The Market System
I. Specialization
and Exchange
A.
Advantages of Specialization of Labor
Specialization of labor refers to different
units of labor being used differently in the production process. In other words, some types of labor might be
used to produce only one particular type of good while others are used to
produce a different good. In fact, as
labor becomes more specialized then a laborer might become so specialized as to
produce only one part of one good. This
is the case when an autoworker is used in only doing one task, say installing
the front driver's side door on cars on an assembly line.
Based on this definition, consider two types
of societies:
1.
"John Wayne" Society - consists of only rugged individualists
who consume only that which they themselves produce.
2.
"Henry Ford" Society - consists of individuals who are all
specialized labor and produce only one good (or only a part of one good).
Now let us compare the advantages and
disadvantages of both types of societies.
The "Henry Ford" society has as its
main advantage that labor productivity increases. In fact, Henry Ford put into action the
principle observed centuries earlier by the economist Adam Smith, that
specialization of labor often has the effect of increasing total output. Henry Ford as an entrepreneur changed how
automobiles were produced. Previously
cars were produced by single, or at most a few, artisans each working to
manufacture their own individual car.
The cars were "works of art" that were so expensive that only
the rich could afford them. Instead of
artisans, however, Ford pioneered a production process by which cars were
produced on an assembly line.
Individual workers were given a single job to do and the assembly line
moved the car along as the specialized workers added parts. (The Henry Ford museum has a
more complete description of the assembly line and how its specialization
increased productivity.)
The "John Wayne" society has as its
main advantage that individuals do not need to rely upon others for their
sustenance. Its main disadvantage is
the decreased productivity and resultant lowered standard of living that such a
society would offer to adherents. On
the other hand, the main disadvantage of a "Henry Ford" society would
be the reliance by individuals upon their fellow men. That is, given that individuals in this society will desire to
consume other goods than the single good that they produce, some method of
exchange between individuals is necessary.
In our modern, highly specialized world, these methods of exchange are
often quite complicated including transportation of the goods that we consume
over large distances. The implication
of this reliance upon others is that were society to break down, or even
experience temporary problems in the system of exchange, people would find it
difficult or impossible to live. When
events like war or natural disasters occur, starvation or, at the least, a
much-reduced standard of living commonly follows.
Of course, the fact is that no known society
of humans has ever lived in a society where individuals only consume their own
production. Even pre-historic human
societies had family groups, which allowed some specialization of labor. In recent U.S. history, the groups of
individuals most likely to be considered "rugged individualists"
nevertheless remained dependent upon others.
"Mountain men," for example, are often portrayed as such
rugged individualists but the fact remains that they existed because of the
market for beaver pelts in Europe and the Eastern U.S. The beaver pelts were used during the heyday
of the mountain man to make top hats for fashionable society. Mountain men traded their harvest of beaver
pelts for their yearly sustenance at trading forts and trapper rendezvous. When silk replaced beaver as the fashionable
top hat then mountain men lost their livelihoods and their numbers declined.
While true "rugged individualists"
have likely never existed, it is important to note that some, like mountain
men, relied less upon others than we do today in our modern
society.
Thus, human societies have invariably relied
upon at least some specialization of labor implying that the advantages of such
specialization outweighs the disadvantages.
B.
Necessity of Exchange
Exchange refers to the process by
which individuals trade the goods that they produce for the goods that they
wish to consume. Given that human societies have chosen to have specialization
of labor, for the reasons discussed above, along with that specialization must
come some system of exchange.
C.
Systems of Exchange
There are a number of possible systems of
exchange. In fact, human societies have
used different types of systems during the course of history. A few of these possibilities are discussed
below.
1.
Force
The simplest system of
exchange is one where ownership of resources and outputs are determined by
force. That is, by the person or group
with the most ability to enforce its ownership through such measures as fear,
intimidation and violence. This system,
although often illegal, remains widely used in the world today both with
individuals and small groups but also between nations.
2.
Tradition (feudal societies)
Societies that use tradition
to determine the basic economic questions of what to produce, how and who will
receive the goods once produced are also known as class societies. In this case, just as with European feudal
societies of the middle ages, what was produced and who received it was
determined by the class in which one was born.
