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1

I.B. Disequilibrium Approach

(A) Short-run “disequilibrium” versus long-run equilibrium

(B) Quantity constraints and price rigidity

(C) Rationing, virtual price & compensated demand

Disequilibrium means either (1) that the market fails to arrive at a state

of persistence or rest; or (2) that the market is stuck in a persistent state

which does not clear supply and demand and is not optimal and/or efficient.

(A) Short-run “disequilibrium” versus long-run equilibrium

One possible modification to the equilibrium approach is the

introduction of adaptive expectations and partial adjustment in human

behaviour. Time lags are assumed to exist between (1) information and

knowledge, (2) knowledge and action, and (3) commitment and completion;

and they are widely used to model the phenomena and in particular

economic cycles. With adaptive expectations and partial adjustment, the

short-run result in the market will be different from the long-run

“equilibrium”, e.g. agricultural cycles in which the supplier responds to

lagged (instead of current) prices. The reason is that production, i.e. farming,

takes time. At the time of deciding the amount to produce (t-1), the supplier

did not know the price level that would prevail when the output enters the

market (t).

D

t

= a – bP

t

----------(1)

S

t

= c + dP

t-1

----------(2)

where D is demand, S is supply and P the price level; while t is the time

subscript (

t-1

meaning the price level of the last period).

Stability: b > d Instability: b < d

price elasticity of dd > vice versa: “farmer’s stupidity”

price elasticity of supply not even L-R equilibrium!

P S

D

Q

P S

D

Q

2

2

So cycles are generated by farmers making supply decisions on the

basis of (P

t-1

) i.e. lagged prices.

Reference: Alpha Chiang, Fundamental Methods of Mathematical

Economics, 2

nd

ed., chapter 16.

Another example is the multiplier-accelerator investment model of

Samuelson. A. Chiang, ch.17.

Y

t

= C

t

+ I

t

+ G

0

---------- (1)

C

t

= ¸Y

t-1

(0 < ¸ < 1) ---------- (2)

I

t

= o(C

t

- C

t-1

) (o > 0) ---------- (3)

From (1) and (3), all cyclical patterns can be generated. Now in eq.(3),

o is called the “accelerator coefficient” (加速系數). Like the CPE planners,

this implies “informational deficiencies” on the part of the investors in the

market economies as investment is made on the basis of past increment in

consumption.

Therefore, the short-run “equilibrium” at any time point, say t, is not

“stable”. Or we can say that a short-run “disequilibrium” exists. Only the

long-run equilibrium fulfils the definition of “a state of persistence/rest”.

3

3

(B) Quantity constraints and price rigidity

Another reason why disequilibrium may occur is that the market is not

functioning entirely “freely” because of the existence of constraints other

than the budget/cost constraint, in particular quantity constraints.

Alternatively, disequilibrium may occur because of price rigidity. Under

such circumstances, what is “equilibrium” may not be optimal and/or

efficient.

(1) The Dual Decisions Hypothesis

We first look at quantity constraints from the demand side.

In a barter economy, the buying and selling decisions are made

simultaneously. One could not buy anything without selling something at

the same time, e.g. buying a sheep by selling two pigs. So Say’s Law holds:

supply creates its own demand.

However, in a modern, monetized economy, money becomes the means

of payment as well as a store of value. When one buys something with

money, one does not have to specify what one wants to sell. Money is a

generalized form of purchasing power, an “machine” of intertemporal

transfer of demands; or a means to avoid irrevocable commitment to

purchases.

Hence the selling and buying decisions are separate; and this is called

the dual decisions hypothesis.

In a monetized economy, Say’s Law may not hold and people’s notional

demand and effective demand could diverge. And some may wish to sell a

lot of things without wanting to buy anything (except hoarding money), if

they are “pessimistic” about the future.

This is equivalent to introducing an “effective demand” constraint,

which is a quantity constraint, into the constrained optimization programme

(like in the Keynesian macroeconomic model). It would affect aggregate

demand adversely and lead to a “self-fulfilling prophecy” of shrinking

demand and recession. Although the quantity constraint is “self-imposed”

because of pessimism, it will still result in a suboptimal equilibrium.

4

4

(2) Price rigidity and disequilibrium trading

(a) Equilibrium: the (auctioneering) model, e.g. gold price "fixing",

where trading only takes place at equilibrium price P*.

(b) Disequilibrium: in reality, in most decentralized markets, trading

does take place at disequilibrium prices, e.g. P

1

and P

2

(with the

transactions given by Q

1

and Q

2

respectively). If we assume that the

price level is totally fixed in a particular market, the "short side

rule" will apply:

The transacted volume will be given by the wedge formed by the

demand curve above P* and the supply curve below P*, i.e.

Q = min (S(p), D(p))

S

D

Q

P

P

1

P*

P

2

Q

2

Q

1

Q*

S

D

Q

P

E

5

5

(3) Aggregation of disequilibrium trading

If we have more than one submarkets trading the same good, the

short side rule may not apply to the aggregated transaction volume

derived through the normal procedure of horizontal summation in the

equilibrium approach, e.g. Benassy (1982, pp.22-23)

Even if we have only two submarkets, indexed 1 and 2, so that

realized transactions are given by:

s d

*

1

*

1

= = min (

d

~

1

,

s

~

1

)

s d

*

2

*

2

= = min (

d

~

2

,

s

~

2

)

where * indicates realized demand or supply and ~ represents

effective ones.

