Thursday, 31 May 2007

When do markets work?

In some situations the free market seems to work reasonably well - the equity markets in ordinary conditions for the largest companies, for instance. In others, the unfettered market (at least as currently set up) does not seem to be as efficient: the internal market in the NHS might be one example, the monopolistic behaviour of some corporations is another. So when does the market work well?

Some thoughts about things which help:

  • There are a lot of items which are broadly the same, and these are transacted often. A market price only means something if price discovery is useful to other market participants. Thus the market price of a stock (and the near certainty of liquidity at that price) is useful information to other owners of that stock. The market price of the only sculpture ever made by a particular artist is of lesser interest to other market participants as it gives almost no information about transactions they might be able to make.

  • There are a variety of different independent willing buyers and willing sellers of the same (or very similar) item. Because otherwise the price can be distorted by the operation of monopolies on one or both sides. This is not necessarily to disadvantage of the buyers, but it does mean that the free market model may not be appropriate.

  • The costs of providing a market are not too high. It may be that there are situations where transaction, marketing or other costs are so high that having a range of providers does not make sense. I suggest this might well be the case for something like railways: a single system is better than a choice between competing alternatives.

  • A public marketplace is acceptable to most market participants. In some markets it may well be that the advantages of a visible price are outweighed by the disadvantages of being seen to transact. Market participants may value privacy highly.

  • There is not an unacceptable level of moral hazard or information asymmetry in participating in the market. Thus for instance buyers are comfortable that sellers are not selling because they know something bad about the item which the buyer cannot easily discover.

  • The market is not thought to be easily manipulable. Market participants tend to shun markets that are seen as unfair.

  • The market is not illegal and actively policed. Although arguably the market for certain drugs is a counterexample.

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