Markets and Industries

The market in economic theory

Empirical approximations to definition

BIBLIOGRAPHY

The market is the stage on which economic actors—firms, households, and unions—meet and make key economic decisions for society. Out of the process of market exchange come the prices, wages, and profits that serve to determine the allocation of the economy’s resources and the distribution of the national income.

The market is thus a central concept in economics. It is, however, an elusive concept. It may mean merely the geographical place where exchange takes place—a nodal point where buyers and sellers meet to exchange goods and services. But the concept of the market as economists use it also embraces the whole set of circumstances that surround the process of exchange, and indeed it concerns as well the outcomes of the process of exchange. Thus we speak of market structure and market behavior and market price. Firms and households may take conditions in the market as external to them, and such conditions affect their behavior. But this behavior in turn affects market results and, indeed, may determine what is the market.

The market in the most general sense is the entire web of interrelationships between buyers, sellers, and products that is involved in exchange. The appropriate definition of the market depends upon which aspects of this web are of interest at the time; for different problems there are different appropriate definitions.

Historically and in much of common usage “the market” means a place where buyers and sellers meet to buy and sell goods. But while this usage serves well enough to identify the Fulton Fish Market, it provides little insight into what is meant by the used-car market, the stock market, the labor market, the mortgage market, or the black market in Japanese yen. Within the market, however defined, buyers and sellers negotiate the exchange of goods or services. A market definition may focus upon what the products are, as the market for cement, aluminum cable, or what. In this usage it is common to speak of the market as an industry. Alternatively, however, it may focus upon who the buyers are, as, for example, the market for loans to Chicago borrowers. It may focus upon who the sellers are, as the market for engineers or the market in which the integrated oil companies operate. Market definition may focus upon the rules by which the market is run, as in an auction market, or upon when goods are to be exchanged, as in the distinction between a present and a futures market. Finally, geographical definition may concern where buyers or sellers reside or do business as well as where they meet to exchange. In this sense the New York Stock Exchange is often regarded as an international securities market.

None of these bases for definition is without interest some of the time. In general, differences in focus will lead to differences in designation of which transactions belong in a market. The market is a concept with many dimensions.

The market in economic theory

Economists use the word “market” in two substantially different senses. While they have etymological precedent for this—the Latin root mercatus means either the place of or the method of contact between buyers and sellers—the result is often confusion.

The first sense in which economists use the word concerns the general conditions under which buyers and sellers exchange goods and services. The conditions may be summarized in a series of alternative theoretical market structures, such as “perfect competition,” “monopoly,” “oligopoly,” and “monopolistic competition.” [seeCompetition; Monopoly; Oligopoly.] These theoretical structures, or models, make assumptions about such things as the number of sellers and buyers and their perceptions of each other and yield predictions about market behavior. In turn this predicted behavior leads to predictions about market results : what will be the prices, quantities, and qualities of outputs that emerge from the market. Market structure is not one-dimensional, but it is often convenient to think of different market structures as differing from one another in terms of the kind and degree of competition that they lead to.

The second sense in which the word is used is to delineate the boundaries (usually geographic) that identify specific groups of buyers, sellers, and commodities. This concept of the market is designated extent of the market. In this sense we define the fluid-milk market for the New York City area or the upper Midwest cement market by an appropriate map.

Up to a point these two usages are both separate and separable. One does not need geographic boundaries to derive predictions about how, for example, a perfectly competitive market works in equating demand and supply, nor does one need theoretical models of market structure to describe or delimit the Fulton Fish Market. The need to confront these separate aspects of a market arises whenever economists wish to use economic theories of market structure to make predictions about the behavior or performance of real-world markets; it arises as well if they wish to use observed data about real-world markets to test the predictions of their theories; it arises, further, if one wishes to use economic conclusions about market behavior and performance in establishing or enforcing public policies that relate to the behavior of actual industries or firms. Since these are among the important uses of economics, it arises often.

