DemandTheoryandGeneralEquilibrium:FromExplanationtoIntrospection,a JourneydowntheWrongRoad AlanKirman 1 RichardBFisherMember, InstituteforAdvancedStudy,Princeton, GREQAM, EHESS, Universit dAix-Marseille lll Gerard Debreu symbolizes the use

e of a new mathematical apparatus, an apparatus comprehended by most economists only abstractly. Nevertheless, his work has given us an improved intuitive understanding of the underlying economic relevance. His clarity and analytical rigor, as well as the distinction drawn by him between an economic theory and its interpretation, have given his work important bearing on the choice of methods and analytical techniques within economic theory on a par with anyotherlivingeconomist. introductionoftheNobellaureateattheRoyalSwedishAcademyofSciences,1983 Thecomplexityofaneconomystandsinsharpcontrasttothesimplicityof a question that must be raised about its operation. Many agents compose the economy, and they have to deal with a large number of commodities. Each one of those agents makes decisions about the quantity of each one of those commodities that he will produce or consume: the number of variablesinvolved is theproduct of the number of agents and the number of commodities. Moreover, in this decisionmaking process the agents act
1

I would like to thank the Institute for Advanced Study for its hospitality and the participants of the HOPE conference for their helpful comments. In particular I have appreciated the valuable remarks of Phil Mirowski and John Chipman.

2 independently of each other, and they are guided by selfinterest. Why is highdisordernottheresult? The agents of an economy are counted in millions, if not billions. The number of commodities is similarly large. The selfinterests of the independent decisionmakers are sometimes in agreement, sometimes in conflict. Why does one not observe for every commodity a large excess of demand,evidenced forinstance, bylengthy waiting times for orders to be filled,oralargeexcessofsupplyoverdemand,evidenced,forinstance,by massiveinventories? Agents no longer make independent decisions, and they interact

with each other, if there are markets for commodities. Their interaction thenreducesthedifferencebetweendemandandsupply. GerardDebreu,Existence1998 AfterthepublicationoftheArrowDebreumodel,economistswereawestruckbythe rigorandconsistencyofthereasoning.Finally,itwasagreed,allthesurplusfleshhad beenstrippedofftheskeletonofeconomictheory,andwenowhadnewlevelsof analyticrigortoliveuptoifweweretobetakenseriouslyastheorists.Thiswasthe evaluationofGerardDebreusTheoryofValue(1959),inparticular,andfew,Ithink, wereinclinedtoquarrelwiththeideathatthewayforwardwasthroughmodification andimprovementofthegeneralequilibriummodel.Afteralongclimbwehadreached anintellectualplateauwhere,ifonecouldbreatheatsuchheights,everyonewouldlike tobe.Indeed,thisideafitswellwithametaphorusedbyEinstein: Creating a new theory is not like destroying an old barn and erecting a skyscraper in its place. It is rather like climbing a mountain, gaining new andwiderviews,discoveringnew connections between our startingpoint

3 and its rich environment. But the point from which we started still exists and can be seen, although it appears smaller and forms a tiny part of our broadviewgainedbythemasteryoftheobstaclesonourwayup. quotedinHahn1974 TherewerenotmanywhowouldhavearguedthatthemountainclimbedbyArrow andDebreuwasnottherightoneandthat,inarelativelyshorttime,evensomeofthe strongerclimberswouldhavereluctantlyconcludedthatwewereonalonelypeakfar fromthepathtracedoutbyearliereconomists.WhatIwillarguehereisthatthebasic frameworktowhicheconomictheoryand,inparticular,demandtheorywasreducedis inappropriateasamodelofeconomicchoice,sinceitdependsonassumptionsabout individualagentsderivednotfromobservationbutratherfromintrospection. Furthermore,theseindividualsareassumedtooperateinanenvironmentdevoidof institutionalcontent.Last,analyticallythemodelcontainedtheseedsofitsown destruction.Iwouldidentifythecrucialmomentatwhichwecommittedourselvesto thisratherfutilepathascoincidingwiththeappearanceofTheTheoryofValue. Thisroutehadthreemainfeatures:first,thecharacteristicsofeconomicagents; second,theenvironmentwithinwhichtheyoperate;andthird,anotionofwhatwould constituteanequilibriumstateofasetofagentsfunctioninginthatenvironment. Supposethat,tosimplify,wesaythatweareinterestedintheallocationsofresources thatareselfsustaininginsomesense,andthatsuchastatewouldconstitutean equilibrium.Byselfsustainingwemightmeanthatnobodyintheeconomywould, giventherulesofthegame,prefertomakeanotherchoice.Thatposestwoimmediate questions.Dosuchstatesexist,andwilltheybeattained?ButalreadyIamjumpingthe gun.Wemusthaveanotionofwhatitmeanstoprefer,andwhattherulesofthegame are.BothofthesehaveevolvedalongthepaththatIexaminebelowandbothhelp explainhowwearrivedatthewrongpeak.

4 Beforeenteringtheheartofthematter,Iwanttoindicatebrieflywhatisinvolved here.Thetheoryofindividualpreferenceshasbeenintensivelydeveloped,notbecause weareinterestedintheintrinsicqualitiesofthosepreferencesbutratherbecauseweare concernedtomodelthechoicesthatthosepreferencesresultin.1Thevarious refinementsandpurificationofpreferenceshavebeenmadewithaviewtomaintaining certainpropertiesofdemandthat,inturn,werenecessarytoguaranteetheexistenceof equilibriumwithinthemarketframeworkIhavealludedto.Thuspreferencesand demandhavebeenintimatelylinked.Thesecondremarkrelevanttothewholeofwhat followsisthatthemarketasaninstitutionhardlyfiguresinthetheoreticalliterature. Indeed,asDouglasNorth(1977,710)says,Itisapeculiarfactthattheliteratureon economics...containssolittlediscussionofthecentralinstitutionthatunderlies neoclassicaleconomicsthemarket. Forthemoment,letmebrieflymentionwhatismeantbymarketinthehistoryof generalequilibriumtheory.Iwillthendiscussthedifficultiesthathavearisenwiththis choiceofframeworkandthencomebacktotheimportanceoftakinganalternative viewandanalternativepath. WhenDebreutalksaboutmarkets,allthathehasinmindisthatthepricesofall goodsatalltimesandinallplacesshouldbedeterminedandknowntoallparticipants intheeconomy.Thisvectorofpricesconstituteswhathereferstoasmarketprices.In particular,heisinterestedinthosepricesforwhichtheexcessdemandiszeroforevery commodity,anditisthesethathereferstoasequilibriumprices,andinthishe followsexactlyinLonWalrassfootsteps.Onthesubjectofhowandbywhomthose pricesareestablished,heissilent,asheisonthesubjectofhowthetradesthat correspondtothosepricesareeffected.Yetthereistheillusionthatsuchconsiderations arepresent.Tobemorespecific,considerthelastpartofthesecondepigraph,which revealswhythemodelproposeddoesnotanswerthequestionposed.Debreusays, Agentsnolongermakeindependentdecisions,andtheyinteractwitheachother,if

5 therearemarketsforcommodities.Theirinteractionthenreducesthedifference betweendemandandsupply.Butthisispreciselythebasicweaknessofthemodel. Nowhereisthereanyexplanationofhowthishappensor,beyondwhatIhavealready said,whatismeantbyiftherearemarketsforcommodities.Yettheseproblemswere centraltothequestionsposedbyWalras,forexample,asDonaldWalker(1996)has pointedout.Indeed,atfirstglance,itseemsthatDebreuisalludingnotonlytothe equilibriumbutalsotoanadjustmentmechanismwhenthepricesarenotattheir equilibriumvalues.YetallwhoarefamiliarwithDebreusworkknowthat,unlike KennethArrow,FrankHahn,andLeonidHurwicz,Debreuwasnotpreoccupiedwith theproblemofhowpricesmightadjusttoequilibrium.Hewasconcernedwiththe existenceofequilibriumandonlyinaverytangentialway,throughhisworkonlocal uniqueness,withitsstability. BythetimethatwehavearrivedatthepeakfirstclimbedbyArrowandDebreu, thecentralquestionboilsdowntosomethingrathersimple.Wecanphrasethequestion inthecontextofanexchangeeconomy,butproducerscanbe,andare,incorporatedin themodel.Thereisaratherarideconomicenvironmentreferredtoasapurely competitivemarketinwhichindividualsreceivesignalsastothepricesofallgoods.All theindividualshavepreferencesoverallbundlesofgoods.Theyalsohaveendowments orincomesdefinedbythepricesofthegoods,andthisdetermineswhatisfeasiblefor them,andthesetoffeasiblebundlesconstitutestheirbudgetset.Choosingthebest commoditybundlewithintheirbudgetsetdeterminestheirdemandateachprice vector.Underwhatassumptionsonthepreferenceswilltherebeatleastoneprice vectorthatclearsallmarkets,thatis,anequilibrium?Putalternatively,canwefinda pricevectorforwhichtheexcessdemandforeachgoodiszero?Thequestionasto whetheramechanismexiststodrivepricestotheequilibriumhasbecomesecondary, andHerbScarfsfamousexample(1960)hadalreadydealtthatdiscussionablow.

