Market Assumptions - Time Lags

Among the many assumptions of perfectly competitive markets, there is one that is largely unspoken. This assumption is that there are no time lags in buyers and sellers entering or exiting the market. This assumption is quite critical because most analysis of this model and its variants has no time lags as a underlying basis. Taking no time lags as a fundamental basis of analysis also supports the other assumptions of this model.

When we assume no time lags, we can talk about instantaneous changes in demand and supply. Whenever there is a change in the supply of a commodity, the demand for it immediately adjusts appropriately and vice-versa. A new equilibrium price is swiftly reached and no extraordinary profits can be made. Some suppliers will swiftly exit or others will swiftly come in depending on the direction of the change. These changes will also be instantly reflected in changes in employment. Labor made redundant in one area is instantly available for other areas.

As a purely theoretical framework, the perfectly competitive model is excellent at understanding the basic forces that operate on different (but not all) commodities. However, problems arise when this model or any variant thereof is made to fit the real world. Take the problem of time lags. In the real world, things do not happen instantly. There is an often significant time lag between a change in demand occurring and companies responding to it. Similarly, there is also often a significant time between a change in supply occurring and companies and consumers responding to it. These time lags allow extra-ordinary profits to be made. They can also have the effect of entrenching existing companies such that new entrants find it harder to compete. Thus time lags can actually enhance entry barriers. Time lags can also result in a mis-allocation of resources. Projects take time to complete. A project can make perfect economic sense when it is proposed, analyzed and started. However, conditions can change almost overnight and a project that made perfect sense suddenly can become a perfect liability. Dubai discovered this when global economic conditions changed for the worse in 2008. All of a sudden, major real estate projects were forced on hold or cancelled. The result was a large number of sad, empty shells standing forlornly. Thus any model that neglects the effects of time lags will result in faulty conclusions being drawn regarding the economy. The actions that are taken as a result of such conclusions will often be worse than taking no action at all.