The number of participants in the market is held to be a key factor in market structure, and thus in market behavior and in market results. The number of participants in a market will, however, vary as we change the boundaries of the market. Market structure and market extent are thus interrelated in applications. The great hazard in analyses of economic markets is the circular, or prediction-determining, definition.

Defining market extent by its structure

Most well-defined theories of market structure contain implicit rules for delineating which transactions belong in the market. Using such implicit rules is superficially an appealing way to solve a difficult problem. Except in rare cases it proves quite unsatisfactory. Consider market definitions under perfect competition and under monopoly.

Under perfect competition. A central prediction of the theory of perfect competition is that the price of all transactions will tend to uniformity, allowing for differences in transportation costs. Empirically, the boundaries of a perfectly competitive market may be established by searching for the area over which transactions occur at common prices. This definition of a market has an honored past and a wide range of contemporary acceptance. It is the definition used by Cournot (1838, chapter 4), popularized by Alfred Marshall (1890, p. 327 in 1920 edition), and repeated in leading contemporary texts (Stigler 1942, p. 92 in 1947 edition).

One drawback of this definition is that actual price behavior in such a market cannot be used to test the prediction of uniformity of prices. A more serious difficulty concerns the interpretation of transactions that occur at other than the adjusted common price. Do they represent transactions in a different market or do they provide evidence that this market is in fact not a perfectly competitive one? The implications of these two possibilities are totally different. In U.S. law, for example, the merger of two firms is legal if they are in quite separate markets but may be illegal if they are in the same, imperfectly competitive market. Using uniform price behavior to define market extent would be satisfactory if such behavior were a common implication of all theories of market structure; this, however, is not the case.

Under monopoly. The theoretical model of monopoly comprehends a situation in which there is but a single seller of the commodity (or a group of sellers who act as if they were under a single coordinated management). The implicit market for a monopolized product consists of all transactions in the commodity in which the monopolist is the seller. It is not a prediction of the theory that the price need be uniform among all customers, since the monopolist can discriminate among buyers. It is a prediction of the theory of discriminating monopoly that prices will be uniform only among sub-groups of customers who can resell the commodity or among whom demand elasticities are approximately equal. Were we to apply the implicit competitive definition of a market in a situation that is, in fact, that of a discriminating monopolist, the group of transactions which occur at a common price would represent only a small part of the total relevant market.

The major deficiency of defining a market on the basis of theories of market structure is that different market structures contain different implicit rules for definition of the market. Indeed, their reason for being is that they make different predictions about market results. To define the market according to the price behavior exhibited destroys any possibility of using the market so defined to say anything about price behavior, and it prejudges the question of which market structure is the relevant one for making predictions. An empirically useful market definition must be independent of the alternative theoretical models of market structure, if we wish to test or to apply those theories.

Defining market extent by demand and supply alternatives

Any particular buyer or seller has a definable set of alternative sources of supply or demand which he considers available to him. From his point of view the relevant market is the set of these alternatives. This kind of individualized definition of a market would be of little general use if there were not important clusters of buyers and sellers for whom the relevant market was approximately the same; suppose there are such groups and that it is thus feasible to define markets that apply to significant numbers of transactions.

As a logical matter, market extent defined in this way may also be circular. The perceptions of, for example, a buyer as to which are the real alternative sources of supply depend upon the prices that prevail. A housewife who says she will never go across town to shop for food means it only within limits. A big enough “sale” will change her view. Thus if prices are, in fact, uniform as among sellers, the radius of the market extent around a customer will be much smaller than the market to which he might turn if prices were not uniform. Some Californians buy cars in Detroit if prices on the west coast get too far out of line.

