A New Way of Looking at Markets

“What is a tenured professor going to teach me about the market economy?” asked Scott McNealy, MBA ‘80, chairman and chief executive officer of Sun Microsystems, when he spoke before students at Stanford’s Graduate School of Business. Notably skeptical of tenured professors, McNealy meant his question to be taken rhetorically; but the challenge he posed deserves to be taken up.

The market economy is as ever-present as the air we breathe, not only for a superstar executive like McNealy but for everyone. We encounter markets every day in countless ways: in our buying and selling, working and investing. We can glean insight, however, by taking a fresh angle on the familiar.

This is a riposte to McNealy’s challenge. Current research by economists is deepening our understanding of markets. These new ideas in economics, and some old ones, are used in what follows to dissect exotic, innovative, and everyday marketplaces: some in physical space, others in cyberspace.

Markets are subtle organizations. This is one of my themes. The mechanisms that underpin transacting are intricate — and they are in everlasting flux. People are ingenious at finding ways to make exchanges that bring mutual gains.

Markets do what they are supposed to do, however, only if they are well structured. Any successful economy has an array of devices and procedures to enable markets to work smoothly. A workable platform for markets has five elements: information flows smoothly; property rights are protected; people can be trusted to live up to their promises; side effects on third parties are curtailed; and competition is fostered.

Even the simplest markets reveal surprising subtleties when you look at them up close. Consider the Makola marketplace in the center of Accra, Ghana, as described by Claire Robertson, an Africanist scholar. The stallholders, who are mostly women, sell fish, vegetables, grains, canned foods, and basic household items. They operate on a tiny scale, a typical day’s turnover being just a few dollars. The marketplace, housed in several large dirt-floor sheds, is overcrowded and dusty. The press of people, the noise, and the smell of fish overwhelm a visitor.

First impressions are misleading. Primitive as it may look, the Makola market is an intricate system. The stallholders are not just retailers but also wholesalers: They buy in bulk to sell small quantities to consumers, and they aggregate small purchases for resale to other sellers. They organize transportation of goods — not a simple matter in a country with inadequate roads and railroads — serving as intermediaries between widely scattered producers and consumers. They do some rudimentary manufacturing: crafting with beads, and processing raw materials into foodstuffs, condiments, and cosmetics. They find recycling uses for cans, bottles, and newspapers. Assessing their customers’ creditworthiness and granting some of them credit, they take on the role of banks.

Being illiterate, the stallholders must keep their business records in their heads, using impressive powers of memory. They make precise calculations of their input costs to keep track of their profits. The price for a string of beads, for example, reflects the price a vendor paid for the beads and thread, the time she or her employee spent stringing the beads, and her target profit margin.

The stall holders have developed their own miniature legal system. Informal property rights have arisen. Although they do not have legal title to their stall space, which is technically owned by the Accra city council, they act as though they do. Spaces are inherited. Often the current stall holder acquired the space from her mother or sister. Spaces are also rented, bought, and sold. Certain respected merchants called “queen mothers” play the part of judges, arbitrating when disputes arise.

Gains from trade are generated. The vendors make others better off — as well as themselves — by making food available to the urban poor and by providing income to farmers with which to buy necessities like clothing. Thus, they exemplify Adam Smith’s analysis of the merchant: “By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.”

The Makola marketplace has continued to operate despite periodic, sometimes violent attempts by the Ghanaian government to shut it down. These attempts reached a height of brutality in 1979 after the military government accused marketplace traders of violating its price controls. Soldiers looted the stalls and then dynamited the marketplace. Later, in the town of Kumasi, soldiers armed with machine guns raided the marketplace and beat up the traders. Accusing one of profiteering, a soldier ripped her baby off her back and shot her. Bulldozers then ground the marketplace stalls into the dust. A soldier remarked, “That will teach Ghanaian women to stop being wicked.”

The Ghanaian government, invoking the “market women menace,” was using the merchants as a scapegoat for its own policy failures, which had led to severe shortages and inflation. Newspapers parroted the government’s line. One described the market demolition as a “happy tragedy,” which produced “tears of joy in the worker, the common man,” who was “helpless at the hands of the unfeeling Makola conspirators” (that is, the vendors).

Within a week the merchants were back where their stalls had been, selling their fish and their vegetables, though now without a roof over them. The Makola traders’ accomplishments, Robertson says, “have been triumphs of intelligence, determination, and sometimes desperation.”

