Demand and Supply

Everyone who studies introductory economics get introduced to the demand and supply curve graph. We may remember nothing about economics but this is definitely remembered. Demand and supply curves are the bedrock of economics and fundamentally underpin the modern capitalist system. Intuitively, these curves make sense; we have a downward sloping demand curve and an upward sloping supply curve. The point where these intersect is a equilibrium. This is the point at which the quantity demanded is exactly matched by quantity supplied. Therefore this is the point at which optimal allocation of scarce resources. These curves help to explain the dynamics of all sorts of products and services.

Makes sense right? Then how does one explain the demand for luxury products? Or for antiques? Or for paintings of the Old Masters? Or for aged wine? Or for financial products? In all these cases, demand increases as its price increases. Some of these cases can be explained through a modification of the demand/supply curves. In the case of the Old Masters and antiques and aged wine, supply cannot increase with demand. So the supply curve is a flat line instead of an upward sloping curve. Increasing scarcity will increase the value of the product. But what about luxury products? Their supply is not finite. It can and does increase as demand increases. Why then does demand increase as their prices go up? Most interesting is the case of financial products. In nearly all of them, increasing demand will result in vastly expanded supply and rapidly increasing prices. This is basically how stock market bubbles form. In both cases, traditional analyses of demand/supply curves will lead to wrong conclusions. A basic failure to understand this was to a certain degree responsible for the financial collapse that the world has been going through since 2008 - a collapse that has affected not just the financial system but the real economy which underpins all of Finance.

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Market Assumptions - Time Lags

Among the many assumptions of perfectly competitive markets, there is one that is largely unspoken. This assumption is that there are no time lags in buyers and sellers entering or exiting the market. This assumption is quite critical because most analysis of this model and its variants has no time lags as a underlying basis. Taking no time lags as a fundamental basis of analysis also supports the other assumptions of this model.

When we assume no time lags, we can talk about instantaneous changes in demand and supply. Whenever there is a change in the supply of a commodity, the demand for it immediately adjusts appropriately and vice-versa. A new equilibrium price is swiftly reached and no extraordinary profits can be made. Some suppliers will swiftly exit or others will swiftly come in depending on the direction of the change. These changes will also be instantly reflected in changes in employment. Labor made redundant in one area is instantly available for other areas.

As a purely theoretical framework, the perfectly competitive model is excellent at understanding the basic forces that operate on different (but not all) commodities. However, problems arise when this model or any variant thereof is made to fit the real world. Take the problem of time lags. In the real world, things do not happen instantly. There is an often significant time lag between a change in demand occurring and companies responding to it. Similarly, there is also often a significant time between a change in supply occurring and companies and consumers responding to it. These time lags allow extra-ordinary profits to be made. They can also have the effect of entrenching existing companies such that new entrants find it harder to compete. Thus time lags can actually enhance entry barriers. Time lags can also result in a mis-allocation of resources. Projects take time to complete. A project can make perfect economic sense when it is proposed, analyzed and started. However, conditions can change almost overnight and a project that made perfect sense suddenly can become a perfect liability. Dubai discovered this when global economic conditions changed for the worse in 2008. All of a sudden, major real estate projects were forced on hold or cancelled. The result was a large number of sad, empty shells standing forlornly. Thus any model that neglects the effects of time lags will result in faulty conclusions being drawn regarding the economy. The actions that are taken as a result of such conclusions will often be worse than taking no action at all.

Market Assumptions - Entry / Exit Barriers

What is the impact of entry and exit barriers in the real world? In the perfectly competitive market model, there are no entry or exit barriers. Buyers can enter or exit any market at any time instantly. And that is an important secondary assumption underlying the assumption of no entry/exit barriers: no time lags between entry and exit. Under such assumptions, no single buyer or seller can dominate the market. More importantly, the possibility of extra-ordinary  profits simply does not exist. If such profits are being made, new sellers will enter and drive prices down. If profits are too low, some existing buyers will exit. In all cases, the market will swiftly return to a hypothetical equilibrium point.

