Is it really feasible that there can be a single theory of ‘the market’ that encapsulates everything from tomatoes to CEOs to houses? Engineers do not think they can apply the same theory to every fluid, and similarly, it is not unreasonable to suggest markets might function very differently depending on what is being bought and sold. In this post, I’ll set out a couple of alternative interpretations of supply and demand for different markets. I developed these alternative approaches based on some well known real world observations.
A few caveats:
(1) I am not interested in deriving these schedules ‘rigorously’ from arbitrary axioms about individual behaviour. Such an approach is unnecessary as phenomena may be emergent, and it always seems to run into problems.
(2) These models should really only be interpreted as working for individual markets on a small scale, as large scale feedback effects render this type of analysis irrelevant.
(3) I am aware that there is no such thing as a demand or supply ‘curve’ in reality. Perhaps the fact that I feel the need to reduce everything to intersecting lines is a testament to how much neoclassical economics has polluted my thought. I am undecided as to whether I regard the supply-demand framework as a useful tool that can be adapted in certain circumstances, or as something that needs to be done away with entirely. I’m sure heterodox readers can give me many reasons demand-supply as a concept is not worth keeping. In any case, I regard these examples as interesting, and at the very least they are a good way to take economists on on their own turf.
(4) Finally, I apologise for my drawings, which were constructed on MS Paint.
It is an observed reality that asset prices and demand are often positively related, since in many cases an asset is purchased for no other reason than selling it later on at a higher price. Price increases can act a signal for later price increases, and the opposite is also true. Hence, we will posit a positively sloped demand curve for this model. This relationship will also be exponential: at low prices, the effects will be relatively small ,but as prices spiral , the effect will get larger and larger. Since the supply of assets is relatively inelastic (in the case of land, perfectly inelastic), the supply curve will be a steep upward sloping line.
From the diagram constructed based on the observations above, we can deduce a few interesting mechanics. First, there large number of demand-supply combinations for which there is no equilibrium. If demand is to the left of the supply schedule, supply will always exceed demand and prices will fall to zero. The most likely cause of this is simply that a company or industry is not performing well, although tight monetary policy could also do it. If the demand curve is to the right of the supply schedule, demand will always exceed supply and price will spiral upward indefinitely. This could be due to excessive credit expansion or misplaced expectations.
However, between these two extremes there is a potential ‘golden zone’ for which equilibria exist. In this zone I have drawn two potential demand curves: D2, which just touches the supply curve, and hence has one potential equilibria; and D3, the likes of which would be more common and would have two equilibria. The two lower equilbria, e1 and e2, are not stable. Any drop in price will result in excess supply that will drive prices down the schedule. An upward increase in price from e1 or e2 will result in excess demand that will continue to increase price in a spiral. In the case of e2, it will propel the market up to the one stable equilibrium: e3. If the price increases, supply will exceed demand and it will quickly fall back to e3. If it decreases, demand will exceed supply, the price will rise and the market will again tend toward e3.
The volatile behaviour displayed by most outcomes in this model is in accordance with much real world experience in the stock market, from the downward spiral of Facebook to the internet stock bubble and other frequent historical experiences. But what about e3? Is it the case that certain firms or industries exhibit relatively high, consistent returns? In fact, relatively stable share prices do exist for some firms and industries: ones that are rarely hit by volatility. Insurance, transport and many consumption goods are all stable industries. Obviously this doesn’t protect them completely: firms, industries or the market as a whole may exhibit relative tranquility before something knocks them over the precipice.
We can draw a few policy conclusions from this framework. There is scope for a central bank to reduce or increase the liquidity of the system in order to try and knock the market into the ‘golden zone.’ The effects of an FTT are indeterminant, which is actually the only conclusion I can garner from the available evidence. However, the primary conclusion I would come to – which admittedly doesn’t flow completely from the model – is that due to the level of volatility, the trading day could be be extremely limited, or trade could be cut off if prices are rising or falling too fast. This way the price spirals can be curbed while the central bank adjust liquidity, and investors and funds adjust their positions, trying to shift the demand curve back into the golden zone (though I am willing to admit the last part verges on a spurious level of precision).
