# INTRODUCTION

The choice to transact in a market—as a buyer, seller or intermediary—depends on price signals. Supposedly, when markets function well they send the ‘right’ price signals. Price levels, movements and trends represent the relative levels, changes and trends in the surplus and scarcity of goods and changes in the inherent value of these goods to both seller and buyer. Under these conditions, when parties transact, exchange benefits all.

But markets may not function well and send the ‘right’ prices. Some markets may exhibit persistent and relatively higher price volatility, may be less well integrated to international and national markets and indicate relatively attenuated capacity to arbitrage across time and space. Most importantly, the relative poor performance of some markets may not be random nor transitory. In the price data from Mexico examined for this study, there are distinct spatial and temporal patterns that one would expect market forces to address. Ceteris paribus, markets function to attenuate heterogeneity in price levels, changes and trends. There was a lot of persistent heterogeneity in these price data.

The motivation for this research was to identify and understand what prices, when and in which markets do not behave as theory would predict. To identify and comprehend the function of markets and price trends and conditions, this research focused on retail markets for perishable and non-perishable consumables of relatively homogeneous quality across Mexico.

This study looks at three dimensions of market efficiency; namely, price dispersion, passthrough of costs to prices and price volatility. With respect to price dispersion, price variations across physical space are expected not to be sizeable or persistent when markets work efficiently and market agents face stiff price competition. Regarding pass-through, in efficient markets a change in costs of inputs will be fully reflected (passed through completely) in the prices of commodities that use those inputs with minimal delay. In addition, when input costs go up, prices will go up as quickly and as completely as when input costs go down —this is a symmetry condition of pass-through of competitive and efficient markets.

Out of three proposed dimensions of market efficiency, volatility may be the least obvious dimension. However, volatility is indirectly related to efficiency. A benchmark on how much volatility is expected in an efficient market can be inferred. In well-functioning markets, volatility would solely be a function of the fundamentals of demand and supply. Because higher volatility introduces uncertainty, it increases the chances of buyer and seller error and it is something that both seller and buyer may be interested in reducing.<sup>1</sup> In addition, higher volatility may introduce temporally missing markets, especially when information is perfect—buyers delay purchases when they know prices will go down and sellers withdraw

> 1 The error is based on buying when prices may go down or selling when prices may go up in the next period. Some may object to categorizing this as an error. Admittedly, this sounds a lot like timing the market and this can only be done, without error, in hindsight (ex post). However, the error is not that unless a buyer or sellers can buy or sell at a better price, they make an error. The point is rather that in more volatile markets, using an average price as a representation of the likely market price, is a poorer heuristic at any period in time than in a less volatile market. When the average is a poorer heuristic, this means that the buyer or seller may pay too high or sell too low, respectively, than would otherwise be the case. This is what is meant here as an error.

1