Wednesday, February 27, 2013

Far-From-Equilibrium Modeling of the Economy

The belief that real markets are inefficient comes about when economists compare equilibrium models of the economy to the real economy and, noticing a huge difference between the two, conclude there is something wrong with the market. For some reason it doesn't occur to them that their models may be wrong.

One gets an equilibrium in one's model when that model uses negative feedback alone. The benefit of this is that the models are then very simple and unmessy. The negative feedback drives human action and prices to equilibrium. Competition among consumers drives up prices while competition among sellers drives down prices. Increase supply while holding quantity demand steady or decrease demand while holding quantity supply steady, and prices will drop; increase demand while holding quantity supply steady or decrease supply while holding quantity demand steady, and prices will rise. We have the law of diminishing returns -- no clearer summation of negative feedback leading to equilibrium. And more, equilibrium models show that in perfect competition (another problematic idea), negative feedback will drive profit down to zero. Thus, if there is profit, there is a problem with the market.

But what if the market is not a process in which only negative feedback exists? What if there is positive feedback as well? There is certainly a law of diminishing returns at any given time for any given individual, but what happens overtime, and when there are groups of people? What about fads, where the more popular something becomes, the more you want it -- even as the price goes up? A fad resembles a sort of mini-bubble -- as well it should. Bubbles are caused by positive feedback processes. And both bubbles and fads end -- often spectacularly.

But we can only see this if we understand the economy as being the product not of pairs of people in a sort of atemporal pinpoint, but as large groups of individuals over space and time. We thus get both positive and negative feedback at work simultaneously, creating multiple equilibria. This creates entrepreneurial opportunities and thus the opportunity for pure profit.

And this ignores the roles of money/finance and technology, two other spontaneous orders that interact with the catallaxy, keeping it in a constant far-from-equilibrium state.

In the end, the economy is and can be creative if and only if it has bipolar feedback. The economy behaves precisely as it does because it necessarily has these two forces at work, and not merely the one. Such a model of the economy will certainly be much messier than equilibrium models, but they will be more true to life -- and far less misleading. They will certainly demonstrate the utter impossibility of predicting the outcomes of certain rules and regulations.

Now, none of this is to say that there aren't aspects of the economy that aren't dominated by a tendency toward equilibrium. It is likely true that there are aspects of the economy that are dominated by negative feedback. But I don't think we are in a strong position to say what those are until we have models of the economy that make simultaneous use of both negative and positive feedback.
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