Another market that would be expected to diverge strongly from the ‘norm’ would be the labour market. Many aspects of labour make it different to other markets: it is required to subsist; it cannot be separated from a person; it is difficult to determine the productivity of potential applicants, or even present workers; time spent in work is related to leisure time. Below I’ll outline two alternative approaches (that are also somewhat compatible).
A more comprehensive approach to labour supply, which takes into account the need for subsistence, has been provided by Robert Prasch (whose book, which inspired this post, is recommended). His approach is illustrated in the diagram below:
This can be seen as an adaption of the typical ‘backward bending‘ labour supply curve found in economics textbooks. The subsistence frontier shows the total pay required to subsist at various wage levels, whether that is interpreted as literal subsistence or a conventional and socially acceptable level of income. Obviously, the higher the wage, the fewer hours required to work to reach subsistence.
Equilibrium C is unstable as either side of it creates a wage spiral toward the next equilibrium. If the wage decreases, the labour supply will be forthcoming as workers seek subsistence level pay. At Wu they hit the limit of how long they can work and give up, settling for a ‘poverty trap’ wage at D. If the wage increases above C, wages become less necessary for subsistence and workers will withdraw their labour while remaining on the subsistence frontier. Once the subsistence frontier becomes a distant memory and wages are high enough, workers will be willing to devote more time to work in order to purchase more goods and services.
The highest equilibrium, A, is also unstable. Should the wage deviate upward, there will be a resultant upward spiral as demand always exceeds supply. Should it be reduced or capped, the wages will settle down toward a lower level. This is consistent with the observed behaviour of CEO, footballer and celebrity pay in recent decades, which shot up when marginal tax rates were significantly reduced (and a direct cap on footballer’s wages was lifted).
Clearly, a couple of evil communist interventions can be proposed based on this framework. The first is a minimum wage at or above Wc to boost the market into the desirable area. The second is steeply progressive taxation above Wa to prevent pay from spiraling Such interventions would help to enhance labour market stability, equality and reduce poverty.
I have also constructed an alternative model of the labour market. My model is shown in the diagram below and illustrates what a labour curve might look if we included the assumption of the ‘conventional’ working day/week which characterises so many people’s lives. This may be enforced legally, by social norms, or by the power of capital of labour. Whatever the cause, it is an undeniable empirical reality.
This model of labour supply could perhaps be interpreted as an elaboration or magnification of the zone between Ws and Wh on the S-shaped labour supply diagram: that is, what happens once wages reach an acceptable level. In fact, I adapted the model from one found in Arthur Lewis’ 1972 paper (p. 10) on unlimited labour, which focuses on a wage given at a conventional level. This is compatible with the above diagram.
However, I don’t wish to stretch the comparisons, as this model can also be thought of in isolation. The point is that a worker will accept work at any ‘reasonable wage’ up to a certain amount of hours – I have suggested 40, which is the norm in most developed countries. After this point the time they have normalised as leisure time is far more valuable and they expect to be paid more at an increasing rate. Eventually, they reach the physical limit of work and the effective wage must be infinite to induce labour. There are multiple equilibria if the demand curve crosses the feasible wage zone, but only one if it moves beyond it.
There are a couple of conclusions we can draw from this model. The first is that a tax on labour will not alter the amount of labour supplied if the tax + the wage is within the ‘feasible wage zone.’ In fact, empirical evidence suggests the effect of income taxation on labour supply is negligible at most (though higher for women – perhaps this analysis only applies to primary earners). Second, an increase in demand need not increase wage inflation up to a certain point, provided there are labourers willing to work within a given wage range. Past this point, an increase in demand will cause a wage-price spiral. It’s harder to verify this point empirically, although it seems consistent with the frequently observed point that inflation isn’t a problem when unemployment is high (having said that, it’s by no means the only model that predicts this).
I think a pluralistic approach such as this would be interesting. It would not be wedded to any particular model, and the task of economists would be deciding which model to apply or devising alternative models to deal with a situation. In fairness, DSGE is characterised by this approach, so it would be unfair to suggest economists do not use it at all. Nevertheless, this calls into question the rigid supply-demand framework that pervades much policy discussion of price controls, taxation and various other ‘interventions,’ and the catch-all arguments made by some economists against them.