Strength and speed of market adjustment
(picture from Wix's library)
Hello everyone! As mentioned in my last article, I started some new investments and I now understand these markets a lot better. I am not going to say exactly where (or on what) I invest because I don’t want to push you guys in what are very volatile assets (at one point I could have lost more than half my investments).
This little experiment made me think about the time it takes for different markets to adjust to their new equilibriums. In our supply and demand models, changes lead to new equilibriums relatively smoothly. In my course (you can find it here), I took time to describe the adjustment mechanism that may appear but I didn’t give any specific timelines.
Some markets, like cryptocurrencies these days, react very fast to changes in the market. Any little piece of news can lead to very high changes in demand and/or supply. These in turn can lead to big changes in price, almost instantly.
Other markets, like the airline industry (see my article here if you want to read more), are very resilient to changes in the market. Demand and supply tend to move slowly and prices tend to be stable.
There are two things to consider here: First, by how much will demand and supply change with a given economic event. Second, how fast will the market outcome adjust to the new equilibrium.
Although they are distinct concepts, it is very difficult to distinguish the two in real-life. Economists usually use changes in market outcomes (price and quantity exchanged for example) to measure changes in demand and supply. If there is a change in one of the curves but market outcomes don’t change (because of a long time to adjust for example), when how do we know if the curves have changed at all? Price and quantity of exchange are also out of equilibrium in most markets. This means that changes in market output might not be caused by any change in supply and demand, it might just be an adjustment to the real equilibrium.
To be able to distinguish between changes in the equilibrium and changes in the outcome of exchange, Economists will often use surveys. They will ask relevant economic actors if their desire to buy or sell have changed. Although this can help estimate a change in demand or supply, this can be very expensive and unfortunately not very reliable. People often mis-judge their own reactions to economic events. They also often mis-calculate their own changes to anything new.
Well… although it might be difficult to know (like almost everything else in Economics), let’s still see what can affect the strength and the speed of change in different markets.
The size of shifts in demand and supply depends on two main things: (1) how important is the economic event for the product itself and (2) how important is an economic event for the consumer or producer.
(1) If an economic event affects greatly the desirability or the costs of production of a good or a service, we should expect the demand or supply curve of that product to change substantially. For example, the introduction of a new substitute that is cheaper and perceived of equal or better quality can lead to a dramatic decrease in demand of a product. For another example, if an important input of production’s price increases heavily, the supply of the final product is likely to decrease as long as no input-substitute can be found. The opposite should be true for economic events that have a small impact on the desirability or the costs of production of a good or service.
(2) If an economic event has a strong impact on consumers or producers, we should expect the demand or supply curve of relevant products to change substantially. For example, changes in income tends to lead to big changes in consumption patters of lower-income individuals. For them, income is a scarce resource and every purchase has a high opportunity cost. Mild changes in income tend to lead to small changes in consumption patters of high-income individuals. For another example, an important change in local regulations for selling a product can lead to a big change in supply for producers selling locally and almost no change for those selling outside the scope of those regulations.
Now that we saw what influences the intensity of change in demand and supply, let’s talk about the amount of time it takes for markets to reach these new equilibriums.
The speed at which a market adjusts to its new equilibrium depends on four main things: (1) how competitive producers are, (2) if the economic event is believed to be permanent or temporary, (3) if there are costs of adjustment for consumers or producers, and (4) if there is regulation that stops or slows adjustment.
(1) The more competition there is between different brands, the faster the market tends to move to the new equilibrium (or profit maximising output in the case of imperfect competition and monopolies). In cases when the price of equilibrium is higher than the price of exchange, firms with strong competitive pressures tend to increase their price to reap more profits before their competitors. In cases when the price of equilibrium is lower, firms tend to lower their price fast to get a price advantage on other firms. When there are few competitors to worry about, firms don’t have the pressure to adjust their output as fast as otherwise.
(2) Firms that believe that an economic event is temporary might decide to keep the same market output. They might want to avoid what Economists call “menu costs”, which are incurred when changing publicised prices for example. If a shock is believed to be permanent, firms tend to adjust faster to either gain or avoid losses from the new equilibrium.
(3) It should be fairly obvious that higher costs of adjustment (menu costs, legal fees, re-branding, and others) normally lead to lower adjustment times. Firms often wait to see how an economic event affect them when they have to invest important resources in adapting to it. More information on the new equilibrium means that they can minimize their costs of adjustment.
(4) Regulations such as price and quantity controls can stop firms from changing their market output. Firms might not even be able to adjust to the equilibrium if government regulations are too tight. As you may have seen in my course, price and quantity controls often aim at stopping firms from reaching the equilibrium.
Always keep in mind that our models are meant to simplify reality so we can understand how the economy works. The real-world is filled with many economic events that affect a multitude of things at once, and at different speeds.
I hope you guys learned something!
Don’t forget to have fun!