One of the major areas of interest—and dispute—among economists concerns how markets function. Those who develop theories along the lines of classical economics believe that market systems function fairly smoothly and are largely self-regulating. Those who lean more towards the Keynesian side believe that market economies need some help from government policy to serve goals of human well-being. But what do economists mean by “markets”?
The Meaning of Markets
When people talk about markets, they may be referring to a number of different meanings of the word, from very concrete to very abstract. In the language of economics there are at least three different uses of the word "market," and the appropriate meaning must be judged from the context in which it appears. We will start with the most concrete and move toward the more abstract definitions
The most concrete and commonsense definition of a market is the idea that a market is a location—that is, a place where people go to buy and sell things. This is historically appropriate: Markets such as the Grand Bazaar in Istanbul or African village produce stands have flourished for ages as meeting places for people who wish to make exchange transactions. The same criterion applies today, even when the “market” has become a shopping center or mall, with many retail stores sharing one huge building, or a stock or commodity exchange, where brokers stand on a crowded floor and wave signals to each other. A market, as suggested by these examples, can be defined as a physical place where there is a reasonable expectation of finding both buyers and sellers for the same product or service.
However not all markets are physical places where buyers and sellers interact. We can think of markets in more general terms as institutions that bring buyers and sellers together.
Institutions are ways of structuring the interactions between individuals and groups. Like markets, institutions can also be thought of in concrete or abstract terms. A hospital can be considered an institution that structures the interactions between doctors and patients. A university is an institution that structures the interactions between professors and students. But institutions can also be embodied in the customs and laws of a society. For example, marriage is an institution that places some structure on family relationships. Laws, courts, and police forces are institutions that structure the acceptable and unacceptable ways that individuals and groups interact.
When we think of markets as institutions, we see that a market does not need to be a physical location. Internet auctions, such as eBay, are market institutions that bring buyers and sellers together. The New York Stock Exchange can be considered both a physical location—a building on Wall St. where brokers buy and sell stocks—and an institution where investors all over the world interact indirectly according to a set of established rules and structures.
Thinking of markets as institutions, rather than concrete places, leads to various ways of discussing particular markets. Many economists spend much of their time investigating one or more such specific institutional markets. They may track the trades made at various prices over time for a specific good, like heating oil or AT&T bonds, try to forecast what might happen in the future, or advise on the specifics of market structures. When such an economist speaks of a market, he or she most often means the institutional market for such a specific good.
In this sense, several different markets may operate under one roof, within the same organization. For example, in the United States the Chicago Board of Trade operates many markets for a variety of farm products, including wheat, corn, and soybeans, among many others. Indeed, even a term like "wheat" may be too general to define a market for some purposes, given the existence of such distinct varieties as "No. 2 dark winter wheat" and "No. 1 dark northern spring wheat." Or such an institutional market might cover a number of different physical locations, such as when an economist speaks of a market in regional terms. The “New England market for home heating oil” for example, may involve transactions by a number of different companies at a number of different physical locations.
In the most abstract terms, people sometimes talk of “the market” as a situation of idealized unencumbered exchange. Without reference to either physical places or social institutions, buyers and sellers are imagined to come to instantaneous, costless agreements. This definition of the market may refer to all market relationships at a national or even global level. When economists speak of the merits (or limitations) of “free markets,” they are referring to the concept at this level of abstraction. Often what people have in mind in this case is not so much specific, institutional markets as a particular model of how markets could behave, in an ideal case. Economists who have a “pro-market” view believe that markets should generally be left to function with very little government intervention in order to maximize economic prosperity. They may claim, for example, that problems of environmental protection can and should be solved by “the market.” Others recognize the effectiveness of markets but believe that problems such as poverty, inequality, environmental degradation, and declines in social ethics may be caused or exacerbated by unchecked and unregulated markets.
The Basic Neoclassical Model
The basic neoclassical model, traditionally taught in detail in most microeconomics courses at the introductory level, is a model of market exchange that—while abstracting away from many real-world factors—portrays in a simple and elegant way some important aspects of markets. Neoclassical economics arose during the late 19th and early 20th century. It took the earlier classical idea that economies can be thought of as systems of smoothly functioning markets, and expressed this idea in terms of formalized assumptions, equations and graphs. (The prefix “neo-" means “new.”)
In this model, the world is simplified to two kinds of economic actors—households and firms. Households are assumed to consume and to maximize their utility (or satisfaction). Firms are assumed to produce and to maximize profits. Households are considered to be the ultimate owners of all resources, and they sell or rent these to firms, receiving monetary payments in return. Firms produce goods and services, which they sell to households in return for monetary payments. This model can be portrayed in the circular flow diagram in Figure 1. The model further assumes that there are so many firms and households involved in the market for any good or service that a situation of “perfect competition” reigns, in which prices are determined purely by forces of supply and demand.
