How Markets Work

So how are markets supposed to work? First, let’s remember what a marketAll the people and businesses involved in the production, distribution and consumption of any good or service. is: A market is the collection of buyers and sellers for a given product. So when we talk about markets, we’re talking about all the people involved in the production, buying and selling of any particular product, from artichokes to Zambonis. When we talk about markets, then, we’re not necessarily talking about a particular place. We’re talking about a lot of places and a lot of people, usually scattered all over the world.

A market has a demand side—the buyers—and a supply side—the sellers. Buyers and sellers seek each other out to improve their welfare. Markets don’t need to be organized; they just happen. At the right price, almost anything is available.A friend of mine from the gym once decided he wanted to get bigger and so set off in search of anabolic steroids (which will make you bigger sometime before they kill you). He found, for a price, all manner of drugs, people willing to do things not normally regarded as legal, and even weapons such as Uzi submachine guns, but, fortunately, didn’t find anyone willing to sell him ‘roids. If there’s a demand for a product, sellers will try to meet that demand. As the demand for fuel-efficient vehicles grows with rising gasoline prices, automakers are more willing to supply them, such as hybrid vehicles. In the last decade, for example, sales of Toyota’s Prius soared while sales of gas-guzzling Hummers plummeted. (Eventually, General Motors stopped producing Hummers altogether and started producing the all-electric Volt.)

By definition, buyers and sellers will reach an agreement on price. The price will be one that lets suppliers make a profit but isn’t more than buyers are willing to pay. For this reason, we say that markets tend to self-regulate. If demand is less than output, or exceeds output, the market will respond by changes in price and/or quantity supplied. Markets for this reason typically don’t require outside organization. As we’ll see, they do, however, sometimes require oversight to ensure that everyone is playing fair. (Not everyone agrees with that idea, and you will have to decide whether you think that’s true.)

Some people have a rather high degree of faith in markets; other people think they’re good at some things but not without their challenges. (And some people argue that markets simply have too many problems; at the moment, those folks aren’t winning the argument.) For example, markets work when there’s real competition. If there isn’t real competition, it’s not much of a market. Despite what everyone says about free enterprise, firms tend to want to limit competition, because that means higher prices. For example, in the 1930s, U.S. airlines (and also the trucking industry) went to the government and sought regulation as way of limiting “ruinous” competition—having to compete on price over what is basically a commodity—airline seats—meant that profit margins were lower. As we will discuss below, that led to 40 years of no price competition in the airline industry.

In a true market, no one sets the price alone. Prices are determined by 1) the costs of production and 2) the demand for the product [remember the laws of supply and demand]. In some countries and in some periods of our history, we have attempted to interfere with markets through price controls: arbitrarily setting the price of goods to ensure that no one has to pay too much. This usually doesn’t work very well. Price controls distort the functioning of a market, typically limiting supply. Remember, according to the law of supply, at a given price, sellers will only supply so much of a good. But the higher price, the more suppliers want to sell, so a lid on prices necessarily means suppliers will only want to sell so much. Selling more means selling at a loss, and nobody does that for very long. Price controls, such as those imposed in this country during World War II, mean that supply will be limited. That meant that people also had to be issued ration cards so that they could get their share of scarce foodstuffs such as meat. Ending rationing would have meant higher prices, but it also would have meant more meat for sale.

Different Kinds of Markets

Figure 8.2 Chart TK: Different kinds of markets, with examples

There are different kinds of markets—different kinds of competition—throughout the economy. Not every market for every product operates the same way.

Before we talk about different kinds of competition, here are a couple of concepts that are useful to understanding the nature of competition:

• Market powerThe ability to set prices higher than they would be given perfect competition.: this is the ability to set prices. If a firm has market power, it can set prices higher than the normal price (the equilibrium point, in economic jargon—the point where supply meets demand) that would be dictated by normal forces of supply and demand. A firm that has no market power is a price-taker—they get whatever price the market is offering. If a firm has market power, however, prices are higher than they should be because there isn’t sufficient competition.
• Barriers to entryThe ability of anyone to enter a given business. High barriers to entry mean that the industry requires substantial capital, equipment and/or expertise to get into that business.: How easy or difficult is it to break into a business? If an industry has high capital costs (it would be very expensive to start building automobiles from scratch), or requires substantial education and skills, it has higher barriers to entry. The business of espresso stands has relatively low barriers to entry. A radiation technology clinic would have high barriers to entry. If, in a given market, there are high barriers to entry, the market may not work as efficiently as we might hope, because, once again, there is less competition.

With that in mind, consider the different kinds of competition that we might find in the economy:

• Pure CompetitionA market where there are many firms, low barriers to entry, and no market power.: Pure competition is best described as featuring many firms, none too big, and no firm has market power. These firms are price-takers. Whatever price the market offers is the price the supplier gets. Farms are probably the best example—lots of farms, a wide-open market, and no one farm can likely set the price for any commodity. This is somewhat typical of commodity markets in general—markets where the product doesn’t vary greatly from batch to batch or load to load. Everything from corn to rice to oil to iron ore to coffee beans is, to some extent, a commodity market.
• Monopolistic competitionA market featuring many firms, varying barriers to entry, and limited market power.: Many firms; low to high barriers to entry; limited market power. This describes a lot of businesses, from accountants to hair salons to restaurants to attorneys. Firms try to distinguish their products and services as different from all their competitors’, which allows them to charge slightly higher prices. Hair salons, for example, target different market segments: From uptown, high-end salons, which may charge very high prices, to a hair factory such as SuperCuts, which charges lower prices. Although both kinds of salons cut hair, each offers a slightly different level and type of service and product.
• OligopoloyA market featuring few firms, high barriers to entry, and limited market power.: Few firms; high barriers to entry; limited price competition. This would describe the automobile industry, for example. (A duopoly has two firms, such as Boeing and Airbus.) Starting an automobile company or any heavy industrial firm requires a lot of money, equipment and technical expertise, so that not many people are going to try this from scratch. As a result, there’s less competition and prices are higher than they might be otherwise. Before foreign car manufacturers began to enter the U.S. market in the 1960s and 1970s, U.S. car prices became somewhat high.
• MonopolyA market where this only one supplier.: One firm. Monopolies happen for a variety of reasons: a firm has a technological advantage that no one is able to replicate; government bars other firms from competing in that market (fairly rare); a firm puts all of its competitors out of business (this can and has happened); or the market is best served by a single firm (a “natural” monopoly).

Usually, when there’s only one firm, government steps in with some level of regulation, attempting to keep the one firm from charging monopoly prices (prices higher than the market would otherwise allow). In the U.S., the government uses anti-trust regulation to keep any single firm from dominating its market, so as to preserve some minimum of competition.

In the case of a natural monopolyA market where it appears that consumers will be most efficiently served by one firm., for some services it may be better to have only firm providing that service. This tends to be true for services such as water, sewer, electricity and garbage collection (though not everyone agrees on this). It would not be profitable for a competing firm to build a second set of water, sewer and electric lines through your neighborhood. Consequently, these natural monopolies usually are regulated by the government—in the case of the United States, usually at the state level. This prevents the firms from charging whatever prices they want, but tends to also mean the state regulators give the service provider some minimum level of profit. It’s an admittedly imperfect system. These utility firms aren’t always as efficient as they might be, nor are regulators perfect at determining when a rate hike is or isn’t justified.