Neoclassical Supply and Demand, Experiments, and the Classical Theory of Price Formation

Abstract

Neoclassical price theory was founded on axioms of price-taking behavior and the law of one price in a market, axioms inconsistent with a theory of endogenous price discovery in markets. Classical economists including Adam Smith narrated a price discovery process based on buyer and seller reservation values and their motivation to buy low and sell high; the classical sketch of price formation offers a quite fruitful foundation for a modern theory of price discovery, supplied below. Market experiments, based on private distributed reservation values and using rules governing open-outcry double auctions, converged endogenously, in three to four periods of repeat interaction, to an efficient outcome. These observations contradicted the widely believed, thought, and taught necessity for perfect information, large numbers, and price-taking behavior. However, these results were consistent with the old, classical, conception of price formation emerging from the collective interaction of the traders. Aggregation and price discovery constitute essential functions of classical markets. We explore the divergence of neoclassical scholars from this classical tradition. Revealingly, in describing the microdynamics of market price formation, prominent neoclassical utilitarians such as Marshall, with his description of a “corn-market in a county town,” and Böhm-Bawerk with his farmers’ horse market, reverted to this classical reservation-value framework.