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Price impact is a consequence of market activity that is often overlooked. It is a measure of how much a transaction will change the prevailing prices in the market in which the trade occurs. This is a concern for people who buy or sell in large quantities, since their actions contribute more to aggregate supply and demand than do those of the average participant.
Economic models of many competitive markets are built on the assumption that buyers and sellers are price takers, which means they see a price in the marketplace and decide to buy or sell based on the relationship of their personal valuation of the product to that price. This assumption is one of the underlying tenets of models of perfect competition, which also assumes an infinite number of market participants. In a perfectly competitive market, whenever you want to buy a product, there is a seller to provide it.
In reality, markets have limited numbers of participants, so each buyer and seller affects overall market conditions. A large order for a product stimulates demand, driving up the price, while a large offer to sell decreases the price. Market participants with significant power in the market must take these consequences into account when making the initial decision. Changes in price can affect other aspects of their business or future actions in the same area.
The starkest example of price impact occurs in markets that are dominated by monopolies. In these cases, one company has complete control over prices because it is the only producer. If it wants to sell at higher prices, it produces fewer items, creating a shortage so that people will be willing to pay more. It puts the customers at a disadvantage for its own profit, which it can do because it holds all the power in the market.
The effect, however, is not limited to monopolistic markets, or even to small markets. Though some markets come close, there are no perfectly competitive markets. It may seem that you are a price taker because you go to the store, see a posted price, and decide whether or not to buy. Consumers, however, do have power, and a concerted effort to boycott a product can have enough effect on demand to change the price. Each individual has some price impact, but generally the result is not measurable until individuals combine forces.
Price impact is not limited to consumer markets. Financial markets are particularly affected by price impact because they are dominated by large investors. Sometimes, these are wealthy individuals who hold many shares of one asset. More often, however, they are institutional investors — the fund managers who invest on behalf of all of their clients. The large amounts of funds they invest give them the power to change stock prices with a single sale or bid.
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