Classical Theory of Competitive Market Price Formation

We offer an information theory of market price formation, formalizing and elaborating on an old, implicit, classical tradition of supply and demand based on buyers’ and sellers’ mone-tary valuations of commodities (formally their reservation prices) and competition as a multilat-eral higgling and bargaining process. The early laboratory market experiments, as it turns out with hindsight, established the remarkable stability, efficiency, and robustness of the old view of competitive price discovery, and not the neoclassical price theory (based on individual utility and profit maximization for given prices). Herein, we present a partial-equilibrium version of the the-ory in which wealth is implicitly constant, and reservation values are fixed, as in the early exper-iments, formulating an information interpretation à la Shannon that corresponds with modern notions of the pricing system as an information signaling system. Competitive equilibrium price, we show, conveys maximum information about the distribution of traders’ valuations. We illus-trate the theory as it applies to a few market conditions (notably a non-clearing market case) and institutions (posted-price market, English auction, double auction, sealed-bid call market).