The Fallacies of Equilibrium Thinking.
Francis P. Ferguson PhD.
Economics is all about equilibrium. Equilibrium is, generally, a balancing of countervailing forces such that a position of stability and repose is achieved. The first economist, Adam Smith, saw economic activity as a balancing (an equilibrium) between greed and competition. Where businessmen might want to produce inferior products, or command prices in the market, their efforts would be foiled by competitors who would produce excellent products and who would undercut the prices of one attempting to control the market. No one producer would get too big, because there would always be competitors to whittle away their advantages.
In product and service markets, current prices reflect a balancing of supply with demand. In Adam Smith’s view, each good or service had a “value” toward which market price would inevitably move. This “value” reflected the product’s “cost of production”, with a bit of profit for the producer as well. If the product were scarce, market price would rise above value, and both increased supplies drawn by the lure of higher prices and demand diminished by the same forces, would lead to a price that would gradually fall to the natural “value” of the product. Since price would gravitate to the natural “value” price, excursions about the value price were not of great interest to Classical economists. These market price excursion were mere epiphenomena, of passing interest at best when compared to the inevitable equilibrium at the natural price, the value of the object at hand.
Karl Marx, also a Classical economist, had his own theory of value. For Marx, the value of a product was the socially necessary labor time needed to produce it. Marx’s theory of value formed the basis of his argument for Capitalism’s inevitable collapse.
The Capitalist’s profit, Marx argued, arose because the worker was not paid the entire value of what he produced. The natural wage for labor, Marx suggested, was the socially necessary amount of labor time needed to produce labor. Wages were naturally subsistence wages because there was an “army” of unemployed who kept wages at subsistence levels—the amount needed to produce (sustain) labor.[i]
With wages pressed to subsistence levels, capitalists were able to pay only the amount needed to sustain labor, and keep the remaining value of what workers produced. Let’s say a worker toiled for 12 hours. In that time, he would produce 12 hours of value. The hours of value needed to support him might be only 4 hours, so the capitalist takes 8 hours of value and pays the worker 4 hours. The 8 hours are the source of profit. Marx called this surplus value. It was the capitalist’s only source of profit. Well almost. New machines (ones that other capitalists generally didn’t yet have) could reduce the amount of labor time embedded in your product. Since the market price reflected the labor time required by less efficient producers, the early adopting capitalist would be paid at the current price reaping, in process, a short term “rent”. Still, since price would eventually drop to the new equilibrium level when all capitalists (or most of them) adopted the new machinery, Marx wasn’t ready to pay much attention to this interim source of additional profit. Things went to equilibrium, and equilibrium (not the epiphenomena of moving from one to the other) was the normal and interesting state of affairs.
The problem with this sort of thinking is that these movements from one target equilibrium to another are the very stuff and fabric of economic life. The simple fact is we rarely, if ever, achieve an equilibrium as defined by economists. By the time we approach one, other factors have changed and we’re directed to a different outcome in an endlessly repeating cycle. This is why Marx’s prediction of the collapse of capitalism was so completely wrong.
Marx was so fixated on the long run equilibrium outcomes where profits fall for capitalists, capital costs rise and fewer workers remain to exploit that he failed to consider that the reality of capitalism wasn’t these long run equilibriums where profit ended and revolution arose, but rather was the ongoing process of capitalism’s adapting to an endless stream of new technologies, processes and products the pursuit of which sustained profitability to the present. These innovations and the activities they generate should have interested Marx. They’re the actual source of capitalism’s long run profitability, and they would have allowed Marx to deal with the central paradox his long run equilibrium model presented. How can the capitalists’ profitability fall, and the wages of labor fall when the total output is getting larger and larger. Why is everyone “starving” while the “pie” grows ever larger. The answer is that, during these inter-equilibrium flutterings, innovation flourishes, total output rises and everyone gets a larger share of the pie—even if the proportions going to each class remain the same.
Economists have long, though not universally, championed free trade. The argument, put deceptively simply, is that if each country produced what it had a comparative advantage[ii] at (was better at), and traded for what it was not better at, then global output would be maximized. The iron logic of the proposition is hard to refute. Still, global output won’t be instantly maximized. That will take time. The equilibrium outcome is global maximization of production. That’s what economists fixate on. There will be “dislocations” they admit. Some people will lose jobs and find it necessary to move to newer jobs in industries where the country has a comparative advantage. But these dislocations are “epiphenomena” of secondary interest to the maximizing equilibrium. Modern economists would be well advised to focus on these dislocations. They have much to tell us and form the very fabric of our economic lives.
The theory of comparative advantage is actually quite old. It originated in the early 19th century, and was formulated by economist David Ricardo. Ricardo built his argument using England and France as examples of trading partners. In his example, France has a comparative advantage in wine, and England in wool clothing. Ricardo argues that France should produce wine, and England should make wool clothing and the two countries trade to get the wine and wool they need. Ricardo could afford to ignore the “dislocations” suffered by French woolen workers and English wine makers. These were very similar economies, with similar wage levels and technology. The movement to woolen manufacture in England and wine making in France would probably be accomplished quickly without much pain. In the modern world, things are very different.
The movement toward free trade in the post WWII era has involved moving manufacturing away from Europe and the US, toward very low wage economies such as China. The comparative advantage the China possesses is not a superior terroir for wine making, of a better climate for woolen production, or even superior technology of any sort. It’s “comparative advantage” is cheap—and one means very cheap—labor. For economists to talk about the emerging equilibria where all will be better off, while ignoring the trajectory of wages and living standards in the west, it to miss the point that these dislocations are very nearly permanent.
The only way for these “dislocations” of American workers to stabilize is for Americans to produce as cheaply as the Chinese. Since in many cases, the Chinese use the same technology we use to produce goods, we cannot argue that our “superior” technology will provide is work and wealth. Only a wage level commensurate with China’s will do the job. That’s what this “inter-equilibrium” adjustment process entails. The average Americana will become much, much poorer. Those who run the companies who have moved production off shore shall become much richer.
Once again, we don’t actually get to the equilibrium of maximum output that captivates the economic mind. We live in an ongoing flow where we head hither and yon based on changing factors that buffet us. Economists have cast us into open and unfettered competition with ancient and sophisticated cultures whose people are clever and resourceful and willing to work for a tiny fraction of what Americans have come to expect. These economists have fallen for the illusion of the long run equilibrium without more than a glance at the economic horror that faces workers in Europe and the USA. In the short run, we become ever poorer. In the long run, as John Maynard Keynes allowed, we’re all dead
[i] Wages might rise above the ”value” of labor (amount of socially necessary labor needed to sustain labor). Certain occupations might become relatively scarce. In this case wages would rise and capitalists would tend to substitute machinery for those workers as rapidly as possible. Eventually, wages would fall to subsistence as more workers trained for that occupation, and machines reduced the number of available openings. Like all classical economists, this “bouncing about” in prices (wages) didn’t interest Marx much since things would return to the equilibrium
[ii] [ii] The explanation of comparative advantage is a bit more complex. It has to do with the rate at which a country can transform resources into various products. If, for example, Oregon can transform it’s resources into timber at a lesser sacrifice other products than, say, California; and if California can transform resources into citrus fruit at less sacrifice of other products than can Oregon, then Oregon has a comparative advantage in timber, and California’s comparative advantage is citrus.
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