No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Five: Supply & Demand: Markets at Work 114 MARKETS: TRADING AT THE SPEED OF LIGHT? Rapid reaction of markets to new information is a cornerstone of modern finance theory, as a measure of so-called “efficient markets.” Fama’s classic paper in 1969 suggests that markets have priced in opportunities to profit from a stock split announcement certainly by the end of the stock split month, but likely immediately after the announcement date. Busse and Greene (2001) find that market prices begin adjustment within seconds, and price action on positive announcements fully incorporated within one minute! Traders who execute within 15 seconds make small but significant profits. This communicative process works not only with consumers, but also suppliers. Consider Figure 5.3 . Assume for a moment a rising price. The actual process requires interaction of supply and demand; we’ll do that later in this chapter. Following the law of supply, the quantity supplied will increase, as indicated by the direction of the arrow. The social goal is for suppliers to increase production in response to the decrease in supply due to the hurricane. No central planner or government bureaucrat need tell suppliers to meet our social goal; the price system will provide the necessary information to give suppliers the incentive to produce more. If the increased prices are expected to be short term in nature (as revealed in “futures markets” where speculators trade contracts for future delivery of a commodity such as gasoline), suppliers may run additional shifts at existing refineries, hire temporary workers, may purchase more gasoline from nearby gasoline producers (e.g., Mexico), or may tap into their own reserves. If the price is expected to last longer (again, as revealed in futures markets’ prices), the supplier may take additional steps such as exploring additional oil fields, building new refineries, hiring permanent workers, contracting with gasoline producers in more remote areas (middle east), etc. As Hayek noted, it doesn’t matter why the price has increased; the producer only has to respond to the price incentive and the social goal of increased production will result. The lure of profit is a powerful motivator indeed. At this point it should be clear why many economists are in favor of immediate price increases when there is a disruption in supply (or alternatively, an increase in demand). The quicker the price adjusts, the sooner the incentive is changed for all market participants to take action and respond in a socially desirable way. If there is government interference with the price adjustment, market participants (both suppliers and demanders) will not change their behavior to reflect the new realities. In this case, if the P ($) Q (#) Q 2 P 1 P 2 Q 1 S 1 Figure 5.3, Increase in quantity supplied. With higher gasoline prices, quantity supplied will increase. Suppliers will have financial incentive to tap into previously uneconomical sources of gasoline production, to work open facilities on later shifts, perhaps forego planned maintenance, etc. all to increase production.