Tuesday, October 28, 2014

substitution, liquidity, and elasticity of demand

One of my formative (insofar as one can use that term for something that happens when one is 35) experiences was trying to explain to an introductory microeconomics student that the elasticity of demand for eggs is somewhat low, but the elasticity of demand for Farmer Jones's eggs is very high; his eggs are (presumably) very good substitutes for the eggs of a lot of other farmers.  If a single person could set the price of all eggs, the price they choose would have a small effect on the quantity that would sell at that price, but if Farmer Jones tried to unilaterally change only the price of his eggs, the quantity of his eggs that would sell would change a lot.

Yesterday Matt Levine wrote that it doesn't matter whether an individual owns most of the copper in London-Metals-Exchange-approved warehouses because that's a very small fraction of global copper, and Professor Pirrong said that, to a reasonable extent for a moderate period of time, it does, and while the clear theoretical economic categories aren't always clear in practice, in this case it seems more clear and correct to say that global copper can't substitute for LME warehouse copper, but with some time and expense can be converted into it. So if you're looking at a 5-year time horizon, it's probably not worth trying to distinguish the two, but the shorter the relevant time period, the larger the gap that could reasonably open up between the prices of the two.

A lot of what I think of as "demand for liquidity", which isn't quite what other people (e.g. Shin, Tirole, etc.) would mean by that phrase, is time-sensitivity; in a certain language, what I'm thinking about is more of a demand for market liquidity and what they mean is funding liquidity, but to some extent these are both closely tied to "how quickly can I convert one asset into another asset?" or "at what terms of trade can I quickly convert one asset into another asset?", especially as distinct from "at what terms of trade could I convert one asset into another asset if I had a lot of time to try to get a good price?" "Liquidity" then is related to convenience yields, but also to elasticity of intertemporal substitution — whether cash tomorrow (or even this afternoon) is equivalent to cash at some point in the next five years. If you're interested in the price of copper in deciding whether to build a new factory, you can probably use the LME price for delivery over the next couple years as a proxy for global copper prices, but if you need to deliver into an LME futures contract next week, you have a demand for LME copper that doesn't admit the same kind of substitution, and you're going to find that the market is a lot less elastic.

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