Empirical approximations to definition

While as a logical matter there is no satisfactory definition of a market that identifies the relevant transactions independent of the market results, reasonable markets do exist in many commodities. While everything in principle depends upon everything else, in many cases the interactions and feedbacks are small enough to be negligible. Bicycles and sports cars are not in the same market, although there conceivably exists a set of prices that would lead to large-scale substitution of one for the other. As a practical matter cement is so rarely sold outside of a radius of 200 miles from the factory that a regional cement market may be defined.

The basic empirical problem of market definition is to define the range of alternatives to which a buyer or seller may practicably turn and to identify the sets of transactions whose outcomes are sufficiently interrelated that to subdivide them further invites error. One definition of an industry is as “a gap in the chain of substitutes” a parallel definition of a market is as “a gap in the chain of alternatives.” As a logical matter it has been argued that industries do not exist (Triffin 1940) and that all firms must be viewed either alone or as part of a generally interdependent network. Most economists reject this nihilistic view and believe the industry is a useful aggregate concept. Similarly, the market is a useful aggregation of sets of related transactions.

Suppose we seek an empirical approximation of the set of real, practicable alternatives. We must ask: “Real alternatives to whom?” One may focus upon the products or the sellers that are real alternatives to a particular group of buyers, one may instead ask what are the alternative sources of demand to a group of sellers, or one may ask what are the products that are effective substitutes for a particular product. There are, indeed, many aspects of each of these different ways of looking at the set of alternatives. Consider the producer of a given product: he may at one time be concerned with the group of other sellers of this product; at another time he may be concerned with other products that are technologically similar so that they represent real alternatives to him in production; at still another time he may be concerned with different products that his customers may regard as substitutes for his product. Of the hundreds of possible ways of defining sets of alternatives, two are of major interest to students of economic markets and how they work.

The first is the real alternative sources of supply available to a defined group of buyers. We may ask, for example, what are the sources of supply of credit available to the small businessman; we may be concerned with the sources of supply of safety glass to automobile manufacturers; or we may be concerned with the sources of supply of automobiles in the $1,500–$2,500 price range to buyers living in Peoria. Much of the public concern with competition is concerned with preserving a sufficient number of independent sources of supply so that every group of customers has genuine alternative sources of supply. The legislative concern evidenced in the major antitrust laws is centrally concerned with preserving effective competition in markets defined in this way.

The second is the group of relevant rivals to a particular seller. This concept of the market is crucial to understanding the market behavior of sellers. The number of rivals that a seller has and the nature of the interactions between them are hypothesized to be major determinants of the price and product patterns that emerge in an industry. Indeed, the very concept of an industry rests upon the identification of a group of sellers in substantial rivalry (actual or potential) with one another. Economists largely concerned with industrial structure and behavior regard this focus as central to the definition of the market.

Implicit in each of these definitions is the notion that a distinct “product” or group of products exists. The classification of products into meaningful “industries” is a major concern of the U.S. Bureau of the Census and other statistical agencies. The recognition that for different purposes different clusters of products are relevant has led to the development in the United States of a Standard Industrial Classification (SIC) at several levels of aggregation. There are seventy-eight “2-digit” industries, hundreds of “3-digit” industries, and several thousand “4-digit” industries. By appropriate recombinations of the 4-digit industries a very much larger number of industries may be defined. The focus of the SIC is on the supply side rather than the demand side, and SIC industries are more nearly appropriate to the identification of interrelated sellers than of alternatives to buyers.

Markets defined in these ways overlap but do not coincide. Every transaction involves a buyer, a seller, and a well-defined product. It may, However, be a transaction in several different markets. Consider, for example, the purchase of a new compact Chevrolet by an individual living in St. Louis. From the buyer’s point of view the relevant alternative products may have been any of four or five models of new cars or any of a number of used cars in the same price range. (The list of alternatives will certainly not include a truck or a tractor and almost certainly will not include a new Cadillac.) The relevant sellers will be the new- and used-automobile dealers in a definable geographic region centered largely on St. Louis, as well as private sellers with whom the buyer may make contact.

