Supply and Demand

Bit of navel gazing today, and some pretty basic stuff, but worth reiterating occasionally.

Here is an interesting piece in an article on Naked Capitalism. What’s interesting to me is the discussion on the ‘law’ of supply and demand. Here is what it says, bolding is mine:

No, it’s NOT the law, it’s a belief and it often is not operative. I would have liked to give it longer-form treatment in ECONNED, but the discussion there should suffice for our purposes:

But it is actually difficult to prove anything conclusively in economics. In fact, some fundamental constructs are taken on what amounts to faith. Consider the most basic image in economics: a chart with a downward sloping demand curve and the upward sloping supply curve, the same sort found in Krugman’s diagram. Deidre McCloskey points out that the statistical attempts to prove the relationship have had mixed results. That is actually not surprising, since one can think of lower prices leading to more purchases (the obvious example of sales) but also higher prices leading to more demand. Price can be seen as a proxy for quality. A price that looks suspiciously low can produce a “something must be wrong with it” reaction. For instance, some luxury goods dealers, such as jewelers, have sometimes been able to move inventory that was not selling by increasing prices. Elevated prices may also elicit purchases when the customer expects them to rise even further. Recall that some people who bought houses near the peak felt they had to do so then or risk being priced out of the market. Some airline companies locked in the high oil prices of early 2008 fearing further price rises.

The theoretical proof is also more limited than the simplified picture suggests. Demand curves are generally downward sloping, but in particular cases or regions, per the examples above, they may not be. Yet how often do you see a caveat added to models that use a simple declining line to represent the demand functions? Not only is it absent from popular presentations, it is seldom found in policy papers or in blogs written by and for economists. McCloskey argues that economists actually rely on introspection, thought experiments, case examples, and “the lore of the marketplace,” to support the supply/demand model.

So, the basic idea with the law of supply and demand is that as the price falls, supply falls and demand rises, and that as the price rises supply rises and demand falls. Traders of financial markets (and others) might have noticed that this is often the case, but not always (traders chasing a breakout will observe an increase in demand once the price rises above a certain point). And also in the real world the law often holds, but not always; the quote refers to luxury goods, houses, airline fuel, as all providing examples of where the simplified ‘law of supply and demand’ didn’t hold.

Contained within the quote is a reason for the exception: “Elevated prices may also elicit purchases when the customer expects them to rise even further.” (For traders, the breakout & momentum trade is a manifestation of this). Also: “A price that looks suspiciously low can produce a “something must be wrong with it” reaction” – traders might reflect on how their buying behaviour alters and is not predicted by a simplistic representation of the ‘law of supply and demand’ when stock/futures/whatever prices are in a freefall (‘crash’).

The law of supply and demand holds when one recognizes and allows for the role of value perception – the price is ‘low’ if it is ‘good value’, the price is ‘high’ if it is not ‘good value’. For traders, the perception of value is very fluid. It often depends on one’s time horizon. Warren Buffett, for example, will often be seeking out stocks to buy that are good value in comparison to what they are going to return over a lifetime. A HFT, on the other hand, might buy a stock that represents good value compared to where it is expected to be in a few seconds time (and factoring in rebates available).

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