L06 Market Functions

©FlatWorld 2021

Economic Analysis of Social Issues, Version 2.0

• Alan Grant

©FlatWorld 2021

PUBLISHED BY:
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CHAPTER 6
The Market System: Functions,
Structure, and Institutions

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LEARNING OBJECTIVES

•Define market and compare the four market structures.

•Summarize the four key functions of prices.

•Explain how government action can improve the functioning of markets.

•Compare and contrast the incentives for productivity and creativity created
by private property and by common property.

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MARKETS ARE MORE THAN PLACES TO
TRADE

•In modern market-based economies, markets determine what will and will
not be produced.

•Consumer sovereignty: The idea that in the market system, consumers
ultimately decide which goods and services firms will produce.

•Led by the profit motive, producers devote their efforts to producing things
consumers want most.

•However, consumers must be willing to pay for the resources in making a
product before sellers provide buyers what they want.

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MARKET STRUCTURES

•Economists classify markets by market structure:
•Number of sellers in the market

•Degree of competition

•Important because it influences how the sellers behave:
•How much is offered for sale

•The price charged

•There are four major market structures:

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MARKET STRUCTURES

•Monopoly: A market where there is only one seller, and there is no close
substitute for the product being sold.

•Perfect Competition: A market with many sellers who all sell an identical
product.

•Monopolistic Competition: A market with many sellers offering differentiated
products.

•Oligopoly: A market dominated by a few large sellers, offering identical or
differentiated products.

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TABLE 6.1 THE FOUR MAJOR MARKET
STRUCTURES

• This table summarizes the four basic types of market structure, ranging from the least

competitive (monopoly) to the most competitive (perfect competition).

Market Structure

Number of Sellers

Type of Product

Examples

Monopoly

One

No close substitutes for the
product

•Utilities like the local cable
and power companies

•Major League Baseball

Oligopoly

A few

Identical or differentiated
products that are close
substitutes

•Tobacco

•Car batteries

•Game consoles

Monopolistic Competition

Many

Differentiated product

•Restaurants

•Colleges and universities

•Clothing

Perfect Competition

Many

Identical product

•Corn

•Coal

•Rice

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MEASURING DESIRE

•Prices, in part, reflect the desire buyers have for a product.

•If markets are left to their own devices, the more a good or service is
desired by buyers, the higher its price will be.

•Prices for products change as our desires for them change.

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FIGURE 6.2: WHEN CONSUMERS WANT MORE
CARP, THE MARKET DELIVERS

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REFLECTING SCARCITY

•Prices reflect scarcity; the more scarce or rare something is, the higher its
price is likely to be.
•Price difference between products isn’t due to differences in their usefulness;
but rather their scarcity.

•The price of an item is determined jointly by the forces of scarcity and
desire.
•Something that is quite rare but not desired won’t sell for much.

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FIGURE 6.3: PRICES COMMUNICATE
SCARCITY TO CONSUMERS

When baseball
cards become
more scarce due
to a fire, their
price increases.

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A MEANS OF COMMUNICATION

•The price system communicates information about:
•Consumers’ desires to producers.

•Scarcity from producers to consumers.

•The outcome of this communication is impressive:
•If there’s not enough product to satisfy consumers, they bid price up, and
producers make more.

•If there’s too much product, producers cut prices until production is purchased
by consumers.

•Ultimately, producers deliver as many goods at a price sufficient to pay for
the resources that go into production.

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COORDINATING PRODUCTION DECISIONS

•Markets are able to accomplish what individuals and government cannot.
•Prices communicated at each stage of production enable the right resources to
be put in the right places at the right times.

•Prices coordinate production with an accuracy and efficiency that no individual
or government could hope to duplicate.

•Leonard Read’s essay “I, Pencil” is a delightful description of how the price
system coordinates production.

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THE MARKET SYSTEM

•Economic growth: An increase in the total value of the goods and services
an economy produces each year.
•Economic growth is important because the only way to improve a nation’s
standard of living is for the economy to grow.

•Institutions: The ground rules, customs, and conventions governing the
behavior of market participants.
•Without good institutions, the markets for many products would function poorly
or wouldn’t exist.

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RULES FOR MARKETS

•Competition

•Honesty

•Information

•Property Rights

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COMPETITION

•Competition: A market condition in which buyers and sellers have choice
about with whom to complete transactions.
•An absence of competition generally reduces the resources available for
society.

•Many governments pay close attention to the market structures in various
industries.
•Monitor various industries for market domination.

•Industries that are too concentrated may be evaluated to see if there is
sufficient competition to generate the largest possible cooperative surplus.

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COMPETITION

•Governments, can establish rules that encourage competition, and reduce
the power of monopolies.

•Legislating against anticompetitive business practices is another way
government fosters a more efficient and effective market system.

•There are other instances when governments do just the opposite.
•Rather than encourage competition, governments may take deliberate action to
create monopolies and often award those monopolies.

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COMPETITION

•Governments, can establish rules that encourage competition, and reduce
the power of monopolies.

•Legislating against anticompetitive business practices is another way
government fosters a more efficient and effective market system.

•There are other instances when governments do just the opposite.
•Rather than encourage competition, governments may take deliberate action to
create monopolies and often award those monopolies.

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FIGURE 6.4: COMPETITIVE MARKETS
MAXIMIZE SURPLUS (AND WEALTH)

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FIGURE 6.5: MONOPOLIES PRODUCE LESS
TOTAL SURPLUS AND CREATE DEADWEIGHT
LOSSES

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APPLICATION 6.1

• Monopoly Power in the Tech Era—Whither Antitrust?

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HONESTY

•Market participants often take measures to reassure one another of their
honesty.

