Transcript Joffe - Post Keynesian Study Group

How types of market differ,
and why it matters
Michael Joffe
Imperial College London
PKSG, Cambridge, November 2011
Structure of the talk
• the current discourse:
– the market vs. the state
– market failure
• real-economy competition between firms:
– cost-tethered markets
– cost competition
• free-floating markets
– a model of bubbles
– rationality
• conclusions
Structure of the talk
• the current discourse:
– the market vs. the state
– market failure
• real-economy competition between firms:
– cost-tethered markets
– cost competition
• free-floating markets
– a model of bubbles
– rationality
• conclusions
The current discourse I
• a large part of economic theory concerns the
properties of “the market”
• central to this is, under certain assumptions,
“the” market has a particular set of properties:
convergence towards a stable equilibrium (and
under certain conditions, Pareto optimality)
• observation: not all economic phenomena can
readily be explained using this framework –
most recently bubbles/crises; but also the
specific property of capitalism, that it grows
– exogenous technical change, or smithian growth
The current discourse II
• criticisms typically focus on the assumptions
being unrealistic, or on market failure of
various types, e.g. monopoly power, missing
or incomplete markets, externalities, public
goods or information asymmetry
– “failure” => the market does not work as the
theory would predict (i.e. the theory itself is OK)
• more broadly, the discourse is one of “the”
market versus the state – with a political
dimension, in which theory is evaluated
largely in the light of one’s political values
Types of market I
• the term “types of market” has a number of
possible meanings:
• place: local, national, international
• time: very short, short, long, very long period
• the ideal types of textbook theory: perfect
competition, monopoly, duopoly, oligopoly,
monopolistic competition, monopsony
• different types of goods: inferior, luxury,
Geffen, positional goods; winner-take-all
markets
Types of market II
• various arbitrary divisions, e.g.
– physical, internet, labour, intermediate goods, stock
market, ad hoc auctions, illegal markets, ...
– financial markets, currency markets, futures markets,
the money market (lending/borrowing)
– consumer, industrial, commodity and capital markets
Types of market II
• various arbitrary divisions, e.g.
– physical, internet, labour, intermediate goods, stock
market, ad hoc auctions, illegal markets, ...
– financial markets, currency markets, futures markets,
the money market (lending/borrowing)
– consumer, industrial, commodity and capital markets
• I argue: different types of market have radically
different dynamic behaviour, for reasons that can
be readily understood, and this can be modelled
Structure of the talk
• the current discourse:
– the market vs. the state
– market failure
• real-economy competition between firms:
– cost-tethered markets
– cost competition
• free-floating markets
– a model of bubbles
– rationality
• conclusions
Structure of the talk
• the current discourse:
– the market vs. the state
– market failure
• real-economy competition between firms:
– cost-tethered markets
– cost competition
• free-floating markets
– a model of bubbles
– rationality
• conclusions
Real-economy competition between firms I
• with goods and non-financial services, costs
play a large role in price setting
• prices are set in the market, in response to the
levels of supply and demand – as always
-
quantity
supplied A
price A
//
profit/incentive
-
quantity
demanded A
Real-economy competition between firms I
• with goods and non-financial services, costs
play a large role in price setting
• prices are set in the market, in response to the
levels of supply and demand – as always
Real-economy competition between firms I
• with goods and non-financial services, costs
play a large role in price setting
• prices are set in the market, in response to the
levels of supply and demand – as always
• competition tends to drive the price down
-
quantity
supplied A
price A
//
profit/incentive
-
quantity
demanded A
-
quantity
supplied A
price A
//
profit/incentive
intensity of
competition
-
quantity
demanded A
Real-economy competition between firms I
• with goods and non-financial services, costs
play a large role in price setting
• prices are set in the market, in response to the
levels of supply and demand – as always
• competition tends to drive the price down
Real-economy competition between firms I
