This section is from the "Economics In Two Volumes: Volume I. Economic Principles" book, by Frank A. Fetter. Also available from Amazon: Economic
4 Effect of trading outside of the market. For example, B 11 might take S 8 apart and persuade him to exchange at the price 8, at which both would gain something as compared with not trading at all. But it would be folly for S 8 to isolate himself in effect from the market
FIG. 11. PRice Resulting from Valuations.
It appears then that a logical market-price5 is that price common to all trades made at the time, which permits the maximum number of transfers with some gain to both parties. This may be expressed also as: that price common to all trades at a given moment, at which no less urgent bidder on either side of the market can trade while any more urgent bidder is excluded. Such a price brings the desires underlying demand and supply to an equilibrium; no buyer is willing to bid more and no seller is willing to take less. It may therefore be called an equilibrium price.
§ 4. The market as a two-sided auction. It may be helpful to think of the market as a double auction-sale in which each bidder in either group has in mind a "reserve-price," a valuation at which he will withdraw from the market. Now in this way. For at that price there would be 8 traders willing to sell and 11 willing to buy. Three buyers able to outbid B 11 must, at the price 8, fail to get into the trade at all. One of them (logically it should be B 1O with a bid of 9) must leave the market without making a purchase (S 10 having a valuation of 9.5). Any buyer from B 11 to B 16 therefore could succeed in getting into the market only as a result of persuading one of the sellers against his own interest, and of outwitting a competing buyer. Similarly, S 11 might get B 9 apart (or any other buyer from B 1 to B 8) and make a trade at 9.5 mutually advantageous (tho not so good for B 9 as he might get otherwise). But at this price there would be 11 sellers and but 9 buyers, and as in the converse case, the less urgent traders would be displacing more urgent traders. Under the assumed valuations any other price than 9 involves the displacing of some more urgent bidder (or bidders) by a less urgent bidder on the same side.
5 This is the logical, or theoretical, market-price in the sense that it is the price which results when all the assumed conditions are fulfilled. Actual market-price is that price at which a trade is made, and this may vary on either side of the theoretical price when something happens such as is described in the last footnote, some one failing to realize his possibilities. When this occurs there is immediately a new theoretical price and the increase of bids from the excluded, more urgent bidders must send the price either higher or lower than at the last trade. In the example above, where 8 was the actual price on one trade, the next theoretical price became 91/2. suppose it is the duty of the auctioneer to find the correct market-price. He would say, "There are 16 axes here, how many will sell at 7 rather than not sell at all?" At this price there would be six sellers and only six trades possible. The other owners of axes hold them (have reserve-valuations) at more than price 7. "How many will buy?" At this price there are sixteen would-be buyers. Then by successive readjustments the auctioneer might finally fix a price at which the maximum number of trades is possible, that is, the price 9, with ten trades.
§ 5. Supply and demand coordinate in price-determination. It should be emphasized that in the foregoing explanation of price, choice must be understood in relation both to demand and to supply. Choice is not peculiarly connected with demand. Demand, like supply, means a quantity of goods which a person chooses to trade at a specified price. Demand is expressed as the number of sale-goods which a buyer will take at the price; supply as the number of sale-goods with which a seller6 will part. Demand and supply are the same goods viewed in different aspects. A trader can have no demand unless he has a supply of the price-goods to give, and will make no offer unless he has a desire for the other goods. There is no more of the psychological element in demand than in supply, and no less of the objective elements (of material goods).
§ 6. Price in a permanent market. We have been analyzing the process of price-fixing, starting at a moment when no price existed. Prices must have their origin in this way beginning in a given situation of human desires in relation to the existing fund of goods. But in a much greater number of cases in practical life to-day, price seems to exist in advance of, and apart from, any individual's valuations. Almost every market, like every active business, is a "going concern," closed only at night, on Sundays, and on holidays. Price seems to be a continuous fact, altho there is, properly speaking, no continuous price; there is merely a succession of separate prices, as shown by the trades from moment to moment. "We watch price change as in a moving picture made up of many instantaneous photographs. Yet each new price seems to grow out of the last price. The opening price each day is usually somewhere near the closing price of the day before, but often somewhat, or very, different as a result of rumors, or of information regarding rains, wars, fires, and countless other influences. The individual trader must take the price at any moment as he finds it. His choice, indeed, is such a small element that price seems to be independent of his valuation. He merely decides whether at that price to buy, or to sell, the same amount as before, or more or less, or none at all, or to bid or to ask a lower or a higher sum. In doing any of these things, however, he not only indicates his attitude toward the market-price, but he exercises his influence upon it. An excluded buyer, if he has anything to trade, shows that he values the price more than he does the sale-good. On the other hand, an excluded seller, the owner of a sale-good, retains it because his desire for it is stronger than his desire for the price (and for the other things which by trade the price represents to him). Trade and the succession of prices appearing are the index and the resultant of the continuous changes in the economic conditions, desires, and choices of the members of the community.
6 Who is also, from the other point of view, a buyer, his sale-goods being the price he is ready to pay.
§ 7. Effect of the market upon valuations. It is clear that price is the result of the valuations of traders in a market taken collectively; yet as each individual's valuation is looked at separately it seems to be largely determined by price. It is very important to keep in mind that the valuations which are spoken of and represented graphically as so different from the market-price, are not actual. They are merely what would be if the individual were not in the market. It was shown in discussing the valuation curve (see Chapter 4, sections 8-11), of an isolated person, that the higher valuations of earlier units sink in accordance with the principle of diminishing gratification when more like units are added. The actual valuations of all the like units of a present supply are all alike (principle of indifference). Now in a market the individual is in the presence of large new supplies which he can buy at a price. If he approached the market with a higher valuation of the sale-good (in terms of the price-good) than he finds prevailing, he buys, and continues to buy successive units until his valuation of the sale-good has sunk to the market-price, or until his price-goods (purchasing power) are exhausted. So long as he keeps on buying he is bringing his valuation as nearly into agreement with the market-price as he can (with units of the size offered). As he gets more sale-goods their value (in money) falls (principle of diminishing gratification) ; as his money decreases the value of the other things he can buy with it relatively increases (principle of increasing gratification). "When all his money is gone he has desire, but no demand, his valuation is merely hypothetical - what he thinks he would pay if he had the money. This is the state of mind of a large part of the population most of the time regarding most kinds of goods.