I thought you might be interested in this question Evan Soltas posed to me (as he started thinking about what became his post “An Alternate View of Markets”) and my answer. I share this with his permission.

Question: I’m thinking about a question which might become a blog post, but before I go anywhere with it, I wanted to put my thoughts out there to someone who will be more knowledeagble on these questions.       

Do you know / have read anything about supply-and-demand equilibriums which are made unstable by certain conditions – in particular, I’m thinking about a stylized micro model in which demand is determined to a significant extent by recent changes in price, and another in which supply is determined similarly by demand, or rather the nominal expenditure level, averaged over a long period of time. 

That probably sounds absurdly vague or basic… Where I suppose I’m going with this is the first model appears to character some asset markets, particularly housing. The second is about hysteresis, particularly as it pertains to labor.

I understand those specific stories pretty well as a qualitative matter, but what I’m interested in here is the abstracted version of unstable systems, and general implication that in a very broad class of markets, the vanilla supply-and-demand story irons out too many wrinkles. Those wrinkles, in sum, point to a rather different model – one which exhibits significant path-dependent behavior, tends not to a single equilibrium but to multiple equilibria or just instability.

Maybe one way to phrase the question is: to what extent does the emphasis upon supply-and-demand blind economists? Are these portentous footnotes on the supply-and-demand really more than footnotes? Are they the “real story”? Thinking about exchange rates, we know that PPP doesn’t explain everything, and that forecasting based on fundamentals does a pretty poor job of things – are economists pretending to see equilibrating systems in realities which are more brittle, fragile, and chaotic?

Answer: This sounds like a great topic for a post. The main thing I would advise would be to preface things as what can happen when there are behavioral (=psychological, non-neoclassical) things going on in people’s behavior.  If you do that, you don’t have to worry too much about being wrong if you have good intuition for a result. But when everyone in sight is optimizing from here to the end of time, there are some very powerful, and subtle, stabilizing influences. What multiple equilibria there are in fully optimizing models don’t usually seem very plausible to me: they require extreme parameter values. There are economists who study that kind of thing, but it usually degenerates into mathematical fun and games rather than serious economics. If your story is based on someone’s non-optimizing behavior, on the other hand, it could be very robust.  Though even then, you have to worry about whether a minority of fully optimizing people could stabilize things. (The noise trader literature worries about that.)