The relationships between the demand for goods and their prices are widely known. Other things being equal, an increase of demand leads to the shift of the demand curve to the right, and the ultimate market price tends to increase. However, this process does not take place immediately; it requires additional time. The current paper examines how soon the changes in demand may affect the changes in prices.
This problem will be examined from various perspectives. The essence of a lag in economics will be specified. Other relevant factors will be examined. The paper will also analyze how the understanding of lags may allow investigating the trends of real-world markets in a more correct and realistic way.
General Relationships between Demand and Prices
The market demand is one of the main determinants of market prices; the other important factor is the market supply. If the supply for a given product is constant, an increase in demand will lead to both higher prices and quantity. It is presented in Fig. 1.
Fig. 1. The Impact of an Increase in Demand on the Market Price
According to the Fig. 1, an increase in demand leads to higher market prices. It is logical as if the market demand increases, then the number of potential buyers willing to purchase a given good at the previous price increases. If the supply is constant, there are no additional sellers willing to sell their goods at this price for new buyers. Thus, the only way to equalize the quantity demanded and supplied is the increase of market prices. In this case, the equalization occurs with the help of the following two processes. On the one hand, as higher prices always correspond to lower quantities demanded, the number of buyers will decrease. On the other hand, as higher prices correspond to higher quantities supplied, the number of sellers will increase. Thus, at some point that corresponds to a higher price level, the quantity demanded and supplied may become equal.
However, Fig. 1 neglects one important aspect. The increase of prices does not occur simultaneously with the changes in demand. As the real market is a dynamic process, both buyers and sellers have to adjust their business and entrepreneurial strategies to the new market conditions (Andreyeva, 2010). The buyers begin to propose higher prices for obtaining of a given good, and sellers become able to increase the ultimate market prices. Thus, the actual increase of market prices always requires additional time
Essence of Lags in Economics
A large number of economic processes do not occur simultaneously or immediately but require an additional time period in order to produce the ultimate outcome. Therefore, the concept of lag is important for understanding the real interactions between various economic factors in the actual markets. In this context, a lag may be defined as the time period between the influence of the independent variable and its ultimate effect on the dependent variable (Cooper, 2003). The demand for goods is an independent variable, and the prices are a dependent variable. Thus, any changes in the market demand have an impact on the money prices, but they require additional time.
Thus, the concept of lag is important in the following two respects. The first one is the understanding of the final effects on the dependent variable (market price). The second one is taking into account the transition period and its effect on the structure of the market. As there are numerous buyers and sellers in the majority of real markets, they do not react identically to the same market situation. Therefore, some will understand that the price will increase earlier and adjust their strategies. Some people will not immediately understand that the new market price will be higher than the previous one and may not be willing to participate in market transactions believing that they observe only temporal price fluctuations.
Some market participants may be involved in arbitrage trying to earn extra-profits through buying goods at a lower price and trying to sell them at a higher price. If their predictions of the future dynamics of the market are correct, they may obtain additional profits. Otherwise, they may suffer losses. The real-market situation is much more complicated because a large number of factors are subject to constant changes, and market participants have to take into consideration all of them.
Temporal Relationships between the Market Demand and Prices
In order to understand how soon the changes in the market demand may affect the market prices, it is reasonable to investigate the entire system of temporal relationships between these parameters. The ultimate causes of changes in demand may be different. However, it is possible to specify two main ones. The first cause is changes in consumers’ preferences regarding a particular good (Carlson, 2010). As people’s preferences are unstable, consumers may begin to value a specific good higher in comparison to other available alternatives. Therefore, the may be eager to propose higher prices in order to obtain it.
The second possible cause is the increase in the money supply. In this case, a large number of people experience an increase in their nominal incomes. Consequently, their nominal demand for all goods increases, and the market prices will also increase. However, this process in both cases requires time.
After the increase in the market demand, all market participants have to search for new market equilibrium. All markets participants (both sellers and buyers) are interested in the following two aspects. The first one is the occurrence of exchange, and the second one is obtaining the most attractive conditions. Sellers typically try to obtain the highest possible price for their goods, and buyers try to purchase them at the minimum price. As their interests are opposite, they need to balance them and find the mutually beneficial solution.
During the transition period, market participants have to rely not only on the objective facts (such as technologies, the stock of goods, etc.) but also subjective interpretations about the expected level of prices and the dynamics of consumer preferences (Alberini & Filippini, 2010). Thus, the time period needed for affecting prices from changes in the market demand depends on the ability of market participants to correctly appraise the situation. It is possible to examine several hypothetical examples.
The first one refers to the situation when the majority of people correctly appraise all major factors. In this case, the changes in demand will affect prices very soon. It may take several days, hours, or even minutes as at the stock market. Everything depends on the specific market infrastructure. The second example refers to the situation when sellers are not highly responsible to changes in demand. If they do not understand the existing tendency and believe that it is only a temporal event, they can maintain their prices at the previous level. In this case, under the current market price, the quantity demanded will exceed the quantity supplied. Consequently, the temporary shortage will emerge. At this stage, the sellers will have to increase their prices. Thus, if sellers are inflexible in their adjusting strategies, more time will be needed to affect the market prices.The third possible example is that sellers see the increase of the market demand but overestimate its effect. In other words, they believe that the prices should increase more considerably than it is in reality. In this case, they will charge higher prices. However, the majority of consumers will be unable or unwilling to pay them. As a result, the quantity supplied will exceed the quantity demanded. Consequently, the temporary surplus will emerge (Roache, 2012). At this stage, sellers will have to decrease their prices, and the state of the long-term market equilibrium may restore.
