The standard supply and demand model is familiar to most people, and especially to economists. While the model serves an analytical purpose (and an important one at that, in this man’s opinion), if not properly understood in the context of the market mechanism, it leaves a false impression. The lessons of the model are subtle and the goal of this post is to address some of the popular misconceptions about the model and what it means.
The first misconception that the model gives is that the market is an equilibrium institution; that is, the market is always (absent externalities, interference, taxes, asymmetric information, etc) in equilibrium. In some sense this is true*, but it is not the whole story. If the market is in equilibrium, then there is no impetus for change: no profit opportunities (for buyers or sellers). In short, there is no need for a market. In equilibrium, all quantity demanded is met with supply and there is no longer any need for the coordinating efforts of the market institution. The standard supply and demand model in equilibrium is a model without a market!
The misconception that the supply and demand model suggests the market is an equilibrium institution leads people (including economists!) to conclude that when the market is in disequilibrium, whether because of some frictions (ie rigid wages), or asymmetric information, or externality, or even disaster, then the market institution cannot work (or does not work as well). But this is a misunderstanding both of what equilibrium is and what the lessons of the model are.
Equilibrium, as I discussed above, is the hypothetical point where quantity demanded and quantity supplied meet and thus economic profits equal zero. I stress hypothetical because of many people, again including economists, assuming this equilibrium point actually exists, it is (or can be) known, and it is just a matter of pulling the right supply/demand policy levers to get to that point. But the equilibrium cannot be known; both in the model and in real life, it “results” from the interactions of suppliers and demanders exchanging at various prices. When a supplier raises his prices for his good, he thinks of the profit he earns, not that the current price is below equilibrium. When the demander consumes more than he had originally planned, it was not because he saw the price was below equilibrium, but because the consumption of one more unit was more valuable to him than the alternative uses of the resources he has to give up. If these opportunities for personal advancement (ie profit or bargains) do not exist, as they don’t in equilibrium, then there is no desire for exchange and thus no market.
The actions of suppliers and demanders searching for profit brings me to my second point: the market is a disequilibrium institution. The market operates at its best when there is disequilibrium. That is the lesson of the supply and demand model. When the market is not at perfect equilibrium, then there exist opportunities for entrepreneurs to enter the market on either the supply or demand side (I emphasize this point because many people only think of entrepreneurs as suppliers, but consumers can seek to be entrepreneurs as well). These entrepreneurs are seeking profit (in the supply side, from selling their goods above what they value them and the demand side, from consuming either more goods or paying for goods less than they value them). The profits these entrepreneurs seek exist only when the market is in disequilibrium. In other words, the fact the market is not in perfect equilibrium means the mechanisms of the market institution are at their best!
The interesting thing about the conclusion that markets are a disequilibrium institution is that most of what economists call “market failure” are exactly these entrepreneurial opportunities that make the market work! Transaction costs, asymmetric information, externalities, and the like can all be exploited for entrepreneurial gain! Efforts to “fix” these market failures block the market mechanism, leading to actual market failure! The evidence of efforts to fix “market failures” leads to actual market failures is obvious (and can be derived from the supply and demand model): price controls (minimum wage, price gouging legislation) lead to waste, trade barriers lead to poverty, etc.
Markets are not in perfect equilibrium. That’s why we need markets.
*Explanation of this point will require a second blog post, which I will provide in the near future, but I do not want to distract from the conversation at this point