Markets, How Do They Work?

By Cahal Moran

Markets are the focus in modern economics: when they work, when they don’t and what we can or can’t do about it. There are many ways to study markets and how we do so will inevitably affect our conclusions about them, including policy recommendations which can influence governments and other major organisations. Pluralism can be a vital corrective to enacting real policies based on only one perspective and a plethora of approaches provide alternatives to the canonical view. Although they have differing implications, these approaches share the idea that we should take a historical approach, analysing markets on a case-by-case basis; and they share a faith in the power of both individuals and collectives to overcome the problems encountered when organising economic activity.

The canonical view sees the study of markets as a technical exercise, with certain cases leading to markets working and others leading to ‘market failure’, which requires government intervention to correct things. The trouble is that these cases are typically explored through hypothetical stories rather than concrete evidence. In Famous Fables of Economics: Myths of Market Failures, Daniel Spulber assembles a collection of essays which dispute purported examples of market failures in economics. Spulber chastises approaches to teaching economics which are “replete with picturesque moral tales meant to illustrate or even support fundamental economic theory”. He laments that although the fables are usually “factually inaccurate, their appeal to economists continues undiminished”.

One prominent example is the so-called Fable of the Bees. As the story goes, bees used for honey would naturally pollinate neighbouring farmers’ crops and farmers could free ride off this pollination without paying. As beekeepers are not compensated for their services they will invest in fewer bees than they would if they captured some of the financial gains the farmer makes from pollination. In economics this is called a positive externality, and according to standard logic positive externalities will be under-provided by the market so there is scope for government intervention. However, the story neglects the capacity of people to engage in what is sometimes called Coaseian bargaining, where the farmers and the beekeepers come to an agreement amongst themselves.

Steven Cheung investigates this story and finds it an inaccurate portrayal of how farmers and beekeepers have dealt with their mutually beneficial situation. As he puts it “contractual arrangements between farmers and beekeepers have long been routine” and to establish this “one need look no further than the yellow pages”. Beekeepers typically offer their bees out for hire to pollinate farmers’ crops, increasing yields, so farmers are happy to compensate them. Cheung goes further, suggesting that not only do the arrangements exist but they are efficient – moreso than government policies enacted in this area.

Cheung’s example illustrates the two essential features, mentioned above, of this more grounded approach to the study of markets. Firstly, attention is paid to specific historical circumstances and the institutions that make up real economies. One can glean more about the market for lighthouses from the article by Ronald Coase (of Coaseian bargaining fame) on how they were privately provisioned in 18th Century England, as well as the ensuing debate, than from a fable about ‘public goods’ which implies they will not be privately provided. Secondly, people have a capacity to innovate, organise and negotiate their way out of problems, which can have unexpected consequences for how markets work – including alleviating potential market failures.

Two distinct (but complementary) schools which have paid special attention to both these points are the Austrians and the Institutionalists. Austrians such as Israel Kirzner and Joseph Schumpeter have detailed the role of individuals, particularly entrepreneurs, in discovering new opportunities - and thus actively shaping and changing markets rather than just participating in them as they exist. Schumpeter famously coined the term creative destruction to refer to the ever-changing nature of markets as new products are created, potentially unmooring existing industries. One of Kirzner’s most interesting contributions is his notion of discovery - the role of individuals in noticing potential sources of profit which have previously gone unnoticed. How many times have you looked at a successful app and thought “that's so obvious”? It’s not that the information or potential didn’t exist; it’s just that it wasn’t exploited. As Kirzner puts it “Boldness, impulse, hunch are the raw materials of entrepreneurial success (and failure)”.

An implication of both thinkers is less of a fear of monopolies, which are presumed to be a temporary state of affairs. Since monopolies represent only one iteration in the ongoing process of discovery and innovation, it is always possible – perhaps inevitable – that they will be displaced at some point in the future. In some cases this is undoubtedly true: think about Myspace versus Facebook; London Cab drivers versus Uber; iTunes versus Spotify. Even companies which retain their monopoly for long periods of time, such as Apple and Google, are perceived to do so because they are innovating to avoid being supplanted.

Of course in other cases this is less plausible – Microsoft is much-maligned and yet retains a monopoly on operating systems – but the idea of competition as a process which can look like monopoly at any one time is very powerful, and the changing nature of markets can lead people to overestimate the power – and underestimate the efficacy - of monopolies. A relevant example in Spulber’s Fables is the myth that the QWERTY keyboard is inefficient method of typing but has persisted due to technological ‘lock-in’, when studies in fact show the QWERTY keyboard is generally as efficient as other designs.

Institutionalists such as Ronald Coase and Eleanor Ostrom – still the only woman to receive the Nobel Prize in economics - were similarly concerned with how people respond to economic problems, but rather than entrepreneurs they focused on how economic and political institutions resolved tensions. Ostrom’s work concerned arguably the most prominent fable of them all: the Tragedy of the Commons. The idea is that if an area – say, a field for grazing cattle – is shared collectively, each individual farmer has an incentive to bring their cow to consume the grass. But if everyone does this the field will be overcrowded and the available grass will be depleted to the point where it is unusable. At an individual level the benefits of bringing your cow to the field outweigh the costs, but at a collective level they do not. One solution is state intervention is to regulate the number of cattle on the field.

Ostrom shows that this is a frankly ahistorical view which assumes a bizarre kind of rational idiocy on the part of the farmers: rational in that they are narrowly focused on maximising their own self-interest; idiotic in that none of them would simply realise what was happening and cooperate with their neighbours to ensure a solution. According to Ostrom, such cooperation is the norm:

“In all self-organized systems, we found that users had created  boundary rules for determining who could use the resource, choice rules related to the allocation of the flow of resource units, and active forms of monitoring and local sanctioning of rule breakers.”

One example is where locals agreed on ‘escalating social punishments’ for overfishing (a potential case of the Tragedy of the Commons): first you would be verbally admonished; next you would have your fish thrown back into the sea; next they would be dumped on your doorstep; and eventually it might escalate into physical violence and/or exile. In practice, the latter were rarely necessary and people happily cooperated, facilitating both personal subsistence and economic activity.

As Spulber and others are quick to emphasise, their analysis does not imply that market failures are not possible, only that they are not as universal as is sometimes implied. As a rule Austrians would take this line of argument a little further as they are generally against policy intervention, even when markets are perceived to fail. Regardless of your view, there is an appeal to analysis of markets which proceeds on a case-by-case basis rather than through the lens of fables – whether they are cute stories about cows, or fables in the form of mathematical models. Stories can be helpful for understanding, but past a certain point they can become a hindrance. It is always necessary to confront your story with the historical facts before believing it and passing it down to the next generation of students.