Tuesday, February 5, 2008

Retail Markets - 8

The economist Arthur Okun coined the phrase "the invisible handshake" to refer to situations where firms are implicitly obligated by fairness considerations. Okun was talking not about retail markets but rather about labor markets where there is an employment relationship between the firm and its workers. The idea has been extended to retail markets where it seems to bind although there is no explicit contractual relationship. Behind this obligation is the implication that the firm will lose its reputation and suffer the business consequences if it does not live up to this standard. (His book, Prices and Quantities, offers an excellent discussion of both markets.)

In coming up with that phrase, Okun borrowed heavily from the famous 18th century Scottish economist Adam Smith who in his book The Wealth of Nations coined the phrase 'the invisible hand' to refer to how competitive markets allocate resources efficiently.

The Wealth Of Nations

Now we can answer our core questions. In retail markets prices tend to be 'sticky' because of the invisible handshake. Prices adjust slowly to changes in supply and demand or they do not adjust at all. It is inventory that does most of the short term adjustment to accommodate trade. Trade can and does occur out of equilibrium. Retailers will often only raise prices under excess demand when it becomes clear to buyers that there is a general shortage that will sustain at the historic price. There may be more downward flexibility in price under excess supply via "clearance sales" and other similar schemes. When price does change it tends to stay there so while it does move toward equilibrium, it might never get there.

The exception that proves the rule may be the gasoline market, where pump prices change frequently. Note, however, that crude oil prices are well known and that pump prices are tied to the crude oil price, though not perfectly so.

You may be thinking, "I understand the concepts equilibrium, excess supply, and excess demand in the simple supply and demand model in which those concepts were developed. But what do they mean here when sellers hold inventory and there is uncertainty in demand? Do those ideas still make sense?" The answer is yes but we have to broaden our ideas a bit. The key is to focus on the market in aggregate, not the individual buyer or seller. Then consider the average inventory per seller, averaging across all the sellers in the market. If that amount remains steady and if the average time the inventory stays on the shelf also remains steady, then we're in equilibrium. If that amount has a downward trend and if the time on the shelf also has a downward trend, then we have excess demand. If the time on the shelf has an upward trend, that is an indicator of excess supply. You may think the average amount would have to be increasing. But sellers likely will not replenish stocks under a known excess supply situation, so the trend in the average age of the inventory is a better indicator of excess supply.

Please post any questions or comments about this exercise.

No comments: