Market Theory

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MARKET THEORY

The market system allows individuals to exchange goods and services voluntarily, based on prices, without knowing one another. For instance, the cup of coffee a person drinks in the morning was brought to that person by thousands of strangers, who cultivated, harvested, processed, manufactured, packaged, shipped, stocked, and sold goods at various stages of production along the way.

One way to appreciate the distinctiveness of market-mediated trade among strangers is to contrast it with other ways in which people transact with one another. The anthropologist Alan Fiske (2004) suggests that all interpersonal transactions can be sorted into four relational models:

In a communal sharing transaction, such as a family dinner, every member in the relationship is entitled to share in what is available.
In an authority ranking transaction, such as a decision made in a traditional military unit or a corporation, there is a clear hierarchy, with people lower in the hierarchy deferring to those who are higher up.
In an equality matching transaction, such as taking turns going through a four-way stop, people operate according to an intuitive sense of balance and fairness.
In a market pricing transaction, such as buying a used car, people make decisions on the basis of their calculations of the costs and benefits.

The cognitive psychologist Steven Pinker, author of The Blank Slate (2002), argues that among these four modes of transactions market pricing is a relatively new phenomenon in the development of the human species:

Market Pricing is absent in hunter-gatherer societies, and we know it played no role in our evolutionary history because it relies on technologies like writing, money, and formal mathematics, which appeared only recently (Pinker 2002, p. 234).

An important aspect of hunter-gatherer societies is that people belonged to tribes or bands of fewer than 150 people. Everyone knew everyone else, and people expected to interact with one another repeatedly. Small groups with repeated interactions are conducive to establishing trust and confidence in reciprocity, which are requirements for communal sharing and equality matching. When societies become larger and people must interact with strangers, something must replace trust and confidence. Only authority ranking or market pricing can "scale up" to large groups.

Economic historians see the modern market system as having arisen only within the last 300 years. Two features of the modern market system were largely absent until that time. One was flexibility of prices in response to supply and demand. In contrast, ancient and feudal trade took place at prices fixed by custom, authority, and tradition. A second feature of modern markets is that they enable people to work for money and trade for food. Before modern times markets did not have sufficient depth and breadth to allow for specialization and cash crops.

Before 1500 almost all people existed at a subsistence level, living on what they could cultivate. Feudal lords took any excess production and in return provided some public goods, notably protection. As late as 1700 the practice of raising a crop for cash and buying goods and services for money was relatively unknown. Even under late feudalism trade was relatively unimportant, and the terms of exchange were fixed by tradition rather than adjusting to supply and demand. The feedback loop between prices and production did not operate.

Between 1700 and 1850 the market system arose in Western Europe and North America. Better farming techniques allowed people to produce surplus food, giving them something to trade and releasing labor to work in manufacturing. Improvements in transportation, particularly railroads, facilitated specialization and trade. Increasingly, people moved from subsistence farming to a money economy in which they obtained cash for either a crop or physical labor. They then exchanged money for goods and services. Land, labor, and capital became responsive to market conditions.

Adam Smith was the first philosopher to articulate the virtues of the market system fully. In The Wealth of Nations (1776) Smith argued that trade was more efficient than self-sufficiency. With trade people can enjoy a wide variety of goods and services while specializing in their labor. In addition, Smith pointed out that the self-interest of producers worked to the benefit of consumers. When consumer demand increases for a good, the price goes up, attracting more producers.

The fact that higher prices induce more production is known as the law of supply. Similarly, a higher price for one good induces consumers to buy less of that good. This is known as the law of demand. Together, the laws of supply and demand determine an equilibrium price and level of output for each good. This impersonal, self-adjusting process is what distinguishes a market economy. In contrast, in a planned economy a bureaucrat determines prices and output levels. In a feudal economy prices are set by custom.

