Monday, March 2, 2009

Equilibrium and Evolution

Traditional economic theory makes it very clear that markets seek equilibrium. Most of the time, when a market is out of balance, it changes itself around until it is back in balance.

For a simple example, consider this scenario: I printed too few copies of my new book. I made only a few thousand copies, and many more people wanted to have a copy of the book. After I realized that a shortage was on the way, I arranged to have more copies made. If for some reason I could not print more copies, or was delayed in doing so, prices for used copies of the book would go higher and higher until everyone who was willing to pay enough could get their own copy. The higher prices might persuade more people who had finished reading the book to sell their copy to someone else. These are all examples of ways people might react to a market that is out of balance in ways that help bring it back into balance.

That is a market seeking equilibrium, and when it is described in terms of supply and demand, it is often the very first thing people hear about economics. There is another tendency of markets that is just as important, but not nearly so obvious or prominent in economic theory. That is the tendency for markets to seek evolution.

Evolution happens when you try to get a result that is similar to what is currently available, but with an improvement. You make a pie, but try a different pie crust recipe. You look for a new job even though you already have a job, hoping the new job makes better use of your skills. You start making computer backups once a week instead of once a month in the hope of reducing the risk of losing files.

The trial and error that brings about useful changes fails most of the time, often spectacularly. Less than a year after the huge national launch of Crystal Pepsi in 1993, when it was one of the top soft drinks in the United States, Pepsi tried to improve on its success. It introduced revised packaging along with a new recipe that would cost less to make and taste more like regular Pepsi. The new formula bombed, and that was the end of the product.

Stories like this occur every day. On an individual level, we try a new product or a new restaurant only to say, “I don’t think I want to do that again.” We accept the failures because the impulse to make things better is part of the human condition, something we can never completely avoid, no matter how frustrating our experiments get. And the successes are what make our circumstances improve in the long run. We spend less time copying files to floppy disks, for example, because there are now smoother ways to move files between computers.

The forces of evolution and the forces of equilibrium work at cross purposes, often making markets a bumpy ride. Most music stores in the United States had to close after a Sony BMG experiment with “copy protection” went bad, scaring millions of music fans away from the audio CD format. The increased interest in solar panels as a simpler way to get electricity, an evolutionary move over the past 11 years, has left the solar industry out of equilibrium, with not nearly enough capacity to meet the demand. Economic theory by itself can’t predict what will happen next, because what happens depends not just on markets, but on people, and on what they are seeking. And even when you know what people are seeking, you will still be surprised by what they find.