The Science of Economics
1. How markets work
In order to understand the concept of a market, it is helpful to look at its evolution.
Trade may have begun with informal agreements among neighbours, such as the basket-weaver offering his handiwork to the farmer next door, in exchange for some of the farmer's fresh vegetables. But, in time, trade became carried out on a more community-wide basis - in particular gathering spots called markets. Today, we use the term "market economy" to refer to a society where people meet their needs through voluntary agreements of exchange. A "market" is not a particular place or group of people, but the process of voluntary production, exchange, distribution, and consumption.
Initially, trade was carried on through barter - the
direct exchange of one good for another. However, for
large-scale trading, barter is a cumbersome business: any
farmer, for example, who wants to swap his vegetables for some
tools, needs not only to find someone willing to trade in tools,
but to trade tools specifically for vegetables. Trade through
barter requires what is called "a double coincidence of wants".
The story of how traders solved this problem has been
related by many authors, Menger (1871, p. 258) being the first
to analyze it in detail. As related by Menger, although barter
limited the exchanges of traders "there were elements in their
situation that everywhere led men inevitably, without the need
for a special agreement or even government compulsion, to a
state of affairs in which this difficulty was completely
overcome. Traders realized that they could exchange their
specialized products for commodities which had a greater
marketability, which they could then trade for what they wanted
to consume." Cattle, for example, were readily saleable in many
And so, in any particular market area, certain goods,
such as cattle, cocoa beans, gold, or wampum, became
intermediate goods with exchange value, and the use of such
goods for payments became a social custom. Menger emphasizes
the importance of custom, since "the actual performance of
exchange operations of this kind presupposes a knowledge of
their interest on the part of economizing individuals" (p. 261).
Money eliminated the need for the more cumbersome system
of bartering, but whether one is trading with money or through
barter, the act of voluntary exchange is what creates a market.
As set forth in Chapter 1, a "market" is the totality of
voluntary economic acts in some context. The term market
denotes anything from an exchange between two individuals on a
street corner, to the more elaborate trading on Wall Street. A
market process cannot be perceived as detached from the people
who create it.
Classical economists noted that a free market will
allocate scarce resources effectively without the need for any
central direction. The output produced is generally the amount
that people wanted to buy, without severe shortages or
surpluses. How is it that production manages to adjust to the
continually changing wants of consumers?
Markets are able to allocate resources through the price
system. Prices serve as a signal to a consumer about the
relative costs of goods, which they compare to their subjective
valuations of these goods. Prices also indicate the costs and
revenues to producers. Consumers and producers react to prices
in their buying and selling decisions, determining the types and
quantities of products.
If more of one item - a hammer for instance - is
demanded, hammers become sold out. There is a temporary
shortage. This will cause the price of a hammer to rise,
eliminating the shortage. But then since producers are making a
greater profit, this stimulates them to produce more hammers.
As more hammers are supplied, the price of hammers will go down
again, though perhaps not to the previous level, since it may
costs more to draw resources from other uses in order to make
more hammers. And so the market ends up with more hammers,
perhaps at a bit higher price, equilibrating the desires of
consumers with the costs of producers.
Similarly, imagine that too much of a certain commodity,
such as coffee, has been supplied. Through competition among
sellers to get rid of their coffee, the price will be pushed
down. But at the lower price there is less profit, so producers
will reduce their supply, thereby reducing the glut of coffee.
So we can see that through an enormous system of trial
and error the price system will ultimately balance supply with
demand - fluctuating prices will ensure that a glut or shortage
of an item or service does not persist.
Adam Smith, in his classic text The Wealth of Nations,
praised the workings of the price system. He demonstrated how
through the price system, the an individual's pursuit of his own
interest contributes to the well-being of others. Thus, from
the pursuit of individual interest, society is led, by an
invisible hand, to the common good.
Smith showed that "self-interest" in the course of
history had led to the specialization and division of labour.
The exchange - through trade in markets - which naturally
followed specialization, was responsible for the world's
progress. As such it should be allowed to progress unhindered
by government intervention.
