The dissonance between Econ 101 and reality

The latest bout of inflation in the world economy has generated intense debate and search for explanations. One of the important contributors to the rising inflation is the excessive price mark-ups by companies in important sectors, more than what's required to cover rising costs. This tendency, especially pronounced in sectors dominated by large corporations, is being described as greedflation. 

The inflation episode is also a good example of the dissonance between economic theory and reality. This NYT report highlights the issues,

Basic economic theory teaches that charging what the market can bear will prompt companies to produce more, constraining prices and ensuring that more people have access to the good that’s in short supply. Say you make empanadas, and enough people want to buy them that you can charge $5 each even though they cost only $3 to produce. That might allow you to invest in another oven so you can make more empanadas — perhaps so many that you can lower the price to $4 and sell enough that your net income still goes up. Here’s the problem: What if there’s a waiting list for new ovens because of a strike at the oven factory, and you’re already running three shifts? You can’t make more empanadas, but their popularity has risen to the point where you would charge $6. People might buy calzones instead, but eventually the oven shortage makes all kinds of baked goods hard to find. In that situation, you make a tidy margin without doing much work, and your consumers lose out.

This has happened in the real world. Consider the supply of fertilizer, which shrank when Russia’s invasion of Ukraine prompted sanctions on the chemicals needed to make it. Fertilizer companies reported their best profits in years, even as they struggle to expand supply. The same is true of oil. Drillers haven’t wanted to expand production because the last time they did so, they wound up in a glut. Ramping up production is expensive, and investors are demanding profitability, so supply has lagged while drivers pay dearly... This is especially evident in industries like shipping, which had record profits as soaring demand for goods filled up boats, driving up costs for all traded goods. Across the economy, profit margins surged during the pandemic and remained elevated... “In the inflationary environment, everybody knows that prices are increasing,” said Z. John Zhang, a professor of marketing at the Wharton School at the University of Pennsylvania who has studied pricing strategy. “Obviously that’s a great opportunity for every firm to realign their prices as much as they can. You’re not going to have an opportunity again like this for a long time.”

This dissonance between Econ 101 theory and reality is a feature of today's capitalism. The likes of Ha Joon Chang have brilliantly and definitively written about this dissonance. 

Take the example of the idea of free-trade. The theory of comparative advantage informs that all sides benefit from trade. But in reality, trade inflicts disproportionate costs on some segments/countries while similarly disproportionately benefiting others. And any idea of compensating the losers by appropriating some of the gains of the winners, while good in theory never materialises. 

Or take the example of taxation. The theory suggests that lower corporate taxes will encourage businesses to invest more, and higher individual taxes will discourage effort by entrepreneurial and highly productive individuals. In reality, lower corporate taxes have encouraged businesses to undertake more share buybacks, higher dividend payouts, and larger executive compensation, and all at the cost of investment. And there are several studies which show 

Or take the example of disciplining powers of markets. Theory tells us that financial markets enforce discipline by channeling finance towards the most efficient and productive corners of the market. Theory also educates that markets reward good performing executives and punish those not performing well. Again evidence from the real world points overwhelmingly to the contrary. 

I have written with V Ananthanageswaran explaining these dissonances, especially but not only in the context of financial markets.  

There are at least four important cross-cutting reasons for the clearly observed difference between theory and reality. 

1. Theories are built on assumptions. The assumptions include no entry barriers, perfect competition, negligible transaction costs, and so on. These assumptions invariably breakdown in the real world. Reality is riddled with entry barriers, business concentration, lop-sided playing fields, co-ordination problems and high transaction costs etc. The network effects that digital economy presents is a salient and powerful example of how nature of the market itself limits competition. 

2. There is a difference between partial and general equilibriums. A partial equilibrium is the immediate response of the system to the change, whereas the general equilibrium is the outcome which emerges at steady state after all adjustments get made. Econ 101 tells us that while the partial equilibrium may be inefficient, the dynamics of the market clears out all the inefficiencies and ushers in an optimal general equilibrium.

The problem is that real-world markets have so many frictions, overcoming which takes an inordinate amount of time. In fact, some of the frictions cannot be overcome, leaving the markets to remain inefficient. As it's said, the markets can remain irrational for longer than the investor can stay solvent. Or businesses can stay monopolistic for long enough to corner massive rents while inflicting prohibitive economic and social costs. And, to paraphrase Keynes, in such long-runs, we're all dead!

3. Theory underestimates the importance of the political economy. As I have blogged several times, the biggest problem with business concentration and widening inequality is in terms of capturing the rules making process and eroding the social contract itself. All of these in turn weaken capitalism itself. Political economy also ensures that market adjustments like compensating losers of trade or increasing labour's bargaining power while being good in theory are virtually impossible in practice. 

4. Finally, there is the Iron Law of free-market systems. In the absence of any regulation, in a free market of any kind, competition will invariably end up favouring the more endowed (with resources, capacity, influence etc) at the cost of the less endowed. This Mathew Effect is a universally observed feature of any free market system. This means that market adjustments rarely happen on their own (and the political economy prevents regulatory interventions). 

The result of all these is the dissonance between theory and reality.