Principle 6: Markets work well with competition, the rule of law, information, property rights, and incentives.
Objectives:
Define a market as an interaction of buyers and sellers
List and explain the five necessary conditions for an efficient market
Identify the motivator and the regulator in a well-functioning market
Why do you want to learn this?
You live and work in a market economy. To succeed in that economy, you have to know the “rules of the game.” This summary is an introduction to those rules.
A market is an interaction of buyers and sellers. While some may think of a market as a physical place, the interaction may take place on the phone, on the Internet, by written correspondence, or some other form of communication. The necessary characteristic of a market is that sellers “come” to the market to sell their products and buyers “come” to the market to buy products.
The market system is one way of managing production and exchange. Every economy must ask and answer the questions what to produce and consume, how to produce, and how to distribute the goods and services. Regardless of the economic system, scarcity tells us that not everyone will get what they want; some people will be told, “No.” As long as scarcity exists, some people will be turned away; a society has to decide what kind of economic system will best fulfill their goals.
Transaction costs are the costs of arranging contracts or agreements between buyers and sellers. People use credit cards at the pump in gas stations to avoid the transaction costs involved with going inside and standing in line to pay. People often buy cars online to avoid the transaction costs involved with haggling with the car dealer. The higher the transaction costs of an exchange, the less efficient is the exchange; the lower the transaction costs, the more efficient is the exchange To the extent that markets minimize transaction costs, they are efficient. But people use economic systems to pursue goals other than efficiency such as equity, security, stability, growth, and freedom. As we will see, the market system does pretty well achieving some of these goals but not so well with other goals.
FIVE NECESSARY CONDITIONS FOR AN EFFICIENT MARKET
Markets achieve efficiency when five conditions exist: competition, rule of law, incentives, property rights and information. (CRIPI sometimes pronounced creepy).
Competition provides the incentive for suppliers to produce their products at the highest quality and the lowest prices possible. Buyers competing against other buyers for scarce products drive prices up; sellers competing against other sellers drive the price down. Sellers who ask too high a price won’t sell their products; buyers offering too low a price won’t be able to buy the products. The interaction of buyers competing against other buyers and sellers competing against other sellers determines the market price. Competition is the regulator.
The Rule of Law provides the stability that markets need to function efficiently. The Rule of Law exists when individuals in government are subject to the same rules as those they govern. When thugs can steal products at will, when governments can seize property with no warning or compensation, when governments own businesses and throw competitors in jail, when governments can change the rules at will, there can be no efficient markets. Zimbabwe, North Korea, and Venezuela are examples of nations without the rule of law.
Incentives provide reasons for sellers to supply their products and buyers to buy the products. Profit is the driving force for suppliers and satisfaction of wants is the driving force for buyers. One of the advantages of the market system is that sellers don’t have to care at all about the people they hope will purchase their products. Sellers may be wonderful, caring individuals or they may not. Their character is not the issue; the issue is whether they have sufficient incentives to provide the product. In a market system, expectation of profit is that incentive. Producers will make products and offer them for exchange if they expect to gain more than the value of what they are giving up. If sufficient profits exist, sellers will attempt to supply the product. Buyers will buy the product if they gain in satisfaction more than they give up.
Property Rights are a part of the Rule of Law. They are essential for smooth functioning markets. Exchange can’t take place if ownership is unclear. Car buyers want to see a pink slip before making a purchase. Homebuyers want to see a title before purchasing a home. In fact, they pay title companies to guarantee that the deed is valid and that there are no other claimants to the home. Producers won’t supply their products if they don’t reap the benefits of their production. Much more will be said about property rights later, but it is important to note that markets can’t perform efficiently without a legal system that establishes and enforces them.
Information is essential to smooth functioning markets. Buyers want to know who is offering what products and at what prices. Sellers want to know who is willing to pay what price for the products. Typically, buyers and sellers will expend some resources in the search for information on price and quality. The lower the search costs, the more efficient the market. An innovation that has increased the quantity and quality of information, reducing transaction costs is the Internet. Buyers can go on the net, discover who offers the product they are seeking at what price, and can order it directly, without leaving the comfort of their own home. As long as the information is accurate, the Internet reduces transaction costs and makes markets more efficient.
Adam Smith, the Wealth of Nations and the Invisible Hand
1776 is a year near and dear to the hearts of Americans as well it should be. Picnics, fireworks, family get togethers are all part of the 1776 celebration. Americans celebrate the signing of the Declaration of Independence, but there is another important event that probably had as much influence on the lives of Americans as the influence of the Declaration of Independence. As mentioned, a market economy was, after all, a relatively new institution in terms of world history.
The American economic system is closely intertwined with the American political system, and for that, we can thank Adam Smith. In 1776, Smith, a Scottish professor of moral philosophy, published his famous book, An Enquiry into the Causes and Nature of the Wealth of Nations. Smith’s book described the workings of a market economy. He described a system that depends largely on individual initiative and the pursuit of self-interest.
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their self-interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our necessities, but of their advantages.”
In a market system people don’t explain to the butcher, the brewer, or the baker how much they would really like to have their products; they offer them money. If they offer them enough money, they get the product; if they don’t, they don’t. The seller may or may not be a caring, loving person; that is irrelevant. Given the proper incentives, she or he will supply the product, without the proper incentives, no product. In a market system, profit is the motivator. While this may sound impersonal, it means that the buyer doesn’t have to depend on the goodwill of the seller but rather the goal of the seller which is to make a living. The seller has to be careful. If he offers a product that people don’t want, or if he asks too high a price, he ends up with no sales. If, however, he introduces a product that is better or lower priced than others, he is in a position to earn a profit.
The producer has to be careful.
“If he charges too much for his wares, or if he refuses to pay as much as everybody else for his workers, he will find himself without buyers in the one case, and without workers in the other.”
Competition forces the producer to charge a price that is “in line” with that of his competitors and to pay a wage that is similar to that of his competitors. Competition is the regulator.
Smith called the combination of profit as the motivator and competition as the regulator the Invisible Hand. It is invisible because no agency or individual tells people what to produce or consume.
The entrepreneur is the driver in a market economy. She attempts to find new ways of producing proven products or introduce new products that she hopes society will want and be willing and able to buy at a price greater than all of her costs including the opportunity cost of her human capital. After all resources have been paid, the entrepreneur takes what’s left which is called profit. If it is nothing, that is the return to the entrepreneur. If it is 50% above cost, that is the return to the entrepreneur.
Bottom Line:
A market is an interaction of buyers and sellers.
The five necessary characteristics of an efficient market are competition, rule of law, incentives, property rights, and information (CRIPI)
In discussing competition, it is helpful to remember that buyers compete against other buyers and sellers compete against other sellers.
In a market economy, profit is the motivator and competition is the regulator
1. Which of the following is a market?
a. Buyers place an order on the telephone.
b. Buyers place an order on the Internet.
c. Buyers and sellers meet at a specific place.
d. All of the above are markets.
2. The major incentive of an entrepreneur is to:
a. Ensure that the nation is growing at an appropriate rate
b. Earn a profit
c. Ensure that all consumers get the goods they want
d. All of the above
3. Which of the following is NOT a necessary condition for an efficient market?
a. Rule of law
b. Fair prices
c. Competition
d. Incentives
4. The regulator in a market economy is:
a. The federal government
b. The state government
c. The county government
d. Competition
5. In a competitive market, prices are determined by the competition of:
a. Buyers against sellers
b. Buyers against buyers
c. Sellers against sellers
d. Both b and c