• with goods and non-financial services, costs
play a large role in price setting
• prices are set in the market, in response to the
levels of supply and demand – as always
• competition tends to drive the price down
• costs set a limit to how low prices can go –
they cannot go below unit costs for long
-
quantity
supplied A
price A
//
profit/incentive
intensity of
competition
-
quantity
demanded A
cost A
-
quantity
supplied A
price A
//
profit/incentive
intensity of
competition
-
quantity
demanded A
Real-economy competition between firms I
• with goods and non-financial services, costs
play a large role in price setting
• prices are set in the market, in response to the
levels of supply and demand – as always
• competition tends to drive the price down
• costs set a limit to how low prices can go –
they cannot go below unit costs for long
Real-economy competition between firms I
• with goods and non-financial services, costs
play a large role in price setting
• prices are set in the market, in response to the
levels of supply and demand – as always
• competition tends to drive the price down
• costs set a limit to how low prices can go –
they cannot go below unit costs for long
• the result is, prices tend to end up just above
unit costs – the difference is the mark-up
• I call this cost tethering
– it is not rigid: the mark-up is variable
cost A
-
quantity
supplied A
price A
//
profit/incentive
intensity of
competition
-
quantity
demanded A
cost A
-
quantity
supplied A
price A
//
profit/incentive
-
-
quantity
demanded A
intensity of
competition
A SYSTEM WITH COMPENSATING (NEGATIVE) FEEDBACK
– IT TENDS TO MOVE TOWARDS STABLE EQUILIBRIUM
e.g. a “supply
shock” – a cheaper
source of a mineral
cost A
-
quantity
supplied A
price A
//
profit/incentive
intensity of
competition
-
quantity
demanded A
e.g. a “demand
shock” – a successful
promotion campaign
cost A
-
quantity
supplied A
price A
//
profit/incentive
intensity of
competition
-
quantity
demanded A
e.g. a “supply
shock” – a cheaper
source of a mineral
e.g. a “demand
shock” – a successful
promotion campaign
cost A
-
quantity
supplied A
price A
//
profit/incentive
-
-
quantity
demanded A
intensity of
competition
THESE PROCESSES OCCUR OVER TIME, BUT ARE
STATIC IN THE SENSE THAT THE ONLY TIMEDEPENDENT ENDOGENOUS PROCESS IS
TOWARDS A STABLE EQUILIBRIUM
cost A
-
quantity
supplied A
price A
//
profit/incentive
intensity of
competition
-
quantity
demanded A
cost A
-
quantity
supplied A
price A
-
//
profit/incentive
profit/incentive
\\
quantity
supplied B
-
quantity
demanded A
intensity of
competition
price B
-
cost B
-
quantity
demanded B
PRICE COMPETITION
cost A
-
quantity
supplied A
price A
-
//
profit/incentive
profit/incentive
\\
quantity
supplied B
-
quantity
demanded A
intensity of
competition
price B
-
cost B
-
quantity
demanded B
Real-economy competition between firms II
• so far, I have assumed costs as given – as is
conventional in mainstream theory
• what happens if costs can be reduced?
Real-economy competition between firms II
• so far, I have assumed costs as given – as is
conventional in mainstream theory
• what happens if costs can be reduced?
• this would necessarily be on a longer timescale,
via investment
COST COMPETITION
via investment
cost A //
-
quantity
supplied A
price A
-
//
profit/incentive
profit/incentive
\\
quantity
supplied B
-
quantity
demanded A
intensity of
competition
-
price B
-
cost B
\\
quantity
demanded B
via investment
The standard market equilibrium model
S
price
D
P1
Q1
quantity
Cost competition
S1
price
S2
D
P1
P2
Q1
Q2
quantity
Cost competition
S1
price
D
S2
S3
P1
P2
Q1
Q2
quantity
Cost competition
S1
price
D
S2
S3
S4
P1
P2
Q1
Q2
quantity
Cost competition
S1
price
D
S2
S3
S4
P1
P2
S5
Q1
Q2
quantity
The core institution of capitalism
• the way this has happened historically has been
by control of the means of production, plus
employment of wage labour – the capitalist firm
• this provides flexibility in the inputs it can call
upon and in the size of the market it can supply
• the firm can readily introduce new technology/
production methods and/or new products
• the capitalist real economy, far from being “a
market economy”, is dominated by market
relations between firms – a hybrid: competition
between authority structures
Cost reduction and capitalist growth
• the fall in unit costs, i.e. real input, for the same
output is equivalent to an increased output for
the same real input – one source of growth
• the other source of capitalist growth is the
introduction of new/better quality products