Some individuals received more goods but provided protection against the
illegal use of violence, sometimes of their neighboring class peers. Others had the benefits of such protection
but at the cost of some of their production going to those providing the
protection. Some societies were
especially rigid as to the class an individual belonged to while others had
some flexibility built into the system.
In any event, birth or tradition was the overriding means by which
exchange was effected in such a system.
3.
Planned Economies
During the 20th
century some societies, usually communist countries, turned to central planning
usually by a strong, central government to control exchange. In such economies, the central body made
extensive and detailed plans for the type of production that would occur,
sometimes taking such plans out for a number of years. The most extensive example of a planned
economy was the Soviet Union, which came into being during the early part of
the century and eventually fell in 1991.
4.
Market Forces
Market forces refer to a
system that allows individuals to decide themselves what to produce and consume
based upon their own preferences, abilities and resources. As discussed below, a "market"
refers to a place where exchange occurs in such a system. This may, as markets did originally, refer
to a geographic location where exchange occurs but has come more commonly, with
increased communication technology, to refer to the process of exchange itself. A system of market forces is sometimes
referred to as a "free market economy."
5.
Mixed Economies
Mixed economies refer to
some combination of the two previous types of systems: (1) planned economies
and (2) market forces. Americans tend
to think of the U.S. system as one where individuals are free to make market
decisions - a free market system.
However, even a brief investigation reveals that the free market is not
always free in the U.S. The government
both forbids some market activities (e.g., some drug use, markets in
living bodies, etc.) as well as regulating a large number of other market activities (e.g.,
other types of drug use, interstate commerce, health care, etc.) In other instances, the government itself
provides a large number of goods and services (e.g., information - the
government is the largest provider of information, education, roads, etc.) In all of these examples, the government is
acting as the central planning agency in a planned economy.
The same is true of the few remaining examples of
planned economies, albeit in reverse.
The central government in China, for example, has moved more and more
towards a market economy while still keeping a tight central control on other
forms of expression. It is fair to say,
in fact, that most, if not all, economies in the world today are mixed
economies. The mixture of government
intervention and free markets does vary from economy to economy but nonetheless
exist.
II.
Definition of Terms
A. The Market
Markets are related to the exchange of goods, services, and resources
between buyers and sellers. The
original markets were geographic locations where exchange occurred. We continue to have geographic markets in
our society today where buyers and sellers gather to exchange goods. The most common example of geographic
markets is shopping malls.
However, as technology has increased other types of markets have arisen
that are not always tied to a geographic location. The essence of a market, then, is a mechanism that facilitates
exchange but does not necessarily involve the geographic gathering of buyers
and sellers in a traditional market.
Often, exchange carried out through the use of even relatively simple
technology such as newspapers, telephones, faxes, etc. The advent of the internet has increased the
use of technology to make easier exchange with web sites both selling goods but
also allowing people to post for sell labor (e.g., web sites like
monster.com that allow one to auction one's own labor) and other goods (e.g.,
web sites like www.ebay.com that allows one
to auction virtually any type of good.)
In addition to the above type of markets, it is common to refer to
markets that are specific to a type of good, service, or resource. These markets may be diffuse - as is shown
when one notes that, for example, "the labor market is doing well this
year." On the other hand, these
markets may be quite specific, noting a specific type of labor market, say the
market for people with a new bachelor's in economics degree. (For information about this particular labor
market see the
Missouri State economics department web site.)
Or they may refer to the selling of a specific commodity, such as soybeans
on the Chicago Board of Trade.
B. An Economy
Suppose you read in a newspaper that, for example, the U.S. economy
grew at a 3.2 percent annual rate in the second quarter of 2000. References to the economy are common in our
society exactly because it represents a concept important to society generally
and, often, each of us as individuals.
Just as with markets, the Economy is also related to the exchange of
goods, services, and resources.
However, in this case, the economy refers to an aggregated set of
production and consumption activities.
In other words, an economy consists of the workings of a number, often a
large number, of distinct markets for goods, services, and resources.
