Price Formation: Overview of the Theory

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).