Economics of Markets

This book proposes a theory of competitive market price formation which generalizes and extends classical views beginning with Adam Smith.

The implicit axiom of price-taking behavior opens the question of who or what is giving prices, to what purpose, how they are formed initially, and how they adjust in response to changes in the economic environment. The early neoclassical innovators, writing nearly one hundred years after Adam Smith, were primarily concerned with applying their new tools to modeling the structure of economic interdependence in a market economy and were content with simplifying assumptions they believed facilitated that objective.

In this chapter, we turn to a reexamination of the early experiments that “rediscovered” classical economics, since it is part of the impetus motivating us to formally model the classical market price formation process. Then we will resume our presentation on classical theory in Chapter 4.

This chapter introduces the theory of competitive price formation in a heuristic and intuitive way, framed by a simple example which echoes laboratory experimental markets. Competition is understood in the classical sense of traders’ “higgling and bargaining” (including multilateral underselling and outbidding). The core result emphasized is a reformulation and informational interpretation of the law of supply and demand. Price, it is shown, evolves to reflect maximum information about the distribution of traders’ valuations. The main conceptual innovation involves a shift from the static notion of excess demand at an isolated given price, to a dynamic and holistic version, the integral of excess demand along a price-profit trajectory driven by trader competition, which allows for a rigorous formulation of the law of supply and demand and focuses markets on price changes in response to gains from exchange, profit motives, and the price discovery process. We identify supply and demand, respectively, with the distribution of costs (where costs are expressed in markets in the form of sellers’ reservation “prices,” the minimum prices they would be willing to accept in exchange for their products) and the distribution of values (or buyers’ reservation “prices,” the maximum prices they would be willing to pay for units of the commodity).

This chapter restates more formally and works through all proofs for the theory of classical competitive market price formation as it applies to a single market. Goods and services are demanded (supplied) in discrete units, where to each unit demanded corresponds a consumer’s valuation (producer’s cost), which are reservation values expressed in units of a monetary medium of exchange (for example, dollars). We take seriously the discreteness of the commodity, treating the case of smooth supply and demand merely as a simplified, specific case of the theory, as a model of a large market. Throughout this chapter the distribution of reservation values (potential prices) is treated as data, that are fixed and given for a period and during static sequential replications of a period, as in typical laboratory market experiments. The theory is generalized to multiple markets in Chapter 6, where, as in classical economics, wealth is explicitly treated as one of the determinants of reservation prices in market realizations.

This chapter extends the theory to multiple markets where, as in classical economics, wealth is explicitly treated as one of the determinants of reservation prices in market realizations.

The theory of competitive market price formation developed so far does not apply if the goods traded can be re-traded for capital gains, for then the stabilizing virtue of competition can be counteracted by speculation. The concept of re-tradability of a good is crucial for understanding market instability at both the macro and micro level, as directly evidenced by laboratory experiments. We offer a relatively simple model of speculative asset price dynamics that explains the excess, fat-tailed, and clustered volatility, three stylized facts of speculative asset prices.