• these account for the dynamism of capitalism:
“capitalism is unique in the extraordinary growth
record it has been able to achieve” (W Baumol)
• so: institutional change → system characteristics
→ specific endogenous causal processes
Arms race model I
τA‘ = – κAτA + ρAτB + αA
τB‘ = – κBτB + ρBτA + αB
τA and τB represent annual expenditure on future
cost reduction; τA‘ and τB‘ are 1st derivatives
κA and κB represent constraint on expenditure,
ρA and ρB represent the response of each company
to the other
αA and αB represent the animal spirits of each firm
Arms race model II
if κAκB > ρAρB:
τB
τB‘=0
(0, αB/κB)
τA‘=0
(αA/κA, 0)
τA
Arms race model III
if κAκB < ρAρB:
τB‘=0
τB
τA‘=0
(0, αB/κB)
(αA/κA, 0)
τA
Simulations (in Vensim)
• a productivity change is introduced: 10% fall in costs
• each run represents a different scenario:
– baseline run, before productivity is altered (black line):
everything is stable – all lines are horizontal
– innovation in a pre-capitalist economy, with no capacity to
reduce costs (blue line): like the baseline, except for the initial
Effect on unit cost A – a one-off effect (step change)
– competition between a capitalist and a non-capitalist firm (red
line): “company” B is unable to respond to company A’s costcutting, leading to its relative decline
– with capitalist competition, in which both companies can reduce
costs (green line): the arms race leads to greater changes in
both firms than the original 10% change in productivity, and
which continue indefinitely
Effect on unit cost A
PRICE A
60
100
95
40
$/chair
$/chair
50
90
30
85
20
0
Effect
Effect
Effect
Effect
on
on
on
on
unit
unit
unit
unit
10
cost
cost
cost
cost
A
A
A
A
:
:
:
:
20
30
40
50
60
Time (Month)
70
80
90
100
80
0
productivity shock A with both having zero efficiency of investment
productivity shock A with zero efficiency of investment B
3 feb productivity shock A 1
3 feb baseline
PRICE
PRICE
PRICE
PRICE
Profit A
A
A
A
A
40
50
60
Time (Month)
70
80
90
100
productivity shock A with both having zero efficiency of investment
productivity shock A with zero efficiency of investment B
3 feb productivity shock A 1
3 feb baseline
chair/year
2,750
105,000
2,500
102,500
2,250
100,000
2,000
0
A:
A:
A:
A:
30
3,000
107,500
Profit
Profit
Profit
Profit
20
Demand A
110,000
$/year
:
:
:
:
10
10
20
30
40
50
60
Time (Month)
productivity shock A with both having zero efficiency of investment
productivity shock A with zero efficiency of investment B
3 feb productivity shock A 1
3 feb baseline
70
80
90
0
100
Demand
Demand
Demand
Demand
A
A
A
A
:
:
:
:
10
20
30
40
50
60
Time (Month)
productivity shock A with both having zero efficiency of investment
productivity shock A with zero efficiency of investment B
3 feb productivity shock A 1
3 feb baseline
70
80
90
100
PRICE B
60
100
50
95
$/chair
$/chair
effect on unit cost B
40
90
30
85
20
80
0
effect
effect
effect
effect
on unit
on unit
on unit
on unit
10
cost
cost
cost
cost
B
B
B
B
:
:
:
:
20
30
40
50
60
Time (Month)
70
80
90
0
100
PRICE
PRICE
PRICE
PRICE
productivity shock A with both having zero efficiency of investment
productivity shock A with zero efficiency of investment B
3 feb productivity shock A 1
3 feb baseline
B
B
B
B
:
:
:
:
10
20
30
105,000
2,500
chair/year
3,000
100,000
1,500
90,000
1,000
Profit
Profit
Profit
Profit
B
B
B
B
:
:
:
:
30
40
50
60
Time (Month)
productivity shock A with both having zero efficiency of investment
productivity shock A with zero efficiency of investment B
3 feb productivity shock A 1
3 feb baseline
90
100
70
80
90
100
2,000
95,000
20
80
Demand B
110,000
10
70
productivity shock A with both having zero efficiency of investment
productivity shock A with zero efficiency of investment B
3 feb productivity shock A 1
3 feb baseline
Profit B
0
40
50
60
Time (Month)
70
80
90
100
0
Demand
Demand
Demand
Demand
B
B
B
B
:
:
:
:
10
20
30
40
50
60
Time (Month)
productivity shock A with both having zero efficiency of investment
productivity shock A with zero efficiency of investment B
3 feb productivity shock A 1
3 feb baseline
Structure of the talk
• the current discourse:
– the market vs. the state
– market failure
• real-economy competition between firms:
– cost-tethered markets
– cost competition
• free-floating markets
– a model of bubbles
– rationality
• conclusions
Structure of the talk
• the current discourse:
– the market vs. the state
– market failure
• real-economy competition between firms:
– cost-tethered markets
– cost competition
• free-floating markets
– a model of bubbles
– rationality
• conclusions
Markets that are not cost-tethered I