6 ThewarningbellwassoundedbysuchauthorsasDonaldSaariandCarlSimon (1978),whoseworkgaveanindication,butonethathasbeensomewhatoverlooked,as towhythestabilityproblemwasbasicallyunsolvableinthecontextofthegeneral equilibriummodel.Themostdestructiveresultswere,ofcourse,alreadythere,thoseof HugoSonnenschein(1974),RolfMantel(1974),andDebreu(1974)himself.Butthose resultsshowthemodelsweakness,notwherethatweaknesscomesfrom.Nevertheless, thedamagewasdone.Whatisparticularlyinterestingaboutthatepisodeisthatitwas scholarsofthehighestreputationinmathematicaleconomicswhobroughttheedifice down.Thiswasnotarevoltofthelowerclassesofeconomistscomplainingaboutthe irrelevanceofformalismineconomics;thiswasapalacerevolution. Howdidwewinduponthispeak,andwhyhasitbeensodifficulttoleaveit? OnmybookshelfsitseveralvolumesofBourbakismonumentalElementsde mathematiques.Notfarfromthemisabookeditedby,amongothers,JohnChipman. AndnearbyisDebreusTheoryofValue.Thethreeepitomizeaviewoftheoretical economicsthatflourishedfromthesixtiestotheseventies.Economicswas,atleastin theviewofthoseinmathematicaleconomicsatthetime,readytobuildastructureas minimalistandabstractasthatprovidedbyBourbakiformathematics.Itisthe emergenceofthisphenomenonthatIwouldliketoexplain.Thefirstelementisthe introductionoftheaxiomaticmethod,somethinginwhichDebreuwasafervent believerandwhichwascertainlynotunrelatedtohisownmathematicaleducationin theshadowoftheBourbakicrowd.Thisdidnotsimplyreducetheexistingframework butchangeditsorientation(seeMirowskiandWeintraub1994).Thesecondisthe natureofthepreferences,whichareheldtocharacterizeeconomicagents.Ifonelooks backtothatclassicbookeditedbyChipmanetal.(1971),oneseeshowfarwehave movedinourvisionofwhatconstitutesrationalchoice.Itwouldbedifficulttoimagine amoreerudite,arid,andinaccessiblevolumethantheirs,yetitwaswidelyconsidered asexemplaryscholarship.Therewaslittlediscussionoftheunderlyingfoundationsof

7 theverynotionofpreferencesbutratheraseriesofcontributionstryingtoestablish variousrelationsbetweenpreferencesanddemand.Onwhatpreferencesare,Hirofumi Uzawa(1971,)sayssimply, Preferencerelations,intermsofwhichtherationalityofhumanbehaviour is postulated, are precisely defined as irreflexive, transitive, monotone, convexandcontinuousrelationsoverthesetofallconceivablecommodity bundles. A demand function associates with prices and incomes those commodity bundles that the consumer chooses subject to budgetary restraints.

Uzawasbasicandimportantcontributionwastoshowthatifademandfunction satisfiestheweakaxiomofrevealedpreference(WARP),thenthereexistsapreference relationfromwhichitisderived.Furthermore,demandfunctionsderivedfrom preferencessatisfyWARP.BothJeanVilleandHendrikHouthakker(seeGardesand Garrouste,thisvolume)hadshownthatanecessaryandsufficientconditionfora demandfunctiontobederivedfrompreferenceswasthatthestrongaxiomofrevealed preference(SARP)besatisfied.Uzawacompletedthepicturebyshowingthat,under certainregularityconditions,WARPimpliesSARP.Thisismorethanalittle disappointing,sinceitwasoriginallythoughtthatrevealedpreferencetheorywas somehowmoresatisfyingthanutilitybasedtheory,sinceitisbased,atleastin principle,onobservablebehavior.Thus,withtheseresults,anavenueoutofthe abstractworldofpreferencerelationssatisfyingcertainaxiomsderivedfrom introspectionwasclosedoff. Onemighthavethoughtthatrevealedpreferencewouldhavelostitsappealafter thisresult,butthiswasnotthecase.Thereasonforthisisclear.Althoughdemand choicesareinfactobservable(inprinciple)intheArrowDebreuframework,an individualisneverfacedtwicewiththesamesituation.Choicesaremadeonceandfor

8 allatthebeginningoftime.Sinceallcommoditiesaredated,seeinganindividual choosingbundlexwhenshecouldhavechoseny;then,subsequentlychoosingywhen shecouldhavechosenz;andthenlater,choosingzwhenshecouldhavechosenxisnot aviolationofWARP,sincethexthatfiguresthesecondtimeisnotthesameastheone inthefirstchoice.Thecommoditiesareavailableatalatertimeandarethereforeno longerthesame.Furthermore,ifanyconsumptiontookplacebetweenthechoices,the preferencesthatdeterminethelaterchoicesmaywellbeaffected.Therefore,ifwe adheretothegeneralequilibriumframework,wecanneveractuallyobservea contradictionwiththehypothesesthatcharacterizerevealedpreference.Theonlyway outofthiswouldbetoposethehypotheticalquestionrepeatedlytoanindividual: whichofthesetwobundleswouldyouchoose?Atthispointtheadvantageofthe observabilityofthechoiceshasbeenlost.Yetrevealedpreferencestillplaysa prominentroleintheoryandintheteachingofeconomics(seeMasColell,Whinston, andGreen1995).Itispromptedbythesimplicitywithwhichitcanbeexplained,and thisisreinforcedbyitswidespreaduseinexperimentaleconomics.Intheexperimental laboratorythepracticeofposingsuccessivehypotheticalchoicequestionsandthen checkingtoseewhetherthesechoicesarecoherentiswidespread.Therearetechnical questions,suchaswhethertopreferSidneyAfriats(1967)strongaxiom,whichis convenientwhenoneisfacedwithafinitesetofobservations.Buttheunderlyinglogic remains:whatwearedemandingofourunsuspectingexperimentalsubjectsisnomore orlessthanwhatwerequireofourtraditionaleconomicagentsendowedwith preferenceswithallthestandardproperties. Moreover,agreatdealofeffortandmathematicalskillwerespentonweakening theconditionsimposedonpreferencerelations.Itwasarguedthatweakeningthe assumptionsinthiswaywouldmakethemmoreacceptable.Littlewassaidaboutthe basicunderlyingassumptionthatindividualsareindeedcharacterizedbysuch preferenceorders.Takingthisasgiven,thegoalwastoweakenthebasicaxiomsas

9 muchaspossible.Today,itisrecognizedthatnoneofthestandardaxioms,evenintheir weakenedform,arederivedfromobservationofchoicebehaviorbutratherarethe resultofpureintrospectionbyeconomists.Yetthisrecognitionhasnothingtodowith recentdevelopments.WernerHildenbrand(1994)citesquotationsfromeconomists suchasLionelRobbins(1935),TjallingKoopmans(1957),andJohnHicks(1956),allof whomwerewellawareofthis.Worse,laterinhislife,VilfredoParetoconcludedthat individualsmakequitearbitrarychoicesandspendtherestoftheirtimejustifying them!Thusskepticismaboutthebasesoftheutilitytheoryonwhichthetheoryof demandisbasedislongstandingamonghighlyreputableeconomists. Ifonedoesembarkonthistheoreticalroute,itseemsnaturaltomakethe assumptionsasweakaspossible.ButParetohimselfwasnothappywiththisinsistence onweakeningassumptionstothemaximum.Hewasstill,forexample,convincedthat theideaofmeasurableutilityhadsomemerit.AsChipman(1973)pointedout,Thus alteringslightlyasuggestivemetaphorofGeorgescuRoegen,justbecausethe equilibriumofatableisdeterminedbythreeofitslegs,wearenotrequiredbyany scientificprincipletoassumethatactualtableshaveonlythreelegs,especiallyifdirect observationsuggeststhattheymayhavefour.Othereconomistsonthesameroad werelessreticent.Hicks,forexample,suggestedthattheprincipleofOccamsrazor shouldalwaysapply,andhewasfarfromalone.Indeed,aswemovedowntheroad fromWalrasandParetoweobserveacleartendencytodothis,andthedrivingforceis noteconomicplausibilitybutmathematicalconvenience.Withtheformalizationand axiomatizationofthebasicmodel,itbecameclearthatwhatwasrequiredfor equilibriumtoexistwassomesortofcontinuityofdemandandhenceofexcess demand.Thiswaswhatpushedeconomiststowardassumptionsofconvexityand continuity.Ifthecontinuityofdemandcouldbeguaranteedbyweakerassumptions thanthestandardones,thiswaswelcomed.Thusthenameofthegamewastofindthe weakestconditionsunderwhichequilibriumexists.