In this idealized world, goods and services are produced, distributed, and consumed in such a way that the market value of production is as high as it can be. The model combines important observations about markets with assumptions about human values and human behavior (as both producers and consumers). (In reading through the following statements, see if you can recognize which parts are “positive” observations of facts, and which are assumptions, which may include a “normative” slant, towards “the way things ought to be.”) Full social and economic efficiency is said to arise because:
- The prices set by the forces of supply and demand in smoothly functioning markets carry signals throughout the economy, coordinating the actions of many individual decision-makers in a highly decentralized way.
- The profit motive gives perfectly competitive firms an incentive to look for low-cost inputs and convert them into highly valuable outputs. Production decisions are thus made in such a way that resources are put to their most (market) valuable uses.
- Consumption decisions made by individuals and households are assumed to maximize the “utility” or satisfaction of consumers.
- Maximizing the market value of production is assumed to be a reasonable proxy for maximizing human well-being
Extending the model to include international trade, the story of “comparative advantage” similarly demonstrates how specialization and trade may lead to a greater (market) value of production on an international scale, compared to a situation in which each country produces only for itself.
The Advantages of Markets
Economies that rely heavily on markets to coordinate production, distribution, and consumption have certain important advantages over the main recent historical alternative to markets, central planning.
The bureaucratic socialist systems that used to exist in the former Soviet Union and Eastern Europe, for example, were notorious for their inefficiency in resource allocation—both within enterprises and across the whole economy. According to economic historian Alec Nove, Soviet economic planning at its peak spelled out production targets for almost 50,000 commodities, involving a staggering and virtually unmanageable level of detail. Separate production decisions had to be made for the millions of distinguishable commodities in the Soviet Union (e.g., every size for each different style of shoes). A large bureaucracy had to be established to run all this. The economy was steered very much toward heavy industry and military production—allowing the Soviet Union to become a world power—while neglecting consumer goods and agriculture. Dissatisfaction with the results of this centrally-controlled system contributed greatly to its collapse in 1992.
Because information and decision-making in a market economy is decentralized, and producers have an incentive to respond to consumer desires, market systems can lead to a more efficient use of resources than entirely centrally planned economic systems. While the workings of real-world markets are more complex, the principle of efficiency highlighted in the basic neoclassical model should not be neglected.
The fact that market exchange is voluntary, not coerced, is often considered to be an additional advantage of markets. While most people are in some sense forced to offer their labor for pay in order to survive in a market economy, market systems generally offer people some choice about where they work and what they buy. Other market advocates claim that, by offering financial incentives, markets encourage people to be creative, innovate, and communicate with each other.
However, it is one thing to recognize that markets have advantages, and another to claim that markets are always the best way to organize economic activity.
Classically-minded macroeconomists tend to emphasize potential efficiency gains from markets, and stay fairly close to the basic neoclassical model in their theories. They tend to believe that most economic decisions should be left to “free markets.”
More Keynesian-oriented macroeconomists, on the other hand, tend to emphasize how real-world markets might differ from the smoothly functioning markets that exist in theory. Real-world markets require an impressive set of associated institutions to work well, they point out. And markets on their own are not well-suited to addressing certain kinds of economic problems.
The Institutional Requirements of Markets
Contemporary large-scale markets do an amazing thing: they allow many, many separate decision makers, acting from decentralized information, to coordinate their behavior, resulting in highly complex patterns of voluntary exchange transactions. They do not, however, operate in a vacuum. Economists have identified a number of even more basic institutions that market institutions require in order to function. We will classify these in four broad groups: 1) individualist institutions related to property and decision making; 2) social institutions of trust; 3) infrastructure for the smooth flow of goods and information; and 4) money as a medium of exchange.
Individualist institutions related to property and decision making. For markets to work, people need to know what belongs to whom. Private property is the ownership of physical or financial assets by nongovernment economic actors. Actors must also be allowed to make their own decisions about how to allocate and exchange resources. Prices, in particular, must not be under the complete control of guilds or central bureaus, but must, rather, generally be allowed to be set by the interactions of market participants themselves.
The institutions of private property and individualist decision making exist both formally, as in codes of law, and informally, in social norms. For example, some Western economists expected markets to grow quickly in the countries of the former Soviet Union as soon as communism was dismantled and opportunities for markets opened up. However, many people were accustomed to being told where to work and what to do by the state. Norms of individual initiative and entrepreneurship, it turns out, do not just arise naturally but need to be fostered and developed.