If we aggregate these two submarkets and define the aggregated

demand and supply functions as:

(p)

d

~

(p)

d

~

(p) D

~

2 1

+ = ; (p)

s

~

(p)

s

~

(p) S

~

2 1

+ =

and the actual transactions as:

D* =

d d

*

2

*

1

+ ; S* =

s s

*

2

*

1

+

From figure 2.3 in Benassy (1982, p.23), we see immediately that in

some price range, the realized transaction volume will be less then the

minimum of the effective functions:

P

P

P

*

2

*

1

< < ¬ D* = D* < min( S

~

, D

~

)

This will violate the assumption of market efficiency because there

are unsatisfied suppliers on the first submarket but unsatisfied

demanders on the second submarket.

Benassy in his book Economics of Market Disequilibrium does not

make the assumption of market efficiency in general.

6

6

Aggregate

) p (

s

~

1

d s

*

1

*

1

=

) p (

s

~

2

d s

*

2

*

2

=

(p)

d

~

2

(p) S

~

S* = D*

(p) D

~

P

P

P

P

*

1

ES

ED

(p)

d

~

1

P

*

2

7

7

X X

Y

(C) Rationing, virtual price & compensated demand

Now we look at the case when a quantity constraint is introduced into a

constrained optimization programme on the supply side. The quantity

constraint can be interpreted as a result of shortage or deliberate planning in

a centrally planned economy. When the quantity is below the demand level,

rationing will have to take place to distribute the limited amount of total

supply to different consumers. It may be in the form of a queue or a voucher

system.

The virtual price/shadow price is the price level that would result in the

consumer demanding voluntarily the rationed amount of good if he is

sufficiently compensated. So the rationed amount will become the

compensated demand. (That is why point B has two meanings: B and .)

e.g. U = XY ----------------------- (1)

I = PxX + PyY ----------------------- (2)

X > X ----------------------- (3)

where Px = 1, Py = 1, I = 100, X = 40

L = XY + ì(I – PxX – PyY) + µ( X – X) ----------------------- (4)

X

U

0

U

1

U

2

C

A

B,

U

0

> U

1

> U

2

A - unconstrained solution

B - rationed solution (involuntary) as

the budget line cuts the IC

C - solution at virtual price without

compensation

- compensated solution (voluntary)

at virtual price as the budget line

touches the IC

8

8

X

L

c

c

= Y - ìPx - µ = 0 ----------------------- (5)

Y

L

c

c

= X - ìPy = 0 ----------------------- (6)

ì c

cL

= I – PxX – PyY = 0 ----------------------- (7)

µ c

cL

= X – X = 0 ----------------------- (8)

There are 4 equations ( (5) – (8) ), 4 unknowns : X, Y, ì, µ

Now if Px =1, Py =1, I = 100 and X = 40, you should be able to obtain

by manipulating the equations: X* = 40, Y* = 60 and U* = 2400

Equation (5) can be rewritten as

X c

cL

= Y - ì(Px +

ì

μ

) = 0 ----------------------- (5’)

So if Px is raised to (Px +

ì

μ

), the equilibrium position will be at C in the

diagram on p.1.

From (5) ì =

x P

μ Y÷

From (6) ì =

y P

X

x P

μ Y÷

=

y P

X

¬ µ =

y

x y

P

X P Y P ÷

Sub Py, Px, X* and Y*

virtual price according to theory

9

9

µ =

1

) 1 ( 40 ) 1 ( 60 ÷

= 20

and ì = 40

So the virtual price Px +

ì

μ

should be, as is clear from (5’)

= 1 +

40

20

= 1.5

As you can check from the diagram, the virtual price is unique, i.e.

there is only one such price in the model, because the quantity and budget

constraints yield unique µ and ì. Graphically, if the original budget line and

X are given, then B, the slope of the new budget line, C as well as are all

unique.

Compensation

Suppose the central planner wishes to liberalize the price level Px to that

of the virtual price without violating the quantity constraint, but at the same

time wants to keep the consumers “happy”, i.e. voluntarily demanding the

rationed amount of X. This is equilivant to moving from the position C

(solution at virtual price without compensation) to B (compensated

solution at virtual price) in the diagram. Then he needs to compensate the

consumer by providing subsidy and therefore shifting the budget line to the

right. But by how much?

We can calculate the results by deriving the compensated demand

function.

So Min I = PxX + PyY ----------------------- (1)

s.t. U = XY – U*

----------------------- (2)

where Px = 1.5, Py = 1, U* = 2400

H = PxX + PyY + ¸(U* - XY) ----------------------- (3)

10

10

X

H

c

c

= Px - ¸Y = 0 ----------------------- (4)

Y

H

c

c

= Py - ¸X = 0 ----------------------- (5)

¸ c

cH

= U* - XY = 0 ----------------------- (6)

From (4) ¸ =

Y

x P

From (5) ¸ =

X

y P

Y

x P

=

X

y P

¬ PxX = PyY ----------------------- (7)

From (6) X =

Y

*

U

or Y =

X

*

U

Sub into (7)

X =

x X

y

*

P

1 U P

×

X

2

=

x

y

*

P

U P

¬ X =

x

y

P

U

*

P

=

5 . 1

) 2400 ( 1

= 1600

X* = 40

Y* =

X

*

U

*

=

40

2400

= 60

Now what is the amount of subsidy?

I* = 1.5(40) + 1(60) = 120

Compared with the previous budget constraint I = 100

subsidy = I* - I = 120 – 100 = 20

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