Wednesday, November 02, 2005

 

Inflation

I was thinking about supply/demand curves recently. I have for some time figured that the sorts of supply and demand curves they teach you about in Econs 101 rather misstate how and why people supply stuff and labor.

If for example, you have some good or service for which, if it becomes profitable to do so, people can enter the market and supply it, then the supply of that good or service will increase with increasing price for that good or service. But suppose there is a good or service which, if you supply it, you would be hard pressed to make your living supplying something else ... and if you don't supply it, it would take some time to switch gears to supply it. For example -- in a region in which only certain agricultural products are produced, farmers/ranchers might have difficulty earning a living supplying something other than ag. products while the cost of land makes it such that, should ag. products become quite profitable, even still few would be able to enter the market.

What would happen in such a case is that, in order for the farmer or rancher to survive, as the cost of ag products goes down, each farmer would supply more product in order to make ends meet. Thus, as people will only eat so much, especially in tough economic times, the demand curve is pretty level while the supply curve goes up with decreasing rather than increasing price -- the price equilibrium, therefore, is unstable and the market is, in the case of slight disturbances, prone to be flooded by increasingly desparate farmers, resulting in a deflationary price spiral. This sort of economic diabetes has actually been well understood for quite some time (I think Sen had noted this glut in the presence of famine for some time).

But what about the other end of the curve: if a field (say farming or auto mechanics) is hard to break into, as prices increase, those who supply the good or service in question, could simply choose to supply less and have more leasure time, while still having more money to spend. Thus, assuming demand is not entirely elastic, as price increases, there would be less supply but not so much less demand -- where is the price equilibrium? There is a stable one at infinite price! This sounds like inflation to me -- but has anybody considered the fact that at least for some markets the only stable price equilibria are at zero cost and infinite cost as a cause of not only deflation but inflation?

In general, my criticism of "U Chicago style"-economics (besides the political implications) is not the use of analogies to physical sciences and the emphasis on math per se, but that the analogies are often wrong and are based on a misunderstanding of the human psychology behind markets. Basing economic policy on a theoretical programme which ignores inelasticity, ignores intuitively obvious non-monotonic supply (and demand) curves and the resultant fact that not all economic equilibria are stable -- and those that are are often not obtainable or desirable (in general, do you want the economy to be at equilibrium anyway? no ... you want it to grow, etc.!), is kind of akin to basing the space program on a level of physics in which, in order to measure the wind resistance of a cow, we assume a spherical cow.

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