If supply and demand equilibrium were an economic “law,” the 1929 and 2008 financial crises would not have occurred. Rather than ready-made theories, economics needs the practical background provided by systems thinking.
| This post is part of a reading series on Doughnut Economics by Kate Raworth. To quickly access all chapters, please click here. Disclaimer: This chapter summary is personal work and an invitation to read the book itself for a detailed view of all the author’s ideas. |
For a long time, it was assumed that since rationality is by definition universal, there was a single model of scientific methodology, notably followed by Galileo Galilei and Isaac Newton. The 19th-century economist William Stanley Jevons, for instance, came to think that since physics explains the world from the atomic to the planetary level, the market should too—from the behavior of a single consumer to national and global outputs. In his own words, “Just as we measure gravity by its effects in the motion of a pendulum, so we may estimate the equality or inequality of feelings by the decisions of the human mind. The will is our pendulum, and its oscillations are minutely registered in the price lists of the markets. I know not when we shall have a perfect system of statistics, but the want of it is the only insuperable obstacle in the way of making Economics an exact science.”1
Overcoming Our Inheritance
“Over in Switzerland,” adds Kate Raworth, “the engineer-turned-economist Léon Walras (1834 – 1910) had a similar vision, declaring that ‘the pure theory of economics . . . is a science which resembles the physio-mathematical sciences in every respect’, and—as if to prove it—he started referring to market exchange as ‘the mechanism of competition’.2 They and others likened the role played by gravity in pulling a pendulum to rest to the role played by prices in pulling markets into equilibrium.” This caricatural vision of markets underpins the widely known diagram of supply and demand.
“What lies behind this iconic pair of crossing lines? Think of a good, any good (let’s say pineapples), and here’s how it works. The demand curve shows how many pineapples customers will want to buy at each price, given their aim of maximising their utility, or satisfaction. The curve slopes downwards because the more pineapples a customer buys, the less utility they are likely to gain from buying yet one more—an assumption known as the diminishing marginal utility of consumption—and so they will be willing to pay a little less for each successive one. The supply curve, in contrast, shows how many pineapples the sellers will be prepared to supply for any given price, given their aim of maximising their profits. Why does the curve slope upwards? Because—the theory goes—if each pineapple farmer has a fixed plot of land, then the cost of growing yet more pineapples on it will start to rise—that’s the law of diminishing marginal returns—and so they will require a higher price for supplying each successive piece of fruit.”
In this crisscrossing pattern, “market price is not set by suppliers’ costs nor consumers’ utility alone,” adds the author, “but precisely where costs and utility meet—and there lies the point of market equilibrium.” For any given mix of preferences that consumers might have, there is just one price at which everyone who wants to buy and everyone who wants to sell will be satisfied, having bought or sold all that they wanted for that price. It is, consequently, assumed that no single actor is big enough to have sway over prices and that all of them follow the law of diminishing returns.
Walras, says the author, “was convinced it was possible to scale the analysis up from a single commodity to all commodities, so creating a model of the whole market economy. And, he reasoned, if those markets were comprised of fully informed, small-scale, competitive sellers and buyers, then the economy would reach a point of equilibrium that maximised total utility. In other words—in a neat echo of Smith’s invisible hand—it would, for any given income distribution, produce the best possible outcome for society as a whole.” The corresponding maths was set out in 1954 in the Arrow–Debreu general equilibrium model that launched a seemingly unified economic theory, laying the foundations of what was to be known as “modern macro.”3
However, thanks to the interdependence of markets within the economy, “it is just not possible to add up all individuals’ demand curves to get a reliable downward-sloping demand curve for the economy as a whole. And without that, there is no promise of equilibrium.” Conditions were formalized in the 1970s (catchingly known as Sonnenchein-Mantel-Debreu conditions) but were so devastating for the rest of the theory that they were kept aside from mainstream academia and students’ curriculum.
General equilibrium theories that, in one form or another, have dominated macroeconomic analysis failed to see the 2008 financial crash coming. Built on the presumption of equilibrium while simultaneously overlooking the role of the financial sector, “they had little capacity to predict, let alone respond to, boom, bust, and depression,” says the author.