In competitive markets with sufficient elasticity, equilibrium is established and maintained relatively easily. Consumer demand and supply respond quickly to the mantra: “The solution to high prices is high prices; and the solution to low prices is low prices.” Obviously, the point is that in the face of high prices, consumers cut back demand and suppliers increase supply to bring down prices. Conversely, in the face of low prices, consumers increase demand and suppliers cut back supply to raise prices. We achieve equilibrium quickly and efficiently.
Except this doesn’t work very well or very quickly in the financial markets and in the economy overall. The problem is that traditional equilibrium economics assumes rational, independent decision makers with full information and sufficient mental energy to compute and re-compute their optimal behavior in complex situations that can quickly change and invoke emotional responses. Contagion effects in financial markets can drive prices dramatically higher in irrational exuberance as higher prices cause people to jump in and follow the crowd to purchase even more in the face of those higher prices instead of less. Conversely, a downward price spiral can be hard to stop when fear overtakes hope and prices fall precipitously. Dan Ariely’s book “Predictably Irrational” reveals a problem that economists have tried to ignore and marketers have profited by exploiting. An irrational herd effect can quickly overwhelm market participants to leave markets in disequilibrium for an extended period. It is hard to understand why economists have taken so long to catch on to consumer irrationality when the people in marketing have understood consumer irrationality and have been exploiting it for hundreds of years.
Moreover, too many people confuse optimal microeconomic behavior with optimal macroeconomic outcomes. The aggregate economy does not converge toward equilibrium when microeconomic incentives do not lead to the intended desirable macroeconomic effects. The classic example is the paradox of thrift where during a recession, when people see friends and neighbors losing their jobs, they try to save a larger share of their earnings in case they might lose their jobs, but the total amount of savings falls because the drop in spending causes more cutbacks in working hours and jobs as consumer demand and prices fall causing businesses to cut back production of goods and services. The microeconomic incentive to save more leads to less total savings at the macroeconomic level. My spending contributing to your earnings and your spending contributing to my earnings can sometimes lead to greater disequilibrium instead of a convergence toward an overall equilibrium for the economy as a whole.
It would be nice to have a world that even in primitive times would have allowed individuals to compete freely and fairly with perfect competition resulting in a natural, efficient and dynamic equilibrium being established in every market. But that is far from reality. In most primitive and many modern societies, the big guy gets what he wants. The equal opportunity and competitive environment is not the natural state. Far from it. It takes a strong and active government to enforce freedom with equal opportunity and competitive markets. In his book “The Myth of Capitalism” Jonathan Tepper has revealed the surprising extent of reduced competition and increased concentration in most major industries in the United States.
For example, consider the market for eyeglasses. Glass and plastic should be very cheap. After all, we throw a lot of glass and plastic into recycling bins every week. But instead of two or three dollars, eyeglasses typically cost about one-hundred and thirty dollars or more. In reality eyeglass manufacturing is basically a duopoly with only two eyeglass manufacturers dominating the market. In the eyeglass market, Adam Smith’s first invisible hand of competition has been suppressed by Adam Smith’s second invisible hand of market power where he said: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the publick, or in some contrivance to raise prices.”
Moreover, government can interfere with freedom and competition by imposing patents, copyrights and licensing requirements, among other restrictions such as child labor laws and government sponsored monopolies. Sometimes government intervention is good in solving problems that the free market is incapable of solving on its own. At other times, government intervention can create problems or make problems worse, so it is important to distinguish between good government intervention and bad government intervention. With limited mental energy, we have a natural tendency to think in all-or-nothing terms, but reality requires careful analysis to devise effective and efficient policies to fix free market problems without introducing significant other inadvertent difficulties. For a better understanding of the role of government in our economy see Mariana Mazzucato’s three books: “The Entrepreneurial State,” “The Value of Everything,” and “Mission Economy.”
Adam Smith’s explicit invisible hand of competition suggested that we just need to focus on maximizing our own personal utility function or profits, and others will benefit from our self-centered behavior. But Adam Smith wrote implicitly about a second invisible hand where competitors conspired together to block competition and exploit consumers. While the invisible hand of competition led to lower prices with a focus on quality, the second invisible hand led to higher prices with less concern for quality. Assuming that the first invisible hand will always dominate is naive at best. The rules and regulations set by government play an important role in determining the balance of power between these two invisible hands.