The achievement of community welfare through the pursuit of individual interest presumes a freely competitive market. The term "competition" has two meanings. One is rivalry among producers and consumers, bidding against one another for goods or sales. It is only through
competition that more producers enter a market when profits are high, increasing supply and reducing the price. As such, the economic society envisaged by Smith was to be devoid of both
economic privileges and monopolies, which hinder competition.
Rivalrous competition is criticized as being chaotic, but it is in
fact an orderly process, a spontaneous rather than planned order
that follows ethical rules, namely that of not harming others.
Far from being destructive, rivalrous firms competing for scarce
resources determine the best use of the resources by their
bidding for them. Without this competition, we could not
perform economic calculations, because in a complex economy
there would be no way of knowing the relative scarcity of
resources relative to consumer demand.
If competition is prevented from operating in any way,
whether by organised groups, criminals, or legislation, the
result is usually higher prices or a lower quality of goods and
services, as well as the social waste of inefficiency.
Competition tends to eliminate profits other than normal
returns to the factors of production. The firms that maintain
the lowest costs of production will earn a greater share of
profits. In an effort to keep costs of production down to a
minimum every avenue of innovation will be explored. Indeed,
the process of competition is essential to efficiency - it
provides for cost saving innovations and induces firms to adapt
The second meaning of "competition" is an absence of monopoly power.
One obvious barrier to rivalrous competition is tariffs and quotas
imposed at national borders will be discussed in Part II. The
main point, for now, is that trade barriers reduce competition
and increase the cost of the goods in the affected industries.
Another barrier is a government-granted monopoly, the
privilege of being the sole supplier in an industry ( eg..
Licenses restrict entry into an industry to certain
specified persons. The alleged reason is to assure some
standard of competency, but the result is often restricted entry
even for qualified practitioners.
Marketing boards - such as the Potato Marketing Board in
the U.K. controls the size of the potatoes coming on to the
market as a means of restricting the supply and thereby
controlling the price.
Other restrictions on competition will be discussed in
Chapter 9, on the role of government.
3. Market structure
The market structure of an industry consists of the
number of firms and their relative size. Different market
structures induce different types of competition.
The degree of industry concentration can be
measured using the Herfindahl index. You first calculate the
fraction of the industry that each firm has. Then square this
fraction. Finally, add up the squares. The result is a
concentration index between zero and 1, 1 being an absolute
monopoly and a number close to zero being atomistic.
The more concentrated an industry is in terms of fewer number of firms and more inequality of size, the greater monopoly power the firms have, and thus the less competition there is in the sense of absence of monopoly pwer. The least monopolistic structure, then, is that in which there are many, thousands and millions, of firms, none of which is large enough to affect the price of the product, and in which there are no barriers to the entry and exit of firms into that industry. This structure is called "atomistic" competition, and also confusingly called "perfect"
competition. The latter term implies that other structures are imperfect, which is misleading, since if the most effective forms of structure for some industry is not atomistic, it is not imperfect.
In atomistic competition, a firm is so small relative to
the rest of the industry that it must sell its output at the
price set by industry supply and demand. This implies that the
product of that industry is homogenous or uniform, so that if
one firm tried to sell at a price a bit above the market, no one
would buy its product, since others are selling the same stuff
for less. As noted above, atomistic competition also has
complete freedom of entry and exit. Any firm can set up
production within the industry and any firm can quit.
If firms in atomistic competition make economic profits
(as discussed in Chapter 7), then new firms will enter the
industry to obtain some profits. As the industry expands, the
industry supply curve shifts out and hence price will be driven
down the demand curve. Economic profits are therefore a
short-run situation; in atomistic competition, economic profit
tends to be zero, and the firms only make normal accounting
profits that provide normal returns to the factors of
But wait a minute, you say. What if, for example, one
farm has superior land than another. Wheat farming may be an
industry with atomistic competition, but the farms with better
land will have more profit!
Yes, they will have higher accounting profits, but the
better land has a higher rent, so after subtracting out the rent
from the accounting profit, the net economic profit is still
zero. The producer surplus goes to rent.
