Thursday, January 30, 2003
Weird Economy
Is it just me, or do many market-dictated prices fail a "reality check" when compared against their true value or costs? Take gasoline, for example. You pay just a buck-sixty per gallon at the pump (in California), but when you consider everything that went into extracting, refining, and shipping it, that price just seems absurdly low. Widening the scope, consider the cost of maintaining a standing army and waging the occasional war in the Middle East to protect the assets of Big Oil. And the environmental costs exacted at oil fields, refineries, and on superhighways as a result of the life cycle of fossil fuel usage. Let's not forget that, from a value perspective, petroleum as a provider of molecular organic building blocks is irreplaceable. All the forgoing accounting makes the concept of paying a buck-sixty at Shell seem speechlessly ridiculous.
"It's all just supply and demand" parrot the economists. And they're partly right. But they're also partly wrong, as the absurdity of the petroleum example illustrates. What's missing is an understanding of where supply and demand curves themselves go wrong. My theory is that two assumptions of economics are violated to create wrong pricing: the assumption of rational behavior and the assumption of equilibrium dynamics.
Irrational perceptions on the supply and demand side cause their respective curves to sit either too high or low. Sometimes the real costs are vastly underestimated, as in the case of petroleum, and the seller is willing to produce at absurdly cheap prices. Alternatively, sometimes the value of a good or service is greatly exaggerated, causing an unjustified bidding war (as in the case of certain tech stocks in the late 1990's).
What causes irrational perceptions? My guess is that it's a combination of things. Information can be bad, it can be nonexistent, it can be difficult to get ahold of, and it can be incomplete due to an overly narrow scope. Human nature allows for sheer stupidity and sophist logic, emotional exhilaration or depression, and group/herd psychology. And some things are just damn hard to price. I'm thinking of making distinctions in an ostensibly homogeneous market (paying for excellent versus mediocre talent), accurately gauging causality (who creates success: management, marketing, or engineering?), considering matters of aesthetics (the strip mall versus the converted Hyde Park home), and assessing broad societal impact (such as air and water pollution).
Figure 1 shows the effect that irrational perception can have on equilibrium pricing. In this case, irrational exuberance and herd psychology have caused the demand of a certain type of technology stock to be significantly higher than the stocks' true value. In the oil case mentioned above, the supply curve is vastly underestimated, putting equilibrium pricing below the true cost.
The second main trip-up with supply and demand curves is the dirty little secret of freshman macroeconomics: many systems don't actually operate in equilibrium. In a perfect world, supply and demand sides would be able to anticipate each other, leading to the nice charts with intersecting curves. But the reality is often far removed from this ideal. It's hard to predict the future, to know what will "hit" and "miss" before they actually do, so we are often wrong when we try. Also, we are a species that tends to be risk-averse when planning college majors or semiconductor FABs; when in doubt, we let demand lead and supply lag.
Figure 2 shows non-equilibrium mechanics at work. Not only is there is no intersection of curves, there really isn't a curve at all because many things are inelastic in their supply, at least in the time scale of shifty economic trends. Think housing in the San Francisco Bay Area or the number of college-educated engineers. In the first case, there's only so much land to build on, leading to absurd home valuations when demand surges. In the second case, an effectively static population of engineering talent is the result of a 4-5 year time lag between when an upward demand signal stimulates college enrollment and that graduating class enters the workforce (by which time the demand incentives may be long gone).
Non-equilibrium is the inherent state of high-tech because by definition it is a system that is always in a state of flux and uncertainty. Ironically, it is precisely this unstable cycle of shortage and surplus that generates the large amounts of wealth associated with technology. You take risks, you stand to collect huge gains. If you want stability (read: equilibrium economics), find another line of work.
Much of the economic unrest in history is the result of irrational distribution of wealth, which is closely related to the value we assign to goods and services. It has been behind every major revolution and I'm convinced it is the root cause behind our current obsession with Iraq. How do we solve the problem of bad market pricing?
Several alternatives have been advanced over the years, but none of them have turned out to work in practice. The most spectacular failure was Communist Russia, who opted to eliminate the supply-and-demand mechanism in favor of an ostensibly more rational central price-fixing program. Germany tried a less-drastic method of closely regulated business development. And the US government practices its own limited interventions into monetary supply and product markets, much of it actually causing more harm than good.
But really what it all comes down to is that it's up to us - the players - to get our act together and start behaving rationally. Maybe that means paying more for gas and less to CEO's. Maybe it will require a blood revolution. I don't know. What I do know is that we need to get back to appreciating what things are really worth instead of bidding prices up or down under the false security blanket of "it's just the market." Yeah, it's just the market. But guess what? The market starts with you, buddy.
posted 12:47 AM
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