Market (economics)

The uses of the term

The word "market" is commonly used to distinguish transactions between individuals from other ways of allocating goods and services. The term "market economy", for example, is often used to describe a society in which most business decisions are made by individuals and companies, rather than by the government - which, as a political regime, is generally known as capitalism. It is also used as a noun to refer to an institution that facilitates such transactions, and as a verb to denote the activity of promoting them.

The term "the market", has a different usage, however. That usage refers to a theoretical model of a process by which prices are determined by supply and demand (a graphical representation of which can be seen in most economics textbooks). That model depends entirely upon deduction from untested axioms, and, without empirical support, it has limited application to the real world. Empirical evidence indicates that, in fact, market behaviour is strongly influenced by the characteristics of the institutions within which trading takes place.

Market characteristics

Markets can be categorised by their openness, structure, flexibility, stability, their degree of information assymetry, and the difficulty of restricting access.

The term openness is here used to denote freedom from regulations concerning, for example, prices. quality and permission to trade.

The concept of market structure concerns the proportion of the items that are supplied that comes from a few suppliers, or the proportion of items acquired that go to a few purchasers. Its practical importance derives from its association with "market power", which is the ability to influence the prices at which items change hands. (The policy implications of market power are discussed below in the paragraph headed competition policy.) Measures of market structure include the 5-firm concentration ratio and the Herfindahl Index. Suppliers can increase their market power by mergers, restrictive trade practices or innovation.

The concept of market flexibility is concerned with the speed with which a market price responds to a sudden change in the supply of, or demand for, its product. Flexibility may be limited by search friction or by commercial or regulatory market constraints.

Markets also differ as to their stability. Instability can develop in markets that require the use of credit if circumstances, such as a demand shock, create a general fear of default. Fear of default can result in a reinforcing rise in the incidence of default - a continuing process that could lead to systemic market failure.

Information asymmetry occurs when the seller has information about the subject of a bargain that is not available to the buyer.

Markets do not, by definition, exist for public goods (such as open spaces and lighthouses) that are not paid for by individual users because of the difficulty of restricting access or use. Where those difficulties can be overcome at a cost (as in road pricing), the cost of overcoming them is a relevant market characteristic.

Market organisation

The term "primary market" refers to one of a variety of organisational arrangements in which buyers deal directly with sellers. All early markets were of that sort. A later development was the creation of "secondary markets" in which transactions are made between specialist "dealers", acting on behalf of prospective buyers and sellers. One way of organising a primary market is to bring together numbers of mutually independent sellers with numbers of mutually independent buyers, either by attending a physical market place, or by using a telephonic or electronic communications centre. Another is to arrange an "auction", in which competing bids for the purchase of goods are made by groups of mutually independent buyers. There are many different ways of organising auctions, and they, too, can involve either attendance or communication.

The traditional way of organising a secondary market involved a physical location (termed an "exchange" or a "pit"), at which dealers matched ask prices with bid prices by "open outcry". That organisational form has now been replaced almost everywhere by the use of telephonic or electronic communication. The term "electronic market" has come to denote the use of computer software to make bargains automatically by electronically matching ask prices and bid prices. Settlement, involving the transfer of payments and purchases, takes place after the completion of bargains, and is usually the work of clearing houses.

Commercial markets

Commodity markets

Commodity markets are exchanges where commodities of standardised quality are traded using standardised contracts. (Commodities are physical goods such as crude oil, and metals). More than forty commodity exchanges worldwide trade in over 100 commodities. Trading is confined to members and is commonly by "open outcry".

The economics of the market

The basic concept

In economic theory, a market exists when a would-be buyer makes contact with a would-be seller for the purpose of agreeing an exchange. It embodies a concept of the process by which the supply and demand for a commodity, product or service are brought into equality. In the late 19th century, the English economist Alfred Marshall offered several definitions and gave a range of examples .

Perfect markets

Marshall also introduced the concept of a perfect market when he wrote .. the more nearly perfect a market is, the stronger is the tendency for the same price to be paid for the same thing at the same time in all parts of the market. The hypothetical ideal of a perfect market has since been developed to mean a situation in which:

• price is determined by the costless interaction of collective supply with collective demand;
• all information that is relevant to the price of a commodity is immediately known to all market participants;
• all market participants act rationally;
• it is impossible for any individual participants or groups of participants to influence the price of a product.

The implications of the concept were explored in the 20th century by a mathematical exploration of the behaviour of a universal system of interconnected perfect markets in a condition of general equilibrium. The resulting theorems of welfare economics demonstrated that such a system would achieve a limited form of economic efficiency termed Pareto efficiency. That demonstration has been widely interpreted to imply that in practice the removal of obstacles to the achievement of the ideal of a system of perfect markets would increase economic efficiency and so raise human welfare. However, the theory of the second best has demonstrated that that is not necessarily true.

The auctioneer analogy

An analogy for the process by which a market brings supply into equality with demand was put forward by the French economist, Leon Walras. He described a market in which an imaginary auctioneer invites offers to sell and offers to buy at an arbitrary starting price, and then announces a succession of price revisions that bring the amounts offered by buyers and sellers progressively closer together until equality is reached - and allows no transactions to take place until that price is established . The analogy is strictly applicable to "information-efficient" markets, in which all participants are fully informed about the consequences of their agreements.

The efficient market hypothesis

The efficient markets hypothesis stipulates that, in an information-efficient market, all of the available information that is relevant to the price of an asset is already embodied in that price. It is based upon the assumption that investors react immediately to any fresh information to buy or sell that asset . If prices are expected to rise tomorrow, investors will buy today and in doing so, will cause the price to rise until it is no longer expected to rise further. A 1970 paper by Eugene Fama gave support to the hypothesis that stock markets are in that sense efficient, and many of the subsequent developments in financial economics embodied that assumption, and the implied conclusion of the efficient markets hypothesis that price variations on the markets for financial assets are random variations which could be represented by established probability distributions formed the basis of a range of widely accepted risk analysis theorems. A conflicting financial instability hypothesis was put forward by Hyman Minsky in 1992, but it was not until the crash of 2008 that it was widely recognised that major risks could occasionally arise from statistically unpredictable patterns of investor conduct,

Policy implications

Financial regulation

In response to the financial crash of 2008, new measures of financial regulation are being introduced. "Microprudential" measures, concerned with the stability of individual financial institutions, are being strengthened and new "macroprudential" measures, concerned with the stability of the financial system as a whole are being added. A paper by the United States Department of the Treasury makes the point that "a narrow micro-prudential concern for the solvency of individual firms, while necessary, is by itself insufficient to guard against financial instability. In fact, actions taken to preserve one or a few individual banking firms may destabilize the rest of the financial system". A Bank of England discussion paper goes further, explaining that microprudential policymakers might impose severe lending restrictions to guard against individual bank failures, whereas macroprudential policies would take account of the long-term damage to the banking system and to the economy that could result from the consequent credit shortages