Desirable Properties of a Price Adjustment Mechanism
The preceding four chapters examined various characteristics of disequilibrium macroeconomic models and introduced some
new extensions. Most of the models presented do not provide
an adequate explanation of price determination and adjustment. This chapter considers various explanations of price
determination and adjustment that have been suggested in the literature and discusses them in the light of some desirable properties to be outlined below.
It should perhaps be remarked that although disequilibrium models have been, heavily criticised for failing to explain w h y market clearing prices are not realised, the problem of price determination is equally pertinent to models of continuous equilibrium which fail to provide an adequate explanation for continuous perfect price adjustment.
Before examining suggested explanations of price adjustment and determination it is useful to consider what might be
desirable properties for an adjustment mechanism. Most of
these are self-evident and well known however a clear statement of each will clarify the arguments to follow.
(a) Price adjustments should be made simultaneously with
quantity adjustments, and should be determined as part of the solution to individual or groups of agents maximization problems.:
This requirement is of course closely related to often quoted observation of Arrow (1959) , that when there is excess demand (supply) agents must abandon the perfectly competitive assum ption that they can buy (sell) all that they wish at the
171
going market price. Agents are price setters who must
choose both prices and consequently quantities simultaneously according to some known or perceived finite elasticity
I
supply and demand curves.
(b) Price and Quantity adjustments should be related
explicitly to the non-synchronized nature of trading, and consequent discontinuous reception of signals. Since agents visit markets sequentially they cannot base price adjustments upon information to be gained upon markets
as yet unvisited. Consequently both expected signals,
extrapolated from past experience, and information deducible. from other agents behaviour should play an important role
in an adjustment process. In this context information
transferred between agents about their future market behaviour must be incentive compatible to be useful.
(c) Price adjustments or agreements should be made upon
the basis of verifiable information.
If prices upon one market are to be agreed or adjusted upon the basis of anticipations or 'second hand' information then agents should be able to verify whether the inform
ation or anticipations were correct. This form of require
ments for a price agreement or adjustment will be important in the context of implicit contracts and asymmetric
information to be discussed in relation to the contributions of Bailey (1974) Azariades (1975) Grossman and Hart (1581) and others.
(d) Adjustment of both prices and quantities should not
be costless.
Either to search for another agent who is willing to complete the other side of a desired new transaction, or to disseminate information to potential trading partners is a costly process.
172
Such costs should be explicit in planned optimal adjustments,
(e) Any mechanism which explains price adjustment should
explain as extreme cases both fixed and perfectly flexible prices.
This is a more prosaic requirement but observation of reality quickly indicates that prices are in some periods and on some markets perfectly flexible, giving the appearance of perfect auction markets, yet are, on other occasions, fixed. It would be desirable that a proposed adjustment mechanism should explain why under certain parameter configurations the two extremes occur.
In the next section candidates for an adequate price adjust ment mechanism will be considered in the light of (a)-(e). However, before doing so a remark about price determination is perhaps required. Several of the mechanisms to be
considered shortly involve interesting arguments
relating to when prices and when quantities adjust,however, frequently the initial.price vector adopted is arbitrary
(or historically giv e n ) , and the models explain why and how prices adjust but they do not determine the actual level of prices.
173
5 .2 A Consideration of Price Adjustment Mechanisms
It is widely understood that if prices are fixed at non-market clearing values then an equilibrium must be established by
some quantity allocation rule. (Rationing Scheme) Despite
the attractive macroeconomic models that such an approach generates, the theory cannot be considered a reliable tool for making policy prescriptions unless an acceptable price adjustment mechanism is incorporated.
In this section various adjustment mechanisms will be considered firstly in the light of the discussion about the desirable properties of an adjustment mechanism given in Section 5.1, and secondly in the light of the implications the mechanisms have for the macroeconomics of the theory.
Numerous arguments for either fixed or imperfectly adjusting prices have been advanced, however five basic approaches, or potential approaches to the problem may be identified.^
(i) The Effective Excess Demand Approach
Previously discussed in section 4.1, the effective excess demand approach develops Leijonhufvud's initial idea that
prices may not adjust due to effective demand failures. He
argues that quantities adjust very rapidly and thus the correct formulation of excess demand functions must include
effective rather than notional demands and supplies. The
reasons why quantities move faster than prices are based upon arguments about informational problems and liquidity con straints. Effective excess demand functions it is then argued may not cause prices to return to their market clearing
values. Whatever the characteristics of an effective excess
adjustment mechanism is not adequate given the desirable
criteria that have been proposed. Most importantly it
can be seen that this adjustment mechanism does not allow simultaneous price and quantity adjustment as part of the solution to individual agents maximization problems.
Benassy (1976, 1980) suggests a price adjustment mechanism conceptually somewhat similar to Leijonhufvud but explicitly
introducing monopolistic price setting. He assumes that
there are two types of good in the economy studied, Hq
being the set of goods the prices of which are exogenously
fixed,and the set of goods the prices of which are deter
mined by agents. Further it is assumed that H i n H^ = {<i>}
V i^j i.e. each goocj is priced by a monopolist, also it is assumed that only suppliers set prices and each produces
only one good. The economy is assumed to behave as follows.
Monopolists perceive demand curves for their goods
Zi h (Pil°i) (5.2.1)
where is the signal of prices and upper and
lower bounds that trader i has observed. The perceived demand curves are assumed to have the natural property of going through the currently observed point.
Traders maximize their utility subject to the perceived demand curves, the solution to which is an optimal price as (5.2.2).
P i * (V = pi* < P * V 2 i > (5.2.2)
C
Once each agent has calculated and announced his
optimal • price, each then maximizes again subject to the
set of all quoted prices and the set of fixed prices H0 .
175
By the usual mechanism a Benassy K-equilibrium in quantities
is then established. If an excess of effective demands Z
★
over realised trades Z is observed agents re-estimate
<
their perceived demand curves and quote a new set of
optimal prices. This process continues until a monopolistic
equilibrium is established which is defined as a price
* +
^
vector p , net trades Z^, effective demands Z^, perceived
constraints Zi and such that
•k —
(1) ( Z ^ ) , (Zj), (Zif Z^) are a fix price equilibrium
★