However, what makes a certain set of production and consumption
activities an “economy” while another grouping is not? For example, it is common to refer to the
U.S. economy, as noted above, but not common to refer to the U.S. and Norwegian
economy. That is because the individual
states comprising the U.S. share a common geographic location and a common
legal system while the U.S. and Norway share neither. Hence, an economy is most often defined as a set of production/consumption
activities that share either or both common geographic locations and common
legal systems.
Economies are most often national economies, such as the U.S.
economy, which share both geographic location and a legal system. However, regional economies within a
given nation are also both commonly referred to and quite useful in
application. For example, the Southwest
Missouri regional economy is considered to consist of twenty-four counties in
the Southwest portion of Missouri. (The Missouri State Bureau of Economic
Research publishes data on this regional economy.) Multinational economies have also
begun to be developed, mostly through attempts to create a common legal system
between geographically close countries.
One example of such a multinational economy is the European Union (EU),
which was formally created on November 1, 1993. (For a brief history of the European Union see the EU web site.)
III.
Actors in the Market
This section briefly discusses the three different
types of actors in a typical system, such as the U.S. In essence, there are three general types of actors, households,
firms, and the government, each of whose roles is discussed in more detail
below.
A. Households
·
Consumers of Goods and
Services
·
Owners of Resources
·
Assumed to act to
maximize well-being or satisfaction
·
Assumed that no internal
conflicts in decisions
Basically, this assumption means that even though
households often have more than one member that those members can come to an
agreement about which decisions maximize satisfaction. In addition, they can be consistent in such
decision-making. Obviously, this is
assumption may sometimes be violated but is made for simplification.
B. Firms
·
Producers of Goods,
Services, and Resources
·
Buyers of Resources
·
Assumed to act to
maximize profit
·
Assumed that no internal
conflicts in decisions
Similar
to households, this assumption means that even though firms may have
conflicting interests – multiple owners, workers, management – that those
conflicting interests can come to an agreement about which decisions maximize
profit. In addition, they can be
consistent in such decision-making.
Such
an assumption is even more problematic for firms than for households. That is because firms are often much larger
than households, with correspondingly larger potential for conflicts. In point of fact, in very large firms the
individuals who make decisions for the firms, the managers, are often either not
the owners of the firm or only have limited ownership. In this case, there is large potential for
decisions that are not in the interest of the firm – decisions that do not
maximize profit. Economists have spent
quite a bit of effort discussing such incentive problems in both firms and households. However, for the purposes for this class we
will make the simplifying assumption that such conflicts do not exist.
C. The Government
·
Provides a legal
environment, ensuring private property rights
This
represents the crucial role of government in a market system. Without the enforcement of private property
rights exchange would be difficult if not impossible, as those with more power
would work to steal property, leading to loss of production and a breakdown of
the market system.
·
Intervenes in cases where
Market failure occurs
Markets do not always work optimally. One of the major topics during this semester
will be the analysis of different types of market structures, including one of
the major types of market failures, monopoly power. The lack of competition that occurs during monopoly causes
markets to “fail”, which in this case implies inefficiency.
Markets also fail in a number of other
instances. Externalities are another
common market failure. An externality
is said to exist in a market when a third party external to the
exchange, that is someone who is neither the buyer nor the seller of the
product, is affected by the exchange.
Externalities also cause inefficiencies in the market.
There exist two different types of
externalities. In a positive
externality, the third party benefits from the exchange. An example of this type of externality would
be vaccinations for illnesses. If you
decide to become vaccinated for an illness, say measles, then it reduces my
chance of becoming ill even though I have not been vaccinated myself. In fact, if everyone were vaccinated but me
then I would have no incentive to purchase the vaccination. However, if enough people behave in this
manner, as they have an incentive to do, then the number of vaccinations will
fall and epidemics will result. Thus,
the inefficiency caused by a positive externality is one where too little of
the good, in this case vaccinations, are produced by the market.
In a negative externality, the third party is
damaged by the exchange. The classic
example of a negative externality is pollution. Suppose that a steel company builds a plant next door and begins
production of steel, but that it also produces air pollution as a byproduct,
which damages nearby residents through respiratory diseases. The increased level of respiratory diseases
is legitimately one of the costs of the production of the good. However, because these costs are born by
third parties, they are not factored into the profitability of the firms. As a result, the firm produces too much
steel and also too much pollution.
