Nova workboard

a blog from young economists at Nova SBE

The Middleman from the Far East (or: Bullish in a China shop)

Just last month, a Chinese company’s decision to go public sent shockwaves across the financial world. It is worth mentioning, for the sake of context, that this company’s initial public offering (IPO) raised a staggering $25 billion in the New York Stock Exchange, which constitutes a new global record (curiously enough, the previous IPO record also belonged to a Chinese company – the Agricultural Bank of China). The name of this record-breaking company is the Alibaba Group, and it operates within the online commerce industry. Alibaba owns websites such as Taobao and Tmall, which can be considered analogous to eBay and Amazon, respectively, with the not-so-small difference that unlike the latter, Alibaba has been consistently profitable – and that transactions in its websites totalled more than $248 billion last year, more than the two American companies combined.

While the stock-market-addicted readers might yawn at what they (quite rightly) consider old news, those without a financial background or interest may wonder what Alibaba’s IPO is doing within a pure economics blog such as the Nova Workboard. The unclear link between the two can be found, as so many can, in the writings of a long-defunct economist. In his work concerning the general equilibrium of an economy, Léon Walras stated that the values of excess demands across all markets are necessarily zero. More intuitively, this means that the agent does not desire any more goods nor intends to dispose of any goods (their budget is fully exhausted), which would bring all the markets for all the goods to equilibrium. This principle (known as Walras’s Law) holds for any set of prices, but it follows from general equilibrium theory that only the “right prices” that make the sum of the excess demands for every good equal to zero will induce the agents to trade goods between them.

At this point in Walras’s analysis, a thorny question emerges: how does the economy arrive at the “right prices”? Here enters one of the most controversial assumptions of the general equilibrium model. To make everything work, we must presume that there is an auctioneer type of agent who matches total demand with total supply for all goods by quoting different prices to the consumers and seeing how much trade would each set of prices generate. The process would end when the auctioneer reached prices that cleared each and every market by motivating the agents to trade goods between them until equilibrium was attained.

The assumptions behind the Walrasian auctioneer have come under fire from the start. One such premise that several later economists criticized is that of perfect information; it is hard to argue that every agent not only knows what all goods cost at any given point in time and space, but that they also use that information to make the most rational consumption and trade decisions. Another such critique is the fact that, empirically and throughout history, prices do not generally come from an auction-like process.

However, early economists such as Walras may have been better predictors of market dynamics than what they were initially given credit for. Advances in technology have enabled the rise of new activities and sectors, namely the e-commerce industry. Amazon, the online retail behemoth, allows for consumers everywhere to compare prices of a good in multiple locations, no longer restricting them to what’s geographically closest to them. Ebay is pretty much a giant, all-inclusive auction website. The opening of Alibaba’s finance to foreign capital is a first step towards further integrating the Chinese goods market into the global economy, not to mention bringing 80% of China’s e-buyers with them. It seems as if these companies are the effective manifestation of the near-mythical Walrasian auctioneer!

Nevertheless, one must approach these new developments in the e-commerce sector with economic caution. Sceptics may point out that these companies are anything but a disinterested auctioneer; indeed, Alibaba and the like have a binding commitment to act so as to maximize their shareholder value. As it stands, we have no guarantee that that would lead to the kind of market behaviour that the model requires; there is no external auditor that forces the companies to disclose all price information, and it is conceivable that maintaining a certain level of information asymmetry could benefit them to the detriment of individual consumers. Additionally, issues about these companies holding inventories of goods may invalidate the condition that excess demand must equal zero across all markets (for further analysis of this issue click here). Finally, Amazon has long been accused of ruthless pricing tactics that forced smaller businesses off the market; the welfare considerations resulting from this must be carefully considered.

This post tried to connect the opening of a major Chinese online store to international finance with one of the main tenets of general equilibrium theory. Alibaba, as well as Amazon and Ebay, may finally be playing the part of a Walrasian auctioneer in the global marketplace, as giant meeting places for sellers and buyers to trade and interact in real time. It can be argued that the resulting price information increase will lead us to a reality closer to the perfect efficiency of the economic model; however, that will depend on whether the online e-commerce companies would quote the same prices as the hypothetical auctioneer, and so far there hasn’t been enough evidence backing up this assertion. What is clear, after all this discussion, is that the role of the middleman in the market has been played by these new actors in ways that escaped our economist predecessors, no matter what side of the Walrasian debate they were on.

Rui Mascarenhas

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Author: studentnovasbe

Master student in Nova Sbe

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