One of the best readings from Carl Menger‘s Principles of Economics, a reading that we covered in the colloquium on Menger on which I was discussion leader in Las Vegas last weekend, is about how prices are formed. The following quote gives the flavor:

If, for example, an economizing individual, A, has a horse that has a value to him no higher than 10 bushels of grain if he were to acquire them, while to B, who has had a rich harvest of grain, 80 bushels have a value equal to a horse if he were to acquire one, it is clear that the foundations for an economic exchange of A’s horse for B’s grain are present, provided that A and B both recognize this relationship and have the power actu- ally to perform the exchange of these goods. But it is equally cer- tain that the price of the horse can be formed between the wide limits of 10 and 80 bushels of grain and can approach either of the two extremes without causing the economic character of the exchange to disappear. It is, of course, extremely improbable that the price of the horse will settle at 11 or 12 bushels or at 78 or 79 bushels of grain. But it is certain that no economic causes whatsoever are present that exclude completely the possibility of the formation of even these prices. At the same time, it is also clear that the transaction can take place naturally only between A and B only as long as B finds no competitor in his endeavor to acquire A’s horse by trade.

But suppose that B1 does have a competitor, B2, who either does not have as great an abundance of grain as B1 or requires a horse less urgently. Still, B2 values a horse as highly as 30 bushels of grain, and could thus provide better for the satisfaction of his needs if he were to give 29 bushels of grain for A’s horse. It is clear that the foundations for an economic exchange of a horse for some quantity of grain exist between B2 and A as well as between B1 and A. But since only one of the two competitors for A’s horse can actu- ally acquire it, two questions arise: (a) With which of the two com- petitors will the monopolist A conclude the exchange transaction? and (b) What will be the limits within which price formation will take place?

Step by step, Menger then introduces transactors on both sides and shows how that bounds the price. He does it all without using a demand curve or a supply curve. It’s a beautifully constructed 20 or so pages and I recommend it.

One of the participants, Catherine Pakulak, an economics professor at Catholic University of America in Washington, D.C., said that she liked it so much that she will use it as a reading in her economic principles class. I said that I would have done the same had I known about that section years ago. (I think I came across it in my history of thought reading in the mid-1970s, but forgot it, actually.)

I pointed out, and Catherine agreed, that one of the advantages of teaching price formation this way is that students taking an economics class for the first time don’t have the intellectual baggage that comes later in economics classes and that this exposition will sound completely realistic and intuitive to students.

By the way, I laid out the Chatham House ground rule, which I also referred to, appropriately enough, as “What happens in Vegas stays in Vegas.” Accordingly, I asked and received Catherine’s permission to reference her thoughts.

You can find a free pdf of Menger’s Principles here.