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Should markets clear?

Author(s): Steve Randy Waldman
The point of this essay is not, however, to make the case for nonmarket allocation mechanisms. There are lots of things to like about letting the market-clearing price allocate goods and services. Market allocations arise from a decentralized process that feels “natural” (even though in a deep sense it is not), which renders the allocations less likely to be contested by welfare-destructive political conflict or even violence. It is not market-clearing I wish to savage here, but the inequality that renders the mechanism welfare-destructive and therefore unsustainable. 

From Interfluidity:

David Glasner has a great line:

[A]s much as macroeconomics may require microfoundations, microeconomics requires macrofoundations, perhaps even more so.

Macroeconomics is where all the booming controversies lie. Some economists like to argue that the field has an undeservedly bad reputation because the part that “just works”, microeconomics, has such a low profile. That view is mistaken. Microeconomic analysis, whenever it escapes the elegance of theorem and proof and is applied to the actual world, always makes assumptions about the macroeconomy. One very common assumption microeconomists frequently forget that they are making is an assumption of rough distributional equality. Once that goes away, even such basic conclusions like “markets should clear” go away as well.

The diagrams above should be familiar to you if you’ve had an introductory economics course. The top graph shows supply and demand curves, with an equilibrium where they meet. At the equilibrium price where quantity supplied is equal to quantity demanded, markets are said to “clear”. The bottom two diagrams show “pathological” cases where prices are fixed off-equilibrium, leading to (misleadingly named) “shortage” or “glut”.

We’ll leave unchallenged (although it is a thing one can challenge) the coherence of the supply-demand curve framework, and the presumption that supply curves upwards and demand curves down. So we can note, as most economists would, that the equilibrium price is the one that maximizes the quantity exchanged. Since a trade requires a willing buyer and a willing seller, the quantity sold is the minimum of quantity supplied and quantity demanded, which will always be highest where the curves meet.

 

But the goal of market exchange is to maximize welfare, not to generate trade for the sheer churn of it. In order to make the case that the market-clearing price maximizes well-being as well as trade, your introductory economics professor introduced the concept of surplus, represented by the shaded regions in the diagram. The light blue “consumer surplus” represents in a very straightforward way the difference between the maximum consumers would have been willing to pay for the goods they received and what they actually paid for the goods. The green producer surplus represents how much money was received in excess of what suppliers would have been minimally willing to accept for the goods they have sold. Intuitively (and your economics instructor is unlikely to have challenged this intuition), “surplus over willingness to pay” seems a good measure of consumer welfare. After all, if I would have been willing to pay $100 for some goods, and it turns out I can buy then for only $80, I have in some sense been made $20 better off by the trade. If I can buy the same bundle for only $50, I’ve been made even more better off. For an individual consumer or producer, under usual economic assumptions, welfare does vary monotonically with the surpluses represented in the graph above. And market-clearing maximizes the total surplus enjoyed by the consumer and producer both. (The naughty red triangles in the diagram represent the loss of surplus that occurs if prices are fixed at other than the market-clearing value.) Markets are “efficient” with respect to total surplus.

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