Saturday, June 27, 2009

Supply + Demand + Invisible Hand

At the risk of perverting Adam Smith's metaphor, the Invisible Hand seems quite an apt image for that force of economics that distorts the surface of things.

If only Supply vs. Demand were a complete picture! This is how one might view the world: Merchant Abe has a supply of 100 units of Quagmire Oil, a very useful substance for releasing oneself from quagmires. One unit suffices for a single use. There are 200 residents in Abe's village of Borbor, who are prone to getting enmired, thus a market is born.

The first week, Abe charges 2 Boreals per unit. He sells out in a day to 100 patrons. He gets a fresh supply the following week, and raises his rates to 3 Boreals. Of the initial 100 units, 50 remain, so eager buyers have diminished to 150. Still he sells out in a day.

The next week, he brings 200 units to market, but only sells 75. The following week, he has competition, and a total of 400 units are for sale. Suddenly, the price drops to 1 Boreal per unit, and supplies stock up. Voilá, an economic theory.

But, see this:
ECONOMISTS tend to think that an industry divided between hundreds of players, each with a tiny market share, should be fiercely competitive, with prices cut to the bone. But economic theory struggles to explain the bizarre world of fund management, where the market is fragmented but fees stay stubbornly high.
-- "Competitive failure," The Economist, June 18, 2009

The only surprise here is that this sort of social and economic complexity would surprise anyone. Perhaps economists would benefit from talking to psychologists and sociologists. Perhaps the world would become a clearer place, or at least a less perplexing one if we encouraged the cross-fertilization of ideas across multiple disciplines, calling on a wealth of methodologies, backgrounds, and approaches. Therein lies true innovation.

Truth is, there are pernicious pockets of irrational pricing that pervade the market, which have seemingly less to do with any supply vs. demand calculations, and more to do with established expectations. One would be inclined to suspect that cost is relative to worth, and that worth is easily calculated by supply vs. demand. How much is it worth? is a question we often ask, wishing to buy and sell at a fair market price.

The greater the supply or lower the demand, the lower the worth; the lower the supply or greater the demand, the higher worth. But, we've seen how that tack was not sufficient to determine appropriate pricing of housing markets across the world (or for that matter appropriate pricing of company shares). Why? Because we all began to expect the value to be justified by the prices others were willing to pay. It became less what do I need? What's it worth to me? and more:
Alright, so I need a house... and this one's sufficient, but that family bought a bigger house, sold it in two years for a handsome profit, and moved to an even bigger one. Gosh, I'd sure like to do that.
And so... a market is born. Only, it was never sustainable. When I was living in Santa Barbara, looking at house prices with multiples of 12, 15, or even more of average household income, I scratched my head, and decided to sit out the market for a while. The old rule of thumb I learned was a house should cost on average 2-3 x a household's annual gross income. Our current house in Wisconsin is 1-2 times current earnings. And we're happy. Sure the weather is nicer year round in SB than here. But now I can afford to visit when the weather gets rough.

More importantly, in Santa Barbara, renting was cheaper, MUCH cheaper. The cost to buy a comparable property carried a premium of at least 40-60%. The calculation is a rather simple one, but so few people did it. But it's not just house prices.

How do we explain that two professors at the same university, with the same experience, teaching the same load of classes, to the same number of students, who each pay the same tuition, can receive widely divergent salaries based on nothing more than their discipline? The argument is that an economist or engineer or lawyer for instance can make far more "in industry" than, say a sociologist or historian, and thus their wages must be higher to compete for talent. But why? They're not working in industry now are they?

Here's a bid for the free market. If people are simply unwilling to pay the higher prices for goods, or houses, or in wages, the market will revert. The article cited above continues:
If enough investors focus on cost, not performance, the fund-management industry will have to give them a better deal.
I've made a similar argument about wages. When I taught adjunct at Chapman University in Orange, California--a private university where tuition is around $30,000 a year--I was appalled that they could offer a PhD a mere $15,000 gross a year to teach 80 students per term, call it part-time employment, and refuse to offer any benefits whatsoever (including an office to fulfill their requirement of office hours). Even more appalling was that, a week after I resigned, being willing to endure those conditions for only one term, two instructors were hired to fill my shoes, one for each of my two classes.

The point is, so long as people are willing to accept the expectations they've been given, the more those expectations are reinforced. If they cue up (providing supply) to receive low wages, low wages will continue. If they cue up to buy overpriced goods, or services, or houses, the prices will continue to rise. That is... until they can no longer. That's the free market. It will correct itself, if we permit it to.

Don't buy when the prices are too dear: whether it's a house, or an accountant or attorney. And don't take less than you or your company is worth. Simple lessons, but they all come down to one enormously powerful ability we all possess: the power to say no! Use it, but use it wisely.

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