From the title of this section, one should not conclude that there exist perfect markets. Equally important, one should not discard the idea that markets represent valuable societal institutions. Because many hold "religious" beliefs about the market institution as ideal or as the cause of all evils, it is important to understand how markets work and how they can be designed and used to work for the goals we want to achieve.

Below you see an ILE with a stock and flow diagram for a quite standard market. This diagram is different from the standard supply and demand diagram used to understand markets in the field of economics, see the diagram in the lower right corner of the ILE. While the two diagrams look very different, they also have much in common. The supply and demand diagram's vertical axis measures (increasing) marginal producer costs and (declining) marginal buyer benefits as functions of respectively production and consumption on the horizontal axis (supply and demand). Market equilibrium is where the two curves cross. This happens for a price equal to 10 monetary units and 100 units of production and consumption.

The two diagrams differ in their ambition to explain how prices are formed. The supply and demand curves make the logical point that demand will be satisfied up to the point where marginal benefits no longer exceed marginal costs, the equilibrium point. However, it is not such that a market institution has full information about these curves and declares what the prices should be from minute to minute. This is because the supply and demand curves summarize an enormous amount of information about the costs and benefits for the market actors. Moreover the curves organize this information along monotonically increasing cost curves and monotonically decreasing benefit curves. This information is not available to anyone and is not used to establish market prices. Do not misunderstand, the field of economics do not claim that this is the way prices are determined, the curves are simply a very practical tool to reason about market interactions. The supply and demand curves also illustrate how utility is shared between market actors. The area of the triangle below the marginal benefit curve and above the equilibrium price line denotes the consumer surplus. This area sums up the net consumer benefits of all units consumed. The triangle below the price line and above the marginal cost curve represents the producer profits from all units produced and sold. For the two curves used to illustrate, consumers gain more in utility than the producers gain in profits. The demand curve also illustrates the difference between the value of something and the price of it.

The ambition of the stock and flow diagram, on the other hand, is to explain how prices are determined in markets. Each market actor has knowledge (although not perfect) about his own costs or benefits. These are the costs and benefits that contribute to the aggregate supply and demand curves for the entire market. Even though this information is not perfect, it is sufficient for the market actors to make the needed decisions. A producer considers whether the current price exceeds the costs of producing one more unit and the buyer considers if the value of one extra unit will exceed the price. These considerations determines production and buying.

It would be a miracle if for current prices, producers and buyers end up with identical numbers for production and buying at any point in time. Keep in mind that at each point in time both production and buying are also influenced by other things than the price. In most markets the difference between production and buying accumulate in inventories (in other markets the difference may accumulate in order books and result in delayed deliveries). In most markets there is limited knowledge about the size of the total market inventory. However, market actors consider their own inventories. If inventories are low, there is no hurry to sell while there is hurry to buy, and prices are bid up. If inventories are excessive, prices are reduced. While this argument may seem sufficient to explain price formation, it is not.

From what price level should the price be increased or reduced? From cognitive psychology, Tversky and Kahneman (1974), we know that people tend to deal with such tasks by using an anchoring and adjustment heuristic (rule of thumb). Here, the anchor is likely to be the expected price while the adjustment is given by the inventory coverage (inventory relative to the desired inventory). The expected price represents a perception of recent prices, captured in a stock variable. In the field of economics this is referred to as adaptive expectations. With these arguments, the stock and flow diagram gives a good explanation of the price formation. Simulations show that this simple model gives robust explanations of price behaviors by relying on information that is available to local market actors.

There are many different market institutions. In an open air vegetable market, sellers announce their prices (posted prices) and may allow for bargaining. Indoor stores typically operate with posted prices and no bargaining. Auction markets, ranging from outdoor animal markets to electronic stock markets, operate with bids and asks, where transactions take place when bids and asks match. Laboratory experiments show that all institutions work and that there are only minor differences with respect to price levels and market efficiency. The choice of institution seems to be more of a practical issue where the transaction costs play a major role, see e.g. Wang (1993).

References:

A. Tversky and D. Kahneman: "Judgment under Uncertainty: Heuristics and Biases", Science 1974 Vol. 185 Pages 1124-1131

R. Wang: "Auctions versus posted-price selling". The American Economic Review, 1993 Pages 838-851.

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