Time Lags in Price Mechanism

The speed of price adjustment to market conditions of demand and supply is a function of information availability.

It is common textbook knowledge that prices react to demand and supply in the economy. The point where the two meet provides the equilibrium price and quantity. However, the price mechanism does not work uniformly across all markets. There are appreciable variations in the time taken for the prices to adjust to the dynamics of market demand and supply. The time lag in the adjustment of prices are different across different markets and they are based on the nature of the product.

In many markets, the prices adjust to the forthcoming changes in demand and supply well in advance. The holiday season will definitely see a hike in prices much before the actual spike in demand. Many tourist destinations have designated a two pronged pricing strategy: one for the holiday season and one for ‘off-season’ and the difference between the two can be significant. All the hill stations in India have seasonal high prices during the summer months, when the tourists leave their hot city behind and want to experience relatively cooler climates in the hill stations. Similarly, the winter season (especially, during Christmas and New Years) will see a spike in demand for beach holiday destinations. The hotels and lodges operating in these areas form definite expectations about the surge in demand, based on the previous years, and adjust their prices accordingly. Since an increase in the supply of lodging cannot be achieved in a short time period and the fact that it is not immediately desirable (the inventory will not be used during ‘off-season’), the only adjustment is via prices. Transportation sees a mixed response. The market does see an increase in supply (extra busses during holiday season) plus a surcharge.

Note that price increases due to an anticipation of a surge in demand in not the optimal response. Ideally, a profit-maximising firm would like to increase its supply in advance and meet the anticipated surge in demand. Retail outlets in the US dramatically increase their supply in anticipation of the Thanksgiving holiday and will be able to offer reduced prices and discounts. [This is a chicken and egg problem – increased demand due to lower prices and discounts or increase in supply and consequently lower prices in anticipation of higher demand]

Few markets actually witness real-time price adjustment mechanism that economic textbooks model. It is only the advances in technology that has enabled real time price adjustments. App-driven cab  operators, such as Uber and Ola, use real time pricing based on the current demand and supply. Given the technology, it is fairly easy to calculate actual demand and supply in any given area and fix prices accordingly. The price  surges in the apps are an excellent example of real time pricing. Financial markets such as equity and currency markets are also examples of real-time price adjustments. It is fascinating to see this play in low volume stocks. One can witness actual price movement of a stock when buying a relatively large number of shares of a stock that is traded in low volumes. Many other market places that have moved online are gradually trying to emulate real-time dynamic pricing. Air-tickets and e-commerce sites do have an element of such dynamic pricing.

Finally, there are those markets where the price tends to adjust only months or even years after the change in market situation. Labour markets are the classic example of delayed price changes. Wages react to demand and supply of labour with a considerable time-lag. Wages also react to inflation expectations, but renegotiating wage contracts are a prolonged process and can take time.

Ultimately, the reaction of prices to the market conditions boils down to the availability of information. Advance information about forthcoming fluctuations in demand or supply will lead to the forward-looking price changes; real-time information availability with the help of technology leads to real-time price fixing; and in a macro situation with many variable, information about market conditions is slow to seep through the system and thus contains a considerable time lag.

Anupam Manur is a Policy Analyst at the Takshashila Institution and tweets @anupammanur

 

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