While economists are pontificating about such issues and teaching millions of innocent souls such theories, in the real world conditions are very different. Both entry and exit barriers exist. Also, things do not happen instantly. There is often a time lag which can be significantly long.

Entry barriers arise from many causes. They can be regulatory, financial or caused by the market size of the incumbents. A good example of regulatory entry barriers are the rating agencies in the US. The regulatory authorities demand that public companies get their bonds and stocks rated by a limited number of firms and by no other. Some markets are natural monopolies. In such cases, the nature of the market itself acts as an entry barrier. Most markets, specially digital ones, tend to have a winner take most nature. Such markets have two or three dominant firms and a bunch of niche players. The dominant firms act as strong entry barriers. Predatory practices also act as entry barriers although these tend to be discouraged by governments. Microsoft, as an example, cemented its near monopoly in the computer operating system market by penalizing hardware manufacturers who wanted to use other non-Microsoft operating systems. Copyrights and patents also serve as very strong entry barriers. These are like toll booths on a highway. Without the appropriate payment, no one else can enter. And the toll booth operator can shut down access to the highway completely. Copyrights and patents can be so lucrative that an increasing number of companies are becoming dependent on them for their revenue; a classic rent seeking action.

What about exit barriers? There are often cases of zombie companies which cannot survive on their own but which also refuse to die. Like zombies, they shuffle along consuming resources that could be put to better use elsewhere. Exit barriers often arise because of market failures. The company is unable to dispose of its assets and thus carries on its miserable existence.

What is the effect of entry and exit barriers on the economy? Does it matter if these exist? I believe that it matters hugely. These barriers distort market signals and result in a mis-allocation of resources. One of the strengths of the market system is supposed to be its ability to efficiently allocate resources through pricing signals. These kind of barriers prevent such allocation. A much more insidious effect of the entry and exit barriers is that these can inhibit innovation. The modern global economy depends on continuous innovation as a major engine of growth. These barriers inhibit this innovation. They tend to encourage the continuation of the status quo even beyond its usefulness. New ways, new product, new services tend to be undervalued and at best delayed and at worst never get to see the light of day. In the end, a few people prosper while the many suffer.

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Market Assumptions - Information Symmetry?

A basic tenet of perfectly competitive markets and one that is assumed to hold for other types of markets is that of information symmetry. This is the assumption that buyers and sellers in a particular market have the same amount and quality of information regarding the transaction under process. A secondary assumption (which is still nonetheless very important in its own right) is that even if there is information asymmetry, it will exist for a very short while and the cost of acquiring the required information is low or non-existent.

Do these assumptions hold in the real world? The short answer is no. I cannot think of any market where these assumptions hold true. In any market environment, there is some form of information asymmetry. Almost always the seller has greater information regarding the product(s) on offer. What is more, the cost of acquiring information is usually large. This cost is not just monetary. There is the cost of the time required and the opportunity cost of not being able to do something else while the search for information goes on.

This particular fallacy is thought to hold particularly well for financial markets especially the stock exchanges. The efficient market hypothesis holds that any information relevant to the stock in question will immediately be reflected in the price of the stock. The reason for this being that given the large number of people playing the market, someone somewhere will analyze and act upon the new information. This is a fundamental reason why some economists insist that stock markets are efficient. However, others have pointed out a contradiction at the heart of this idea. If any new information will immediately be acted upon by someone somewhere, then there is no point in seeking out this information. This will hold true for all players. Therefore no one will have an incentive to seek out new information that may be relevant and so the price of the stock will not reflect all available information. The financial services industry has also evolved new financial products nearly all of which have one primary feature: they literally require a rocket science degree in order to understand them. The sheer complexity of these products also means that the buyer (and frequently the seller too) does not understand the basic product. Theoretically this poses no problem since such products are supposed to be sold to sophisticated institutional investors. However as we have already seen, such investors are actually not very sophisticated. The result has been that all sorts of buyers have been exposed to a high level of risk. Is this efficient? No.

