Wednesday, October 7, 2009

A point of intersection?

The notion that markets set prices is generally quite a good one. However, the symbol that is often used to present this idea (two lines meeting on a graph) is a rather poor descriptor for the true mechanics of this concept. When a buyer and seller meet in a free market they do not meet at a Euclidian point where supply and demand intersect each other precisely. Instead, they meet within a range. The buyer is willing to buy at any price below a certain level, and the seller is willing to sell at any price above a particular level. They do not meet exactly, instead they have wiggle room--sometimes more, sometimes less. If their respective ranges do not overlap no exchange is possible, if they do then they must settle on a price within that range. But how is the actual price set? Just as no exchange is possible without overlap no exchange is possible without a specific agreed upon price. Enter skill. Negotiation must now take place, with the greater share of the range going to one or the other party. It is no longer a question of how much is wanted or available, but how well each party can fight for a better deal (within the relevant range). With this view in mind, the lines of supply and demand cannot be said to meet at a point, but rather in a fuzzy zone with an exact place to be worked out without regard to desire or capacity to provide. Exchange is not accomplished through a physics like process that produces a certain and necessary result. Instead, it is the result of art constrained by differing values between parties. To claim that price is merely where supply meets demand is to ignore the necessarily human--and subjective--element that so greatly impacts economic exchange. This point is sometime washed over by speaking of a large market of millions of actors, but price is always unique. Each exchange is a particular, singular event, the negotiations of which are influenced by the other transactions, but never exactly set by them. Although it can be pointed towards (and is a useful concept) the market price--in reality--is nowhere to be found.


  1. This wiggle room you speak of certainly exists. It seem the higher the degree of competition the smaller it is. Look at stocks, there is almost no wiggle room what so ever when million and million of shares are traded a day. On top of that all share are equal and perfect substitutes for each other. A share is a share is a share. But for a good such as a house the wiggle room is much larger. For starters houses are not sold as frequently as stock and a house is not a house. They are all special. While they are substitutes for each other they are not perfect substitutes and the housing market is significantly less competitive than the stock market.

    I like your observation, I have not thought of it before and it is very accurate.

  2. Yes the idea of two linear functions meeting at some point and that determining the single clearing price for a good or service is a gross simplification of reality meant to allow those who study markets to glean information from a complex system and abstract rules or concepts. In reality, the market (and higher level economics) is not so simple. The assumptions necessary for a single market price under perfect competition are found almost nowhere in the real world. The combination of perfect information, low transaction costs and costless transition of labor and capital alone eliminate many markets from the application of this simple analysis. This concept is just another example of academic simplification that is necessary to progress students to the point that they understand a few basic concepts and can eventually introduce more complexity.