Social institutions of trust. A second critical institutional requirement for markets is that some degree of trust must exist between buyers and sellers. When a buyer puts down her payment, she must trust that the seller will hand over the merchandise and that it will be of good quality. A seller must be able to trust that the payment offered is valid, whether it is in the form of currency, personal check, credit card charges, or other kinds of promise of future payment. Social institutions must be created to reduce the risk involved.
Again, trust is an institution that exists both in social norms and formal establishments. Cultural norms and ethical or religious codes can help establish and maintain an atmosphere of trustworthiness. One-on-one exchanges between customers and businesses help build trust and make future transactions smoother. Many companies have built up a reputation for making quality products or providing good service. Marketers try to capitalize on the tendency of buyers to depend on reputation by using advertising to link certain expectations about quality and price to a recognizable brand name and thus creating “brand loyalty” among repeat customers.
In modern complex economies, contracts are often needed to define the terms of an exchange. An informal or implicit contract exists when the terms of an exchange are defined verbally or through commonly-accepted norms and traditions. Explicit contracts are formal, usually written, agreements that provide a legally-enforceable description of the agreed-upon terms of exchange. For formal contracts to work, there must be laws that define contracts, state the legal obligation to honor contracts, and establish penalties for those who fail to do so, and a system for enforcing those laws.
In highly marketized economies many other institutions have evolved to deal with the issue of trust. For example, credit bureaus keep track of consumer credit trustworthiness, Better Business Bureaus keep track of complaints against businesses, “money back” guarantees give consumers a chance to test the quality of a good before they commit to purchasing, and escrow accounts provide a place where money can be put until goods or services are delivered. Government agencies like the U.S. Food and Drug Administration and local boards of health are charged with monitoring the quality and purity of many goods that are sold.
However, even in complex transactions among large groups of strangers, social norms are still essential. Detailed formal contracts are costly to write and costly to enforce. It is not practical to police every detail of every contract, and it is impossible to cover every conceivable contingency. The legal system can work smoothly only if most people willingly obey most laws and believe that it is dishonorable to cheat. In effect, relationships, social norms, and the government-created apparatus of law are institutions that must exist side by side, reinforcing one another. None of these alone can carry the whole burden of making complex contracts work, and hence make markets possible.
Infrastructure for the smooth flow of goods and information. A third set of basic institutions for market functioning has to do with making possible a smooth flow of goods and information. Most obviously, there needs to be a system of physical infrastructure for transportation and storage that provides the basic foundation for moving goods around. Such infrastructure includes roads, ports, railroads, and warehouses in which to store goods awaiting transport or sale. This sort of infrastructure can be most noticeable when it is absent, such as in economies ravaged by war.
In addition, there needs to be an infrastructure in place for the flow of information. Producers and sellers need information on what, and how much, their customers want to buy; in a well-functioning marketized economy, this information indicates what, and how much, should be produced and offered for sale. At the same time, consumers need to know what is available, and how much of something else they will have to give up (i.e., how much they will have to pay) to get the products that are on the market. In fact, ideally consumers should be able to compare all potential purchases, as a basis for deciding what to acquire and what to do without.
Money as a medium of exchange. The final critical institution required for markets to operate smoothly is a generally accepted form of money. Many different things have been used as money in the past. Early monetary systems used precious or carved stones, particular types of seashells, or other rare goods. Gold, silver, and other metal coins were the most common choice for many centuries; more recently, paper currency has become important. Today, financial instruments such as bank account balances play an even larger role; in a developed country, the amount of money that changes hands in the form of business and personal checks is several times as great as the volume of transactions conducted with paper and metal currency. The use of credit cards (a form of debt, to be later paid by a bank account draft), electronic bank transfers, and payments over the Internet further ease the making of payments in exchange.
What makes something money? One obvious criterion is that money must be widely accepted as a medium of exchange; money is whatever everyone else thinks it is. Yet this alone is not enough. Imagine the problems that would occur if everyone agreed that heads of lettuce were money! A form of money that starts to rot within a week or two would be difficult to use. Thus a second criterion is that money must provide a durable store of value, of the same value today as at any time in the near future. If there is inflation—that is, an increase in the average price level for all goods and services—then money gradually loses a little of its value. Usually, however, inflation occurs slowly enough that people can retain confidence in the value of money from day to day. Relatively rare episodes of "hyperinflation"—in Germany after World War I; in several Latin American countries during the second half of the 20th century; or in Russia after 1989—when prices shoot upward and money suddenly wilts like old lettuce, have led to great social stresses and inequities.
