Supply, demand, and information transfer

A reference post with an animation showing how information equilibrium operates

I frequently reference this animation I made a few years ago, so thought I should make a reference post with essentially just the animation and explanation. Added footnotes and additional links because I just can’t help myself.

The picture here is derived from Becker (1962) and shows a random cloud of selections from a “state space” (Becker: “opportunity set”) consisting of two goods x₁ and x₂ with prices p₁ and p₂. Changing that state space by moving the budget constraint (i.e. raising the price p₁) traces out a demand curve (less of x₁ is bought).

The connection to information transfer framework is that the agents selecting points of the opportunity set map it out — they “read” the information about demand and “transfer” it to supply. Information “equilibrium” is where the two sides of supply and demand contain the same information¹.

If you do not sample the entire opportunity set whether through groupthink, lack of diversity, or simply risk aversion the whole ‘supply and demand thing’ breaks down. There’s no demand curve:

This is called non-ideal information transfer in the framework and it means the information about the demand state space (opportunity set) is being incompletely transferred to the supply state space². This results in prices falling below their ideal market price (i.e. the action is below the supply and demand curves which are a bound). You can see p₁ falling below the curve in the second animation. This should be thought of in terms of deflation and economic collapse rather than a discount on blueberries.

1. It is also a “maximum entropy” state where every state is visited. If the demand state space is A and the supply state space is B, an information equilibrium relationship that I write in shorthand A⇄B then the picture you should have in your mind is something like this:

2. How we arrive at the equilibrium is an interesting question and I did some work awhile ago using causal entropic forces as an explanation. See here and here.