10 Whythisinsistenceontheexistenceproblem?Simplybecausegivenhowthe programwasformulated,thenaturalideawastolookatstatesoftheeconomyand thentocharacterizetheequilibriumstates.Thispreoccupationwasnotnew,butitcame sharplyintofocusintheArrowDebreusetting.Wheneconomiststalkaboutthestateof theeconomy,theymaymeandifferentthings.Dependingontheparticularproblemat hand,theeconomistmaybeinterestedinadetaileddescriptionofsomepartofthe economyormaysimplywishtoexaminesomehighlyaggregatevariables.Atthemost generallevelwemightbeinterestedinspecifyingeverythingabouttheallocationand activityofeveryagentintheeconomy,and,indeed,thiswastheloftyambitionof generalequilibriumtheory.Attheotherendofthespectrumwemightsimplybe interestedinthenumberofpeopleoutofworkorthepricelevel.Theoreticalmicro economistshavetypicallybeeninterestedinthefirstproblemandhavebeen preoccupiedsincetheearly1900swith,forexample,thecharacteristicsofthe competitiveequilibriumofafullyspecifiedeconomy. Itisimportanttorecallatthispointthatallofthistheoryisdevelopedinthe contextoftheperfectlycompetitivesystem.Inthegeneralequilibriummodel,no organizationorspecificationofinterpersonalrelationshipsisassumed.The consistencyofallocationsinthesensethatwhatindividualsreceiveisjustwhatthey desireisachievedbyananonymouspricesystemthatallagentstaketobegiven.Thus thereisnoneedforanyspecificationoftherelationshipswithintheeconomy;theonly wayinwhichagentscommunicateisthroughthepricesystem.Indeed,topursuetheir analyses,economistshavestrippedawayalltheinstitutionaldetailsandstructuresthat werestillverymuchpresentintheworkofbothWalrasandParetoandevenmoresoin theworkofAlfredMarshall.Inparticular,economistshavefocusedontheassumptions aboutindividualcharacteristicsandresultantbehavior,whichwillensureachievingan equilibriumoutcome.

11 Thisis,ofcourse,averystaticviewofeconomics.Evenwhenlookingat economicdynamics,economistshave,ingeneral,concentratedonlookingatsteady statesorequilibriumgrowthpaths.Howdideconomistsbecomesoweddedtothis viewoftheworld?Aneatandclearexplanationofthedevelopmentofeconomictheory inthiscenturywouldbethatitwasessentiallydominatedbytheanalyticmethodsof classicalmechanicsandthatovermostofthelastcentury,physicstriumphedasa modelforeconomics.ThisisindeedtheviewadvancedbyBrunaIngraoandGiorgio Israel(1990)andPhilipMirowski(1989).Inotherwords,thepeak,whichwereachedin theArrowDebreumodel,wasindicatedbysignpostsfromphysics,whichhavebeen theresincethenineteenthcentury.Yet,itseemsreasonabletoask,isthisexplanation justified? EconomicsandPhysics WhatisclearfrombothParetosanalysisandthatofmanyofhiscontemporariessuch asF.Y.Edgeworth,WilliamStanleyJevons,andFranklinFisheristhattheyallshareda convictionthattherewasananalogybetweeneconomicsystemsandthoseofclassical mechanics.Edgeworthwasquiteexplicitinsuggestingthatamecaniquesociale wouldtakeitsplacealongsidethemecaniqueceleste(quotedinCohen1994,90). Jevons(1905,631)saidthateconomicsresemblesphysicsinthattheequations employeddonotdifferingeneralcharacterfromthosewhicharereallytreatedinmany branchesofphysicalscience.Anothercontemporary,JohnElliottCairneswaseven moreexplicit:PoliticalEconomyisaswellentitledtobeconsideredapositivescience asanyofthosephysicalsciencestowhichthisnameiscommonlyapplied(quotedin Cohen1994,42).Hewentontoarguethattheprinciplesofeconomicshaveidentical featurestothoseofthephysicalprinciples,whicharededucedfromthelawsof gravitationandmotion(198).Mirowski(1989),IngraoandIsrael(1990),andBernard Cohen(1994)haveexaminedatlengththevalidityandconsequencesofsuchassertions.

12 Theextenttowhichtheanalogybetweenphysicsandeconomicshasensnared economicsinapositionthatitcouldhaveavoidedhaditfounditssourceofinspiration elsewhereforexample,inbiology,asMarshallsuggestediswelldocumentedby theseauthors.Pareto(1953,185)himselfremarkedthat,whenexaminingtheequations thathavetobesolvedtodetermineaneconomicequilibrium,someonewellversedin mathematicsorphysicswouldsay,Theseequationsdonotseemnewtome,theyare oldfriends.Theyaretheequationsofrationalmechanics.Hewentsofar,intheCours, astodrawupatableofanalogiesbetweenthetwodisciplines. Althoughthisargumentispersuasiveandallowsustoestablishasimpleroute fromWalrastoDebreu,itisnotcompletelyconvincing.Thevisionofequilibriumis subtlydifferentinthetwocases.Ineconomicsitisreallythesolutionofasystemof equations,afixedpoint;inthephysicsinterpretation,atleastthemetaphorofaresting pointofadynamicalsystempersistsas,indeed,itdidinthewritingsofWalrasand Pareto. Intheeconomicsview,agentsinaneconomymaximizesomeconcaveorquasi concaveobjectivefunctionoveraconvexsetdefinedbyparametersoverwhichthey havenocontrol.Thenaturalwaytoanalyzesuchasystemistolookforanequilibrium state,thatis,valuesoftheparametersdeterminingtheconstraintsoftheindividuals andchoicesofthoseindividualssuchthatnoneofthemhasanyincentivetomodifyhis orheractions.Thepassagefromindividualtoaggregatebehaviorissimplyadditive. Furthermore,noexplanationisgivenastohowtheequilibriumcomesabout;thisisthe subjectofstabilityanalysis,whichhasusuallybeenreducedtoexaminingthe convergenceofartificialpriceadjustmentprocesses.Yet,asMichioMorishima(1964,) pointedout, If economists successfully devise a correct general equilibrium model, even if it can be proved to possess an equilibrium solution, should it lack the institutional backing to realise an equilibrium solution, then the

13 equilibriumsolutionwillamounttonomorethanautopianstateofaffairs whichbearnorelationwhatsoevertotherealeconomy.

UniquenessandStabilityofEquilibrium AsIhavesaid,thereisliterallynothingintheArrowDebreumodelabouthowan economyoutofequilibriumcouldattainthatstate.Ifweareinterestedinthatproblem, thenwemustshowhowanonequilibriumpricevectorwouldbealteredtowardorinto equilibrium.Thesimplestadjustmentprocessisthewellknownttonnementprocess suggestedbyWalras,whichhearguedwouldleadnaturallytoequilibrium.He assumedthatthelevelofpricesforwhichthereisapositiveexcessdemandshouldrise andthelevelforthoseforwhichtheexcessdemandisnegative,thatis,forwhichthere isexcesssupply,shouldfall.Thettonnementprocesscanbewrittenasfollows:

pt+1 = pt + Z(pt )
Just writing this expression presents a problem. What is the time involved? The usual argument is that one should think of the adjustment as taking place in virtual time. It is common practice also to write this process in continuous time as
& = Z ( p ) p

Since the time involved is not related to the model, this does not really matter. Yet this is purely artificial. Although it is easy to convince oneself of the basic intuition behind the process, the way in which it works is very odd. Indeed, it usually assumed that no trade takes place until equilibrium prices are established. Wheneveronelookscloselyatthemechanicsoftheadjustmentmechanismsthat havebeenproposed,however,theyalmostallreferbacktoWalras.Theeconomistsjust mentionedsawthemselvesasbeingthedirectdescendantsofWalrasandPareto.Hicks

14 (1939,2),forexample,says,whenhewishestospellouttheadjustmentsonseveral markets, When looking for such a technique, we are naturally impelled to turn to the works of those writers who have specially studied such interrelationsthat is to say the economists of the Lausanne school, Walras and Pareto, to whom, I think, Wicksell should be added. The method of General Equilibrium, which these writers elaborated, was specially designed to exhibit the economic system as a whole, in the form of a complex pattern of interrelations of markets. Our own work is bound tobeinthattradition,andtobeacontinuationoftheirs.

DespitethecontributionofEdgeworth,thewrittenpledgesmodelofWalras,and laterbraveeffortsbyHicks,Hahn,TakashiNegishi,andothers,analysisofsocalled nonttonnementprocesses,inwhichmorerealisticallyeconomicactivityisallowed beforeequilibriumisreached,hasreceivedmuchlessattention.Thedesiretopursuea morerealisticmechanismthroughwhichmarketequilibriumcouldbeattainedled HickstoestablishthewellknownHicksianweekduringwhichtradewouldtake placeatnonequilibriumprices.Inasense,thisisanalternativetoWalrasswritten pledgesmodel,describedindetailbyWalker(2005).Yetinallthenonttonnement adjustmentprocessesproposed,thereisalwayssomeartificialargumentaboutthe consistencybetweenthesignofindividualandaggregateexcessdemandsasthe processproceeds.Ineffect,nobodyisonthewrongsideofthemarket.Thisis disappointing,sincenonttonnementisclearlymorerealisticthanttonnement. However,letusgobacktotheroutethatwasfollowedandleavenonttonnement processestooneside,astheliteraturedid,andassumeforamomentthatweacceptthe artificialttonnementprocess.