• not all markets are cost-tethered; these can be
called free floating: the price depends only on
what the potential buyer and seller can agree
• the main examples are in the financial sector,
e.g. the stock market, but also collectibles
(Baumol): there is no “natural” price to which
actual prices gravitate, nor is there a unit cost
that tethers the price
• price setting is thus highly dependent on what
information is available
• commonly this is trend extrapolation
Markets that are not cost-tethered II
• those could be called “capital” markets
• real estate is similar, but the dynamic is slightly
different because a boom stimulates new
construction; property booms are typically
accompanied by a financial boom
• markets in commodities (e.g. minerals) have
unit costs, which adjust slowly in response to
price changes; futures are free-floating
• both could be regarded as aspects of “land”
• bubbles: self-fulfilling prophecy (+ve feedback)
The model I
starting from a standard market equilibrium model:
D(P) = a – bP
S(P) = c + dP
(1)
(2)
where P is the price; D(P) and S(P) respectively
represent the willingness to buy and to sell the
asset now at the existing price;
assuming for simplicity that the demand and the
supply curves are both linear and given by the
parameters a,b,c,d, with b,d > 0
The standard market equilibrium model
S
price
D
P1
Q1
quantity
The model II
trend extrapolation condition: perception of a
price trend expected to continue into the future
this brings about a price increment ΔP “now” to take
into account the cost or benefit of waiting: the
price modified by trend extrapolation is (P + ΔP);
ΔP is negative with a falling trend
ΔP can be represented by:
ΔP = θP
(3)
where θ is the proportional expected future price
increment
The model III
for simplicity the perceived trend P’ is regarded
as linear
θ is given by
θ = f(P’)
(4)
with f(.) an increasing function:
θ<0 for P’<0, and θ>0 for P’>0
θ may vary, e.g. in response to new information;
or possibly “investor sentiment” or tendency to
buy (Caginalp and Ermentrout 1990)
The model IV
The original equations now become:
D(P) = a – bP + mθP
S(P) = c + dP – nθP
(1’)
(2’)
where m,n are parameters (>0) that determine
the extent to which the price is affected by
trend extrapolation
The model IV
The original equations now become:
D(P) = a – bP + mθP = a – P(b – mθ)
S(P) = c + dP – nθP = c + P(d – nθ)
(1’)
(2’)
where m,n are parameters (>0) that determine
the extent to which the price is affected by
trend extrapolation
The model IV
The original equations now become:
D(P) = a – bP + mθP = a – P(b – mθ)
S(P) = c + dP – nθP = c + P(d – nθ)
(1’)
(2’)
where m,n are parameters (>0) that determine
the extent to which the price is affected by
trend extrapolation
Compare (1’) and (2’) with (1) and (2):
D(P) = a – bP
(1)
S(P) = c + dP
(2)
The model IV
The original equations now become:
D(P) = a – bP + mθP = a – P(b – mθ)
S(P) = c + dP – nθP = c + P(d – nθ)
(1’)
(2’)
where m,n are parameters (>0) that determine
the extent to which the price is affected by
trend extrapolation
Compare (1’) and (2’) with (1) and (2):
D(P) = a – bP = a – P(b)
(1)
S(P) = c + dP = c + P(d)
(2)
The model V
bubble occurrence depends on reversal of the sign
of the coefficient of P
we now have two conditions for this:
if mθ > b, a rise in P will lead to a rise in D(P)
if nθ > d, a rise in P will lead to a fall in S(P)
under these conditions, therefore, instead of the
usual decreasing function in P for D(P) and
increasing function for S(P), as represented by
equations (1) and (2), the situation is reversed
(5) and (6) can be written as θ>b/m and θ>d/n
(5)
(6)
The standard market equilibrium model
S
price
D
P1
Q1
quantity
A bubble
D
S
price
P1
Q1
quantity
A bubble
D
S
price
P1
Q1
quantity
A bubble
D S
price
P1
Q1
quantity
A bubble
S
D
price
P1
Q1
quantity
The model VI
recall that b,d,m,n > 0
therefore θ>b/m => θ>0
and θ>d/n => θ>0
the property of reversing the overall direction of
equations (1) and (2) only occurs when θ>0,
and thus also P’>0
this model therefore predicts asymmetry – unlike
most of the models in the bubbles literature
The model VII
D(P) = a – bP + mθP
(1’)
S(P) = c + dP – nθP
(2’)
in the case where θ<0, the terms mθP and nθP
would have the same signs as bP and dP
respectively
they would merely accentuate the normal
decreasing and increasing functions
represented respectively by equations (1)
and (2)
The model VIII
the model predicts what would happen either if
θ>b/m and θ>d/n OR if θ<b/m and θ<d/n
what if only one of these conditions is met?
