How Markets Slowly Digest Changes in Supply and Demand

TLDR

The ideas reviewed here are relevant to market microstructure regulation, agent‑based models, cost‑optimal execution strategies, and understanding market ecologies. The article revisits tatonnement in price formation, reviewing recent theory and empirical work on how supply and demand fluctuations are slowly incorporated into prices. The study examines how low revealed liquidity forces large orders to trade incrementally over months and reviews theory predicting volume‑ and time‑dependent market impact, bid‑ask spread, order‑book dynamics, and volatility. Empirical analysis shows that order flow exhibits long‑memory persistence, that market efficiency imposes strong constraints on price formation, liquidity, and impact, and that the resulting framework attributes most price changes to supply‑demand dynamics rather than external news, with encouraging agreement between theory and data.

Abstract

In this article we revisit the classic problem of tatonnement in price formation from a microstructure point of view, reviewing a recent body of theoretical and empirical work explaining how fluctuations in supply and demand are slowly incorporated into prices. Because revealed market liquidity is extremely low, large orders to buy or sell can only be traded incrementally, over periods of time as long as months. As a result order flow is a highly persistent long-memory process. Maintaining compatibility with market efficiency has profound consequences on price formation, on the dynamics of liquidity, and on the nature of impact. We review a body of theory that makes detailed quantitative predictions about the volume and time dependence of market impact, the bid-ask spread, order book dynamics, and volatility. Comparisons to data yield some encouraging successes. This framework suggests a novel interpretation of financial information, in which agents are at best only weakly informed and all have a similar and extremely noisy impact on prices. Most of the processed information appears to come from supply and demand itself, rather than from external news. The ideas reviewed here are relevant to market microstructure regulation, agent-based models, cost-optimal execution strategies, and understanding market ecologies.