15 Ifsuchaprocessdidactuallyconvergetoequilibriumfromanarbitrarystarting point,coulditbesaidthatthingswouldsurelybemuchsimpler?Notreally,because thefundamentalproblemisthattheconditions,whichareknown,whichguaranteethe stabilityofthisprocess,cannotbeobtainedfromassumptionsonthebehaviorofthe individuals.Tobeabsolutelyclear,whatSonnenschein(1972),Mantel(1974),and Debreu(1974)showedisthatthereisnohopeofageneralresultforstability,sincethe onlyconditionsontheaggregateexcessdemandfunctionthatcanbederivedfromeven thestrongestformoftheassumptionsonindividualpreferencesarethewellknown four:continuity,Walrasslaw,homogeneityofdegreezero,andboundaryconditions thatguaranteethataggregateexcessdemandexplodesifanypricegoestozero.Since therearefunctionssatisfyingtheseconditionsthatarenotstablewithrespecttothe ttonnementprocess,andthatdonothaveauniqueequilibrium,theseproperties cannotbeguaranteedbytheassumptionsonindividualcharacteristics. ThefullforceoftheSonnenschein,Mantel,andDebreu(SMD)resultisoftennot appreciated.Withoutstabilityoruniqueness,theintrinsicinterestofeconomicanalysis basedonthegeneralequilibriummodelisextremelylimited.Morishimasobservation aboutstabilityiswelltaken,butformacroeconomistsuniquenessisalsoimportant. Comparativestaticsinwhichonecomparesequilibriumandanotherone,predicated onachangeintheparameters,makesnosenseinthepresenceofmultipleequilibria. Theusualwayoutofthisproblemistoassumearepresentativeagent,andthis obviouslygeneratesauniqueequilibrium.However,theassumptionofsuchan individualisopentofamiliarcriticisms(Kirman1992;Stoker1995),andrecoursetothis creatureraisesoneofthebasicproblemsencounteredontheroutetotheplacewhere generalequilibriumhasfounditself:theproblemofaggregation.Infact,weknowthat, ingeneral,thereisnosimplerelationbetweenindividualandaggregatebehavior,and toassumethatbehavioratonelevelcanbeassimilatedtothatattheotherissimply erroneous.

16 Atthispointitisworthmentioninganattempttorestoresomestructurethathad beenabstractedawayand,hence,toovercomethedifficultiesproducedbythefactthat uniquenessandstabilityofequilibriacannotbeguaranteedinthebasicmodel. Interestingly,thisstemsfromideasadvancedalreadybyAugustinCournot.This approachsuggeststhat,iftheeconomyconsistsofalargenumber(necessaryforprice takingbehaviortomakesense)ofsufficientlyheterogeneousagents,thenproperties likeuniquenessandstabilityofequilibriummayberestored(Grandmont1987,1992; Hildenbrand1983,1994).Structuremaybeintroducedintoaggregatebehaviorbythe presenceofsufficientdifferencesbetweenthecharacteristicsoftheagents.Thereis,of course,animportantdeviationfromtheconventionalroutehere,theideabeingto introduceassumptionsonthedistributionofpreferencesratherthanontheindividual preferencesthemselves.Unfortunately,thisapproachhasnotyetledfar,asrecentwork byEtienneBillettedeVillemeur(1998)andHildenbrandandAloisKneip(2005)has shown.Theproblemseemstoresidewiththedefinitionofheterogeneity.Whathas beenshownsofarbyHildenbrandisthatheterogeneityofbehaviorbecauseof particularincomedistributionsimposesstructure,aversionofthelawofdemand,on aggregatebehavior.Whathasnotbeenshown,asyet,ishowonecanmake assumptionsonthedistributionoftheunderlyingpreferencesinthestandardmodel thatwillguaranteethedispersionofbehavior.Itisconceivablethatdispersionofthe parametersofutilityfunctionsmaywellnotleadtodifferentbehaviorofthe individuals.TheincreasingdispersionintroducedbyGrandmontessentiallymakesthe economybehaveasifitwereonegiantCobbDouglasindividualandtherepresentative agentappearsagain.However,mybasicargumentherewouldbethatthedifficulties withthebasicmodelaretoofundamentaltobesolvedbysuchassumptionsonthe distributionofcharacteristics. AnotherargumentthathasbeenusedtodiminishtheimpactoftheSMDresultis thatofDonaldBrownandRosaMatzkin(1996).Theyarguethatexcessdemandshould

17 bethoughtofasdependingonbothpricesandincome,andthatdoingthiswillimpose somestructureonaggregateexcessdemand.Totakethesimplestexample:suppose thatweboundendowmentsandtheninsistthatconsumptionshallnotbenegative; thenwemayhaverestrictionsonpossibleexcessdemandfunctions.Atthispointthe argumentbecomesalmostphilosophical.WeknowfromanearlyresultofAlanKirman andKarlKoch(1986)thatwecanpositafunctionandanincomedistributionandstill findaneconomythatcorrespondstoit.However,whatisalsotrueisthat,todothis,we cannotboundtheresourcesapriori.Chipman(thisvolume)givesanelegantaccountof relatedproblems.Fewwill,Ithink,findthatthebasicmessageoftheSMDresulthas beenreallyweakened.AsHahn(2002,224)haswritten,whentalkingoftheattemptsto establishstabilityresultsandreferringtotheSMDresult,Theenterprisewasdoomed nottobecapableofreachinggeneralconclusionsintheWalrasiansetting.Atheorem notdirectlyrelatedtoconnectedwithdynamicsdidthedamage.Havingexaminedthe weaknessofthegeneralequilibriummodelanditsincapacitytotellusanythingabout thefunctioningoftheeconomyoutofequilibrium,wemightaskwhetherwecannot establishthesourceofthedifficulty. InformationandStability OneofthemajorattributesofgeneralequilibriumtheoryalsorevealsitsAchillesheel. Itisoftenassertedthatoneofthemajorachievementsofgeneralequilibriumtheoryis itsabilitytodemonstratethatthecompetitivemechanismisremarkablyparsimonious intermsoftheamountofinformationthatituses.Suchanobservationiscouchedin termsofthemechanismdesignliteraturebecauseofHurwiczandothers(fora discussionofthemechanismliterature,seeLee,thisvolume).Amechanismfor attainingallocationsforagiveneconomicenvironmentspecifiesthemessagesthathave tobetransmittedbytheeconomyandthenamappingthattranslatesthosemessages intoallocations.Themeasureofhowmuchinformationsuchamechanismusesis

18 consideredtobethedimensionofthemessagespace.Supposethatweareinterestedin attainingParetoefficientoutcomes.Weknowthattheoutcomesofthecompetitive processachievethis.Thestandardtheoremderived,initsmostgeneralform,from Jordan1982saysthatthecompetitivemechanismneedsamessagespacewith dimensionn(l1),wherenisthenumberofagentsandlthenumberofgoods.Thisis quiteremarkable.Toseewhythisisso,considerasimpleexchangeeconomy.At equilibriumeveryagentexceptone(sinceatequilibriumitisenoughtoknowtheexcess demandsofn1agents)needstotransmithisvectorofexcessdemands(l1goods becauseofWalrasslaw),and,thankstothehomogeneityofdegreezeroofexcess demandfunctions,avectorofl1pricesisneeded.Thisresultseems,atleastatfirst sight,tojustifytheclaimsfortheefficiencyofthecompetitivemarketmechanism,since onecanshowthatnoothermechanismthatachievesParetoefficiencyusesless information.Thisresultcanbeextendedtoincludecasesinwhichweareinterestedin attainingallocationsthatsatisfyothercriteria. Forexample,consideraveryoldproblemineconomics,thatinwhichoneis interestedinmechanismsthatnotonlywillachieveParetoefficiencybutwillalsobe fairinthesensethatnoindividualpreferssomeoneelsesallocationtohisorherown. Thiswouldseemtobeaverydemandingrequirementintermsofinformation,since everyindividualmustbeabletocomparehisorherallocationwiththatofalltheother agents.Nevertheless,onecanshowthatamechanismwithamessagespaceofonlynl dimensionscanachievethisresult(CalsamigliaandKirman1993).Inotherwords,the informationrequiredishardlymorethanthatusedbythecompetitivemechanismto achieveParetoefficientoutcomes.Thesecretofthisresultistousethecompetitive mechanismfromanequaldivisionofresources.ThustheWalrasianmechanismpermits anenormouseconomyofinformation.Onemightarguethatthisisastrongreasonfor thinkingthatwehavenotcomedownthewrongroad,andthatthosewhodefendthe modernversionofgeneralequilibriumanalysisarejustifiedindoingso.Inmyview

19 thisiswrong;toseewhy,onehastorecallthattheresultsjustmentionedshowonly thatlittleinformationisneededfortheeconomytofunctionatequilibrium.Butwhat thissaysisthatiftheeconomyisactuallyatanequilibrium,theamountofinformation neededforittofunctionisverylimitedindeed. Butwhatshouldinterestusaseconomistsisnotonlyhowinformationally demandingthemechanismisatequilibriumbutalsohowmuchinformationitrequires togetthere.Wefindourselvesbackattheproblemofstability,onethat,anditisworth insistingonthisagain,Debreuconsistentlyavoidedandindeedlaterclaimedthathe hadalwaysconsideredtobebeyondhope.Yet,asIhavealreadysaid,itissurelythe casethateconomicequilibriaareofinterestonlyiftheycanbeattainedthrougha reasonableadjustmentprocess.Soifwewanttoaskthequestionastohowmuch informationisinvolved,wehavetorethinktheoriginalproblemintermsoffindingan adjustmentprocessthatwillmodifythemessagesandbeguaranteedtoachievePareto efficientoutcomes.Aswehaveseen,thettonnementprocessfromaneconomicpoint ofviewhasabasicproblem.TheSMDresultshowsthattheequilibriaofeconomiesare notnecessarilystablewithrespecttothatprocess.Itisthennaturaltoarguethatthe problemlieswiththeadjustmentprocessratherthanwiththegeneralequilibrium model.Ifamoregeneraladjustmentruleweretobespecified,perhapstheequilibriaof theeconomycouldbeshowntobestable.Yetwhatbecameimmediatelyclearafterthe innovativeworkofSteveSmale(1976)wasthatstabilitycouldbeachievedonlyatthe priceofanenormousincreaseintheamountofinformationrequired.2 SmalesglobalNewtonmethodextendsstandardmethodstoallowonetofinda fixedpointofamapping,suchasanaggregateexcessdemandfunction,ifonestarts sufficientlyneartheboundaryofdefinition.Ithastwomajordrawbacks.First,itdoes notbehavewellintheinteriorofthedomainthat,inthecaseunderconsideration,isthe spaceofallstrictlypositiveprices.Second,asalreadymentioned,itusesagreatdealof information.Whatisneeded,ateachpointintime,isknowledgeofallthepartial