But wait another minute! Something seems goofy here.
Each firm in atomistic competition has no control over the
price, yet the industry price can move up and down as industry
supply and demand curves shift. So how can industry prices
change if no one firm can change the price?
Here's how it works. Suppose we have a million wheat
farmers. One farmer wants to sell his wheat. He calls a
wholesale dealer. The wholesale dealer might be overstocked
with wheat, so he calls his broker at the commodity exchange,
where the wholesaler can buy or sell all he wants at the quoted
price. In the commodity market, there are thousands of buy and
sell bids being entered every minute. The price is set
second-by-second by the brokers who match the buy and sell bids.
No single bidder can dictate a price, but each bidder has a
small influence by increasing the bid in one or the other
direction. So the price is set in auction markets, with each
bidder having a tiny influence but none being able to dictate a
In atomistic competition, firms produce at the lowest
possible cost, which is the industry's minimum average cost. If
any one firm could produce at a lower cost, it would do so to
get an enormous competitive advantage, selling at a bit lower
price than the others, so the other firms would copy the first
one's production function and also produce at lowest possible
Atomistic competition has the happy result that
production takes place in the most efficient way, not only for
the firms, but also for society, since the price of the product
is just equal to the marginal cost of producing it. As you may
recall from Chapter 7, the marginal cost crosses the average
cost line at the bottom of average cost. Atomistic competition
is socially efficient because the marginal revenue of a firm
equals the price of the good, so that if any more were sold, the
social costs would be higher than the price, and if any less
were sold, the cost of one more unit would be less than what
people would be willing to pay. When price equals marginal
cost, social benefits from the good just match the social cost
of the resources.
The other extreme of market structure is monopoly. A
monopoly exists either when there is only a single seller of a
particular good or service, or as a different type of monopoly,
when there is no entry into the industry for the expansion of
product. We can call the first type an absolute monopoly and the
second an entry-monopoly. Economists today usually mean absolute
monopoly when they use the term "monopoly," although classical
economists also referred to entry-monopoly.
If there is only one firm in an industry, the firm's
demand curve is that of the industry, so it has the ability to
set either the price or quantity of output. Note that in a
market economically it cannot do both, since if it sets a price,
market demand will determine the output sold at that price. A
government monopoly, operating outside a market, can of course
dictate both price and quantity, forcing people to consume and
pay a price.
A profit-maximizing number-monopoly will set its price
at the level where its marginal cost equals its marginal
revenue. Since its demand curve slopes down, its marginal
revenue curve slopes down too, and even steeper. This is
because each extra unit of output is not only sold at a lower
price, but all previous units area also sold at that lower
price. So where the two curves intersect, the marginal revenue
is less than the demand curve, where the price is, and the
difference is an economic profit (since the marginal cost curve
also includes all implicit costs). This is not an
entrepreneurial profit, but a monopoly profit, since it is not
due to the uncertainty of the market, but on the contrary, to
assured profits due to the lack of competition.
An absolute monopoly, secure in the fact that it is the
only producer of a good, can limit supply so as to maintain a
higher price. Consumers could be made better off if production
were expanded production, lowering the price (the monopoly owner
could even be compensated for his loss of profit and society
would still be better off).
A monopoly can also practice price discrimination, the
practice of charging different prices to different types of
users. Firms price discriminate when they have discounts to
older people or children. In Eastern Europe, some expensive
restaurants charge a higher price to tourists than to the
locals. Price discrimination increases sales by adjusting the
price to the elasticity of demand, with the demand of wealthier
customers more inelastic, or less responsive to price increases,
i.e. they continue to buy even at the higher price.
A monopoly having no current competition may face
potential competition if its economic profits are consistently
high (such as from abroad), so it may be induced to keep its
price below the short-run profit-maximizing level.
In entry-monopoly, even where there are many firms, they
can earn economic profits, since other firms cannot enter to
expand the output. An example of entry monopoly is taxi cabs in
New York City; one needs a government permit to enter the field,
but the number of permits is fixed, so to enter, one needs to
buy a permit from a previous owner. Land, being fixed in
supply, works the same way.