Thus, the inefficiency caused by a negative externality is one of
overproduction of the good in the market.
For both types of externalities, government
intervention may be able to correct the market failure, either by stimulating
production, in the case of a positive externality, or suppressing production,
in the case of a negative externality.
·
Provides public goods
A public good is defined based upon two crucial
characteristics.
·
Rivalry – a good is rivalrous if only one individual
can consume it at a time and non-rivalrous if multiple individuals can consume
the good simultaneously. Oranges, for
example, are an example of a rivalrous good while roads are an example of a
non-rivalrous good.
· Exclusion
– a good is exclusive if it is relatively easy (costless) to exclude consumers
who do not pay for a good from consuming the good and non-exclusive if
exclusion of non-paying consumers is difficult or impossible. Oranges are also an example of an exclusive
good while computer software is an example of a non-exclusive good.
A public good is
defined to exist when the good is both non-rivalrous and
non-exclusive. In these cases, private
provision of the good is likely to be inefficiently low because private parties
will be unable to reap the full profits from production of the good, both
because multiple consumers can use the good simultaneously and because it is
difficult to stop its use by non-paying consumers. As a result, the government often provides public goods. Examples of public goods include roads,
police and fire protection, and national defense.
·
Makes Normative
Decisions
A good deal of the workings of government has to do
with making normative, or opinion-based, decisions. Examples of normative decisions commonly made by governments
include taxation and welfare policies, regulation of public health and safety,
and provision of public goods.
·
Not assumed consistent in its decision making
Unlike households and similar to many firms,
governments tend to be large entities.
As noted in our discussion of this issue for firms, larger organizations
have more internal conflicts and, hence, less consistency in decision
making. Many governments, including the
U.S. system of government, are typically designed in order to have internal
conflicts, a system of checks and balances with different branches of
government with independent powers that, as a result, are sometimes in
opposition to each other. Furthermore, the
many governmental officials have their own incentives that may vary between
officials and over time. For example,
the primary incentive for elected officials is generally their desire to be
re-elected in the future. Re-election
concerns may cause different officials to behave differently given such factors
as the varying nature of their constituency.
As a result of these problems, the government will not be assumed to be
consistent in its decision making unlike firms and households.
D.
A Circular Flow Model of
an Economy
The circular flow model is presented in order to place together the
three actors in market and mixed systems together in a single model
demonstrating their interactions. Graph
1, below, illustrates these interactions.
The flow of payments, either for goods and services, for resources, or
for taxes are highlighted in red. The
flow of goods and services, resources, and transfers are highlighted in
blue.
As discussed above, households are consumers of goods and services,
which they buy in goods and services markets.
In order to obtain the necessary money for such purchases, households
sell resources in factor markets.
Firms are producers of goods and services, which they sell in goods and
services markets. The firms use the
payments from such transactions to buy the resources in factor markets
necessary to produce the goods and services.
The government’s roles in the market system include gathering taxes
from both households and firms. They
use tax revenue both to buy resources and to give transfers of wealth, such as
welfare payments, to both households and firms. While it may not be common to think of the
government transferring wealth to firms, such is a relatively common occurrence
in our society. This may be done
through tax breaks for favored firms – given perhaps to induce a firm to locate
to a particular locale. Or it may be
done through subsidies for other firms, such as subsidies often given by the
U.S. government for the production of certain agricultural products.
The government also serves the role of producing some
goods and services, such as the public goods discussed above. In this role, they must purchase resources,
providing payments for their purchases, in the factor markets. The goods and services produced by the
government may either be sold through the goods and services markets or
provided free of charge directly to firms and households. For example, a price is now charged for
entry into U.S. national parks and monuments.
Many other governmental provided goods and services may also require
payment and, hence, go through the goods and services markets.
However, the immediate consumers do not pay directly for many
other governmentally produced goods and services. For example, governments do not commonly charge prices for fire
and police protection. Another example
would be the provision of information, which the government often
produces and provides without charge.
Libraries often have depository rights for such information, which is
then disseminated to the public without charge. Such information has also begun to be produced through the
internet (The Bureau of Labor Statistics is
one site that provides information on such things as employment, unemployment
and prices.)
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