both are driven by θ, and therefore expected to
move in the same direction – but not necessarily
to reach these values simultaneously
with no trend extrapolation: d > –b
with mild trend extrapolation: d–nθ > mθ–b
condition for a bubble: d–nθ < mθ–b
i.e. when θ > (b+d)/(m+n)
Comments on the model
• because θ varies over time, in response e.g. to
information, bubbles tend not to progress linearly
• the point at which a bubble ends is difficult to
predict, or even explain – as a bubble grows, it
generates an increasing affordability gap; this
together with new information are likely to
determine when/why a bubble ends
• further work is needed on how to estimate the
parameters empirically
• so: free-floating market plus trend extrapolation
→ a bubble, given these quantitative conditions
Structure of the talk
• the current discourse:
– the market vs. the state
– market failure
• real-economy competition between firms:
– cost-tethered markets
– cost competition
• free-floating markets
– a model of bubbles
– rationality
• conclusions
Structure of the talk
• the current discourse:
– the market vs. the state
– market failure
• real-economy competition between firms:
– cost-tethered markets
– cost competition
• free-floating markets
– a model of bubbles
– rationality
• conclusions
Other types of market
• this discussion does not exhaust the topic of types
of market
• in particular, the labour market has long been
recognised as having distinct properties:
– failure to clear, i.e. the unemployment issue
– “backward-leaning” supply curve of labour
– observations, e.g. inter-industry wage differentials;
standard-model predictions re fx of minimum wage
– Akerlof: “sociological” component in wage setting
• factors of production are peculiar? – technology?
• other special cases, e.g. healthcare provision
Methodological observations: systems
• the market mechanism as a negative feedback
system leads to convergence, even without
rationality or optimisation – they’re unnecessary
• specific types of market have other types of
feedback: arms race, and self-fulfilling prophecy
• Forrester: systems containing feedback loops
generate their own endogenous causal
processes that make them less sensitive to initial
conditions
– they are also subject to exogenous causal influences
– this is the obverse of complexity/chaotic behaviour
Methodological observations: prices
• price setting is a feature that is common to the
above analyses
• how prices are set is a weak spot in neoclassical
theory – Walrasian tatonnement
• a particularly glaring example is the behaviour of
prices and quantities in the labour market –
wages and employment
Conclusions I
• the idea that all markets have similar dynamic
properties has led to a distorted analysis of
many specific types
– in particular, this view can explain neither specifically
capitalist growth, nor bubbles
• in addition, it means that observed deviations of
the real world from traditional theory have
generated explanations in reactive mode (in
relation to e.g. assumptions), or in terms of why
the theory does not apply in particular cases
(e.g. market failure of various types)
Conclusions II
• analysing different types of market in systems
terms uncovers their endogenous causal
processes, thereby showing how not all of them
converge towards a stable equilibrium
• the dynamic behaviour of the sub-components
of the capitalist economy can then be dissected
out, providing a clearer analysis of the sources of
growth and of instability
• juxtaposition of capitalism/market economy/the
free market against the state is crude, and
conceals the heterogeneity within the former
Thank you!
Thank you!
[email protected]
Situational rationality I
• a rational calculation in the context of imperfect
information
• can be seen as a form of bounded rationality, but
limited calculating ability is not a feature here
• the extrapolated trend is external to each market
participant
=> they have to join in, even with misgivings
• it is difficult to distinguish between “behavioral
theories built on investor irrationality and rational
structural uncertainty theories built on incomplete
information about the structure of the economic
environment” (Brav & Heaton)
Situational rationality II
• Caginalp & Ermentrout: “emotional”; also “groupthink”, “optimism” or “panic”
• e.g. Akerlof & Shiller: “Animal spirits”
Situational rationality II
• Caginalp & Ermentrout: “emotional”; also “groupthink”, “optimism” or “panic”
• e.g. Akerlof & Shiller: “Animal spirits”
Situational rationality II
• Caginalp & Ermentrout: “emotional”; also “groupthink”, “optimism” or “panic”
• e.g. Akerlof & Shiller: “Animal spirits”
• these emotions may occur – but are they causal?
– hard to answer
• are they invariably present? consider someone
buying a property to live in, when property is seen
as likely to increase in price – it’s a calculation
• emotion is likely to be added to this, with a small
group of operators + face-to-face contact: e.g.
financial market traders; ? the real estate context