Imagine the sweet life of mediocrity
Imagine there’s a mediocre guy that lives a routine and relatively happy life. He lives life smoothly, makes well-calculated decisions, and a squirrel rushing in front of his car, twice a year, is as “surprising” as it gets. He has a 9-to-5 at the widget factory, a family of four that eats at the dinner table most nights of the week, and is very supportive of his family members’ endeavors. He reads to his kids every night before bed, shares intimate moments with his wife and is up-to-date with the local news. He and his family gradually become more productive as the kids become smarter and they make small changes that help them become “better” as people and as a family. Nonetheless, he and his family experience a gradual positive progression in the hopes of achieving what we all secretly want…mediocrity.
One day, though, he becomes tired of mediocrity and becomes an alcoholic. (Who would’ve known he had such an addictive personality!) At first, his immediate family tolerates this change in behavior, but not before long, his easy living becomes tough. His kids take out their frustration in school with poor performances. His wife becomes depressed and often decides not to come home. He then gets fired from work for coming in so late. Finally, he gets into a car accident in which he severely injures an innocent driver due to him being under the influence.
Now, this is an extreme example of how one small change in behavior affects not solely the individual, but the individuals and environment around him. By applying this illustration to markets, we come close to the root of why economists try to take on the theory of “general equilibrium.”
What happens to other markets when an individual market gets a wrench thrown into the system? One economist contributed so much to answering this question, he won the Nobel Prize for it.
Developing the theory
Gerard Debreu won the Prize in 1983 “for having incorporated new analytical methods into economic theory and for his rigorous reformulation of the theory of general equilibrium.” As this description implies, the theory of general equilibrium is not new. Kenneth Arrow, who received the prize along with John Hicks in 1972, also contributed to this theory and even collaborated with Debreu in the famous paper “Existence of an Equilibrium for a Competitive Economy.” However, it was Leon Walras, that pioneered the development of this theory. The thought behind the theory is this: though we could demonstrate that prices equaling where the supply and demand curves cross in individual markets, it was not certain that there was an equilibrium for all markets at the same time.
Let’s back it up a little. What does it mean to be in equilibrium? Equilibrium is a state in which opposing forces or influences are balanced. In economics, it’s where demand equals supply. Yeah, that ol’ “X” graph our boring economics professor drew on the board one too many times. Demand and supply oppose each other in regard to prices. The cheaper a good or service is, the more of that good or service will be demanded. Conversely, the cheaper the good or service gets, less of it will be supplied. Where they meet in the middle is known as the equilibrium point.
Without getting too deep in the weeds, constructing these supply and demand curves often involves a bit of math. It entails figuring out how much is bought and produced at different price levels and then connecting the dots until you have a smooth line. Check out Debreu’s “Theory of Value: An Axiomatic Analysis of Economic Equilibrium” if you don’t believe me.
After constructing these supply and demand curves for a single market and finding the point of equilibrium, economists are then, supposedly, able to make more accurate judgement calls on how different types of shocks to the market would affect demanders and suppliers. Emphasis on supposedly. Keep in mind this is still in a single market, such as the market for widgets, and referred to as “partial equilibrium.”
With general equilibrium, Debreu and friends were interested in finding the effects of shocks to a market on the equilibrium of a bunch, or all, the markets. Being in equilibrium meant, as Debreu would put it, where “excess demand is equal to 0.” In other words, if there was only pizza and beer in a hypothetical (and fun) world, having the perfect amount of pizza and beer that satisfies your preferences under your personal budget constraint would be an equilibrium point.
To be sure, using two goods, like pizza and beer, is where economist first start out developing the theory of general equilibrium. Regrettably, there is more to life than just pizza and beer. This is evident when we look at problems like Venezuela.
Go home, Venezuela. You’re drunk.
If you haven’t heard, Venezuela is in a full-fledged crisis. Due to the government’s mismanagement of the economy, many government programs have lost their funding. Food isn’t getting to the grocery stores, the currency is experiencing rampant inflation, and there is a massive shortage of medications and other health care goods and services. Along with that, homes are getting their power turned off causing riots on the streets.
This obvious failing of the nation is mostly rooted on one particular change in behavior. Similar to our mediocre guy that was doing well, but became an alcoholic and ruined his life, Venezuela’s vice was the fact that it based its entire economy on the oil industry. Oil accounts for around 95 percent of Venezuela’s export revenue and is a major source of funds for a number of social programs, including the provision of homes for poor Venezuelans. When oil prices dropped by over 50 percent in the last several years, the funds for these programs also disappeared.
Virtually everything in the Venezuelan economy is managed by the government. So, with their economy being hinged almost entirely on the oil business, it wasn’t able to adapt. Everything broke down.
Not only do all these different markets within Venezuela feel the negative effects, but so do neighboring countries! Colombia and Brazil are feeling the brunt of it as hungry and poor Venezuelans rush into their country in search for a better life. Colombian mayors are blaming this crisis for the increase in crime and unemployment in their provinces. The flood of refugees have also strained the supply of medical and health services in Brazil. In short, this [small] hiccup of dipping oil prices in a country that had all its eggs in that basket has caused a massive ripple in the general equilibrium of the regional and global economies.
Being able to mathematically lay out how markets interact and how they tend to work their way to equilibrium is not just a thought exercise for economists like Debreu. For others, due to how unrealistic it is to be able to quantify markets in this way, they do see it as just a thought exercise; a fruitless endeavor, in fact. Critics of Debreu and other general equilibrium theorists see markets as a process in which new goods and services are constantly replaced, preferences of consumers and producers change, and shocks to the economy are often unpredictable, so there’s really no way to prepare for it.
Despite the criticisms, Debreu and the economists that contribute to this staple in economics, do demonstrate the interconnectedness of the economy. Though some may take the advances in general equilibrium theory as a sign that we might be able to control the economy one day, hopefully Venezuela’s drunkenness on oil will act as a deterrent against this way of thinking.
If anything, general equilibrium theory can help prove why becoming an alcoholic will ruin your life.