Saturday, October 4, 2008

A model of economic equilibrium

Economists have shown that perfectly competitive markets with perfect information are the most efficient at delivering the right quantity at the lowest price. This of course only holds in equilibrium, when supply equals demand. But how do markets reach this equilibrium?

In the short-run, they’re not likely to do so. The dynamics of such a situation can be captured in what is called a cobweb plot. In the first period, businesses may over shoot market demand, and so there is a surplus. Business then close up as some are making a loss. Perhaps too many close, and so now we have a shortage. Since there are good profits to be made, more businesses arrive, and eventually, over time, the correct amount is produced, and we have equilibrium. This of course assumes that either demand, and so all the shocks that could affect both demand and supply, are constant, or that all of the producers can see all of the information about demand and these shocks (but not other producers production) perfectly. If you don’t have this, its basically chaos for reaching equilibrium.

But even under the incredible assumption of almost perfect knowledge, there are problems. Even without weather fluctuations, farmers have a tough time figuring out what to plant.

Assume I’m a farmer with some unused land, and there are many other farmers like me. I see that profits are good for food now (ignore the fact drought was partly to blame for this profit), so I decide to use the land. I can choose between corn (maize) and tomatoes, with the profits of corn > tomatoes. Also assume I know the weather and the demand for each perfectly. Which should I plant? I can decide at least three ways:

1. I choose corn since it looks to offer the greatest profit.

2. I realize that other farmers are going to be thinking the same thing, and so they will choose to plant corn, and there will be a surplus of corn next year, with no profits. I should then choose tomatoes. But if others are thinking like me, they will decide the same and all plant tomatoes. So maybe I should go back to corn. But then the cycle continues. Fed up with the logic, I flip a coin and choose the winner.

3. Instead of flipping a fair coin, I flip one that is weighted by the difference in profits. For instance, if corn is making twice the profits of tomatoes, I flip a coin where corn comes up with a probability of 2/3 and tomatoes with probability 1/3.

If every farmer makes decisions 1 or 2, we are faced with a disequilibrium next year. If they continue to make these decisions in the years ahead, there is no reason to believe we will ever reach an equilibrium of food.

If everyone chooses 3, or a combination of 1 and 2, then, with some simple assumptions about the market, we have equilibrium.

3 seems pretty reasonable, but it’s hard to do. I think this is an interesting empirical question. If we can observe the number and profits of farms at time t, and then the number and profits for farms at t+1, we may be able to determine which of the choices (or potentially the combination of choices) farmers make.

There is another smart option for an individual farmer. If I wait until everyone else has made their decision, and I know what their decisions are, then I can better guess which of the two to plant. There is thus a last mover advantage in farming.

I chose farmers as an example since crop choices are final for the year once made, but can change next year. But let’s now assume I’m an NGO in northern Uganda and I am offering grants to vulnerable people in order to help them start a business. Everyone comes to me and says they want to learn carpentry because it is the most profitable business (option 1 above). What do I do?

The program evaluation I am working on faces just this issue. I have so far visited 7 randomly selected small businesses funded by NUSAF in West Nile. 6 are carpentry and 1 is shoe repair. 2 of the 6 carpentry projects are just now receiving their funding. As there are already quite a few carpenters in business in the north, it seems logical to ask: how many carpenters are really needed in West Nile? (As this is a small sample, we can’t really conclude everyone is doing carpentry, but it looks like a lot in one area will be)

A similar problem is detailed in the SWAY report for Acholi land, where women were being trained in large numbers for tailoring, then finding the market was oversaturated.

Training is a one time thing and, for most people here, will be the only training in their lives. There is also no such thing as a last mover advantage for deciding a business, as new businesses are starting up every day.

We are doing a business census in a few areas to get an idea of what other businesses exist, and so may be able to identify when the market is oversaturated. A census though is a hard thing to do, and even if we get it perfectly right, it’s too late to help the newly funded people.

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