Market Theory

Overview

Key Terms and Concepts

• Competitive markets. Markets are the most efficient known mechanism for the allocation of goods and services. Wherever possible, markets will be more efficient than planned (bureaucratic) systems of allocation.
  • Stock markets guide capital to the most productive use, based on the collective wisdom of sophisticated investors. Efficient allocation of capital can be undermined by government regulations, labor unions, and other forces which prevent investor information from being converted immediately and directly into stock prices. By extension to public administration, creating futures markets in various domains is proposed as an efficient means for allocating capital to public goods as well (ex., using futures markets rather than direct subsidies as a method of agricultural support policy; see World Bank, 1996).

• Public goods, such as national defense, are those which cannot be marketed. Public goods are characterized by (1) free ridership (non-excludability), because it is difficult or impossible to prevent non-payers from benefitting; and (2) non-rivalry, because one person's consumption of it does not reduce it for the next person. These characteristics mean vendors will not produce the public good unless governmentally subsidized. Public goods must be provided by governments, not by markets alone.

  • Public corporations, which are government entities expected to act (and free of regulation and therefore enabled to act) according to market principles, are a type of structure often favored by market theory advocates for use when dealing with public goods. Trends in the 1990s saw public corporations displacing traditional state controlled agencies even in countries, such as Sweden, which had been more favorable to state control compared to the United States (Wise and Stengård, 1999).

• Supply and demand. In a chart where the X axis is price and the Y axis is number of units produced, the supply curve will be upward-sloping since producers will produce more as price increases. Similarly the demand curve is downward-sloping since consumers will buy less as prices rise. In an efficient market, prices will settle at an equilibrium point where the supply and demand curves meet. On the premise that supply will inexorably meet demand, market theory can be used to argue that it is better public policy to invest on the demand side than on the supply side (ex., a given investment in drug education to reduce demand will have more effect than the same investment in drug interdiction enforcement to reduce supply).

• Marginal analysis. When costs are considered, rational decision-makers focus on the marginal costs of producing one additional unit, not on total average costs, which include sunk costs.

• Transaction costs. As the costs of conducting the sale/purchase go up (apart from the actual price of the good or service), sales/purchases go down. Increasing or decreasing transaction costs can be a form of overt or inadvertent public policy. Making public services, or even application for services, available online has the effect of reducing transaction costs, for instance, thereby increasing demand.

• Externalities. Externalities are side benefits or costs produced in the process of production and sales. Pollution may be a negative externality of production. Lower mental health costs may be a positive externality of providing daycare centers. Producers of negative externalities have an incentive to allow such costs to fall on the public rather than be incurred by the organization Liberal reformers may seek to tax producers for negative externalities produced. Conservative reformers may seek to create markets in negative externalities, as, for instance, allowing less-pollution-producing firms to trade pollution credits/certificates with more-pollution-producing firms.

Assumptions

• Competition. In the absence of competition (ex., under monopoly, oligopolistic price-fixing, and certain other conditions) markets will not be efficient.

• Full information. To make rational purchasing decisions in a market, the consumer must have full information. For instance, efficiency of health services markets is impaired by consumers not having access to information on health costs and service quality from competing vendors prior to purchase.

Frequently Asked Questions

• What are some critiques of market theory in terms of stock/futures markets?

Critique: Stock market prices are much more volatile than the actual productive entities to which they are ostensibly allocating capital. Stock prices may increase faster than average precisely because they are cheap relative to the profits of corporations to which they are attached, whereas market theory might suggest that stock markets should be allocating funds to the most profitable corporations. The assumption of the fully informed investor is as much myth as reality. Even in public sector financial markets, such as that for U. S. Treasury bonds, major market distortions have occurred (Clouse, 2006).

Bibliography

• Clouse, James (2006). Remarks of Deputy Assistant Secretary for Federal Finance James Clouse, U.S. Department of the Treasury, Before the Bond Market Association, Government Securities and Funding Division, 27 Sept. 2006. Retrieved 11/28/06 from http://www.ustreas.gov/press/releases/hp118.htm.
• Stokey, Edith & Zeckhauser, Richard (1978). A primer for policy analysis. See pp. 297 - 308 regarding market theory.
• Wise, L.R., and Stengård, P. (1999). Assessing public management reform with internal labor market theory. In Frederickson, H. G. and Johnson, J., eds. Public management reform and innovation. University, AL: University of Alabama Press.
• World Bank (1996). Managing price risks in India's liberalized agriculture: Can futures markets help? Report No. 15453-IN. November 27, 1996. Agriculture and Water Operations Division, Country Department II, South Asia Region, World Bank. Retrieved 11/28/06 from http://www-wds.worldbank.org/servlet/WDSContentServer/WDSP/IB/1996/11/27/000009265_3970311113828/Rendered/PDF/multi_page.pdf.