4.1 Understanding Markets
Imagine that it’s your job to organize society. It’s much harder than you might think. For instance, you have to decide which goods get produced. Given that a typical grocery store stocks around 40,000 items, and Amazon sells more than 10 million different items, this might take forever. And that’s only the beginning. You also have to decide who will produce each of these goods, where to produce them, and how they’ll be made. You’ll need to buy enough raw materials and make sure you’ve hired workers with the right skills, each equipped with the right tools. Somehow, you want to ensure that each good is produced in the most efficient way possible by the lowest-cost supplier. Once you’ve made these production decisions, you still need to decide how to allocate these goods, figuring out who gets what. Making good allocation decisions requires understanding who would really value which goods. There’s no point, for instance, in giving a hamburger to a vegetarian.
Thankfully, this isn’t how we organize our society. There’s no central planner telling each of us what to do, or what we each get. Instead, we rely on markets to organize what is produced, how it’s produced, and how it’s allocated. In place of the central plans used in planned economies like Cuba and the former Soviet Union (and to a lesser degree, China), the market economies in North America, Europe, and Australia are organized around markets. Instead of central plans, there are prices, and these prices provide incentives. For instance, if you really want a hybrid car, you’ll be willing to pay a higher price for one. In turn, the prospect of selling hybrid cars for more money than a nonhybrid alternative provides an incentive for Toyota to produce the Prius, their best-selling hybrid.
Markets transform your desires into a price that you’re willing to pay. This price provides a profit signal that motivates firms to produce and supply desired products.
What Is a Market?
A market is any setting that brings together potential buyers and sellers. We often refer to sellers as “suppliers” and buyers as “demanders.” Armed with this definition, you’ll see that markets are everywhere, organizing most of what we do. When you buy a cup of coffee, you’re a buyer (demander) in the coffee market. Indeed, whenever you spend money buying something, there’s a good chance that you’re acting as a demander of consumer goods or services.
Markets are everywhere.
But there are many other economic roles that you’ll also play, beyond “consumer.” For instance, as a worker, you’re a supplier in the labor market, selling your hard work for a weekly wage. If you run your own business, you might end up as a buyer in the labor market, buying the hard work of your employees. When you take out a home loan or small business loan, you’re on the demand side in the market for credit. When you put your savings in the bank, you’re a supplier of credit, supplying your savings to the bank, which will lend them to other borrowers. You’re also embedded in a global market, and your purchase of an imported laptop from China sets off a chain of transactions in which the retailer selling the computer trades U.S. dollars for Chinese yuan in the foreign exchange market, and then uses those yuan to purchase the laptop in China.
Each of these transactions involves a buyer and a seller meeting in a market. And in each case, there’s a price that plays a central role, whether it’s the price of a cup of coffee, the wage earned by a worker, the interest rate on a loan or a savings account, or a foreign exchange rate.
Take an expansive view of markets.
A long-dead philosopher once said, “Teach a parrot the terms ‘supply and demand’ and you’ve got an economist.” He was only half-joking.
Modern economists believe that markets play an even larger role in your life beyond simply what you buy and sell. This expansive view of economics requires a creative understanding of what the relevant “prices” are. For instance, as a voter, you’re a supplier in the market for votes. These votes aren’t literally bought and sold, but you’re more likely to vote for the politician who promises the policies you want. And so the price in the market for votes is the set of policies that a politician promises. The higher this price—that is, the better the set of promises that a politician makes—then the more likely it is that you’ll supply your vote to that politician.
Someday you may also be in the marriage market, open to the possibility that the right boyfriend or girlfriend will become your husband or wife. In this market, the “price” is the promise you make about how much love and support you’ll offer, and the effort you’ll put into helping run your joint household. The higher the price you offer—that is, the more you appear to be a terrific catch—the more likely your demand for a spouse will be met by a willing supplier. But as much as the market metaphor may help you understand dating markets, I still suggest calling your partner “sweetie” rather than “supplier.”
There’s also a market for grades. I don’t mean to suggest that your professor is corrupt. Instead, students are on the demand side for grades, and professors are on the supply side. The “price” for good grades is good performance on quizzes, papers, and exams. As we’ll see, when there’s a lot of demand in a market, prices tend to be higher. This means that when there are a lot of students trying to earn an “A” (that is, demand is high), it will require more hard work (that is, the price will be high).
When you think creatively, you’ll start to see markets everywhere. Your introduction to economics will involve close study of the markets for consumer products, labor, machinery, land, financing, government bonds, foreign currencies, and more. But there are also markets for information, health, education, friends, influence, attention, and even love. Armed with this broader notion of markets, you’ll come to see just how pervasive markets forces are. That’s why the core principles of economics can help you make better decisions across nearly all domains in your life.
How Markets Are Organized
There are many different ways in which buyers and sellers meet, and each of them counts as a market. A few examples are illustrated in Figure 1. In some cases, like in a coffee shop, prices are posted, and you simply pay the price, grab your latte, and go. Alternatively, perhaps you’ve participated in an auction, where the price you pay depends on how much the other bidders forced you to raise your bid on Justin Bieber’s right shoe. Or consider the raucous financial market that is the floor of the New York Stock Exchange. Prices change second by second as millions of dollars are won and lost, as traders buy and sell stock in Ford, Sprint, General Electric, and other companies. Increasingly, markets are migrating online, and so shopping for your next television might involve comparing prices across dozens of websites. While each of these settings seems very different—brick-and-mortar stores versus internet stores, bidding versus posted prices, a coffee shop versus a trading pit—they’re all markets because they bring buyers and sellers together. And in each case, the price is determined by the forces of supply and demand.
Figure 1 | Various Markets
In each of these cases, outcomes are determined by the forces of supply and demand, so we can use the same economic framework to understand all of them. Indeed, the power of economic analysis is that supply and demand are the key forces shaping outcomes in many different kinds of markets. But there’s also an important qualification: The supply and demand curves that we’ve studied so far are most appropriate for analyzing markets that are characterized by perfect competition. Recall that perfect competition involves many buyers and many sellers of an identical good, and each of these buyers is small relative to the whole market. In this chapter, we’ll work toward an understanding of how supply and demand interact in perfectly competitive markets. In reality, many markets are not perfectly competitive. And so in later chapters, we’ll see how some of our conclusions can change depending on the degree of competition in the market. But for now, let’s see how perfectly competitive markets operate.