When an economist talks of the “price mechanism”, it can be assumed that his theory is bunkum. Of course, it doesn’t mean that prices don’t play a role but the role played is entirely different than what the raw intuition of a normal person or the learned intuition for neoclassical economists says. Economists – neoclassical and their cousins – also talk of a Walrasian auctioneer whose role is to collect preliminary buy and sell orders, which he uses to find the “clearing” price. A look at the microstructure of markets reveals this is quite misleading and very incorrect inferences can be drawn from the price clearing story.
The blogger Lord Keynes (!) has a nice post quoting Nicholas Kaldor – mainly from his 1985 book Economics Without Equilibrium – The Okun Memorial Lectures At Yale University.
The following is from pages 13-18 – which have great insights on this. It draws heavily from Kaldor’s own paper from 1939: Speculation And Economic Stability.
Perhaps for that reason general equilibrium theory retains its fascination for teachers and students of economics alike. Indeed, judging by the number of Ph.D. students working on the implications of the rational expectation hypothesis, it is gaining ground, at any rate, in America. One reason is the intuitive belief that the price mechanism is the key to everything, the key instrument in guiding the operation of an undirected, unplanned, free market economy. The Walrasian model and its most up-to-date successor may both be highly artificial abstractions from the real world but the truth that the theory conveys — that prices provide the guide to all economic action — must be fundamentally true, and its main implication that free markets secure the best results must also be true. (This second proposition was indeed demonstrated but under assumptions so restrictive that Professor Hahn turned the argument around and suggested, in his inaugural lecture, that the importance of general equilibrium theory lies precisely in showing how stringent the conditions must be for “free markets” to secure the results in terms of welfare that are naively attributed to them. This may well be true, but if so, it is truth bought at a very high cost.)
But the basic assumptions in all this — that prices are very important in the working if a market economy — is rarely, if ever questioned. Yet it is precisely this over-emphasis on the role of the price system that I regard as the major shortcoming of modern neoclassical economics, particularly the Walrasian version of it.
The Role of Dealers and Speculators
Walras knows only two categories of “agents”: producers and consumers. He makes no mention of the third category which is vital to the functioning of any market economy, namely, the “dealer” or “middleman” (or “merchant”) who is neither buyer not seller, because he is both simultaneously. It is the dealers or merchants who make a “market” which enables producers to sell and consumers to buy, and who carry stocks of commodity the deal in in large enough amounts to tide over any discrepancies between outside sellers and outside buyers over any short period of time, and in practice fulfill the role designed for the “heavenly auctioneer” since they are the people who at any moment of time quote prices for purchases or for sales. They are not required under actual rules to buy or sell only at “equilibrium” prices — whatever that is taken to mean — though there are special markets, like the London bullion market, where the actual dealing price is struck after ascertaining the demands and the offers of dealers at various prices. (This is possible when, as in the London gold market, everybody’s demand and supply can be handled through a small number of dealers.) At any given moment of time, or to be a little more realistic, at the start of business, say the first thing in the morning, all prices are given to them as a heritage of the past. The important thing is that it is the dealers who initiate the price changes necessary for aligning, or rather realigning, the demand of the consumers and the supply of producers. They make their living on the “turn” between the buying price and the selling price; and the larger the market and the greater the competition between dealers, the less this “turn” is likely to be, as a proportion of price (always provided that the “turn” must be large enough to cover interest and carrying costs on stocks plus some compensation for the risk of a fall in market prices in the future). Thus buying or selling necessarily involves transaction costs that cannot be said to fall on the seller any more than on the buyer; they are divided between them, but it is not meaningful to ask how much falls on one side rather than the other.
