Illiquidity and the Hot Dog Effect

This article uses an example of buying hot dogs and hot dog buns to illustrate how liquidity in a market can improve efficiency.

Hot dogs and hot dog buns are often sold in incompatible quantities. This causes us to consume more or less than our ideal basket of consumption. For example, you may be able to purchase packs of 8 hotdogs and packs of 12 hot dog buns. If you would like to have 12 hot dogs and 12 hot dog buns you must purchase 12 hot dog buns and 16 hot dogs. If you can't afford 16 hot dogs you will be forced to consume only 8 hot dogs with buns, and have 4 extra buns which may end up going to waste.

Now consider that supply and demand in this market are both higher, but the number or items per package are constant. Previously, you wanted 12 hot dogs and buns. Now, you want 120 of each. Now there is no waste. Consider, however, that there was some waste. Consider that there were 4 units of malconsumption, just as there was in the previous example. 4 too many hot dog buns purchased or 4 too few hot dogs purchased both indicate 4 units of malconsumption.

Although the level of waste is constant across the two examples, the rate of waste was lower in the second example. This means the more liquid market is more efficient.

Think about the quantity of hot dogs you can buy for a certain amount of money. In other words, think about the shape of the supply curve. For low amounts of money it appears to be a staircase! As we increase the total available money in the market, we end up "zooming out" on the supply curve and it becomes relatively smoother. Of money, or liquidity, in the market is unlimited then the supply curve becomes perfectly smooth. This corresponds to a lack of waste.

In any market where increases to supply and demand are non-smooth, which is the case in most real markets, there will be inefficiency due to the effect which is exactly the same as a liquidity effect.

To see why this is the same as a liquidity effect, consider that loose change does not exist. The smallest unit of currency available is a single dollar. Many goods will be priced at a cost of $1, even if they would have sold for $1.4o or for $.60, simply because they do not have the choice of such prices. It's the hot dog effect in reverse! If a hot dog is worth $.5, it is as if we can only buy a minimum of 2 hot dogs, even if the producer would be happy to sell only one.

One solution to the second kind of issue is to print money. If there is only $1 in the economy and 2 hot dogs in the economy which are each worth $.5, then we can print a second dollar. This will cause the price of each hot dog to rise to $1, and we will now be able to eliminate this sort of inefficiency from the hot dog effect or illiquidity.

Is economies become more productive then goods become cheaper. In the very long run, without increasing the money supply, we would run into this hot dog effect very often and it could create massive problems. This is one source of real demand for money, whether that money is physical or otherwise.