To the General Motors Company the transaction appears in a very different light. Its rivalry with Ford and Chrysler and American Motors for the new-car dollar is nation-wide and includes Buicks and Cadillacs as well as Chevrolets. At the same time, the compact-car market—in which the various American manufacturers are in open competition with certain foreign manufacturers, particularly Volkswagen—involves a different set of rivalries.

From the product point of view, the transaction occurred in SIC industry 37, Transportation Equipment; in industry 371, Motor Vehicles and Motor Vehicle Equipment; and in industry 3717, Motor Vehicles and Parts. Even the smallest of these is a substantially comprehensive classification including the manufacturing or assembling of (among other things) passenger automobiles, trucks, ambulances, and fire engines and also including the parts that make up such motor vehicles, such as axles, radiators, drive shafts, exhaust systems, universal joints, and automobile bumpers. For many purposes SIC 3717 is much too broad; an automobile muffler and an automobile bumper are not in any sense substitute products. The statistical problem of industry definition is made complex by the fact that some firms make a large variety of such component products and others specialize. For other purposes the definition of industries in the SIC is too narrow. Multiproduct firms may operate in many industries, and their wage policies and their labor market negotiations may extend across industry lines. All production workers of American Motors, whether they are making cars or refrigerators, are covered by contract negotiations with the United Automobile Workers.

The market to buyers

Major impetus to empirical definition of markets in the United States has been a by-product of the Anti-merger Act of 1950 (the so-called Celler-Kefauver Act). It made very general a prohibition on mergers “where in any line of commerce in any section of the country, the effect of such acquisition may be substantially to lessen competition, or to tend to create a monopoly.”

A first step in every one of the cases involving this statute is the definition of the relevant market. Pathbreaking opinions in a series of antitrust decisions have sharpened the notion of what is a relevant market, as well as defining the legal issues involved. It is clear that one can always define a sufficiently localized geographical area in such a way that there is but one seller of a particular product; conversely, one can usually define an area so broadly as to make the effect on competition appear trivial. Every merger leads to the disappearance of one seller. But one out of how many? For example, the 1961 merger of the Continental Illinois National Bank and the City National Bank reduced the number of banks in the 200 S. block of LaSalle Street, Chicago, from 2 to 1, the number of business district banks from 16 to 15, and the number of banks in the Chicago Metropolitan Area from 219 to 218. For the whole United States there were about 14,000 commercial banks. After the merger there was one less.

Recent court opinions have established guidelines:

.. . the boundaries of the relevant market must be drawn with sufficient breadth to include competing products. .. to recognize competition where, in fact, competition exists. (Brown Shoe Co. v. U.S., 370 U.S. 294, 326, 1962)

The relevant market is the area to which customers can practicably turn for supplies. (Paraphrase of U.S. v. Philadelphia National Bank, 374 U.S. 321, 1963)

The proper question,. .. is not where is the customer located, but what is the geographic area of effective competition for his patronage. (U.S. v. Manufacturers Hanover Trust Co., CCH Trade Cases 71,708, pp. 80,744, 1965)

A relevant geographic market cannot be defined, However, solely on the basis of where. .. banks have actually done business, or even where customers have actually turned for their banking needs. The market must be drawn also on the basis of potential competition.. .. Where could customers practically turn for alternative sources of supply? (ibid., pp. 80,746)

These are sensible guidelines; implementing them is hard. The problem is in relating observation to guideline. A customer buys from a particular seller for any or all of a number of reasons: it may be habitual, it may be convenient, it may be a matter of some indifference, or, importantly, it may be necessary. Defining the relevant choices of the buyer is in fact defining the group of sellers from one of whom it is necessary that he buy. Put differently, if we can define sellers from whom it is impracticable to buy, we have defined sellers outside of the relevant market. If one is to base empirical delineation of the extent of a market upon observations of which sellers are in fact utilized by buyers, the key problem is to differentiate the factor of necessity from that of convenience.

