Friday, February 17, 2006

Crazy Marbles

Normal econ 101 supply/demand says that if prices are higher than what people want to pay, the sellers will naturally lower their prices.
And if prices are too low, sellers will naturally raise prices to pick up the slack.
But...
The thing is, price itself is often the main determinant in what people are willing to pay in some markets (like housing right now). There are several reasons why that's true, but the important thing is, sometimes a rising market makes people believe they should pay more, because they will get a good return (as the market continues to rise). Similarly, if the market is dropping, they will jump ship at a lower price than they might otherwise.
This is the normal idea in economics of how "expectations" alter the price. But usually the theory is applied to argue that the equilibrium price is shifted (upwards by expectation of good things coming). In fact, expectations don't merely shift what people are willing to pay, altering the intersection of the supply & demand curves a little, settling on a slightly different sales price.
Expectations totally destroy the normal "invisible hand" forces that would make buyers and sellers arrive at something like a static price.
Buyers will believe, as the market rises, they should pay even more. Sometimes more than the asking price (as happens in the housing market regularly). Similarly, dropping prices are a signal to sell rapidly. Time is the key. Buyers and sellers are focused on return over time. If they believe in 5% monthly appreciation, they will want to close the deal as rapidly as possible, and will happily pay a 5% premium to do it.
The opposite of equilibrium: In an Adam Smith/David Ricardo happy balanced market, a price is like a marble in a bowl (you can imagine the right side of the bowl represents low prices and the right side, high). No matter where the marble goes, right, left, anywhere except the one price at the bottom, it will be forced back to the bottom. The invisible hand. But expectations turn the bowl upside down.
Now the marble sits on top (if it can ever get there at all). If it starts to slip up or down, the speed will feed on itself. All of the forces are away from equilibrium and stability - which may never occur. If prices level off for a while, it's because people are waiting for signals, or the market is tired (volatility itself can be a damper on some markets, if the participants are risk averse for the scale of investment required - like a house).
The logical mode of pricing in such a (rising) market is to avoid setting a price at all, and simply solicit multiple offers.
If you believe the market is falling, it makes sense to set a price, just below what you think the market price of that moment might be.
Sell quickly. And that's what happens. Isn't it? So who says the economy as a whole isn't at least tugged by these forces of disequilibria, and all those pretty supply/demand/money supply models are fairy tails, told by Greenspan, full of supply and demand, signifying nothing.

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