The four types of absolute monopoly are locational
monopoly, natural monopoly, new-product monopoly, and
A locational monopoly is the only firm in some immediate
market area, such as the only drug store in a small town. Such
firms can have monopolistic profits, but these profits are
limited by competition from farther-away firms and from
non-market factors, such as the personal relationships that may
develop in a small town.
A natural monopoly occurs when there are economies of
scale and, since the supply for a firm curve slopes down, the
first firm to achieve a big size has a competitive economy,
driving the smaller ones out of business. Examples include
municipal utilities such as piped water; a second firm would
duplicate the pipes of the first, and bringing in water by truck
is much more expensive.
A new-product monopoly is a temporary
restriction against competition for creators of new literature
(copyrights) and for new inventions (patents).
A government-protected monopoly is a legal barrier to entry not
warranted by new products.
Patents are a controversial form of monopoly. Some argue
that patents are necessary to protect the investment in research
of the inventor and stimulate new inventions; others that they
give the inventor too much of a monopolistic privilege.
Actually, patents are simply a method of economizing on
contracts. It would be costly for the maker of a new firm to
make a contract with each buyer not to copy the item, especially
to enforce such a contract. Patents, like copyrights, simplify
the contract with a notice on the product that it is patented
and a conventional number of years that the contract applies
for. Patents also enable the inventor to register his invention
and check to see that it is really new. No one is coerced into
buying the product, so the patent facilitates the market by
simplifying property rights rather than being a privilege or
Hence, new-product monopolies may charge higher prices
than they would in a competitive market structure, but these new
products might not be brought to market otherwise, so the net
result is usually beneficial. This is not so for
government-protected monopolies. Here, the public pays a higher
price and gets less output for no good economic reason.
Government-protected monopolies are an intervention, and do not
exist in a pure market economy.
That leaves us with natural monopolies, a difficult
problem for economics as well as politics. One way government
has dealt with them is to set a price, usually at the average
cost (including some margin of accounting profit). A problem
with this method is that the firm has little incentive to
control costs, other than from government oversight and
hearings, which may not be effective in controlling costs. The
commissioners regulating a monopoly may have come from that
industry and may in fact be working to benefit its owners rather
than the public.
In many cases, the government runs the industry
directly. In some cases, government enterprises such as trains
and subways provide good service, though often not, but it is
again difficult to control the costs, and the incentive of the
government agents may be to increase their own benefits and
power, which increases costs.
A third option is to periodically open control of the
firm to a competitive bid. The industry itself is a monopoly,
but bidding to own it for a while can be highly competitive.
The highest bidder then runs the outfit for a certain period of
time, charging what it pleases. But the government keeps the
fee paid by the bidder. If the bidding is competitive, this fee
represents the monopoly profit, which is now paid to the
government. The company then has the incentive to minimize
costs during its operations. This option is also not perfect,
because the firm still charges the public a monopoly price, but
it avoids the social waste of artificially high costs that may
compensate for that.
A fourth option exists when the firm cannot make a
profit only from the user charges, but when the service is a
territorial collective good that increases rents. Suppose there
is a subway in a city, which is a natural monopoly. Even
maximizing profits, the revenues would not cover the costs. But
there is a second profit in the increased land value and rent,
which when added to the fares would make the operation
profitable. The service can therefore be funded by a
combination of rent and user charges, especially when the
charges are based on the congestion of the service, charging
more when it is crowded to compensate society for the crowding
the users impose and to even out the usage.
Whereas with atomistic competition, there is a uniform
product, with monopolistic competition, there are many firms,
but there is product differentiation: each firm produces a
different version of the product, such as a different style,
brand, or location. There is competition, but each firm also
has a mild monopoly on its variant, the products being close
substitutes. There are also no barriers to the entry of new
firms and increased production. Examples of product
differentiation include different brands and types of
toothpaste, and different locations of retail stores.
Because of this mild monopoly, each firm faces a
downward-sloping demand curve, and has some control over price.