20 derivatives,andthisgreatlyincreasesthesizeofthemessagespace,without guaranteeingconvergencefromanyarbitrarystartingpoint.Anadditionalobjection wouldcontendwiththeeconomiccontentoftheprocess.Whiletheoriginal ttonnementprocesshasanaturalinterpretation,thisisnotthecase,despitetheefforts ofHalVarian(1977),fortheNewtonmethods. DotheinformationallydemandingrequirementsoftheNewtonmethod representanecessaryevil?SaariandSimon(1978)askedthefollowingquestion:can onefindwhattheycalledlocallyeffectivepricemechanisms,thatis,onesthatturnall economicequilibriaintosinksorattractorsandthatuselessinformationthanthe Newtonmethods?Theyproved,unfortunately,thatthiscannotbedone.Thisisodd, sincethegeneralizedNewtonmethodhastheundesirableandrestrictivepropertythat itreducesexcessdemandsmonotonicallyandthatanysinglemarketinequilibriumis keptinequilibrium.Onemighthavehopedthat,byrelaxingthisrequirement,one couldhavefoundlessinformationallydemandingmechanisms. AsJimJordan(1986)pointedout,allthealternativeadjustmentprocessesthat hadbeenconstructedatthetimehewrotehadnonaturaleconomicinterpretation. Therehavebeenmanyeffortstoconstructgloballyanduniversallystableprice adjustmentprocessessincethen,andinacertainsenseKazuyaKamiya(1990),Gerrit vanderLaanandDolfTalman(1987),PeterFlaschel(1991),JeanJacquesHerings (1995),andJanTuinstra(2002)havesucceeded.Yetifonelookscloselyattheseresults, thereisalwayssomefeatureopentoobjection.InKamiyascasetheexcessdemand functionisartificiallydefinedoutsidetheoriginalpricedomain.InFlaschelscasethe adjustmentprocessdependsonaparameterthatvarieswiththeeconomy,and,indeed, hesaysthatitistoomuchtohopethatonewouldfindaprocessthatwouldworkforall economies.Heringssmechanismhasthecuriousfeaturethatpricesareadjusted accordingtotherelationbetweencurrentpriceandthestartingprice.Allofthisseems, tomeatleast,tosuggestthatthereisnohopeoffindinganeconomicallyinterpretable

21 adjustmentprocessthatwillconvergefromanypricevectorindependentofthe economy.Indeed,onecharacterizationofSaariandSimonsresultistosaythatany adjustmentprocessthatwouldleadtoanequilibriumfromanarbitraryinitialprice vectormustuseaninfiniteamountofinformation!3 Wheredoesallthisleaveus?Itappearsthattheinformationalrequirementsof adjustmentprocessesaresoextremethatonlyeconomyspecificprocessesareplausible. Thisishardlyreassuringforthosewhoarguefortheplausibilityoftheequilibrium notion.Anychangeintheparametersofaneconomywouldentailachangeintheprice adjustmentmechanismthatwouldkeeptheeconomystable.Ifweareinterestedin describingastablesystem,thentheargumentsforthegeneralequilibriummodelasone thatisinformationallyefficientareillusory.Theveryfactthatweobserve,inreality, increasingamountsofresourcesbeingdevotedtoinformationalacquisitionand processingimpliesthatthestandardgeneralequilibriummodelandthestandard modelsoffinancialmarketsarefailingtocaptureimportantaspectsofreality. Alternatively,onecouldarguethateconomiesarenot,ingeneral,stableinthissense.If oneacceptsthispointofview,thenonehastofocusonthedisequilibriumdynamicsof economies,asacertainnumberofauthorshavedone,butthistrackhasbeenregarded asadetourfromthemainstream. TheNatureofPricesandtheStabilityProblem WhatIhavejustarguedisthatthereissomethingproblematicabouttheverystructure ofthegeneralequilibriummodelifwewanttogobeyondmereexistenceof equilibrium.Therealissuehereismuchdeeper,however,andthedifficultieswith stabilitythatIhaveoutlinedaresymptomaticofmorefundamentalconceptual problems.Withveryfewexceptions,theliteratureonthestabilityofeconomic equilibriumconsiderstheevolutionovertimeofapricevector,thedimensionofwhich correspondstothenumberofcommodities.YetintheArrowDebreumodelsuchtime

22 isundefined.Timeisarguablypresentinthatcommoditiesaredated,buttoconsider adjustmenttotheequilibriumpricesweneedanothernotionoftime.Withrespectto timeinthemodel,adjustmentmustbeinstantaneous.Onecouldthinkofthisas physicistsdo,ofequilibriumpricesbeingonasurfaceandofanadjustmentprocess,by rationingquantities,forexample,asleadinginstantaneouslytothatsurface.4Yetthis wellknownproblemsimplyreflectstheunrealisticorientationofthebasicmodel.More disturbingaretheobviousquestions:whatarepricesatanymomentintimeandwho setsthem? Inalmostanymarketonecanthinkof,thereisnovectorofpricesofcommodities atanyonetime.Differentpricescoexistforthesamecommodityunlessonetakes absolutelyliterallythedefinitionofcommodityinthetheoryofvalue.Individualsset theseprices,andtheymodifythemaccordingtowhatishappeningonthemarket.Rare arethemarketsinwhichsomecentralclearingmechanismexiststomatchdemandand supply.Considerfinancialmarketsthatfunctiononadoubleauctionbasis.Atanypoint intimeabidismatchedwithanofferandatransactiontakesplace.Thepriceatwhich thistransactiontakesplaceisinnosenseanequilibriumprice.Allthosewhomight havewishedtotransactatthispricewouldnotnecessarilyhavebeensatisfied,yetitis thispricethatappearsinthehighfrequencystockpriceseries.Whathappensatthe nextpointintime?Theothertradersobservethepriceandthetransactionandnow decideonwhattobidortooffer.Thusnewbidsandoffersaremadethatmayreplace thosemadeinthepreviousperiod.Whatisimportanthereisthatthetradestaking placeateachpointrevealinformation.Whydidthattraderpurchasethatshareata pricethatIwasnotwillingtopay?PerhapshehadinformationthatIdonothave?Such inferencesmayhaveimportantconsequencesfortheevolutionofprices.(SeeChamley 2004foracomprehensiveaccountofthisproblem.)ThecontrastwiththeArrow Debreumodelisstriking.Forexample,transactionstakeplacesequentially,and,ateach point,agentsobservewhatotheragentsaredoing.Theythenobtaininformation,and

23 thisinfluencestheirsubsequentconduct.Thusthereisinteractionamongtheagents otherthanthroughapricesystemthateveryoneacceptsasgiven.Suchinteractionisan essentialfeatureoftherealeconomybutislargelyabsentfromeconomicmodels,and thisisparticularlytrueformoststandardmacroeconomicmodels. Wastheabstractionfromsuchconsiderationsaninevitableresultofthe formalizingprocessthatculminatedintheArrowDebreuresult?Ifonereadsthe Chipmanetal.(1971)volumetowhichIreferredearlier,oneisstruckbytheinsistence ontheideathattheargumentspresentedarederivedfromtheworkofGiovanni Antonelli,VilfredoPareto,EugenSlutsky,PaulSamuelson,andHendrikHouthakker. Soonemighthavetheimpressionthatthesepioneersandothersalongtheroadwere notreallyinterestedinhowmarketsactuallyfunction.Twoobservationscanbemade aboutthis.First,thisisacarefullyselectedlistofpioneers,eachofwhomindeed markedamilepostontheroutetotheaxiomaticapproach.However,thereweremany otherssuchasWalrashimself,Paretoinotherphases,Marshall,andHickswhohada verydifferentvisionofhowtheeconomyshouldbemodeledanddevotedagreatdeal oftheirworktothefunctioningofmarkets.Again,oneshouldinsertacaveatatthis point:althoughtherewasmuchdiscussionofthenatureandfunctionsofmarkets,there wasratherlittlediscussionoftheempiricalrealitiesofmarketfunctioning.Anexample ofthisisWalrassdescriptionoftheParisbourse,which,asWalker(2005,14142) pointsout,showsanimportantmisunderstandingofthewaythatinstitution functioned.Tradetookplaceatnonequilibriumprices,andeventhenotionofwhatthe equilibriumpricewasisnotwelldefined.ThisdidnotstopWalrasandmanyofhis successorsfromarguingthattheirpurposewastounderstandrealeconomic phenomena.EventheliteraturefromWorking1927on,discussingtheestimationof empiricaldemandfunctions,doesnothavemuchdiscussionofwhatsortofmarkets generatedthedata.ThatliteraturewaslargelydetachedfromtherouteIhavebeen discussingbutwas,also,inmanywaysempiricallydeficient.5

