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Market Failure and Government Intervention

Figure 17-6c  Instability

The example on the left is referred to simply as “accelerating explosive” change while the example at right is referred to as “oscillatory explosive” or “strange explosive” instability.

In economics, the discovery of equilibrium provides powerful opportunities for forecasting.  But all bets are off when markets are unstable.  The source of instability has been extensively studied in economics, and is increasingly the focus in work done at the Santa Fe inststitued and books such as Taleb’s “The Black Swan”.  Lags in obtaining information and responding effectively to it can lead to dynamic instability in a market.  Such instability may cause a market to wander away from a social optimum.  Following are three examples of dynamic market failures from such instability:

(1)  The Cobweb Model and lagged adjustment:  When demand is relatively inelastic while supply is very elastic, lagged adjustment can move a market away from equilibrium as shown in the hypothetical chemical example pictured in Figure 17-6d.  A price above equilibrium one year causes chemical firms to supply a large quantity of goods the next year; in effect the firms are responding with a one year lag to the price signals of the previous year.  However, the larger quantity supplied results in a precipitous price reduction.  Again with a one year lag firms respond by cutting back the quantity supplied.  However, the lower quantity supplied results in skyrocketing prices.  The process continues and progressively moves away from the equilibrium quantity and supply.

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