•The government can create formal institutions that encourage buyers and
sellers to bargain in good faith.
•Laws and courts makes markets work more effectively and society richer.

•Contract laws penalize people for failing to adhere to its terms.

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APPLICATION 6.2

•Enforcing Honesty in India:
Justice Delayed and Justice
Denied

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INFORMATION

•In a well-functioning market, information flows smoothly between market
participants.
•Helps facilitate markets by letting buyers know the options available to them.

•Fosters competition.

•Gives sellers more negotiating power by exposing their products to more
potential buyers.

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INFORMATION COST

•Sometimes there is a cost to obtaining information.
•Markets won’t function as well.

•When obtaining information is costly, competition is less effective on controlling
prices.

•It is often in both buyers’ and sellers’ interests to make information easily
available.

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INFORMATION: GOVERNMENT’S ROLE

•Government’s role in information:
•Reduce the cost of obtaining information.

•Improve the technology by which information is dispersed.

•Require sellers to make information public.

•Help ensure the quality of the information consumers receive.

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APPLICATION 6.3

•Is Honesty the Best
Policy? Making Bank on
Good Information

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PROPERTY RIGHTS

•Markets rely on transactions that result in the transfer of property from one
party to another.

•Property right: The right to own or control a resource.
•Generally allows a person to use and earn income from that resource.

•Are generally transferrable

•Can be informal and implicit

•Must be enforced in order to have value.

•Ensures productive resources are preserved.

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ECONOMIC FORMS

•Communism: A form of economic and social organization in which all
property is held in common, and the government decides what to produce
and how to distribute it.

•Capitalism: A form of economic organization in which productive resources
are privately owned by individuals, who independently decide what to
produce.

•Socialism: A form of economic organization in which individuals may own
private property but in which the government owns and operates productive
resources.

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OTHER PROPERTY RIGHTS

•Property rights aren’t limited to just tangible assets. They also protect ideas
that lead to invention.

•Patent: An exclusive property right the government gives an inventor to
produce and/or market an invention.

•Copyright: An exclusive property right the government grants the creator of
an original work to produce and sell that work.

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EXAMPLE

•Mellors and Nero are neighbors and own adjacent orchid plots.

•Each can choose to work on their gardens somewhat hard (expend $50
worth of effort) or to work extremely hard (expend $75 worth of effort).

•Working somewhat hard will produce orchids that will sell for $110 to a local
florist.

•Working extremely hard will produce orchids that will sell for $150.

•Each person has to make his own decision about how hard to work.

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TABLE 6.2: PAYOFFS TO MELLORS AND NERO
UNDER PRIVATE PROPERTY

•When Mellors and Nero keep all the revenue they earn for themselves,
each has an incentive to work extremely hard.

Nero

Somewhat Hard

Extremely Hard

Mellors

Somewh
at Hard
60, 60

60, 75

Extremel
y Hard
75, 60

75, 75

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EXAMPLE

•Table 6.2 shows working extremely hard is a dominant strategy for both
players.

•A Nash equilibrium is thus where both work extremely hard.
•This equilibrium maximizes both the production of orchids and the payoffs
received by the two players.

•But what happens if the two neighbors are forced to combine their garden
plots and share what they make?

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EXAMPLE: SOMEWHAT HARD WORK

•Now suppose the two neighbors combine their garden plots and share what
they make.

•Suppose Mellors and Nero both decide to work somewhat hard.
•They then sell their production to a florist for $220 and split that amount equally
($110 each).

•After subtracting $50 cost of working somewhat hard, each receives $60.

•This outcome is identical to the one in the first version of the game.

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EXAMPLE: EXTREMELY HARD WORK

•If Mellors and Nero both decide to work extremely hard:
•They sell their production to a florist for $300 and split that amount.

•That leaves $150 each.

•

After subtracting $75 cost of working extremely hard, each receives $75.

•This outcome is also identical to the first version of the game.

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EXAMPLE: ONE WORKS EXTREMELY HARD;
THE OTHER DOESN’T

•Suppose Nero works extremely hard, and Mellors somewhat hard:
•Their combined production will sell to the florist for $260 (Nero’s for $150 plus
Mellors’ for $110).

•They will split that amount evenly, and each earns $130.

•After subtracting $50, Mellors nets $80; Nero subtracts the $75 cost effort, and
nets $55.

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TABLE 6.3: PAYOFFS TO MELLORS AND NERO
UNDER COMMON PROPERTY

•When Mellors and Nero combine their gardens and operate as one, the
incentive structure changes. Both Mellors and Nero now have a dominant
strategy of working somewhat hard.

Nero

Somewhat Hard

Extremely Hard

Mellors

Somewh
at Hard
60

60

80

55

Extremel
y Hard
55

80

75

75

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RESULT

•The best outcome is still for both players to work extremely hard.
•Joint earnings are maximized at $150, which is higher than the $135 by only
one working extremely hard.

•If both choose to work somewhat hard, they make only $120.

•However, working extremely hard is not a Nash equilibrium.
•No matter what Nero does, working somewhat hard is a dominant strategy for
Mellors, and vice versa.

• What kind of game are Mellors and Nero playing?

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APPLICATION 6.4

•Property Rights and the Chinese Agricultural Revolution

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CONCLUSION

•Markets work best if they are well structured.

•Successful economies are successful because they enable markets to work
smoothly.

•Government can help markets realize their potential in two ways.
•By encouraging competition, upholding contracts, and assisting the flow of
information.

•By establishing and enforcing property rights, government can create the
incentives necessary for productive and progressive economies.

© FlatWorld 2020

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EXPERIMENT

•Capitalism and Communism Games