24 Itisanopenquestionastowhetherthosewhodidnotpursuetherouteallthe waytothetopweresimplydiscouragedbythedifficultyoftheformalismorwhether theyweredissatisfiedwiththecapacityofthetheorytomatchtheempiricalfacts.What isprobablybeyonddisputeisthatthosewhodidfollowthehighroadtotheaxiomatic approachwerethosewhowerelessconcernedwiththepracticaldetailsofeconomic reality.Yetevenwhenonefindsoneselfonapeacefulpeakintheintellectuallandscape, thisshouldnotpreventonefromtracingtheroutebacktothebusyplacefromwhich onestarted.Whatisimportantisnottolosesightofthefactthattheremaybeother routes,stillmuchtraveled,whichleadelsewhereandfurther.Inpursuingaparticular routeonemaylosesightofimportantfeaturesofthelandscape.AsIhavejust mentioned,theproblemofwhosetsthepricesisabsentfromtheArrowDebreumodel, andthetreatmentsofthisquestionbyeconomistsareworthexamininginthisregard. Onecouldarguethatthemostimportantquestionthatdisappearedasthe perfectlycompetitivemodelcametodominatetheneoclassicalscenewaswhosetsthe prices?Thefictionofanauctioneerisnotanadequatedescriptionformanymarkets, andthebasicproblemofwherepricescomefromisonlytreated,andthisissignificant, inwhataredescribedasmodelsofimperfectcompetition.Iftheeconomicagentsset pricesthemselves,thenweclearlyhavetodispensewiththenotionthattheytakethem asgivenandtoreturntothepreviousdiscussion,which,inturn,wasnotconsistent withthemechanismconceptthroughwhichinformationalefficiencyisobtained. Althoughtheideathatpricesadjustinsomesystematicwayinresponsetoexcess demandhasbeencommonplace,sincethelatterpartofthenineteenthcenturylittle attentionhasbeenpaidtohowthisisdone. Ofcourse,thereisaliteratureinwhichindividualsmeet,bargain,trade,andthen continuetocirculateinthemarketuntilallprofitableopportunitiesareexhausted.The workofFisher(1989),andofArielRubinsteinandAsherWolinsky(1985),isverymuch inthisspirit.Undercertainconditions,suchmeetingandbargainingprocesseswill

25 convergetothecompetitiveoutcome.However,pricesnowplayaverydifferentrole,as theyaretheresultsofbargainsbetweenindividualsandarenotanonymoussignals observedbyindividualsinisolation.Onlyasthisprocesscontinuesovertimecanthe pricesbethoughtofasindicatingthetermsoftradeavailableinthemarket. Thereisafurtherliteraturethatrecognizesexplicitlythatdifferentpricesmay existforthesamegoodonamarket(see,e.g.,Diamond1989)andthenlooksatwhat mightbeanequilibriuminsuchamarketinwhichindividualssearch,atacost,tofind thelowestprice.Anumberofauthorshaveshownthatpricedispersionmaypersist. Hereonecantaketheviewthatthemarketsignalisnowthedistributionofprices ratherthanthepriceitself,butthesemodelscan,atleast,allowforthesellerstosettheir prices.TheonlypointthatIammakinghereisthatalongtheroadfromWalrasto ArrowDebreuthereweremanyturns,amongtheseonesthatsoughttotakeexplicit accountofhowpricesareformed.Forthoseofusinterestedinhowtheeconomys activitiesarecoordinated,thoseotherroutesnowlookmoreattractive. Market Organization Uptothispoint,theonlyfeatureoftheeconomythatsomehowgotlostontheroadto thepuregeneralequilibriummodelishowpricesareset,andithastobeadmittedthat ourtheoreticalancestorsdidnothaveagreatdealtosayaboutthiseither.Butmuch morebasicisthequestionastohowthetradesnecessarytoclearthemarketsare organized.Intheabsenceofanycentralauthority,howdothosewithexcesssupplyat thecompetitivepricefindandtradewiththosewithexcessdemands?Exceptforvery specialmarketssuchasthatforgold,theWalrasianauctioneerwhoequilibratesthe marketafterreceivingbidsandoffersfromallagentscannotbeinvokedasareasonably realisticdescription.Whatthissuggestsisthatmarketorganizationisimportantand thatthepricesobtaininginamarketandtheirinformationalcontentmaywelldepend onthatoutcome.AsWalker(1996)clearlyexplains,Walraswaspreoccupiedwithhow

26 exchangesandcommunicationinmarketsareorganized.Althoughthestandard paradigmreferredtoasWalrasianisnormallytakentobeoneinwhichindividuals receivepricesfromsomeunspecifiedsourcesuchasanauctioneer,Walrasinfactnever specifiedsuchanauctioneer,and,indeed,eachofhismodelsspecifiescarefullyhow individualsmeetandchangeprices.Marshall(1938)isalsoatpainstopointoutthe importanceofhowmarketsareorganizedforeconomicoutcomes.FriedrichHayek (1989)suggestedthatorganization,ororder,isanemergentphenomenonandargued thatwhatisknownasthemarket,inmodernterms,wasbutoneformofspontaneous order.Hemaintainedthatthisformoforganizationwassuperiortoothers,thereby makingexplicitlythepointthattheefficiencyofoutcomesisintimatelylinkedtohow theeconomyisorganized. Forexample,consideranindividualwhowishestoselloneormanygoods(the

classicexampleisthatofthesaleofgovernmentbonds).Theindividualhasachoiceof differentmechanismstodothis.Whichoneshouldheorshechoosetomaximize revenue?Anumberofauthorsshowedsometimeago(see,e.g.,RileyandSamuelson 1981,MilgromandWeber1982,orMcAfeeandMcMillan1987)that,intheabsenceof transactioncosts,anauctionwithreservepriceistheoptimalsellinginstitutioninthe sensethatitachievesthehighestyieldtotheseller.Oncecostsareintroduced,the situationbecomesmorecomplicated,andindeedithasbeenshownthatpostedprices maybepreferableifthecostsofimplementingauctionsaretoohigh. Thepointinsistedonhereisthattherelationshipbetweenpricesandmarket

organizationisimportant.Sincedifferentmarketmechanismscanyielddifferentprices forthesamegood,theroleofpricesneedstobereevaluated.Furthermore,itwould seemthepriceachievedwilldependontheinformationavailableinthemarket.If individualsevaluationsofgoodsarethesame,neitherthepricesnortheoptimal mechanismwillbethesameasinthecasewherevaluesareprivate,particularlyifthey arenotdrawnfromsomeknowndistribution.EricMaskinandJohnRiley(1989)

27 demonstratehow,byusingacleverpricingschedule,amonopolistwhohasseveral unitstosellcanachieveabetteryieldthanbyusinganauctionifhisclientshave downwardslopingdemandcurves.Thequotationmarksaredeliberate,since demandhastobecarefullydefinedinthissortofsituation.Thuseveninthecasewhere weacceptastandardmodelinwhichconsumersdemandisderivedfromthe maximizationofutility,theanalyticcategoriesofmechanism,information,andpriceare intimatelyrelated.Onecannottalkofequilibriumpricesindependentlyofthemarket organization.Ifoneacceptsthispoint,thentheassumptionoftheanonymous,perfectly competitivemarketisfarfrominnocuous.Settingononesidethenatureofmarkets leavesasignificantholeinanyattempttoexplaineconomicphenomena. Indeed,themajorcontributiontoeconomicthoughtmadebyDouglassNorth (1990)wastoinsistthatmarketinstitutionsareimportant.Totheanthropologist,such anassertionseemstrivial.6Butforthetheoreticaleconomistitismuchlessso.Northis atpainstoexplainthatcloseranalysisofinstitutionsisessentialtoeconomichistory, whileeconomictheorytendstofocusontimelessandfrictionlesstransactions.He suggests,therefore,thatinstitutionalanalysisisanappropriatewaytousesomeofthe lessonsfromstandardeconomictheoryineconomichistorybutdoesnotgoonto suggestthattheoryitselfmightneedtobesubstantiallymodifiedinlightofthe institutionalconsiderationsthatheraises.Hisemphasisisontheconstraintsand incentivesprovidedbyinstitutionalorganizationbutnotontheneedtopursue differentavenuesthanthatassociatedwiththegeneralequilibriumapproach. Infact,IwouldbeinclinedtofollowMirowski(2006)andsuggestthatwhatwe arefacedwithisamultitudeofcoexistinginstitutionsthatwemaycaretocallmarkets, butthatthereisnostandardmarket.Eachinstitutionevolvedforsocial,cultural,and economicreasons,andtheymayproduceverydifferentresults.Thenetworksoftraders thatdevelopvaryacrossmarkets,andevenwherethemarketissupposedtobe essentiallyanonymous,asinmanyelectronicmarkets,tradersoftenconcentraterapidly

