Wednesday, February 15, 2006

How do markets clear?

My best friend at work, whom I've mentioned before argues that markets need regulation, has stopped calling me a "neoliberal" (which is rather a meaningless term). I think it stemmed from his surprise at hearing me say that Austrian economics doesn't "admit" imperfect information, rather, it depends on that for some of its theories. Information is often asymmetrical between parties, and undiscovered information waits to be found by Kirznerian entrepreneurs, etc.

My friend insists that because information is imperfect, markets need "help" from government to clear properly. Perhaps I've misunderstood him all this time, but his claim still puzzles me. Markets clear all the time, and on their own. The market clearing price is the price at which the quantity supplied equals the quantity demanded. There's only one requisite for markets to arrive at such a price: prices need to be left free to adjust on their own. So not only can government not help markets clear, any government attempts to regulate transactions will hinder a market in arriving at its true clearing price.

I thought about that this morning when commencing my commute into the city. The local Metro-North train station is only several minutes away by foot, so driving about 2-3 there doesn't save that much time (and I spend a couple of minutes to start my car about 10 minutes before I go, so that the engine warms up a little). Paying $3 to park for the day, though, is very much worth the convenience of not having to walk home in 20-degree weather and uncomfortable dress shoes. But when I arrived this morning, all parking spaces in the main lot were already taken; many were still covered with snow from the weekend's huge blizzard. The only available spots were in the expansion lot, far enough away to completely negate the benefit of driving. So, I went back home, left my car and went back to the station, hoping the night air wouldn't be too cold.

My dilemma was a true shortage, not just a scarcity. A shortage is a scarcity at a price below market equilibrium (i.e. below the clearing price, where people want to buy more than sellers can supply). In my case, the demand for parking spots (near the train platform, I should clarify) exceeded the supply at a static price, which is not left free to adjust upward. Thus there's no adjustment when supply suddenly drops but demand stays the same, but if prices can go upward, eventually they would reach a point where the number of parking spaces perfectly equals the number of people who want one. Would people still pay $4 or $5 to park for the day? Probably, since that's not a very significant difference. How about $10? By that point, which is over $200 a month just to park, I'd expect quite a few people would turn to lifts from family, perhaps friends on their way by, or even carpool with other train commuters. I know that I'd rather keep $10 and walk.

Price controls on gasoline were the sole cause of its shortages in the 1970s. The price controls didn't cause the scarcity, nor would they have caused high prices had prices been left to adjust, but they did cause the shortages: people waited in long lines only to discover the gas station had run out, and many local and state governments restricted people in what days they could purchase gasoline (like "odd/even days" depending on the last digit of your license plate). As I explained in that entry on oil prices, repeating it for my Valentine's Day entry, higher prices help reduce (even eliminate) search costs. Price controls may make something appear cheaper, but society actually loses more because people run around trying to find it at that price; not only will it run out sooner, the lower prices don't encourage others to supply it. Prices really are the fair way to determine resource allocation.

I wasn't the only car who circled around the main lot a couple of times, in vain looking for an open space. How, then, should I be allowed to compete with others? If we followed 1970s policy, then people would be permitted to park in the main lot only on certain days, and in the expansion lot on any day. Instead of what's essentially a lottery system, prices work best. If parking near the station were $5, and just $2.50 in the expansion lot, then more people would park in the expansion lot, because they'd decide spending $1.50 less is worth walking for a few more minutes. This would free up spaces in the main lot for those willing to pay $5.

And what if the $5 is too high, such that the main lot has a lot of open spots nobody would pay $5 for? Again, this is why it's imperative that the price be left to adjust freely: it can be lowered to $4.50 or even $4, some price where the market will clear perfectly. Note that it's virtually impossible for a seller to calculate $x and have the market clear perfectly, but Austrian economics has no problem with that. As Israel Kirzner explained, supply and demand curves are never static like they're drawn: always in a state of flux, their intersecting point of equilibrium is never precise. But supply and demand curves will eventually gravitate toward that point, based on the purity of their information. Information is where the entrepreneur comes in, the Kirznerian concept more than the Schumpeterian one. The entrepreneur in Austrian economics is not just a risk-bearer, but an arbitrageur of information. Part of his purpose is to search for information, including a comparative advantage in the readiness (like the Boy Scout motto "Be Prepared") to discover new information by happenstance.

When I regularly played Ultima Online (a "massively multiplayer online role-playing game"), I had a "vendor" through which I sold various commodities and specialty items. If I charged too much, my inventory would sell slowly (if at all); if I charged too little, my inventory would sell quickly, but I wouldn't make much. Either way, my profit over time wouldn't make the endeavor worthwhile compared to other things. But how do we define "too much" and "too little"? Very simply: "too much" is above market equilibrium (the price at which it clears), and "too little" is below it. By adjusting my prices based on experience and competition (observing what others charged, which is a form of discovering information), my prices were always approaching market clearing prices.

What I'd like to add about shifting curves is that supply and demand graphs are about total quantities, not individual sales. Single transactions will themselves effect changes in market conditions, a big reason that the curves are always in flux. People make decisions on the margin, not the average, and market conditions are affected by marginal supply and demand, not the average. Five minutes ago, you may not have bought a particular item, deciding there was ample supply to wait a few days. But when you suddenly see (which is a form of discovering information by chance) several people begin to buy nearly all those items on the shelf, and you are uncertain about the inventory, suddenly the remaining ones may become more valuable. As I've pointed out before, even if the official price stayed the same, you now value the item more than the money required to buy it.

Others' purchases do not even need to increase scarcity significantly to change the demand curve: merely seeing someone else's grocery cart (again, a form of discovery) may cause you to buy something you otherwise would not have. Perhaps you didn't know it was stocked at all or that it was at a good price, or seeing it in someone's cart tempted you to buy one for yourself. Regardless, that gain of information is part of competition -- a competition to maximize one's resources, which, as Adam Smith explained, tends to improve society's well-being even when you're thinking only of yourself:
...he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.
In the aforementioned Ultima Online example, if my vendor had just one suit of armor remaining, and I were the only one on the server who was selling such a suit, I could charge a higher price, and someone would be willing to pay it, so long as my price was no higher than that of the armor a step up from mine. However, others would enter the market, offering the same suit as mine (or an equivalent substitute) for less. Whether in the real world or a virtual one, the formerly solo seller may have lost the opportunity for great profit, but it is more than offset, because society gains by having a greater supply of demanded items. The desire for profit spurs people to produce more goods, and to find new ways to create more by expending less, increasing wealth.


Anonymous Anonymous said...

The thing I don't get is the argument that, if the market depends on imperfect information to function, why it then follows that introducing more imperfect information, which benefits neither party no less, can be a good idea.

Thursday, February 16, 2006 2:36:00 AM  
Anonymous Anonymous said...


Market intervention does not introduce further imperfect information, but rather erects a barrier, preventing individuals from improving upon their imperfect information.

In other words, if there are price controls, prices can not act as an indicator of the marginal value of a good. The entrepreneur has no idea whether it is worth his while entering the market (even if does have access to a more economical way of supplying a good). Moreover, consumers have no idea what the real value of that good is, relative to others. For instance, with price controls on oil, people will overconsume it (leading to depleting stocks) because prices aren't telling them to use a more economical fuel.

Monday, November 13, 2006 10:04:00 AM  

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