Current Equilibria May Impede Progress

Societies can get stuck in a bad equilibrium without realizing. Getting out of them may require outside intervention.

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Sometimes we may not realize we’re stuck in a bad equilibrium. We may only find out that there was a better equilibrium for us if a large jolt knocks us out of it. Although this may seem like a situation that may impact us as individuals, like being stuck working at a job or living in a town, economies can also be stuck in bad equilibria.

Economics and Equilibrium

In economics, we often use the concept of equilibrium. Equilibrium refers to a situation where the macroeconomic variables are stable (at the same value) forever. For example, if the US economy was currently in equilibrium, then that would imply that the unemployment rate in the US would stay at 3.8%, the interest rate would stay at 5.25-5.50%, and GDP growth would be at 3.4% forever. 

We can be pushed out of an equilibrium by economic ‘shocks’. A ‘shock’ can be anything that temporarily moves an underlying variable. A common shock is an energy shock – when global oil markets get disrupted (for example, due to decreased supply from oil-producing countries that may be affected by war), oil prices may spike, pushing an economy out of equilibrium. This can result in higher inflation and higher unemployment. But once the shock dissipates, the economy will gradually return to its equilibrium – the balance it was in prior to the shock.

Bad Equilibrium

A common example of a ‘bad’ equilibrium is the Prisoner’s Dilemma. In the Prisoner’s Dilemma, two suspects, A and B, are accused of a crime and interrogated separately. If the two suspects remain silent and do not blame the other one for the crime, each will receive 1 year of prison. If one suspect, A, blames the other, B, while suspect B remains silent, then A will be freed, while B will go to prison for 3 years. Similarly, if suspect B testifies against A, while A remains silent, suspect B will be freed, while suspect A will go to prison for 3 years. If both suspects testify against each other, both suspects get 2 years in prison. Below is a matrix representation of the outcomes.

It is clear that the two suspects would prefer to stay silent (cooperate together) rather than testify against each other since they’ll spend 1 year fewer in prison. However, this is not an equilibrium that can be sustained. That is because suspect A will always prefer to testify. If suspect B stays silent, suspect A will get 0 years in prison if he decides to testify, and 1 year if he stays silent. If suspect B testifies against A, the A will get 3 years in prison if he stays silent, but only 2 years if he testifies. Thus, suspect A will always prefer to testify. Due to the symmetry of the situation, suspect B will also always testify. The only equilibrium, where no one will change their decision is when both suspects testify resulting in 2 years in prison for both of them.

Although they would be better off staying silent, there is no credible way for them to get to that outcome in a one-off situation.

Multiple Equilibria

The Prisoner’s Dilemma is an example of a situation with one equilibrium. Let’s now look at an example where there are multiple equilibria. Suppose we have the following situation, where two people can choose either to cooperate or compete with each other. If both cooperate, they’ll each get 10, if they both compete, they’ll get 6, and if one of them competes while the other cooperates, then the competing one will get 5, and the cooperating one will get 2.  

From the above, we can see that there are two equilibria¹ – one where they both compete, and one where they both cooperate. That is because if both players are cooperating, neither would be better off by switching to competing (instead of getting 10, you’d only get 5 if you compete). Similarly, if both players are competing, neither would be better off by cooperating (instead of getting 6, you’d get 5).

Which Equilibrium

So how do we determine which equilibrium prevails? This is where the problem arises. There’s nothing really telling us why one of the equilibria should occur over the other. Even though in the multiple equilibria example above, the ‘cooperate’ equilibrium is better, we cannot get there from the ‘compete’ equilibrium. 

In economics, we often state that ‘initial conditions’ can influence which equilibrium occurs. That is, if everyone started off competing, then the ‘compete’ equilibrium prevails. If everyone started off cooperating, then the ‘cooperate’ equilibrium prevails. ‘Initial conditions’ is something that is often not measurable – this can be things like the environment, culture, and experience that may result in people preferring one choice over the other. 

Transitioning to a Different Equilibrium

Changing equilibria can be very difficult. In our multiple equilibria example, there is nothing that would incentivize people to change decisions and go from the ‘compete’ equilibrium (6,6) to the ‘cooperate’ equilibrium (10,10). One way to get people to shift would be to intervene in the decision and tell both players that they would be better off if they mutually decided to cooperate. On a larger scale, where it would involve the entire population of a country, convincing everyone would be difficult, costly, and unlikely to succeed.

Another way to push to the superior equilibrium would be to alter the payoffs from each decision. Suppose instead of receiving 5 if you cooperate when the other player competes, you would receive 7 (by temporarily subsidizing the decision). This will encourage both participants to cooperate, resulting in the final outcome being the cooperative equilibrium. 

Lastly, a large external shock might push us to a new equilibrium. In our example, it’s as if everyone was forced to cooperate, as competing was not possible due to some external force.