These firms will then set prices where marginal costs equal
marginal revenues. But over the long run, because of
competition, there will tend to be no economic profits, firms
operating where the price equals the average cost. But since
this cost curve is tangent to the demand curve (coming down to
touch it and then bouncing off), the firms are not operating at
the minimum possible average cost. Critics call this type of
market structure "imperfect competition," saying that there are
too many firms, and also too many artificial varieties of
products. But product variety is valued by many people.
Critics also say there is too much advertising, but again, given
different varieties, it is natural to want to draw customers to
your brand, and advertising helps pay for newspapers, magazines,
radio, and television.
It is unrealistic to expect markets where products are
or can be differentiated to behave like those where they are
uniform. The market has in fact produced generic brands as well
that have less fancy labels for lower prices. Firms try to
influence consumers, but in the end, consumers choices are
voluntary. There is nothing imperfect about an outcome that is
the best one can have given the conditions of the products.
An oligopoly, an industry with few sellers, includes
both a "pure oligopoly" with a homogenous product and a
"differentiated oligopoly," with product differentiation. There
are often few firms in an industry due to economies of scale,
which induce firms to become large. A firm in an oligopoly is
very much affected by the action of any of its competitors, but
exactly how it responds depends on circumstances. A type of
game can be played by one firm lowering price and the others
responding, and like chess, the oligopoly game has no one exact
sequence of plays.
Oligopolists can collude to create an industry monopoly
among them, either secretly or openly as a cartel. But there
will be a great temptation to cheat on the agreement, since a
firm that lowers its price just a bit will be able to sell much
more product. If one or more of the firms sell below the cartel
price, then eventually that price cannot be maintained, and the
oligopoly will fall apart. Also, new firms may enter the
industry to take advantage of the cartel price, and as the
supply curve shifts outward, the increased product must be sold
at a lower price. The cartel must either lower its price or
4. Government and competition
Governments have reacted to oligopolies and collusion
with anti-trust laws, breaking large firms into small ones. But
the success of this policy has been questioned, since large firm
size or high concentration does not necessarily imply that the
market can be improved by intervention. Some firms become large
because they provide superior goods and services - breaking them
up would punish market success. Large firms can also capture
the benefits of research, and focusing only on industry within a
country overlooks the fact that we live in a global economy, and
in a market economy, there can be plenty of competition.
Moreover, government agents do not have the knowledge needed to
know just how much competition is optimal, and they are unable
to know the unintended consequences of meddling in the market.
While trying to break up some industry oligopolies,
governments sometimes deliberately create them with price
controls and restrictions on entry. For example, some city
governments limit the number of taxi cab firms and cars. Before
1978, the airline industry in the U.S. was prevented from
competing in prices, and the entry of new firms was restricted.
The industry therefore engaged in non-price competition, such as
offering more luxurious service or more frequent flights on
half-empty airplanes. Many consumers prefer lower prices to
such high-cost services.
As noted, competition is not just the existence of many
firms, but of rivalry among them. In a free market, rivalry for
the consumer's marginal dollar or pound will ultimately win out
against inefficiencies, since in a global economy any excess
profits or costs are like bait to the hungry wolves stalking the
woods for profit opportunities. The best that government can
normally do is to take down the barriers but prevent the
consumer sheep from being fleeced, with stiff laws against
fraud, and easy access to the courts, making the loser of a
lawsuit pay all legal costs.
Though competition is rivalrous, at the same time, firms
have an incentive to cooperate where their interests are mutual.
Firms create industry associations to provide them with
research, information, and cameraderie. Hence, competition and
cooperation are complements rather than opposites in a market
The best policy for government with respect to
competition is normally to let the market process do its work,
avoid imposing restrictions and costs, and concentrate on
protecting property rights and the resolution of disputes
brought before its courts. It is difficult enough to provide a
sound legal basis for market processes without trying to improve
outcomes when the cure may well be worse than the alleged
The next chapter will take a closer look at the outcomes
of our current economies and analyze them to see whether it is
indeed the market or intervention that is the foundational