In the previous Microeconomic Monday posts, the tools for microeconomics were illustrated with some basic assumptions attached. So, how does all that make a market work?
In our first post, we talked about how markets are all around us and in virtually everything we do. Every entity tries to maximize their utility, or gain in the marketplace. Markets are subject to constraints, artificial and induced-and so are individuals. The word individuals should be thought of broadly-could be a person, a small company or a large multi-national corporation. Adam Smith said this about individuals and markets,
“… every individual … neither intends to promote the public interest, nor knows how much he is promoting it … he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention … By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it”
What is sort of interesting is when we look at Coase Theory, when property rights are allocated and two parties can bargain efficiently, whatever bargain they reach is the best for overall society. Hmmm, sensing a trend?
The more decentralized a market is with more individuals interacting in it on both the buy and sell side, the better and more efficient the market. Capital will be allocated more efficiently. Price will be more transparent, and the marketplace will maximize gains to all of society-even though everyone in that marketplace is acting in their own self interest.
This is a crucial point, and some cannot make that leap of faith. But we see it each and every day.
Markets are also smarter than one individual or entity. 1974 Economics Nobel Prize recipient Friedrich Hayek said,
“How can the combination of fragments of knowledge existing in different minds bring about results which, if they were to be brought about deliberately, would require a knowledge on the part of the directing mind which no single person can possess?”
The Price system. Price is the initial read on any market. It’s something that gives you a sense of what’s going on. Price is your first information source for anything. Invest in a stock? You want to know the price. Not the commission. Invest in a company? You want to know the pre-money valuation, not the costs associated with investing. When you buy a pencil, you want to know the price. A car? Same thing.
Markets direct activity, provide information, and create behaviors. When they are decentralized, they work a lot more efficiently and provide for the greater good better than if they are run by central planners. If there is a need, a market will start to solve the problem. If someone artificially plans a market, as long as it is solving a problem, and is decentralized, it will work to solve the problem in the best manner for all of society. As soon as artificial contraints like price floors, ceilings, subsidies, taxes and regulation on behavior are applied, the market loses efficiency.
Things that are seemingly overly complex and organized, like supply chains, are really mini-markets. As Coase outlined in his paper The Nature of the Firm, companies are organized into marketplaces, and interact with other companies in marketplaces to maximize their own value. In doing so, they maximize value for everyone.
As you venture out into the world, start looking at different interactions, both commercial and human. See if you can find the marketplace effect that is influencing behavior. Sometimes it can change daily. Stronger effects were covered in the Microeconomic Monday where we talked about “network effects”.
No typical marketplace is perfect. Even marketplaces like futures exchanges, or stock exchanges aren’t perfect. But they are close. Decentralized decision making that tries to maximize individual value and it happens in a central location with transparent price as an indicator of activity.
One more Micro Monday to go, but you have a tool box now. You can go out and look at the world a lot differently than you used to.
In posts like the above, everything is generalized. Sometimes it helps to have a concrete example and Craig Pirrong from Streetwise Professor provides a timely one right here.