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

Sabiou M. Inoua () and Vernon L. Smith ()
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Sabiou M. Inoua: Economic Science Institute, Chapman University
Vernon L. Smith: Economic Science Institute, Chapman University

Working Papers from Chapman University, Economic Science Institute

Abstract: "The 1870s neoclassical marginal revolution in economics culminated a century later in a striking conclusion: The core utility maximization principle of neoclassical economics was shown to have no interesting implication for aggregate market behavior (Sonnenschein, 1972, 1973a, 1973b; Debreu, 1974; Mantel, 1974; Kirman, 1989; Shafer & Sonnenschein, 1993; Rizvi, 2006). We argue that neoclassical price theory was founded on two axioms—price-taking behavior and the law of one price in a market—that, if imposed on the theory, were logically inconsistent with a theory of market price formation. This logical gap in neoclassical theory was filled essentially with thought experiments: Jevons derives utility maximizing quantities, given prices, then postulates a ‘theoretically perfect market’ in which every trader has complete information on supply and demand and the consequent equilibrium price(s) (Jevons, [1871] 1888, p. 87); 3 Walras also derives utility maximizing quantities for given prices. (Walras, 1874, Lesson 8) Further, however, he proposed a mechanism whereby the price in each market might be determined by a trial-and-error (or tatonnement) process of adjustment (Walras, 1874, see, e.g., Lesson 48).4 However, Bertrand (1883, p. 505) noted that Walras’s process caused path-dependency problems that impacted the postulated equilibrium state. Careful analysis of this problem led Walras to realize increasingly the awesome difficulty of dealing with disequilibrium dynamics within the neoclassical framework.5 Walras thus reformulated his original theory of tatonnement, rephrasing it instead as a virtual trial-and-error disequilibrium price adjustment process executed while trade is suspended at disequilibrium, hence setting the stage for the modern concept of tatonnement as a virtual dynamics executed ‘as if’ it were effected by an auctioneer. 6 Although seriously incomplete, Jevons, Walras, and their general equilibrium followers, introduced the principle that rationality is a property of the individual, and indeed, rationality in the economy became identified with individual rationality throughout economics, game theory, and financial asset markets. The new tradition committed economic science to the proposition that markets and all economic interactions are rational if and only if their component individuals are rational."

Keywords: History of Economic Thought; Methodology of Economics; Microeconomic Theory; Experimental Economics (search for similar items in EconPapers)
JEL-codes: B C D (search for similar items in EconPapers)
Date: 2020
New Economics Papers: this item is included in nep-his, nep-hme, nep-hpe and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:chu:wpaper:20-19

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