At the Internet auction site eBay, bidders feverishly compete for everything from junk to high art. It all began in 1995 when Pierre Omidyar set up a website called AuctionWeb for people wanting to exchange information about collectibles and to make trades. Legend has it that his initial goal was to sell his girlfriend’s collection of Pez dispensers. The site’s services were initially offered free of charge, as a service to the public. After six months’ explosive growth in usage, based on word-of-mouth recommendations, Omidyar began charging a fee, a small percentage of the sale price, to cover his costs of running the website. Payment was left up to the honesty of the seller, but the checks rolled in. He gave up his day job and was joined in the firm by Jeffrey Skoll, MBA ‘95. Together they developed the auction software and the customer-support infrastructure. “We would work virtually anywhere we could find an office,” recalls Skoll. “We started off in Omidyar’s living room, then we moved to my living room.” They initially contemplated focusing on a particular market segment, such as coins or stamps. “In the early days, our strategy changed by the day,” says Skoll. They finally decided not to specialize, but to let anyone sell anything.

With the auction system reengineered to handle the massive volume of traffic, they relaunched AuctionWeb as eBay in September 1997. Less than two years later, eBay’s stock market value reached $22 billion. The business press proclaimed eBay’s reinvention of markets. Business Week reported that, with its online auctions, “eBay has single-handedly created a new market.” According to the Economist, “Internet auctioneers such as eBay may be the instigators of a revolutionary leap forward in the efficiency of the price mechanism.”

The eBay website is a high-tech flea market. It has over 10 million registered users; the typical user spends 20 minutes a day on the site. Around 5 million auctions are running on any given day, selling everything from cast-offs to fine art. As I write this, there are, for example, nearly 1,500 items listed under the heading “Victorian trade cards” — which, it turns out, are a 19th-century version of junk mail.

EBay has created a global market for goods that previously had a purely local market. One of the secrets of eBay’s success was in recognizing that the Internet, by making it easy for buyers and sellers to get together, created new possibilities for trading knickknacks of all kinds. The other secret of its success was in building a user-friendly and flexible auction mechanism. Pre-Internet auctions had the disadvantage that they required the potential buyers to assemble in one place. (Bids were sometimes made by fax or telephone, but this was clumsy.) Bidders in an eBay auction get together only in cyberspace.

EBay lowered the costs of transacting enough that people anywhere wanting to trade low-value items are able to deal directly with each other. Its popularity induced others to start offering Internet auctions. Now, at hundreds of different auction sites, people bid for computer equipment, antiques, fine art, stamps, toys, jewelry, travel services, real estate, and wine. EBay showed that the Internet and auctions were made for each other.

What do the eBay founders have in common with the Makola merchants? Each set up exchange mechanisms to generate gains from trade. Where markets are absent, mutual gains can be realized by establishing them. Where markets are present, further gains are sometimes to be had by finding ways to make them work better. People have forever been devising new markets and improving existing ones.

While the Internet has linked people more closely than ever before, this is not the first or even the biggest such transformation. Earlier advances in communications technology had a similar effect in broadening markets. Entrepreneurs were improving markets long before the Internet came along. “The telegraph and the printing press,” observed the magazine Contemporary Review in 1886, “have converted Great Britain into a vast agora, or assembly of the whole community.” The postal service, the railroads, the telephone, and radio and television all in their own way transformed communications. In his 1847 Principles of Communism, Friedrich Engels remarked of the industrial revolution, “Big industry has brought all the people of the earth into contact with each other, has merged all local markets into one world market.”

Engels was not enamored of the reinventing of markets, of course, but it is inexorable. Potential gains are missed if a transaction cost of some kind impedes buying and selling, so there is a profit opportunity in finding a way to lower that cost. Novel market devices appear. Someone may design a whole new marketplace. Or, through the separate actions of many, the market’s rules and procedures may gradually emerge.

Modern markets are sophisticated organizations. Markets for multifaceted products like automobiles and computers, and for labor and financial services, must solve a range of problems that may not arise with simpler items like clothing and food. A market works well only if information flows smoothly through it. An uneven distribution of information hinders negotiations and limits what can be contracted. Information transmission requires devices that ensure the communications are reliable. A market works well, also, only if people can trust each other. Trust requires mechanisms to bolster it since, regrettably, not everyone is inherently trustworthy. Many goods have hidden characteristics, so there must be some way of assuring buyers of the goods’ quality. Trust is needed also in transactions that take time to complete. People are reluctant to invest in the absence of some assurance that the others’ promises will be kept. A modern market economy needs a platform sturdy enough to support highly complex dealings.

Some of the pieces of a market’s design are devised by the market participants themselves; other pieces are devised by the government. It is by spontaneous change, for the most part, that the rules of the market game develop, with the market participants designing better ways to transact. Lowering transaction costs is a task not only for entrepreneurs, however, but also for public policy. The government has the responsibility to establish and maintain an environment within which markets can work efficiently.

Some invoke the supernatural to explain what they find extraordinary: that markets can work with no one in charge. The Rev. Richard Whately, a professor of political economy at Oxford University in the 18th century, believed the coherence of the market to be proof that God exists. If no human planner is guiding the market to the optimal outcome, God must be. The invisible hand is the hand of God.