Information asymmetry can be seen in many other markets. Take as an example, the market for lawyers. Why are legal fees so high? The reason is that legal documents are couched in obscure jargon which is almost impenetrable to a lay person. Ordinary people simply do not have the information required to be able to bring down legal fees. Infact virtually all professional services markets are able to command high prices because of information asymmetry. Almost all secondary markets suffer from the same malady. Why do previously owned cars sell at a steep discount? Because the buyer does not have the same amount and kind of information regarding the condition of the car that the seller has. Fear of buying a lemon brings down prices for all sellers. Assuming markets have information symmetry is not only wrong, it is actually foolish. A model based wrong assumptions will inevitably lead to wrong conclusions and wrong policy decisions. And then everyone wonders what went wrong?

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Market Assumptions - Are People Rational?

The most basic definition of markets would be a place - physical or otherwise - where people can exchange goods of equivalent value in such a fashion that all parties to the exchange are better off than before the transaction. This is an elastic definition that covers a wide range of markets. We are all familiar with traditional markets. These are places we go to shop and hang around in. These are sometimes classified as business to consumer (B2C) markets. We are also aware of business to business (B2B) markets. Then there are financial markets, commodity markets, internet markets and even virtual markets. These are all types of markets that exist in the real world.

Do the assumptions of perfectly competitive markets hold for them? Examining these assumptions one by one, we are forced to conclude that they largely do not hold true in reality. Studying perfectly competitive markets therefore may make sense at an elementary level when students need to be given a model that can be compared to the real world. When these assumptions are applied to the latter, the wrong conclusions will be drawn and these will result in misguided policy prescriptions.

Take one of the most basic assumptions of economics: rationality. Are humans rational? Economists certainly assume so. Assuming rationality is an extremely tempting simplification to make of a complex reality. After all, each of us has the power of our intelligence to make decisions that will best suit our circumstances given the information on hand. Yet, despite our powerful brains we continue to make important decisions based on emotions.

Emotions are integral parts of our personality. Our rationality is tempered by our emotions. When these two are in balance, it is only then that we make optimal decisions. Unfortunately, often our emotions overrule our rationality. This is most obviously seen in financial markets particularly the stock exchange. If any market is considered to be the closest in characteristics to perfectly competitive markets, then stock exchanges are it. Elaborate models have been built that show that we cannot beat the market and that bubbles and busts cannot happen. But they do. With annoying regularity. And often devastating effect. For example, in 1987 Wall Street crashed by 22.6%. This was the largest single drop ever and was considered to be statistically improbable. In fact its probability was calculated as happening once every 20 billion years. An event so extremely unlikely that it could not happen in any human lifetime. Nor was this a one-off. Wall Street crashed again in 2001 and then once again in 2007. Three statistically improbable events happening within a lifetime! What happened? Economic models based on rationality ignore the elements of greed and fear which play important roles on the stock exchange. When greed rules, the market goes up and a bubble can form. When fear rules, the opposite can happen and the market can crash.

Stock exchanges are not the only places where emotions sway people. Research has shown that people value possessions very highly even at the expense of rational economic calculations. People also fear loss more than they fear gain. They will make a less than optimal choice based entirely on this. So one of the most important assumptions of perfectly competitive markets do not hold in the real world. Yes, people are rational but this rationality is tempered by emotions. Marketers know this and in many markets, they take full advantage of emotional impact. Fear is a great motivator to persuade people into courses of action they would otherwise be reluctant to take. Models that do not take emotions into account simplify reality to an extent that they become useless. Relying on such models is not only pointless but can cause needless suffering and misery.

Next time - an examination of another assumption of perfectly competitive markets.

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What are Markets?

Economists love to talk about markets. Listen to them and it sometimes seems that markets are the panacea to all the ills of humanity. Whatever problems we may be facing, the best solution inevitably is deemed to be a market based solution. So here is a question that quite naturally arises: what are markets? For most people, we think we know. But do we really?

Mention the word market and the image that jumps to mind is a bucolic rural scene filled with small shops selling different things to throngs of happy people buying stuff they need. This image is reinforced for most of us by our memories of Economics 101 where we learn about perfect competition. However, markets like this do not really exist any more. Over time markets have mutated into many different forms each with their own characteristics. This has happened to such an extent that talking about perfect competition is actually a disservice since this reinforces the myth that the conditions that apply to perfectly competitive markets also apply to these other forms of markets.