Even with durability added, the definition of money is still not complete. Some durable goods would not be successful as money. Bottles of wine retain their value for many years but are too bulky and breakable to be used widely in exchanges. A final criterion, therefore, is that money must have minimal handling and storage costs. By this criterion, paper currency is better than coins, and financial records on a computer are better still.
In many cases, money is created or sanctioned by the government but this is not essential. For example, cigarettes were a form of money in prisons and concentration camps during World War II. Money is, ultimately, based upon common agreement. While once backed by precious metals in Fort Knox, the value of a U.S. dollar is now based only on the understanding that other people will take it in exchange. In this sense, money is also a social institution of trust, as well as part of the institutional infrastructure of functioning markets.
The Limitations of Markets
Real-world choices are not limited to either a system where a centralized government exerts total control or the radically “free market” system described in the basic neoclassical model. Actual market-oriented economies always include a mixture of decentralized private decision-making and more public-oriented decision-making.
This is not because voters and government officials are not aware of the advantages markets can have in helping an economy run efficiently. Rather, it is because in real world economies there are a number of important, complex factors that are not taken account of in the basic neoclassical model. Some of the major factors which are important include: public goods, externalities, transaction costs, market power, questions of information and expectations, and concerns for human needs and equity.
Public goods. Some goods cannot, or would not, be well-provided by private individuals or organizations acting alone. A public good (or service) is one where the use of it by one person does not diminish the ability of another person to benefit from it (“nondiminishable”), and where it would be difficult to keep any individuals from enjoying its benefit (“nonexcludable”).
For example, if a local police force helps make a neighborhood safe, all the residents benefit. Public roads (at least those that are not congested and have no tolls) are also public goods, as is national defense. Education and quality childcare are public goods because everyone benefits from living with a more skilled and socially well-adjusted population. A system of laws and courts provides the basic legal infrastructure on which all business contracting depends. Environmental protection that makes for cleaner air benefits everyone.
Because it is difficult to exclude anyone from benefiting, public goods cannot generally be bought and sold on markets. Even if individual actors would be willing to pay if necessary, they have little incentive to pay because they can’t be excluded from the benefit. Economists call people who would like to enjoy a benefit without paying for it "free riders." Because of the problem of free riders, it often makes sense to provide public goods through government agencies, supported by taxes, so that the cost of the public benefit is also borne by the public at large.
Externalities. Other activities, while they may involve goods and services that are bought and sold in markets, create externalities. Externalities are side effects or unintended consequences of economic activities. They affect persons, or entities such as the environment, that are not among the economic actors directly involved in a particular economic activity. These effects can be positive or negative. Sometimes positive externalities are referred to as “external benefits” and negative externalities are referred to as “external costs.” Externalities are one of the primary ways in which the true social value of a good or service may differ from its market value.
Examples of negative externalities include a manufacturing firm dumping pollutants in a river, decreasing water quality downstream, or a bar that plays loud music that annoys its neighbors. Examples of positive externalities include the fact that parents who, out of love for their children, raise them to become decent people (rather than violent criminals) also create benefits for society at large, or the way in which one person getting vaccinated against a communicable disease to protect himself or herself also protects people around him or her from the disease’s spread. In both cases, there are social benefits from individual actions. Well-educated, productive citizens are an asset to the community as well as to their own families, and disease control reduces risks to everyone.
Some of the most important externalities have to do with the economic activity of resource maintenance: Relying on markets alone to coordinate economic activities allows many activities to happen that damage or deplete the natural environment, because the damage often does not carry a price tag and because people in future generations are not direct parties to the decision-making.
If economic activities affected only the actors directly involved in decision-making about them, we might be able to think about economic activity primarily in terms of individuals making decisions for their own benefit. But we live in a social and ecological world, in which actions, interactions, and consequences are generally both widespread and interknit. If decisions are left purely to individual self-interest, then from a societal point of view too many negative externalities will be created, and too few positive externalities; the streets might be strewn with industrial wastes, while children might be taught to be honest in dealings within their family, but not outside of it. Market values and human or social values do not always coincide.
Transaction costs. Transaction costs are the costs of arranging economic activities. In the basic neoclassical model, transaction costs are assumed to be zero. If a firm wants to hire a worker, for example, it is assumed in that model that the only cost involved is the wage paid. In the real world, however, the activity of getting to a hiring agreement may involve its own set of costs. The firm may need to pay costs related to searching, such as placing an ad or paying for the services of a recruiting company. The prospective worker may need to pay for preparation of a resume and transportation to an interview. One or both sides might hire lawyers to make sure that the contract terms reflect their interests. Because of the existence of such costs, some economic interactions that might be lead to greater efficiency, and that would occur in a transaction-cost-free, frictionless idealized world, may not happen in the real world.