A religious fervor characterizes some of today’s fans of the free market. “The true spirit capital of the current capitalist economy is not material. It is moral, intellectual, and spiritual,” declared George Gilder, an evangelist for libertarianism. He also said that entrepreneurship “most deeply springs from religious faith and culture” and that entrepreneurs “embody and fulfill the sweet and mysterious consolations of the Sermon on the Mount.” Ronald Reagan liked to use the catchphrase “the magic of the market” — inadvertently bearing out the jibes about his “voodoo economics.”

Carlos Fuentes, the novelist, derided what he calls economic fundamentalism, “with its religious conviction that the market, left to its own devices, is capable of resolving all our problems.” Mocking market zealots, Harvey Cox, who happens to be a professor of divinity, said that for its true believers the market is like God in “the mystery that enshrouds it and the reverence it inspires.” Like God, the market is avowed by its proselytizers to be “omnipotent (possessing all power), omniscient (having all knowledge), and omnipresent (existing everywhere).” These divine attributes, Cox continued, “are not always completely evident to mortals but must be trusted and affirmed by faith.”

Faith is not needed. The “hand” that guides the market may be invisible, but it is not actually supernatural. The market is not omnipotent, omnipresent, or omniscient. It is a human invention with human imperfections. It does not necessarily work well. It does not work by magic or, for that matter, by voodoo. It works through institutions, procedures, rules, customs. One of my aims is to demystify the market.

Modern economics has a lot to say about the workings of markets. Theorists have opened up the black box of supply and demand and peered inside. (The Nobel Memorial Prize committee recognized this work with its 2001 award to George Akerlof, Michael Spence, and Joseph Stiglitz.) Game theory has been brought to bear on the processes of exchange. Examining markets up close, the new economics emphasizes market frictions and how they are kept in check. Expressed in mathematics and impenetrable jargon, these new ideas reside obscurely in the technical journals. They have, however, a deeply practical content.

Exchange is “one of the purest and most primitive forms of human socialization,” sociologist Georg Simmel wrote in 1900; it creates “a society, in place of a mere collection of individuals.” A market is a social construction. If it is to work smoothly, it must be well constructed. By market design is meant the methods of transacting and the devices that serve to allow transacting to proceed without obstructions.

Market design consists of the mechanisms that organize buying and selling; channels for the flow of information; state-set laws and regulations that define property rights and sustain contracting; and the market’s culture, its self-regulating norms, codes, and conventions governing behavior. While the design does not control what happens in the market — as noted, free decision making is key — it shapes and supports the process of transacting.

A workable market design keeps in check transaction costs — the various frictions in the process of making exchanges. These include the time, effort, and money spent in the process of conducting business: both any costs incurred by the buyer in addition to the actual price paid, and any costs incurred by the seller in making the sale.

Markets provoke clashing opinions. Some revile them as the source of exploitation and poverty. Others extol them as the font of liberty and prosperity. There is the dogma that markets are inherently harmful, so they should be routinely overridden by the state; and the dogma that markets are unambiguously beneficial, so we can leave everything to the free market. “For every problem there is a solution,” said H.L. Mencken, “that is simple, direct, and wrong.” Both of the simple, direct solutions regularly offered for all kinds of societal ills — “suppress the market” and “leave everything to the market” — more often than not are wrong.

“Find me a one-armed economist,” President Herbert Hoover ordered, out of frustration with economic advisers who kept saying, “On the one hand … on the other hand … ” Honest answers to the big questions in economics, however, are rarely free of caveats. On the merits of markets, most economists are unapologetically two-armed.

Markets are too important to be left to the ideologues. In fact, markets are the most effective means we have of improving people’s well-being. For poor countries they offer the most reliable path away from poverty. For affluent countries they are part of what is needed to sustain their living standards.

Markets, then, are the most potent antipoverty engine there is — but only where they work well. The caveat is crucial. Over a billion Africans and Asians, according to the World Bank, eke out a living of sorts on one dollar or less a day. That is more people than live in the affluent West. For a great many, it would seem, markets are not doing much good.

Governments in poor countries sometimes intervene excessively, stifling markets and exacerbating the poverty. But that is not the entire story. If the state were to cease its counterproductive interventions, those countries would remain poor. In Calcutta or Cairo or most other third-world cities, markets operate everywhere. You can’t steer clear of peddlers eager to sell. The problem is not that markets are absent; it is that they are working badly.

Left to themselves, markets can fail. To deliver their full benefits they need support from a set of rules, customs, and institutions. They cannot operate efficiently in a vacuum. If the rules of the market game are inadequate, as often they are, it is difficult and time-consuming to set them right. Many countries, to their citizens’ detriment, have not yet been able to do so.

Markets are not miraculous. There are problems they cannot address. If their platform is unsound they do not even solve the problems they are supposed to solve. Viewed as tools, markets need be neither revered nor reviled — just allowed to operate where they are useful.