up with reading than some would expect from a junior fellow and instead worked on a deeper understanding of what I already – seemingly – know.

The third reason for my priorities as I set them in the recent past builds on the previous one. It is clearly important to search the literature for new or comparable ideas, whether it is in favour of inspiration or just to avoid unnecessary repetition. However, already in the course of my study I did not content myself with just knowing an approach and its implications as they were taught in class. I liked to trace its derivation and apply it on my own. I claim that I was often rewarded with a more detailed understanding than many of my colleagues were able to show.

Of course, by sticking to this approach I clearly risk a further increase of my steadily growing reading list. This in turn increases the risk for repetitions of trials unknown to me. However, due to the admired authors and their frequently released literature surveys the shortfall, at least with regard to scientific content, may be not that comprehensive as the number of unread articles and books may suggest. Given that, involuntary repetition may not be rewarded with appreciation, but may again prove worthwhile with regard to a general and deeper understanding of the issues. Weighing up the remaining risk with the aspired chance of strengthening my comparative advantage I stayed on track: try and err, instead of only read, believe and copy in favour of an easy success.

At this point I want to refer to some economic model I am currently dealing with. It captures a sector of firms applying research and development in favour of new machines. The firms in this sector try to invent on the one hand, and imitate on the other hand. Efforts in favour of imitation means that they search for better machines in their competitors’ portfolio. Efforts in favour of invention means that they try to develop a new machine on their own.

Progress and its dispersion clearly needs both, research and development. It does not end with those diligent role models, who commendably keep track with the literature and reliably complete the paths scribed by it. There is also a need for those taking the entrepreneurial risk of abandoning the popular track now and then, testing new approaches or combining old ones in a new way – as Schumpeter would maybe state it.

Economics on the beach I: allocating stream water

It could easily have ended in a fist fight. Or more likely a plastic shovel fight. This is how it began. My kids, my wife, and I went down to a Cornish beach. A beach with an interesting feature. There is a small stream that runs high up the beach parallel to the sea for more or less the whole length of the beach. Kids find this stream almost more fun to play in than the often pretty rough sea, which is mostly inhabited by bodyboarders smashing into each other. As the stream runs essentially over and through sand with lots of stones around as well, it is very malleable. Kids (and, invariably, their fathers – mothers do not seem so keen) love to build little dams, dig up new channels, and create little pools to play in. On the given day, easily 20 to 30 kids (and some of their fathers) were happily engaged this way somewhere along the length of the stream, when suddenly the water was reduced to a tiny trickle and had stopped flowing altogether further down the stream.

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Video: David Friedman’s case for anarchy

On June 6, David Friedman gave a lecture at the Economics Club making the case for an archo-capitalist society. For those of you who missed it, you can watch a video of the talk here!

(Unfortunately, the sound quality is not great. If anyone has an idea how to improve it, please leave a comment.)

There will be a video of the second lecture at some point, but it still needs some editing which is definitely not my comparative advantage.