Market power. In the basic neoclassical model, all markets are assumed to be “perfectly competitive,” such that no one buyer or seller has the power to influence the prices or other market conditions they face. In the real world, however, we see that many firms have market power. For example, when there is only one firm (a monopolist) or a few firms selling a good, they may be able to use their power to increase their prices and their profits, creating inefficient allocations of resources in the process. Workers may also be able to gain a degree of market power by joining together to negotiate as a labor union. A government, too, can have market power, for example when the Department of Defense is the sole purchaser of military equipment from private firms.
Businesses may also gain power by their sheer size—many corporations now function internationally, and have revenues in the tens of billions of dollars. The decisions of individual large corporations can have substantial effects on the employment levels, economic growth, living standards, and economic stability of regions and countries. Governments may need to factor in the responses of powerful business groups in making their macroeconomic decisions. National leaders may fear, for example, that raising business tax rates or the national minimum wage may cause companies to leave their country and go elsewhere. Corporations frequently also try to influence government policies directly, through lobbying, campaign contributions, and other methods.
Information and expectations. In the basic neoclassical model, in which purely decentralized decisions lead to efficient outcomes, people are assumed to have easy access to all the information they need to make good choices. This analysis is static; that is, it deals with an idealized case in a timeless manner. The model doesn’t consider the time it might take for a person to make a decision, or the time it might take for a factory to gear up to produce a good. In the real, dynamic, world, getting good information may be difficult, and planning for an uncertain future is a big part of anyone’s economic decision-making.
A manufacturing business, for example, might be considering whether or not to borrow funds to build an additional factory. If the company’s directors were able to know in advance exactly what demand for its products will be like in the future and what interest rates will be—along with additional information about things like future wages, energy costs, and returns on alternative investments—the decision would be a simple matter of mathematical calculation.
But the directors will have to guess at most of these things. They will form expectations about the future, but these expectations may turn out to be correct or incorrect. If their expectations are optimistic, they will tend to make the new investment and hire new workers. Often optimism is “contagious,” and if a lot of other business leaders become optimistic, too, then the economy will boom. If, on the other hand, people share an attitude of pessimism, they may all tend to cut back on spending and hiring.
Since no one business wants to take the risk of jumping the gun by expanding too soon, it can be very difficult to get a decentralized market economy out of a slump. How people get their information, how they time their actions, and how they form their expectations of the future, then, are all important topics in macroeconomics that are not addressed in the basic neoclassical model. Taking these factors into account means that sometimes markets may not work as smoothly as that model suggests.
Human needs and equity. In the basic neoclassical model, the only consumer demands for goods and services that count are those that are backed up by a consumer’s ability to pay. This has several implications.
First, there is nothing in the model that assures that resources are distributed in such a way that people can meet their basic human needs. If a few rich people have a lot of money to spend on diamonds, for example, while a great number of poor people lack the money to pay for basic health care, “free markets” will motivate producers to respond to the demand for diamonds, but not to the need for basic health care. More deliberate policies of economic development, government provision, subsidies, or income redistribution—sometimes incorporating, or sometimes replacing, market means—are often enacted to try to ensure that decent living standards become more widespread. Second, the model does not take into account non-marketed production, such as the care given to children, the sick and the elderly by family and friends. There is nothing in the basic neoclassical model that assures that these sorts of production will be supplied in adequate quantities and quality.
Lastly, it is also the case that problems like unemployment and inflation usually tend to affect some people more than others, so that how a country deals with these problems also has distributional consequences.
Clearly, although market systems have strong advantages in some areas, they cannot solve all economic problems. Economists sometimes use the term "market failure" to refer to a situation in which a market form of organization would lead to inefficient or harmful results. Because of the existence of public goods, externalities, transaction costs, market power, questions of information and expectations, and concerns for human needs and equity, macroeconomic systems cannot rely on “free markets” alone if they are to generate human well-being.
To some extent private non-market institutions may help remedy “market failure.” For example, a group of privately-owned factories located around a lake may voluntarily decide to restrict their waste emissions, because too much deterioration in water quality hurts them all. Likewise, a widespread custom of private charitable giving may help alleviate poverty. But sometimes the problems are so large or widespread that only governmental, public actions at the national or international levels seem to offer a solution. Exactly how much governmental action is required, and exactly what governments should do, however, are much-debated questions within contemporary macroeconomics.