Chapter 26 Principles of Market Adjustment and Stability

First, market prices can exhibit the type of instability predicted by classical dynamic models. Second, the conditions under which instability is observed are not captured by the cobweb model but such conditions are captured by models of the form developed by Marshall and Walras in which the market has perversely shaped curves, such as an upward-sloped demand or downward-sloped supply. Third, the appropriate model, Marshall or Walras, depends on properties of the underlying demand and supply. If the special shape is due to the existence of an externality such as a fad or a Marshallian external economy, then experiments have demonstrated that the Marshallian model is the appropriate model. If the special shape is due to income effects, then the appropriate model is the Walrasian model and not the Marshallian model. That is, if the special shape is due to income effects such as Giffen goods or a backward-bending supply of labor, then the Walrasian model reflects the appropriate principles. In summary, the mystery of the price discovery process is solved, in part, by classical models of adjustment.