A housewife in a moderate-sized city will in general have a dozen or more supermarkets at which she may conveniently shop, and another dozen at which she might shop if there were any real reason to do so. In fact she will usually tend to shop at two or three, because, other things being equal, she has certain preferences. Indeed she may only shop at one. But this one is an explicit or an implicit choice from the larger set of practicable choices. It is the larger group that constitutes her real opportunities and that defines the market.

The determinants of a customer’s choice of a supplier may in general be several. Some of these are (1) portability of the product, (2) cost of transportation of the product, (3) information about the availability and conditions of supply of the product, (4) acceptability of the customer to the seller, (5) price of the product, (6) convenience, and (7) chance and habit. These factors may be related to one another: for example, while there are limits to the geographic range over which fresh milk and live lobsters can be transported without spoiling, these limits may be extended by increasing costs of delivery. Refrigerated trucks and rail-road cars extend the markets for fresh produce, some Maine lobsters are shipped to the Midwest by air (but none are shipped to San Francisco), and so on. Similarly, information can be gathered, but at some cost and some inconvenience. What is of concern in defining markets is the distinction between the first four listed factors (singly or in interaction), which represent real limits on practicable alternatives, and the last three, which represent instead the bases of choices among real alternative sources of supply.

As a practical matter geographic market definition becomes relatively easy when one of the first four considerations exercises a dominant limitation on sources of supply. Consider a few examples. For commodities such as cement, for which transportation cost per unit is a high fraction of unit value, the geographic limits on choice of suppliers is very clear. It is easy to define the relevant cement market for a given customer. The relevant housing market for an individual is delimited by distance from his work, by his income, and in some cases, additionally, by his race. The market for a business loan for a small business is effectively limited to those financial institutions that will accept local credit evaluations. Such a small borrower is typically limited to his home city or a portion thereof. Purchase of a used car tends to be limited more by available information than by anything else. On the other hand, well-organized markets in securities make the supplier from whom one buys 100 shares of General Motors stock a matter of substantial indifference. The borrowing of $1 million for working capital by a national corporation is not practicably limited to any small geographic region.

Observing from whom each of the individual members of a large group purchases will tend to define the relevant geographic market if transportation cost, portability of product, information, or acceptability provides a binding constraint on available alternatives. Chance, convenience, and habit will average out over a large group, and over time variations in price will average out as well. The fact that over 90 per cent of all loans to businesses with assets of less than $50,000 are made by banks in the same city, county, or metropolitan area strongly suggests that the relevant geographic market is limited. Of customers with assets of over $100 million, only one-third borrow from local banks. (As this example suggests, one can perhaps infer geographic limitation by observed behavior. This is a complex matter of statistical estimation, discussion of which is inappropriate to this article.) Where no binding limitations of these kinds can be identified, geographical delineation of market extent is virtually impossible.

The market to the seller

Identifying the relevant rivals to a particular seller is typically a very much easier matter than identifying markets for customer groups, particularly for manufacturers of major commodities. But not always. Some forty firms in the United States manufacture electrical equipment, but only six of them manufacture turbine generators, only four manufacture meters, about a dozen manufacture industrial control equipment. And General Electric and Westinghouse are clearly in rivalry with General Motors in the manufacture and sale of refrigerators, though they are no part of the automotive industry.

In practice the relevant group of rivals has to be defined in the context of a particular problem. With respect to price determination, of primary concern in many cases, sellers who regard each other’s commodities as close substitutes and employ consciously parallel price policies clearly are in the same market. Products whose prices move closely together over a sufficient period of time to permit other influences to vary are usually regarded as in the same market, and the suppliers of them are considered to form an industry. Again, difficulties in precise definition exist but need not prevent reasonable estimation of related groups of suppliers who sell in the same market.