Perfectly competitive markets only exist if we make a number of assumptions. Some of the most important assumptions underlying these markets are:

• Buyers and sellers have equal information regarding the good or service being sold.
• There is no cost to gathering and assimilating information regarding the good or service being sold.
• No single seller or buyer has the power to affect the functioning of the market.
• There are no entry or exit barriers.
• An efficient legal and regulatory framework exists for enforcing contracts.
• There is a minimum (ideally no) time lag between some new information becoming available and that information being assimilated and acted upon.
• The same forces (primarily supply and demand) act in the same fashion on all commodities.
• All the actors in the market are economically rational.
• Also all actors in the market are able to instantly calculate the amount of "utility" that they will obtain from buying an extra unit of a particular commodity (whether a good or a service).

Needless to say, there are no markets in the real world where such conditions exist. The reason why perfectly competitive markets are studied is that they serve as a good model to understand how an "ideal" market should work; the idea being that lessons learned in a study of this type of market can then be applied to other, more realistic markets. The problem is that most of the important assumptions that underlie perfectly competitive markets are then also implicitly assumed for these other types in more or less their original form. This results in the wrong kind of lessons being drawn. These wrong lessons are transmitted to students, especially business students and eventually percolate to policy makers where they influence policies that can result in actual harm as we have recently seen.

What are these other kinds of markets? To what extent the assumptions stated above hold in these other types? What are the actual characteristics of these other types? These are some of the questions regarding markets that I will be exploring in subsequent pots.

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Innovation

The private sector is touted as being a font of innovation. The government is derided as being ossified, a lumbering dinosaur unable to comprehend the nimble private sector. This is now taken as being a self evident truth. Which is why it is fair to ask whether this assessment can be considered true or false or perhaps partly true.

First why is innovation important? Innovation introduces new tools, methods and processes. Innovation allows us new ways of communication and new methods of consumption. The process of industrialization has placed a premium on innovation. As consumers, we have become attuned to learning new methods of consumption and production. But where does innovation come from?

The accepted answer is the private sector. If we examine this claim more closely, it becomes evident fairly quickly this is a lazy assertion. As always, the reality is more varied and interesting. Innovation does not occur in a vacuum. It requires a context to operate in. Much of that context is provided for by governments. Consider markets. Unlike what a lot of people think, markets need some essential physical and legal infrastructure to operate in. Only the simplest of markets can operate in the absence of these. Who is best positioned to provide the necessary support? Governments. Another area where governments become important for innovation is education. If the process of innovation is to become a regular part of the economy, we need a minimum mass of educated people to support it. Public education is a service that the private sector by itself will not provide on a sufficiently large scale. To fill in the gap, governments need to step in.

By its very nature, the private sector's primary focus is on the bottom line. As such, nearly all companies tend to have a short term, commercial outlook. A particular process or gadget or widget or whatever is evaluated in terms of returns. As such, the private sector is predisposed towards applied science. Basic science is being done by relatively few companies. But advances in basic science eventually lead to commercial applications. In cases where discoveries are made in applied science, these need to be backed up by some theoretical framework before full advantage can be taken of them and further development is done. Again it is primarily governments that provide much of basic science. Even in applications, there have been many commercial spinoffs of government science and government innovation. The Internet is just one of many technologies developed because of government.

To say that government has no positive role to play in promoting innovation is simply wrong. The market system is very efficient but a big flaw in it is that it is by its nature short term and generally not reliable in introducing new techniques and technologies. For that, a much longer view is required. However this does not mean that all such development can be handed over to governments. While governments often excel in basic research and in long term applied research, they frequently fail to commercialize their discoveries. This is not necessarily because government employees are idiots or evil. Usually its just that their training and experience is non-commercial. They simply do not think in a market minded fashion. For commercializing promising innovations, we often need the private sector. Innovation is the life blood of a modern economy but to make it work both the private sector and the government sector are needed.

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