The concept of a market remains counterintuitive in the early twenty-first century. This can be seen in discussions of energy policy, in which it is suggested that the United States could become independent of foreign oil by reducing its domestic consumption and increasing the production of alternative energy. In fact, the world energy market is highly integrated. If the United States reduced its demand for oil, the world oil price would be reduced. However, Americans still would be affected by a disruption in the world supply of oil because such a disruption still would cause the price to rise.

The Ethics of the Market

The market system has ethical virtues in the view of libertarians and utilitarians. The libertarian view is that voluntary exchange among consenting adults is preferable to coercive allocation of resources by government. The utilitarian case for markets, which goes back to Smith, is that market exchanges make people better off.

Markets improve living standards in two ways. First, for any state of knowledge and technology markets achieve an efficient allocation of resources. Flexible prices and competition send signals that accomplish this. Consumers choose the goods and services that satisfy their wants most effectively. Firms choose the inputs and outputs that maximize the value of what is produced. Workers choose the occupations that best apply their talents and interests to social needs.

The second way in which markets improve living standards is through a Darwinian selection of innovative products and processes. Entrepreneurs attempt new techniques, with successful methods surviving and achieving widespread adoption. As unprofitable firms go out of business, failed innovations and obsolete methods fall by the wayside.

The support that markets give to innovation accounts for the high standard of living in the contemporary developed world relative to the past or to the underdeveloped world. The difference is large. Whereas the poorest people in the early 2000s and people who lived 500 ago lived on the equivalent of less than a dollar per day, the average American consumes more than $30,000 in goods and services each year. Market-driven South Korea has a standard of living more than ten times that of communist North Korea.

Feedback between Technological Innovation and Markets

Technological innovation and markets reinforce each other. Markets promote innovation by rewarding success and punishing failure. Technological change broadens markets and makes them more efficient.

Every innovation faces resistance. Scientists may doubt the validity of the theory behind an innovation. Firms are reluctant to discard tried-and-true production methods. Workers in existing industries find their livelihoods threatened by new competition. Consumers may be afraid of new products.

Interest groups that are threatened by new technology attempt to mobilize social institutions to retard innovation. Governments are asked to intervene. For example, some countries in Europe have banned genetically modified food. In the United States opposition to Wal-Mart stores often is driven by store owners and labor unions seeking to stifle competition.

Markets overcome resistance to innovation. The impersonal price system gives its approval to innovations that increase productivity and consumer well-being as firms that adopt the innovations earn profits. Simultaneously, the demise of unprofitable businesses frees resources to be used in more productive ways.

In addition to the ability of markets to foster innovation there is positive feedback from technological innovation to markets. Each improvement in transportation, communication, and trading technology serves to strengthen the market system, increasing the scope of transactions occurring in markets.

The revolution in oceangoing shipping that took place in the fifteenth century helped spur trade, which in turn fostered the transition from feudalism to a market economy. The invention of the steam engine and the railroad lowered shipping costs, enabling cash crops to replace subsistence farming. The internal combustion engine increased the mobility of labor and goods, leading to an increased share of economic activity taking place in the market. Electric motors and labor-saving devices helped release women from household labor and move into market-paid work. In modern times the Internet has increased the breadth of markets, including new possibilities for international trade in white-collar services.

Ethical Concerns with the Market System

There is a long-standing set of ethical concerns with markets. Major problems include inequality, failure to provide public goods, and erosion of cultural traditions.

Markets provide different rewards to different individuals. Those with talent, capital, entrepreneurial instincts, and luck do well. Those who lack valuable talents and/or encounter bad luck do poorly.

Critics of the market system believe that goods and services should be distributed more equally. The socialist thinker Karl Marx (1818–1883) described capitalism not as a neutral system of market pricing but a hierarchical system, with the ruthless capital-owning class exploiting the helpless working class. "From each according to his abilities, to each according to his needs" was Marx's slogan, promising the alternative of communal sharing. However, as anti-Marxists such as Max Weber (1864–1920) and Friedrich Hayek (1899–1992) predicted, large economies could not be made to operate efficiently without markets. Hayek in particular emphasized that the information developed by the price system and individual incentives is much more effective than is central planning.