Macroeconomic Examples

With theory out of the way, what are some macroeconomic examples of this situation? We recently wrote about the Work Home from Revolution and how now there appears to be a permanently higher number of people working remotely. Prior to the Covid-19 pandemic, remote work was negligible, and nearly all jobs required employees to be on-site. This was the equilibrium we were in. Working remotely was possible prior to the Covid-19 pandemic – we already had the technology to go there, but we were stuck in the in-office equilibrium. With Covid-19 (a large external force), many jobs became remote. Since that shock, the number of people working remote or hybrid has permanently increased. This is the new equilibrium. The Covid-19 pandemic moved us out of the old equilibrium into the new equilibrium. But it is worth emphasizing that the new equilibrium was always possible – we always could have had people working remotely.

Another example is when women joined the labor force. Artificial rules prevented women from being part of the labor force, which kept us in a ‘bad’ equilibrium. Through the suffrage movement and world wars, we moved to a new equilibrium where women became integral parts of the labor force. 

Bad equilibria can also occur with city designs. In many US cities, due to low interest rates and subsidized fuel prices, car ownership was cheap. This meant that cities could be more spread out (urban sprawl) rather than dense. Converting a city that has significant urban sprawl to a dense city, however, is very difficult, as it would require tearing down a lot of infrastructure (roads, homes, etc). Being in an urban sprawl equilibrium isn’t without costs though. With the recent inflationary spike, purchasing cars and car insurance became very expensive for many. But in these urban sprawl cities, it is impossible to go to work without a car. This means that living in an urban sprawl equilibrium may be costly, and a more dense city equilibrium could be better for all. 

One last example of being stuck in an equilibrium was the low/zero interest rate environment from 2008 to 2022. During this time period, interest rates were set at zero or quite close to zero, for a majority of the time. The reason this can be harmful to the economy is that it reduces economic dynamism. This occurs when large, not innovative, low productivity companies (referred to often as ‘zombie’ companies) remain in the market for too long rather than being replaced by new, high innovation firms. The reason these zombie companies persisted is because they could borrow at close to zero interest rates, and erect barriers to entry for competitors. This behavior lowers overall economic dynamism (McGowan, Andrews, Millot, 2018). With the recent rise of interest rates, caused by the Covid-19 supply shocks, the hope is that such zombie companies will disappear, allowing for more innovative and productive firms to grow. However, to get to these higher interest rates, it appears that we needed a large external shock (Covid-19) to jolt us out of the zero-interest equilibrium.

If It Ain’t Broke, Maybe Fix It

A common phrase we hear is “if it ain’t broke, don’t fix it”. The danger of such an approach is that sometimes we may be stuck in a bad equilibrium and that there is an outcome out there that will make everyone better off. Moving to this new, and potentially better, equilibrium may require significant intervention, whether by governments or external forces. There are many such equilibria, both economic and non-economic, that currently may not be optimal – city designs and layouts (many cities never expected to grow so large and were not designed for their larger size), national transportation infrastructure (investing in roads instead of rail networks) and even the Internet (the underlying communication method between computers could be significantly better but it would be virtually impossible to overhaul the current system).

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Interesting Reads from the Week

1. Article:

   Carl Allen
   continues the discussion on polls – being ‘ahead’ in polls does not necessarily mean the candidate is favored.

2. Guy Berger
   (here) and
   Pascal Michaillat
   (here) give us the April US Labor Market update

3. Note: Interesting recent economic findings on the Caesarean section procedure and outcomes for children and mothers: “US counties with greater rates of C-sections are associated with lower rates of infant and maternal morbidity, suggesting increased usage could lead to improved natal welfare…a 10 percentage point higher C-section rate is associated with 12 to 18 percent lower infant morbidity and 14 to 32 percent lower maternal morbidity.”

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How the Internet is Changing Economics (December 3, 2023) – the Internet has had a meaningful impact on certain economic relationships that used to hold true in the past. The creation of new markets and products used to be considered a positive, but findings regarding social media suggest otherwise. Separately, online shopping may have made us less price-sensitive, impacting inflation dynamics.

1. One interesting fact is that the number of equilibria in any economic model is always odd (or infinite). In this multiple equilibria example, we have only discussed two equilibria. These are called ‘pure’ equilbria, as you always make the same decision (in the ‘comete’ equilibrium each person always chooses to ‘compete’, while in the ‘cooperate’ equilibrium each person always chooses ‘cooperate’). There is clearly an even number of pure equilibria. There is, however, a tthird equilibrium, called a ‘mixed’ equilibrium. A ‘mixed’ equilibrium occurs when instead of definitively making a choice (i.e. choosing ‘cooperate’ or ‘compete’), we choose to ‘cooperate’ or ‘compete’ with a certain probability. There is a unique set of probabilities (or ‘mixes’) such that no player would change their probability of playing compete or cooperate.In this particular example, the ‘mixed’ equilibrium is each person picking to ‘cooperate’ 11% of the time and ‘compete’ 89% of the time.