Davidson, J., and A. Weersink. What does it take for a market to function?

Outline

1) Define the concept of a market and related ideas:

efficiency, price, market failure, role of transactions costs and related institutions

2) Examine actual markets - how they evolved in the context of emerging markets in Eastern Europe

3) Summarize principles and necessary criteria

(A) What is a market ?

1) market as a complex web of interactions

2) The market as an institution

3) Market as a geographic sphere

- price making forces

- law of one price

4) What's a market ?

there's a price, many buyers/sellers, a geographic area and a commodity

5) Group of institutions

(B) What is Market Efficiency ?

Two fundamental welfare theorems

1) When do you get a Pareto optimum ?

a) complete markets b) buyers and sellers - competitive behaviourc) equilibrium

2) Efficiency versus equity

What does “PRICE” represent? (Signal)

Eugene Fama - Efficient Market Hypothesis (J. of Finance, 1970)

C) Market Failure

What does this mean?

When does it happen?

agents can not equate MRS (consumption and production)exchange is not possibleno price to guide decisions, allocation

Necessary conditions for the price system to work

Sufficient marketsCompetitive behaviourEquilibrium (S/D)

Non-competitive behaviour (e.g. monopoly - welfare not max)Non existent equilibrium - RTS (natural monopoly)Asymmetric information - (George Akerlov - JPE 1970)

D) Role of Transactions Costs (TC)

Cost of exchange and enforcement of rightsrelatively large proportion of GDP

Other necessary conditions for a market to exist

protection from post exchange opportunismneed to define and protect/enforce property rights - this is costly

What rights are important ? (4) 

use, derive income, exclude, exchange

Principle: market existence requires low transactions costs

TC can kill a market and lead to an externality

E) When is a Market Efficient ?

No other institutional arrangement exists with lower transactions costs

If you are creating a market - find ways to minimize TC's

R. Coase: Exchanges INSIDE or OUTSIDE the firmMake it inside or contract it out ?

Cars – GM and Ford

Cell phones (Apple, Samsung)

University education

Modern communications supports this: ecosystem

Elements of Market Design

(1) Medium of exchange (money) - to reduce TC - search costs versus barter(2) Trading rules

institutional trading arrangements - reduce TC of exchange

Evolved from informal to formal

Allows the market to expandto include agents who do not know each other

trade at a distance

Example: Law Merchants (traders)

Good reputation – allowed market accessReduced information costs

Oversight – private or public ?

Criteria for Successful Market (3)

What other aspects of the property right need to be defined?

2) Initial Allocation

1) Definition of property right

needs to be exclusivedefine who owns what - what does ownership mean?what uses of property are OK?

What: define the goodWhere: the physical areaWhen: timeframe

Costs to Exchange (TC)?Initial allocation => efficiency

TC can be high enough to prevent exchange

e.g. native land claims - give resource to natives, or auction ?

3) Exchange of rights

A) because of information asymmetries, markets may not give efficient allocation

B) system needs an enforcement mechanism

What is exchange? 3 elements, all of which involve costs

searchbargainingcontract

What is Enforcement?

monitor agents involved in exchange - e.g. CBOT market surveillance committee

enforcement of contracts - application of penalties

cost of enforcement > potential gains from trade => no trade and no market