Critics of inequality tend to view the economy as a zero-sum game, with the success of some individuals necessarily coming at the expense of others. Supporters of the market system view it as a positive-sum game, making it possible for nearly all people to raise their standard of living.

Another area where critics see a zero-sum game is in terms of resource constraints. The argument is that the earth's resources are finite and will be "used up." Economists counter by pointing out that human ingenuity seems boundless. As a result, Jerry Muller comments, "the history of capitalism, as Schumpeter observed, is of finding new ways to make use of formerly insignificant resources. Coal ... petroleum ... uranium ... sand for silicon chips. We may well be at the beginning of the fourth wave of capitalist industrial innovation, the biotechnology revolution" (Muller 2002, p. 391).

Federal Reserve Chairman Alan Greenspan is fond of pointing out that the physical weight of the American gross national product (GDP) is declining, an indication of reduced pressure from economic growth on physical resources. This trend may continue as nano-technology allows products to be built from raw atoms. Rodney Brooks of the Massachusetts Institute of Technology talks about the possibility of not having to cut down trees and carve wood to make a table but instead simply growing a table with genetic engineering. The technology futurist Ray Kurzweil has suggested in The Age of Spiritual Machines (1999) that the information component of GDP is asymptotically approaching 100 percent, which would imply that physical scarcity will never constrain growth.

Another criticism of markets is that they give choices to individuals at the expense of collective purpose. It is argued that there is no overall direction or goal for a market economy. Those who want society to have a common objective see the market as too anarchic. A related criticism of markets is that they fail to pursue cultural ideals: The market may not reward fine art, classical music, or religion.

One strength of the market is that it promotes innovation. However, the market may fail to preserve cultural values and institutions. Occupations made obsolete by market forces represent ways of life that are no longer sustainable. Unique cultural identity may be replaced by homogeneous, anonymous market forces.

Market Imperfections

Economists have found a number of flaws in the market system. The most important are externalities and imperfect information. An externality is a cost or benefit that is not internalized by the market. Pollution is the classic example. The pollution caused by an automobile does not cost its owner anything but the total pollution caused by all automobiles is costly to society. Even though laissez-faire leads to too much pollution, economists still favor market-oriented approaches, including taxes on pollution and tradable pollution "permits." These solutions preserve the flexibility and efficiency of the market while forcing the market to internalize the cost of pollution. Consumers' lack of information provides a rationale for a number of government interventions in the market. For example, government meat inspection helps ensure the safety of meat and regulation of medicines helps protect consumers from harmful or ineffective drugs.

Modern Challenges for the Market System

The market system faces a number of challenges from modern technology. The increased importance of health care and education, the increased role of research and development, the issue of network externalities, and the increased importance of information goods all raise issues for the market.

As human capital increases in importance relative to material resources, health care and education are accounting for an increasing share of the economy. These sectors traditionally have been ones in which government involvement has been extensive.

Health care expenses can soar for the people least able to afford them. Someone who is sick often cannot work. The elderly, who are most likely to have illnesses, are on fixed incomes. Private health insurance may be prohibitively expensive for those with the highest likelihood of needing costly health care. All these issues provide a rationale for government provision of health-care coverage, at least for some segment of the population.

The question is where to draw the line between the market and government involvement. At one extreme are national health-care systems that attempt to put the entire sector under government control. However, this leads to bureaucratic rationing of care and, as is the case any time market forces are suppressed, to slow adoption of new technology and lack of innovation. The United States, which has the most market-oriented health-care system in the industrialized world, also does the most to advance the state of the art through pharmaceutical development, diagnostic equipment, and innovative medical procedures.

Education is another area where the individuals with the greatest needs may be least able to afford the best service. As with health care there is a long tradition of government involvement. Critics argue that this has meant slow innovation and the persistence of ineffective schools. Some economists believe that a more market-oriented approach of giving parents vouchers and letting entrepreneurs supply schooling would be more effective.