Any discrepancy between sales and purchases (or “outsiders,” that is, of producers and consumers) is simultaneously reflected in the stocks (or “inventories” to use the American term) carried by merchants. Experience has taught them how large their “normal” stocks need to be in relation to their turnover in order to ensure continuity of dealing, for a dealer’s reputation (or good will) depends on his ability to satisfy his customers at all times; refusal or inability to deal is likely to divert business to others. They protect their stock by varying both their buying and selling prices simultaneously, raising prices when stocks are falling and lowering them when they are rising.
The size of price variation induced by a change in the volume of stocks held by the market depends on the dealer’s expectations of how long it will take before prices return to “normal” and how firmly such expectations are held. Even before the Second World War, the short-term fluctuations in commodity market prices (i.e., the markets of the staple agricultural and industrial raw materials, including metals) were very large. According to Keynes’s calculations in 1938 (in an article in the Economic Journal)* the average annual variation in the ten previous years between the lowest and the highest prices in the same year in the case of four commodities (rubber, cotton, wheat and lead) was 67 percent. Unfortunately, the corresponding figures for the fluctuations in stocks carried that were associated with these prices variations could not have taken place unless there were frequent changes in the prevailing expectations concerning future supplies of demands.
* “ The Policy of Government Storage of Food Stuffs and Raw Materials.” Economic Journal, September 1938, pp. 449-460
Nor is it known how far the price movements were exaggerated as a result of the activities of yet another class of “agents”, the speculators. Professional dealers act under the influence of price expectations, and to that extent their market behavior can also be regarded as speculative in character. But their actions are motivated by the desire to reduce the risks facing them (which they inevitably assume as dealers) by their willingness to reduce their stocks in times of high prices and the opposite willingness to absorb extra stocks when prices are regarded as abnormally low. In any case the risks they carry are an inevitable by-product of their function as dealers. Speculators on the other hand assume risks for the sake of a gain and thereby provide facilities for hedging by buying “futures” from those who are committed to carry stocks of a commodity, and selling “futures” from those who are committed (by their productive activities) to acquire commodities in the future for uses for which they have already entered contractual commitments.
The activities of both dealers and speculators are supposed to smooth out both fluctuations in prices and variations in the size of inventories. Price rises should be moderated by the reduction of inventories held by dealers; similarly, a price fall should be moderated by a consequential increase in inventories. As Arthur Okun pointed out in one of his papers, * as a matter of “stylized fact” this is the very opposite of what actually happens.
The hallmark of U.S. postwar recessions has been inventory liquidation, following a major buildup of inventories at the peak of the expansion. Standard models that assume price-taking and continuous market clearing do not suggest that a disappointment about relative prices will lead to liquidate inventories. For example, a sudden drop in the demand for, and hence the price of wheat that leads farmers to decrease production in the future will generally lead traders to increase stocks initially. (The price tends to fall enough currently relative to its new future expected value to provide traders with that incentive.) Why then, in the business cycle, is an aggregate cut back in production accompanied by a cutback in stocks?
*Rational Expectations with Misperceptions As a Theory of the Business Cycle, proceedings of a seminar held in February 1980 and printed in the Journal of Money, Credit and Banking, November 1980, Part 2]
This was mentioned as the first of eight “stylized cyclical facts” that Okun regarded as inconsistent with the rational expectations hypothesis; it related to the behavior of a special class of “agents” whose main business it is to be rational in their expectations.
All this related mainly to the behavior of commodity markets which come nearer to the “auction markets” of general equilibrium theory than all the other “markets” in the economy. Yet they fail to satisfy the theoretical requirements from more than one point of view. First, they are not “market clearing” in the sense of equating demand and supply on the strict criterion that the maximum amount sellers desire to sell at the ruling price is equal to the maximum buyers desire to buy. There is a change in inventories from period to period, held by insiders in the market, that is quite un-Walrasian – it means that demand was either in excess of, or short of supply-the market has not “cleared” and the transactions, even in the shortest of periods, such as a day or even an hour, did not take place at a uniform price but at prices that varied sometimes minute by minute.
Nicky Kaldor from the back cover of Economics Without Equilibrium