The many markets for a commodity

Consider the market(s) for business loans. A Federal Reserve Board survey in 1955 revealed over 1.2 million outstanding loans by some 7,000 U.S. member banks, amounting in aggregate to over $30,000 million. Most of these loans were very small: over 1 million were for less than $25,000, and they accounted for only one-sixth of the dollar total. On the other hand, 42,000 of these loans were for over $100,000, and they accounted for two-thirds of the total dollars of outstanding loans. There is no doubt that there is a national market for very large loans. There is also little doubt that small loans are largely limited to local markets. There are thus hundreds of local markets and a national market as well. (There may be regional markets in addition.) Let us consider the definition of one such local market, that for the Chicago Metropolitan Area (CMA).

In a total of 20,500 loans representing about

$3,105 million in value, either borrower or bank was located in the CMA. What fraction of this business was in the CMA “local loan” market? Table 1 shows this total business classified by location of bank and borrower. For only $1,125 million were both bank and borrower in the CMA. Chicago-located borrowers borrowed $756 million from other banks, and Chicago banks loaned $1,224 million to other borrowers. Some of the loans for which both bank and borrower were located in the CMA were very large loans, in which dealing with a local bank was a matter of convenience rather than necessity. Table 2 presents all loans with an outstanding balance of less than $100,000. Of these about 15,000 loans, representing $215 million, were between CMA banks and CMA borrowers. Judge MacMahon (in the Manufacturers Hanover case) suggested that only business loans under $100,000 should be considered limited to the local market. If he is correct, then the transactions in the CMA local market of $215 million are but a small fraction of the total transactions involving Chicago banks or Chicago customers.

Definition of a local market for loans no doubt requires more sophisticated measures than merely the address and size of loan used here. One would wish to pay attention to the size of the borrower, the nature of his business, his other sources of funds, and so on. Further, one would wish to consider nonbank suppliers of funds as well. But the illustration is suggestive.

Does it really matter how one defines a market? In some cases it matters very much. For example, in the CMA bank illustration the share of the market of the four largest suppliers (called the 4-firm concentration ratio) varies enormously as the definition of the market is changed. For 1955, the four largest Chicago banks made 84 per cent of the dollar volume of business loans of banks in the CMA, 42 per cent of the dollar volume of loans to CMA located borrowers, but only 25 per cent of the dollar volume of loans of under $100,000 to CMA borrowers. These are major differences in terms of the relevant theoretical model to apply: 84 per cent is in the range where monopolistic models are often invoked; 25 per cent is near the competitive level. These differences are also important in terms of the legal status under antitrust laws. To take a different example, failure to recognize the geographical limits to the economical shipment of cement would lead to the conclusion that the U.S. cement industry has dozens of small sellers. In fact regional cement markets are highly concentrated and in some cases have but a single supplier.

The concept of a market is multidimensional and it is complex, but reasonably accurate delineation of markets is required if economic theory is to be brought into contact with economic observation. No single-definition serves the many uses to which the concept is put; the relevant definition must be suited to the particular application required. Logical difficulties exist in attempting to define market extent independent of market behavior and market performance. Notwithstanding these difficulties, there is scope for approximations to the extent of relevant markets. These require both care in formulation and sophistication in empirical estimation. No greater barrier exists to the fruitful application of economic theory than the failure to forge the links to observable data. The operational definition of economic markets is such a link.

Peter O. Steiner

[see also Antitrust Legislation.]

BIBLIOGRAPHY

Cournot, Antoine Augustin (1838) 1960 Researches Into the Mathematical Principles of the Theory of Wealth. New York: Kelley. → First published in French.

Marshall, Alfred (1890) 1936 Principles of Economics. 8th ed. New York and London: Macmillan. → A two-volume variorum edition was published in 1961.

Stigler, George J. (1942) 1960 The Theory of Price. Rev. ed. New York: Macmillan.

Triffin, Robert 1940 Monopolistic Competition and General Equilibrium Theory. Harvard Economic Studies, Vol. 67. Cambridge, Mass.: Harvard Univ. Press.