The inequality that characterizes market outcomes may be a more significant issue as education and health care increase in importance. One may be able to shrug at the differences between what the rich and the poor can afford in terms of cars or wine, but it is more difficult to feel comfortable when the rich are able to obtain better medical care and education.

Economic growth depends on research and development. In the future the fields of computer science, biotechnology, and nanotechnology will be particularly important to the economy. As a theoretical matter, "basic research," which is generally applicable but yields no immediate profits, will be undersupplied by markets and will have to be supported by the government. By the same token "applied research," which is specific and provides immediate rewards, is best done by private firms so that unprofitable ideas are discarded quickly.

In practice the distinction between basic research and applied research is not as easy to draw. In any event the questions of how much the government should invest in research and where it should invest are very important. People's future standard of living will depend to a large extent on how well those decisions are made.

Modern technology gives rise to networks, in which the size of the network is a source of value. For example, the value of a fax machine is low if no one else has one. When everyone else has a fax machine, the value is much higher. The same is true for e-mail accounts, instant messaging services, CD burners, and popular word-processing file formats.

People may choose a word-processing program for compatibility with their colleagues even though they would prefer the features in a different program. In theory everybody could choose to use an inferior program because it is the program others are using. In that way the market gravitates toward an inferior standard. This possibility is called a network externality.

Another aspect of the economy that has changed in recent years is the increased importance of information goods relative to physical goods. Information goods pose a challenge to the market system.

With physical goods the price system is effective at allocating resources. The price of a bicycle or an apple reflects the marginal cost of producing and distributing those goods. Moreover, there is rivalry in consumption: The bicycle that one person rides is one that another person cannot ride; the apple that a person eats is an apple that nobody else can eat.

With information goods the marginal cost of production and distribution approaches zero. Once an essay or a song is stored as information (bits) on a computer, it costs very little to copy those bits or send them to another computer halfway around the world. Furthermore, an author's ability to read an essay on his or her computer does not interfere with another person's ability to read that essay.

The dilemma caused by information goods is that the marginal cost of production and distribution is zero but the up-front development costs may be substantial. For example, consider the case of a new pharmaceutical to treat diabetes or AIDS. That drug may cost hundreds of millions of dollars to develop. However, the pills can be manufactured for pennies apiece. What should be the price? On the one hand, the price should be low enough not to discourage use, which at the margin costs very little. On the other hand, the price should be high so that companies recover their up-front costs and have an incentive to continue to innovate.

There are a variety of possible pricing mechanisms for information goods, none of which is perfect. In the case of pharmaceuticals the government grants a temporary monopoly in the form of a patent. This allows drug companies to set prices above marginal cost so that they can recover the cost of research. However, at the margin this discourages the use of medications because the price is higher than the marginal cost of production.

The challenge with research-intensive goods is to come up with a way to cover fixed costs while leaving the marginal price as low as possible to encourage broad use. Price discrimination—charging higher prices to the consumers most willing to pay—can be not only profitable but also socially optimal. Alternatively, it may be desirable for many consumers to combine to cover up-front costs through a subscription model or a membership model. It may be desirable for taxpayers to cover some up-front costs through a subsidy or prize offered by the government.

Doomsday Scenarios

There is a long-standing tension between economic growth and cultural stability. Markets, which facilitate the former, undermine the latter. Many futurists project an acceleration of technological change in the twenty-first century. This has the potential to raise the standard of living dramatically, but it also has the potential to cause great culture discontinuity. There are many examples:

In computer science, Kurzweil (1999) argues that Moore's law, which roughly states that the power of computers doubles about every eighteen months, implies that there will be a computer with the intelligence of a human brain by about 2030. Moreover, once computers catch up with humans, they will surpass humans rapidly. Thus, the long-term future is one in which humans and machines will be integrated and coevolve, with the human species becoming inferior or extinct.
In nanotechnology Eric Drexler (1986) and Bill Joy (2000) warn of the possibility of chemical production processes expanding uncontrollably. In the worst case, dubbed the "gray goo scenario," a substance could reproduce indefinitely until it swallowed the planet.
In biotechnology the President's Commission on Bioethics (2003) emphasized a number of possible dystopian scenarios, including one in which human beings are designed and created to serve the purposes of their masters. The commission also pointed to issues raised by medicines that enhance performance or might prolong life indefinitely.

