On the Dynamic Behavior of Prices in Disequilibrium

SATISFIED AS WE MAY BE with the overall efficiency of the market system and with the tenets of the perfect market model, we all viscerally know that were we down on the market floor we would certainly react to a multitude of apparent price discrepancies. Indeed, it is intuitively inconceivable that a man-made institution (such as the market) could be so mechanically perfect that all such discrepancies would be totally annihilated before they can be observed. Accordingly, we would expect floor traders and other professionals to be speculating abundantly on what they perceive to be the direction in which the market is going. Almost surely, such behavior has an effect on the dynamics of stock prices. A financial theory that cavalierly ignores this component in the determination of prices would be regrettably deficient. Theoretical studies of security prices have traditionally concentrated on fundamentals, e.g., the relationship between a security's anticipated cash flows and its price, given the time and risk preferences of the investors bidding for it. Recent research on the microstructure of security markets draws attention to the role of the market's organization in the determination of security prices. It is now increasingly recognized that institutional factors-such as the brokers' handling of investors' orders, the management of the limit order book, or the existence of designated specialists entrusted with an affirmative obligation to maintain "price continuity"-affect the speed of the prices' adjustment to changing conditions. This study extends the scope of the analysis one step further. It takes explicit consideration of the investors' reaction to the limitations of existing markets. When traders attempt to exploit market "imperfections", and act on their perception of the current price trend, their actions can cause phenomena which are totally unrelated to economic fundamentals, and are thus unpredictable by fundamental analysis. For economists, who view the market as an instrument for resource allocation, the platonic ideal of a market price is a price that instantaneously equilibriates the notional supplies and demands of all traders. These equilibrium prices guarantee an efficient allocation of resources, and are fully determined by the current state of the economic environment, i.e., the agents' endowments, prefer