Economics of Markets : Neoclassical Theory, Experiments, and Theory of Classical Price Discovery

This book establishes that neoclassical economics based on the marginal utility calculus failed to derive a theory of consumer market price discovery consistent with the experimental market evidence. Such markets involve inherently discrete final-demand items bought for consumption and not subject to resale. Classical economists following Adam Smith articulated a rich narrative of price discovery theory consistent with experimental evidence based on operational concepts of discrete demand values (maximum willingness-to-pay), and symmetrically, supply costs (minimum willingness-to-accept). We develop and extend a mathematical model of classical market price formation. Chapter 1 & 2 describes this theme and chapter 3 connects it with experiments. Chapter 4 builds on experimental examples for an intuitive overview of the theory. A partial equilibrium version of the theory constitutes Chapter 5. Chapter 6 extends this framework to price formation by wealth constrained agents in multiple-goods markets. Chapter 7 applies this framework to the study of re-tradable durable-goods and financial claims that are subject to sources of instability absent in markets for consumer non-durables. Sabiou M. Inoua is a visiting research associate at the Economic Science Institute at Chapman University. His primary research now pertains to value theory and its intellectual history; his other research interests include the stylized facts of financial markets, the link between economic complexity and economic development, and the theory of inequality measurement. Vernon L. Smith received the Nobel Prize in Economic Sciences in 2002 for his groundbreaking work in experimental economics. Smith has joint appointments with the Argyros School of Business & Economics and the School of Law, and is part of the team that has created the new Economic Science Institute at Chapman University. He is also a cofounder of The Smith Institute for Political Economy and Philosophy which has been established to create the Humanomics undergraduate research and education program at Chapman University Acknowledgments Contents List of Figures List of Tables 1 Prologue Reference 2 Introduction 2.1 Experiments: Markets Worked Where Theory Failed 2.2 Classical and Neoclassical Perspectives on the Focus of Modeling: The Failed Promise of General Equilibrium Theory 2.3 Prices Are Unknown Until They Are Formed in Market Processes Based on Dispersed Individual Values 2.4 Classical Theory, Wealth, and Information in Price Discovery References 3 Rediscovering Classical Economics in the Laboratory 3.1 Experiments, Following Marshall, Implemented a Classical Market 3.2 Experiments, However, Were Perceived as Rooted in the Marshallian Neoclassical Perspective 3.3 The Dynamics of Convergence: Excess Demand or Excess Rent? 3.4 Brief on the Double-Auction Trading Institution 3.5 One-Sided vs Two-Sided Competition: Silence Is Golden; How Buyers Outperform Sellers 3.6 Summary References 4 Price Formation: Overview of the Theory 4.1 Heuristic Example of Price Formation 4.2 Competition: Price Dynamics The Competition Principle The Classical Law of Supply and Demand The Principle of Maximum Information The PMI Illustrated: Böhm-Bawerk’s Horse Market and a Non-clearing Market 4.3 Competition: Quantity Allocation 4.4 Individual Rationality: Utility versus Surplus Maximization Competition as a Collective Optimization in the Profit Opportunity Space 4.5 Path-Dependency, Trading Institution, and Time Scales Institutions Matter Path Dependency 4.6 Summary References 5 Price Formation: Partial Equilibrium 5.1 Notations, Definitions, Identities, and Assumptions 5.2 Implications of the Theory 5.3 Large-Market Model 5.4 The Theory Illustrated by Specific Market Conditions and Institutions Isolated Exchange: The Smallest Market Swastika and Box Supply–Demand Configurations Auctions: English Versus Other Institutions Sealed-bid Auctions or Call Markets Posted-Price Market Double Auction 5.5 Mathematical Appendix: The Invariance Principle References 6 Price Formation: General Equilibrium 6.1 Setting the Stage: The economy’s Data The Supply Side of the Economy The Demand Side of the Economy The Generalized Competition Principle 6.2 Assumptions 6.3 Implications 6.4 A Large-Economy Model 6.5 The Neoclassical Axioms Preclude a Theory of Price Formation References 7 Financial Instability: Re-tradable Assets and Speculation 7.1 Re-tradable Assets and Economic Instability Consumer Components of Domestic Product, Instability, and Housing Housing and Household Balance Sheets in Economic Instability; Severe Recessions and Household Balance Sheet Crises Asset Market Performance and Experiments Fat-Tailed and Clustered Volatility: Two Universal Empirical Regularities in Financial Markets 7.2 A Model of Speculative Asset Price Formation The Model The Purely Speculative Market Model A More General Specification with Both Speculators and Investors References Index