Thus, it may be stated that the final influence of changes in the market demand on prices may be observed only when all market participants fully adjust their strategies to the new structure of preferences and the level of demand. If the majority of market actors are realistic in their market appraisals, the amount of time needed to affect prices will be minimal. If they are either over-pessimistic or over-optimistic in their judgments, the transition process will take a longer period of time.
Influence of Elasticity of Demand and Supply
The demand for different goods is not identical. In some cases, the demand for a given good is elastic. It means that even a slight change in market price will result in a considerable change in the market demand. If the market demand is inelastic, the quantity demanded will not change considerably. The same analysis may be also applied to the market supply. It should also be stressed that determining elasticity of supply or demand is possible only during the move along the supply or demand curve.
It is necessary to examine the process of changes of the market demand in more detail. If the market demand increases, and the supply of goods is constant; then, the following is observed. The demand curve shifts to the right while the supply curve remains at the previous level (as described in Fig. 1). It means that the move along the curve is observed only in relation to the market supply. Correspondingly, the elasticity of demand does not have any direct impact on time needed for the changes in prices (Litman, 2013). In this context, the degree of changes plays the central role. In other words, the disposition between the previous and actual demand curve is central. Only the elasticity of supply is relevant in this context as the movement along the curve exists in this case.
If the market supply is inelastic, then, the quantity supplied will remain comparatively stable. In this case, the price changes may occur in a comparatively short period of time (Lin & Prince, 2009). Sellers will have only to adjust the market prices proportionally to the observed changes in the market demand. If the market supply is elastic, the situation is different. A large number of producers are willing to expand their market supply in accordance with the new prices. In this way, the level of uncertainty increases, and it is more difficult to correctly appraise the future state of the market. Thus, more time may be required to influence market prices.
Mutual Impact of Numerous Factors
The correct analysis of real-world markets is very complicated due to the fact that numerous factors operate simultaneously. As some of them may facilitate the adjustment process while other may create additional problems, it is problematic to determine what the ultimate effect will be. Moreover, some changes in the aggregate price level and money supply affect the equilibrium in specific markets. According to Carlson (2010), the increase in the money supply may be fully absorbed by the economic system only in 5 years. It means that all markets experience the influence of the central bank’s policy and try to adjust their strategies accordingly.
It is possible to present the most desirable and undesirable combinations for the adjustment process. The most desirable combination refers to the situation when the adjustment processes takes the minimum possible time. It means that the market price is affected by the changes in demand during a very short period of time. At the level of the central bank, the policy should be predictable, and any substantial changes in the money supply should be absent. For example, Friedman’s monetary rule seems to be satisfactory for all economic agents as they may formulate the rational expectations about the future dynamics of their cash balances (Mackowiak, 2009). In relation to the changes in demand, the optimal situation for the adjustment process is slight changes. The demand may increase or decrease, but it should be insignificant in percentage points in comparison to its overall level. If the increase or decrease constitutes several percentage points, it may be effectively absorbed by the market. Sellers can make reliable prognoses and determine the future equilibrium price in a very short period of time. The optimal situation with the market supply refers to an inelastic market supply. Sellers simply make proportional changes in the market price according to changes in the market demand in this case.
Thus, the ultimate optimal combination includes a conservative policy of the central bank when the money supply becomes constant or increase at a comparatively low rate, insignificant changes in the market demand, and the inelastic market supply (Reimer, Zheng, & Gehlhar, 2012). It is also possible to specify the combination that will lead to the most difficult and time-consuming adjusting process. It includes unpredictable changes in the boney supply (especially its significant increase by the central bank), considerable changes in the market demand and consumer preferences, and the elastic market supply (Klenow, 2010). In this case, market participants will have to act under the conditions of the global uncertainty.
Other combinations will lead to some moderate results. The type of the market and products may also influence the adjustment process. The market of perfect competition may adjust at the highest speed while the oligopolistic market is the most inflexible. It may also be expected that the market of homogenous products will adjust faster in comparison to the market of heterogeneous products because the former market does not require additional analytical decisions.
Although the impact of the market demand on prices is well-understood, its time component is not deeply investigated at the moment. Although any changes in the market demand affect the ultimate market prices, this process requires time. The specific period of time that is required may be different, and it depends on numerous factors. It is determined that the degree of changes of the demand curve substantially affects the process. The elasticity of demand is not crucial while that of supply is significant.
The optimal combination of factors contributing to the facilitation of the adjustment process includes the predictable monetary policy, slight changes in the market demand, and the inelastic market supply. The opposite combination will create the most difficult adjustment process. The market of perfect competition requires the minimal amount of time needed for this adjustment. The oligopolistic market requires much more time. If the market consists of homogenous goods, it makes the adjustment process easier and more predictable. Thus, it is impossible to determine a priori how soon the changes of the market demand will cause changes in prices. It is necessary to closely examine all aspects of a given market.