If these doomsday scenarios are possible technologically, markets are unlikely to prevent them. Accordingly, fear of doomsday scenarios could lead people to favor strong, worldwide government action to intervene in markets. Opposition in Europe to genetically modified food and opposition in the United States to embryonic stem-cell research could be symptoms of antimarket regulation to come.

The Future

Markets are conducive to technological innovation, and vice versa. People who place a high value on the benefits of technological innovation tend to want to expand the scope of the market. People who are more concerned with the risks of technological innovation are more inclined to favor government intervention.

The chief benefit of technological innovation is that it raises people's standard of living. People's labor, capital, and natural resources become more productive as they use science and engineering to develop more efficient techniques for satisfying human wants.

The combination of markets and technological innovation creates economic inequality. Successful entrepreneurs, business leaders, and others earn outstanding rewards. Unskilled workers have a higher standard of living than was the case a century ago, but they are significantly less wealthy than those at the top of the income distribution.

Markets and innovation also cause cultural dislocation. Old ways of life disappear, and people must adapt to new circumstances. The possibility appears to exist for dramatic, discontinuous change.

People are close to having capabilities that may undermine their identity as human beings. Will people merge with machines? Will pharmacology or genetic engineering give people control over their emotions, memories, aging process, and physical and cognitive skills? Will scientific discoveries serve primarily to enhance the lives of the rich, or will they also give new opportunities to the poor?

The market offers only one way to answer these types of questions: with trial and error. Individual responses to opportunities and incentives will cumulate to an overall social result. Those who want the outcome to be arrived at by a different process, such as the deliberations of moral philosophers and experts, will seek to find a way to disrupt the decentralized, experimental market mechanism and replace it with something more planned and controlled.

ARNOLD KLING

BIBLIOGRAPHY

Blinder, Alan S. (1987). Hard Heads, Soft Hearts: Tough-Minded Economics for a Just Society. Reading, MA: Addison-Wesley.

Drexler, K. Eric. (1986). Engines of Creation. Garden City, NY : Anchor Press/Doubleday.

Kurzweil, Ray. (1999). The Age of Spiritual Machines: When Computers Exceed Human Intelligence. New York: Viking.

Mokyr, Joel. (2002). The Gifts of Athena: Historical Origins of the Knowledge Economy. Princeton, NJ: Princeton University Press.

Muller, Jerry Z. (2002). The Mind and the Market. New York: Knopf. Muller provides an intellectual history of pro-market and anti-market philosophers from Adam Smith through the contemporary age.

North, Douglass C. (1981). Structure and Change in Economic History. New York: Norton. Emphasizes the role of political and social institutions in the development of modern markets.

Pinker, Steven. (2002). The Blank Slate. New York: Viking.

President's Council on Bioethics. (2003). Beyond Therapy: Biotechnology and the Pursuit of Happiness. Washington, DC: Author.

Rosenberg, Nathan, and L. E. Birdzell, Jr. (1986). How the West Grew Rich: The Economic Transformation of the Industrial World. New York: Basic Books. The authors explain how market institutions evolved from feudalism in Western Europe.

Shapiro, Carl, and Hal. D. Varian. (1999). Information Rules: A Strategic Guide to the Network Economy. Boston: Harvard Business School Press.

Stock, Gregory. (2003). Redesigning Humans: Choosing Our Genes, Choosing Our Future. Boston: Houghton Mifflin.

Smith, Adam. 1998 (1776). An Inquiry into the Nature and Causes of the Wealth of Nations. Washington, DC: Regency.