28 onasmallgroupwithwhomtheyinteractregularly.Eachmarketwithitsown characteristicsandnetworkislinkedtoothers,anditisthistissueoftradethat organizesitselftogoverntransactionsandtheallocationofresources.7Demand,inthis view,isnotdefinedinanysimpleandgeneralwaybutdependsontheinstitutional frameworkinwhichitisexpressed.WhilethispicturecorrespondstoWalrass preoccupationswiththeinteractionbetweenvariousmarkets,itissurelyverydifferent fromtheportraitthatheinscribedinhisequations. TimeandItsRole Ihavelefttolasttwoproblemsthatseemtometobecrucialinthehistoryofdemand, theroleoftimeandsocialinteraction.AsIhavementioned,timehasnorealroleinthe ArrowDebreumodelotherthantodatecommodities.Anynotionofanevolutionofthe systemislargelyabsent.Justdatingafinitenumberofcommoditiesisnotaserious acknowledgmentofthetemporalcharacterofexperience,andtheextensionbyTruman Bewley(1972)toaninfinityofcommoditiesdoesnotsolvetheproblemofhowpeople dealwiththefuture.Yetifwecannotsaysomethingclearaboutthis,ournotionof demandissimplynotwelldefined. Toassumethatpreferencesaregivenfromtheoutset,whentimeispresentinthe model,isclearlyunrealistic.Therehasbeenwidespreadrecognitionwithinrecent economictheorythattheeconomicagentisnotanunchangingindividualwhose characteristicsarecapturedbyawelldefinedsetofpreferencesthatdonotevolveover time.Thisrecognitionunfortunatelyhasnothadmuchimpactoneconomictheory. Havingpreferencesfixedonceandforalltimeinvolvesathoughtexperimentthat representsachoicebetweenalternativeselvestiedtotimeandcircumstances(Mirlees 1982,65).Thisrequires,asJamesMirleesobserves,thattheagents preferenceregardingwhathewillbedoingatoneparticulartimeinone particularsetofcircumstancesbeindependentofwhathemaybeplanningfor

29 allothertimesandcircumstances....[Hethusacknowledgesthat]everything thathastodowithlifeasaconnectedwholesuchashabit,memory, preparationforfutureaction,anticipation,achievementandfailureseemsto havebeenignored.(66) Yettoconsiderpreferencesthatevolveovertimeisaseriousmoveawayfrom thestructureofthegeneralequilibriummodel.Atonepoint,Guinnesshadarather successfuladvertisingcampaignbasedonthesloganIdontlikeGuinness.Thatswhy Ihavenevertriedit.Thisline,whichalwaysprovokesanamusedreaction,shouldnot seemabsurdtoaneconomist.Sincewehavewelldefinedpreferencesoverthewhole goodsspace,thissortofstatementisperfectlyconsistent.Inthestandardmodel preferencesarenotformedbyexperience;theyaregivenfromtheoutset.Theagents characteristicsare,inthisrespect,fixedandimmutable,andindependentofthose aroundhim.Thisisalsoanideawithearlyorigins.ThomasHobbes([1651]1949,)said, Letusreturntothestateofnatureandconsidermenasifsprungoutoftheearth,and suddenly,likemushrooms,cometofullmaturitywithoutanykindofengagementto eachother.Theideathatpreferencesmightdependonexperience,andevenother changingfeaturesoftheenvironment,posesarealquestionwhenoneistalkingabout intertemporaloptimizationand,inparticular,thecausalmaterialfromwhichcurrent demandisderived.Theideaofretainingtheoneperiodutilityfunctionandthen simplymaximizingthesumorintegralofthediscountedutilitiesovertime,proposed bySamuelson(1937),addedmore(unrealistic)structuretothepreferencesof individualsbutdidnotnecessarilyleadtosteppingoutofthebasicframework.He himselfwassurprisedthatthissimplisticideaencounteredsomuchsuccess.Yetthis attempttoadddynamicpropertiestothegeneralequilibriummodelhasrunintomajor difficulties.Experimentshaveshownthatpeopleseemtoviolatetheconclusionsofthis extendedmodel,and,recently,muchattentionhasbeengiventothefactthat

30 individualsseemtoplaceundueweightonthenearfuture,andformanyphilosophers thisvisionofthehumanissimplyincoherent(seeFrederick,Loewenstein,and ODonoghue2002foracomprehensiveandelegantaccountofsuchproblems).Despite valiantattemptstorescuethemodelbyintroducingsuchnotionsashyperbolic discounting,toomanyquestionsremain.Thosewhoinvestigatethiskindofquestion havejoinedthealternativepathsofthepsychologistsandphilosophers. Toputtheprobleminperspective,thinkoftheArrowDebreuworld.Ifone wantstopreservethatframework,onehastosaywhatitisthatindividualswishto optimizetomaketheirchoices.Iftheirfuturepreferencesaresubjecttocomplicated changes,whichare,inpart,endogenous,theproblembecomesoverwhelming.Within thestandardmodelweavoidthisbyassumingthatpreferences,wherevertheycome from,areunchanging.Yetthelatterassumptionwascertainlynotthatmadebysomeof ourdistinguishedpredecessors.Toshowthattheroutegoesbackalongway,consider thefollowingquotationfromPlato: A man is said to be the same person from childhood until he is advanced in years: yet though he is called the same he does not at any time possess thesameproperties;heiscontinuallybecominganewperson...not only in his body but in his soul besides we find none of his manners or habits, his opinions, desires, pleasures, pains or fears, ever abiding the same in his particular self, some things grow in him while others perish. (Symposium,207D208B) Furtherdownthisroad,DavidHume([173940]2000,1.4.6.3)statescategoricallythat whenhelooksintohismostintimateself,hedetectsnothingbutabundleorcollection ofdifferentperceptions,whichsucceedeachotherwithaninconceivablerapidity,and areinperpetualfluxandmovement.Thereisnothingthatremainsthesameover time.Eventhougheachofusbelieves(orlikestobelieve)ourselvestobethesameand

31 identicalpersonovertime,oursupposedidentityisbuiltupthroughcontinuous change.ForHume,wearelikeatheaterinwhichthereisacontinuingsequenceof playsandscenes.Tothinklikethisdoesnotrepresentarevolutionbutsimplystepson aroute,whichisverydifferentfromthatleadingtoArrowDebreubutnevertheless longandwelltrodden.Thereisanextensiveliteratureontheideathatanindividuals identitychangesovertime,and,indeed,philosophersandeconomistshavebeen preoccupiedbywhatitisthatdoesnotchange.8 Now,ifweagreeonthefactthatinthefaceofanindividualsfutureidentity, whichwillreflectlittleofhisorhercurrenttastes,thatindividualisfacedwithataskof momentousproportionsinformulatingchoices,theneitherwehavetoembarkonone ofthenumerousalternativeroutesorwehavetofindawaytostayonthegeneral equilibriumstandardrationalityone.Howmightwesaveouroptimizingagentsinthe complicatedproblemofhavingtooptimizewithrespecttopreferencesthatare evolvingovertime?Thereisoneideathatmightjustifystayingwherethegeneral equilibriumpathhastakenus:thatindividualsdonotoptimizebutsimplylearnfrom experiencehowtomakethebestchoices.9Theeconomicindividualmakeschoices accordingtosimplerulesdevelopedfromhisorherexperiences.Thusindividualsare notoptimizers,theyareadaptiveandonlybehaveasiftheyoptimize.Ifthe underlyingpreferenceschange,theindividualwilllearntomakechoicesthat accommodatethis. LearningtoBeRational ThisviewisadmirablysummarizedbyRobertLucas(1986,S401)whenhesays, Ingeneralweview,ormodel,anindividualasacollectionofdecision rules(rulesthatdictatetheactiontobetakeningivensituations)anda setofpreferencesusedtoevaluatetheoutcomesarisingfromparticular

32 situationactioncombinations.Thesedecisionrulesarecontinuously underreviewandrevision:newdecisionsaretriedandtestedagainst experience,andrulesthatproducedesirableoutcomessupplantthose thatdonot.Iusethetermadaptivetorefertothistrialanderror processthroughwhichourmodesofbehaviouraredetermined.

However,Lucasthengoesontoarguethatwecansafelyignorethedynamicsofthis processbecause,technically,Ithinkofeconomicsasstudyingdecisionrulesthatare steadystatesofsomeadaptiveprocess,decisionrulesthatarefoundtoworkovera rangeofsituationsandhencearenolongerrevisedappreciablyasmoreexperience accumulates. MichelDeVroey(1998)hasdescribedLucasspointofviewasoneofbenign

neglect.However,itismorethanthat.Hisargumentis,rather,thattheevolutionof theeconomicenvironmentismuchslowerthanthespeedatwhichagentsadjusttothat evolution;hencethetwoprocessescansafelybeseparated.However,thispositionis opentoafewobjections.First,evenifwewerepreparedtoacceptthatthecollective resultofthisadaptive,individualinteractionconverged,ithastobeprovedthatthe resultwillbesomestandardequilibrium,whetherWalrasianorNash.Inthatcasewe haveajustificationforfocusingontheequilibriumandnolongerhavetoworryabout thepathtoit.Second,itmaywellbethecasethatthechangesintheeconomic environmentareatleastinpartcausedbythemodificationsinindividualbehavior arisingfromtheiradaptation.Inthiscasetheenvironmentwillevolvetogetherwith individualbehavior.Thewholesystemwillthenbeincontinualevolution.Thusthe configurationofactionsbeingtakenbytheplayersmayevolveinacomplicatedwayas theresultoftheircollectiveimpactoneachother.Itmaywellhappenthatinsome cases,thesystemconvergestoanequilibriumoftheunderlyingstaticgameor

