Article Reviews

Soros’ Reflexivity vs. Microeconomics 101

PM Jar recently had a post (link here) on Chapter 1 of George Soros’ Alchemy of Finance. I had never read the book before, but reading through PM Jar’s post, Soros’ point makes a lot of sense.

The idea here ties in with Soros’ theory of reflexivity. Basically, in the markets, the actions of market participants are influenced by market prices, which in turn are influenced by the actions of market participants, hence the process of price discovery is always dynamic and “reflexive”, there are no static demand / supply curves so to speak. For example, when prices go up, momentum players go long, and value players hold off. Conversely, when prices go down, value players go long and momentum players go short.

This is unlike basic microeconomics where given demand and supply curves, you can “predict” the equilibrium market price that will clear the market. It’s a bit clearer how different it is when you consider the classic Economics 101 class experiment (see example here). Students are divided in buyers and sellers, where buyers have different pre-determined selling prices at which they can sell what they bought in class, and sellers have different pre-determined production costs to produce what can be sold in class. Given a range of pre-determined selling prices and production costs, one would naturally get a upward-sloping supply curve (higher price, more goods offered), and a downward-sloping demand curve (higher price, less goods demanded), which then allows you to determine the “market price”.

What we can see is that in the microeconomics class experiment, the pre-determined selling prices and production costs “anchor” the situation. In a stock market, one does not have those constraints. Indeed, there is no technical limit to your potential selling price if you buy, and your “production cost” can technically drop to zero if you short. Even if had bought a stock and the price is now below your purchase price, you can sell and take the loss (and feel great relief immediately and then feel horrible thereafter) whereas in the microeconomics case you would choose not to produce. Hence Soros’ point to focus on the process of change, instead of looking for the equilibrium point.



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