Markets are the Greatest Invention

Markets

I maintain that the idea of markets ranks amongst the greatest inventions of humankind, up there with the wheel, fire and zero. It is also among the most misunderstood and underappreciated of ideas. That’s unfortunate since the misunderstanding of the idea of markets has negative consequences, primary among them being missed opportunities for human welfare.

Because markets are ubiquitous, we fail to appreciate that they are an invention and do not exist anywhere else in nature other than in human societies. At some specific time in human history, a fairly recent one actually, that invention arose. As time went on, the idea spread across the world and found increasingly numerous applications. More and more human interactions started being mediated by markets.

Markets have become an indispensable institution of civilization. Indeed, any sufficiently advanced society can do without markets as much as it can do without fire, the wheel or the idea of zero: meaning not at all. You cannot have a technologically advanced society without the use of markets.

We all participate in markets all the time. It is worth extending our understanding of what the idea of markets is. Why do we need them, what precisely is their function, what happens when we forego their use, when do they fail, why do they fail, what mechanisms are there to address market failures — all of these questions are not just intellectually challenging but are important because they have real consequences. If society as a whole does not have a basic understanding of these matters, the choices that people collectively make can lead to poverty.

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Exchange

At the broadest level of abstraction, humans engage in three activities: production, consumption and exchange. Exchange — another word for it is trade — happens in markets. When you go to work, you exchange your labor for stuff that you need to consume. Of course, the employer does not literally hand you food and clothing. Instead you get something that you can exchange for food and clothing: money.

We exchange stuff because we are not good at producing all the stuff we wish to consume. Furthermore, we are better at producing some things relative to others and to other things. So we exchange those things that we are better at producing for things that we want to consume with others who are better at producing them than we are.

When you buy something, you exchange money for the thing; when you sell something, the reverse process occurs. In any exchange or trade, there is a buyer and a seller. Buying and selling are, so to speak, two sides of the same coin.

A quick reminder is appropriate here: money facilitate exchanges. Absent the opportunity to exchange stuff — the real stuff that you produce and consume is called “wealth” — money is quite worthless. The distinction between money and wealth is important to keep in mind. Money is “nominal” while wealth is “real.” Conflating the two leads to all sorts of stupidity (and worse.) More about that later. We will use the word “money” sparingly and focus largely on the real stuff that we produce and consume.

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Voluntary Exchange

In any trade (or exchange) undertaken voluntarily, both parties to the trade gain. You voluntarily engage in the trade because you must necessarily value the stuff you give less than you value the stuff that you receive. If I voluntarily exchange my apple for your orange in trade, I must value the orange more than I value the apple; and you value the apple more than the orange.

Therefore, in any voluntary trade both parties gain. Thus, all voluntary trades increase what we call “social welfare”, which is the sum of the private gains that each party to the trade gets. Markets enable voluntary trades and therefore lead to social welfare gains. Anything that enables markets is therefore social welfare enhancing and therefore economically good. Conversely, barriers to markets (and voluntary exchanges) are welfare reducing.

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Third Parties

The world consists not just of the two parties that trade in a market. There are others who are not engaged in the trade — the third parties — who may be affected positively or negatively by the trade. What about them?

The effects on third parties are called “externalities” because these are external to the calculations that the two parties to the trade make. The seller and buyer of gasoline don’t take into account the pollution that the use of gasoline produces which others have to suffer. That’s a negative externality and it goes in reducing social welfare.

The presence of externalities, positive and negative, affect the optimum functioning of markets. It has important implications for public policy regarding markets. For now we will put them aside.

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Competition in Nature

Every living organism competes. The competition is always with its own kind because only one’s own kind shares one’s environment and needs the same resources. There is no need to compete with others who don’t share the same environment.

From the individual’s point of view, it is never good to be in competition with others of its kind. It is forced to compete but it would prefer not to. Yet, an individual generally benefits from competitions which it is not engaged in. From a collective’s point of view, competition is good. This is counter-intuitive. How can something be individually “bad” but collectively “good”?

Competition is widespread in the natural living world. It is central to the mechanism of evolution through natural selection — which gives rise to the variety of species that exist in the world. Think of the competition that predators engage in.

At first glance it may appear that predators — say lions — compete with prey — say gazelles. But the truth is a little more complex. Lions compete with other lions, not gazelles. And gazelles compete with other gazelles. Both lions and gazelles have an interest in being fast compared to others of their kind. The slow lion (compared to other lions) starves and the slow gazelle (compared to other gazelles) gets eaten.

Now here’s the interesting bit. The slow lions starving “improves” the group of lions, just as the slow gazelles becoming lunch “improves” their group. There is competition among predator and prey, but only at the group level.

When the lions become faster as a group, the pressure is on the gazelles to become faster. They co-evolve. If lions become too few or disappear altogether, the pressure eases on the gazelles and consequently they slow down as a group. Fast lions arise from competition among lions. Fast gazelles arise from competition among gazelles. That’s intraspecies competition. Then there is interspecies competition, between lions and gazelles, which improves both species. Healthy lions guarantee healthy gazelles, and vice versa.

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Competition in the Market

Buyers and sellers as groups occupy the two different sides of a market. Competition in a market, like competition in the natural world, occurs primarily within the groups, not between the groups. Sellers compete with each other, and buyers with other buyers. This point of view is essential to understand the dynamics of markets.

The primary conflict of interests is not between buyers as a group and sellers as a group. Each seller competes with other sellers, and each buyer competes with other buyers. This inevitably leads every seller to be as “good” to the buyers’ group as it possibly can to beat out the other sellers. In other words, as long as there is competition among sellers, it is good for buyers (individually and collectively.) We call this “competition in the market.”

There is another kind of competition — “competition for the market” — which is distinct from competition in the market. We will get to that distinction eventually.

If for whatever reasons competition in the market among sellers is prevented, buyers as a group lose. Restricting competition in the market is good for the sellers who have access to the market but it is bad for overall social welfare. Sellers can get together and collude to reduce competition among themselves. Collusion among sellers is good for the sellers but bad for buyers. There are laws to prevent and punish collusion.

The gold standard for markets (rarely achieved, if ever) is called the “perfectly competitive” market. Most markets are imperfectly competitive. But even with their imperfections, most markets serve the basic function of enabling trades — which as we noted before, if they are voluntary trades, they lead to social welfare gains.

Summary

The story so far is simple — and perhaps boring. It is boring because it appears to be going nowhere special. That’s just the way it is. The starting is boring because it’s just the beginning and the characters being introduced are not interesting yet. We need more intrigue, more cloak and dagger.

So we started with markets and noted that the idea is a recent invention. Markets are good because they enable voluntary trades. Voluntary trades are good because parties to the trade gain value. Then we noted that market participants compete. Competition appears to be good although not everyone playing that game is happy to be competing.

In the next bit, we will explore some applications of the idea of markets and competition. That’s where it gets seriously interesting. The domain that I will touch upon next is politics. Politics, like most other human endeavors, is played out in the marketplace. There are buyers and sellers, there is competition among the sellers and there is competition among the buyers. There are market imperfections in political markets, there is collusion and “market power”. Shortly we will figure out why India’s failure to develop has something to do with imperfect political markets. For that, we will have to consider political parties as firms (corporations) which are in the business of “selling” to voters.

This is a work in progress. So keep tuned in for the next bit tomorrow.

[Image at the top of the post, “Free as in free markets“, borrowed without permission from Mimi and Eunice. Here one more — free!!]