33 economy.10But,ingeneral,unlesstheindividualsinvolvedlearnextremelyrapidly,the otherconsiderationsthatIhavementionedenterintoplay. Thusthelearningtoberationalconceptdoesnotseemtoadequatelyanswer thedifficultiesthatwefindwiththemodel.Inparticular,thereisonequestionthatis fatal:ifwetakethegeneralequilibriummodelatfacevalue,whendoesthelearning takeplace?Onceagain,weseehowthemodelsbasicstructureproducesitsown difficulties. TheEconomicIndividualandtheSocialContext Therehasbeenanincreasingrecognitionwithinrecenteconomictheorythatthe economicagentisnotatotallyautonomousoratomisticbeingwhointeractswithothers throughanonymoussignals,suchaspricesalone,butthattheeconomicagentis situatedinasocialcontextandthatthissocialaspectwillhaveconsequencesforthe agentsbehavior.Societychanges,andwithpreferencessociallyinfluenced,andtheyin turninfluencingthecommonvaluesofasociety(BeckerandMurphy2000,Sen1999), theindividualmustsomehowtakeaccountofthiswhenheorshemakesdecisions. AttheoutsetIarguedthatamajordrawbackofgeneralequilibriumtheoryis thatitassumesthattheonlyinteractionamongeconomicagentsisthroughtheprice system.Itisnotreasonabletoassumethattheonlysocialinfluencesonindividuals occurbeforetheyparticipateinthemarket,andthatafterthateverythingisfrozen. Whathappensifwetrytorepairthisbystayingconfinedwithinthestandardmodel butassumethatthepreferencesandhencethechoicesofoneindividualareinfluenced byothers?Willwenowbeabletoretaintheequilibriumnotion,forexample?Thisisan oldproblem,asthefollowingobservationfromKoopmans(1957)shows: Changesinconsumerspreferenceswouldbeamuchlessimportantsourceof uncertaintyifinfactsuchchangesoccurredfordifferentconsumersindependentlyof eachother.Thelawoflargenumberswould,inthatcase,reducethevariabilityinthe

34 distributionofaggregatedemandatconstantpricesoverthevariouscommodities.Itis throughwavesofimitation...thatinteractingpreferencesbecomeanimportantsource ofuncertainty.(quotedinFllmer1974) Anumberofauthorshavelookedattheproblemofthestochasticinteractionbetween individualsparticularlyasitaffectstheirpreferences.ThispathwaspioneeredbyHans Fllmer(1974),andagoodaccountisgivenbyBuzBrockandStephenDurlauf(2001). However,mostimportantfromthepointofviewoftheargumenthereisthatin modelswhenagentsaretoodependent,ifapriceequilibriumexists,itmaydependina crucialwayonthedistributionofpreferencesthatresultsfrominteraction,evenifthe agentsareidenticalapriori.Soifouraimisreallytocharacterizeaggregatebehavior, wehavetoheedLucass(1986,S411)advicewhenhesaid,Applicationsofeconomic theorytomarketorgroupbehaviorrequireassumptionsaboutthemodeofinteraction amongagentsaswellasaboutindividualbehavior. InteractionandAggregateBehavior Thethemethathasrunthroughthewholeofthisdiscussionistheconflictbetweenthe requirementsofthetheoryoftheindividualandthedesiretohavepropertiesof aggregates.Ifweadheretothebasictenetofthegeneralequilibriummodelthatmacro oraggregatebehaviormustbederivedfromunderlyingrationalmicrofoundations, thenwehavetoexplainhowthecharacteristicsoftheaggregatearedeterminedby thoseoftheindividuals.Itisherethatthegeneralequilibriummodelhasletusdown, becausewecansayverylittleaboutaggregatebehaviorinthatmodel.Butifwelookat theothersideofthecoinandarguethatthereismoreinteractionbetweenindividuals thanthatforeseeninthegeneralequilibriumapproach,thenwehavetotakeaccountof theinteractionbetweentheindividualsandhowthisisorganized. Thediscussionoftheroleofinteractionbetweenindividuals,whethertheybe neurons,molecules,orinsects,isverymuchpresentinotherdisciplines.Thereis,for

35 example,aconsiderabledebateastowhether,intheneurosciences,itisnecessaryto reverttothestudyofthebehaviorofneuronstoexplainthoughtprocesses(see,e.g., ChurchlandandSejnowski1995).However,thesituationineconomicsiscomplicated bythefactthatthepracticeofanalyzingmacrorelationships,withoutconsideringtheir microfoundations,isnow,ineconomics,almostuniversallyconsideredas unscientific. Ineconomicswearenotfacedwithunthinkingparticles,ormoleculesoreven socialinsects;wearefacedwithbeingswhohaveintentions,andamajorproblemis whathappensifinteractionisactuallychosenconsciously.Thusitisnotonlythe interactionthatmattersbuttheverynatureoftheindividualandhisorherconscious choicesconcerningthatindividualandthesurroundingcommunity.11Thisleadstoa visionveryfarfromthatoftheArrowDebreuworldandcertainlyfarfromthefixed preferencesattributedtotheindividualinthatmodel.Preferenceshavetobedefined oversomesetofpossibilities,andchoicesamongthosepossibilitiescan,inamore realisticworldthanthatdepictedbyArrowDebreu,bemuchmorecomplicatedthan justchoosingthebestelementinabudgetset. Onceweconsidertheindividualasembeddedinasocialcontext,possiblyofhis orherownchoosing,otherconsiderationsenterintoplay;theindividualmaybe concernedwithhisorhersocialimage(seeBernheim1995;AkerlofandKranton2000, 2002),andthiswillchangeovertimeastheindividualandsocietychange.Allofthis leadsonceagaintoavistaoftheworldfarfromtheonevisiblefromthepeakofthe generalequilibriummountain. Conclusion Thepurposeofthisarticlehasbeentoshowthatgeneralequilibriumtheoryandthe demandtheorycontainedinithavenotprovidedamodelthathasempiricallytestable contentandthuswillallowustoexplaineconomicphenomena.Yetthismustsurelybe

36 thegoalofanyeconomist.Thetheorythatwehavedevelopedisselfcontainedand logicallyconsistentbuthaslittletodowiththeactualfunctioningoftheeconomyand itsmarkets.Thesearchforempiricallyrefutablepropositionshasnotbeenahigh priority.Wehavereachedanisolatedpeakfarfromtheotherchallenginghillsthatwe mightprofitablytrytoclimb.Sometimes,inmomentsofweakness,Iconjureupthe visionofoneofthosesectsthatgatheronamountaintop,absolutelysureoftheir destiny,waitingfortheendoftheworld.However,Iwouldnotventuretoproposethat imageasadescriptionofeventhemostenthusiasticgeneralequilibriumspecialist.My pessimisticviewisnotsharedbyeveryone,andtherearedistinguishedeconomistswho believethatcalibratinggeneralequilibriummodelsmayprovideawayout. TheWalrasianmodelofcompetition,eventhoughitis sufficientlyflexible to incorporate a number of formal modifications, is far from being the exclusive analytical framework for the study of microeconomic problems. But it is an important method of analysis and one whose usefulness, we hope, will be enhanced by the ability to obtain specific numerical solutions. HerbScarf(1973) Yetmybasicfeelingisthatintheepigraphatthebeginningofthispaper,Debreu

puthisfingerontheessentialphenomenonthatwewouldliketoexplainandthatall theworkbydistinguishedtheoreticaleconomistsinthisdirectionhasproduced essentiallynoreply.LestthereaderfeelthatIhavebeentoonegative,letmequotefrom BobClowerandPeterHowitt(1997,)whobelievethatthewholeenterprisewas compromisedearlyon:Wereweseriously,byasimplephrase,toattemptto characterisethemodernagetheageofKeynes,Samuelson,weshouldcallittheageof delusion,becauseitseemstoinvolvenothingsomuchasageneraliseddelusionthat sheeranalyticaltechniquemightsomehowpermitustoresolvemostofourproblems.

37 Noneofthisisanargumentinfavoroftakingaroadalongwhichthereislessrigorous thinking.Ourproblemismuchmorethatwehavedevelopedourmodelsusingcertain mathematicaltechniquesandthatwehavebecomeslavestothosetechniques.Itis surelythismorethananythingelsethathasledustopersistwithamodelthat,toany outsider,seemssuchapoordescriptionofwhatactuallyhappensinmarkets.Thereal worldisoneinwhichvariousmarketformscoexist,wheredifferentpricesforgoodsare observed,andwheretheindividualswhoparticipatehaveonlyverylocalinformation. Theappropriatenotionofdemandinsuchaworldiscertainlynotclosetothedefinition thatwefindingeneralequilibriumtheory,butthisdoesnotmakeitanylessinteresting toanalyze.Theonlydrawbackisthatwemayhavealotmoreintellectualclimbingto do. Footnotes 1.Therecentburgeoningofinterestintherelationbetweenpsychologyand economics(see,e.g.,Rabin1998)mightseemtobeacounterexample,butthis developmentishardlyrelevanttothedevelopmentsthatIamdiscussinghere. 2.Forafullaccountoftheproblemsoutlinedhere,seeFlaschel1991. 3.ThosewhohaveworkedonthisproblemdonotalwaysagreewithSaariand Simonsdefinitionofanadjustmentmechanism.Flaschelsmechanism,forexample, doesnotsatisfytheirdefinition. 4.MichaelBladandImadeaneffortinthisdirection,butithadlittleecho(see BladandKirman1985). 5.SeeChipman,thisvolume. 6.See,forjustoneexample,CliffordGeertzs(1978)remarkableworkonthe functioningoftheMoroccanbazaar.

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