A brief history of markets

Stephen L Cheung, University of Sydney

John McMillan, Reinventing the Bazaar: A Natural History of Markets, New York: W.W. Norton 2002 (256 pp). ISBN 0-9305-021-1 (hard cover) RRP $39.95.

‘What is a tenured professor going to teach me about the market economy?’ This is the challenge, posed by Sun Microsystems CEO Scott McNealy, that Stanford business professor John McMillan says he set out to answer in this book.

In some respects, McMillan’s answer is striking for its timelessness. For a market to function effectively, there are five requirements: information flows smoothly, people can be trusted to live up to their promises, competition is fostered, property rights are protected (but not overly so), and side effects on third parties are curtailed.

With notable qualifications—McMillan’s emphasis on trust, and his caveat that intellectual property rights can be overprotected—these are familiar. They are largely the conditions for the efficiency of markets taught in first year economics courses, and formalised in what is sometimes called the ‘fundamental theorem of welfare economics’.

However, in McMillan’s hands, the abstract formalisms of theory come to life as he guides the reader through a wealth of headline-grabbing examples and cases from the real world. These illustrate why each of his requirements is important, and what goes wrong when it is absent. Anyone who has sat through a semester of economics, watching a hapless lecturer gasp for air trying to extract life from a wooden modelling edifice, can return to McMillan’s book to finally discover what all the fuss was about.

Echoing Hayek, McMillan argues that the basic flaw of central planning was not the incompetence or malevolence of planners, but the more fundamental impossibility of centralising all the information needed to make coherent production and allocation decisions. By contrast, markets function with more limited information. Indeed, the economic function of markets is largely to aggregate the dispersed information of thousands of traders into a signal, in the form of prices, of value and scarcity.

In the textbook formulation, the demand and supply curves are always known and the price is simply read off a chart, but of course that is not how things work in practice. More compelling, perhaps, are results obtained by Vernon Smith in a celebrated experiment that is now replicated in dozens of classrooms every semester. So long as every participant can observe each trade that occurs, Smith found that prices converged rapidly to the level predicted by theory, even though no individual buyer or seller has enough information to work out what that price will be.

As is well known, markets are less effective when power is distributed unequally among participants. A monopoly seller, for instance, sets a high price so there are frustrated buyers who value an item more highly than its cost of provision. More subtly perhaps, markets also fail when information is distributed unequally. Much recent research in economics focuses on this issue, including the work that was awarded the Nobel Prize in 2001.

‘Business is based on the ability to make credible promises’.

McMillan uses an example of a tourist shopping for souvenirs in a Moroccan bazaar to make the basic point. Even though there are many buyers and sellers—a precondition for competitive behaviour—a high price can still prevail. Because buyers are poorly informed about prices, and it is costly to shop around, there is little competitive benefit to a seller in cutting prices. In effect, the poor information of buyers allows sellers to sustain a form of monopoly power and pricing.

An innovation that has improved price information in many markets is the Internet. When buyers are well informed, and comparison-shopping is cheap, there is more benefit to a seller in cutting prices to increase sales, and more pressure on competitors to match lower prices. Does this mean the problem of information is solved? No, for unequal information about quality and opportunistic behaviour raise much thornier issues. This leads McMillan into his discussion of honesty and trust, and what in more fashionable circles might be termed ‘social capital’.

McMillan takes issue with critics who contend that market competition is anarchic, destructive and riven with exploitation. The only truly impersonal market exchanges, he says, are one-off cash transactions in items with easily verified characteristics. For everything else, ‘business is based on the ability to make credible promises’. Of course, this is not to claim that capitalism was built upon anyone’s natural proclivity toward honesty—economists are far too jaded for that sort of thing—but rather institutions and practices that contain inbuilt incentives to forgo opportunism. Reputation building, long-term relationships, warranties, and even advertising and educational credentialing can all be understood as means of structuring transactions so the parties must incur a cost to earn the trust of others, and suffer a penalty if ever they should violate it. The progress economics has made in understanding issues of this type is not well known, and McMillan provides an accessible discussion of the findings.

Among the most likable features of McMillan’s writing are the engaging manner in which he develops subtle conceptual arguments and the level-headed way that he goes about weighing evidence. Of course, this means his book contains its share of the qualified ‘on one hand … on the other hand’ arguments that are such a necessary yet frustrating part of economics. He is careful to distinguish the wellbeing of the community as a whole from that of specific interests, when these are frequently conflated in political debates. At the same time, he is prepared to take sides and reach firm conclusions where that is warranted. Nowhere are these features more evident than in the two highly insightful chapters on intellectual property that are the highlight of this book.

The very nature of knowledge is that once an idea (or creative work) has been brought into being, it can be made accessible to anyone at little or no additional cost. A potentially tremendous benefit is created for the community, yet its cost falls entirely on the creator, since anyone else can benefit from their efforts without contributing. How, then, is the innovator to recover their costs, which in the case of inventions such as pharmaceuticals can run to hundreds of millions of dollars? What incentive is there to engage in innovation? It is for this reason—to provide a reward and inducement for innovative and creative activity—that intellectual property rights such as patents and copyrights are awarded.

Intellectual property rights are inherently a compromise.

That is quite different from the rationale for protecting most other forms of property. When a car is stolen, its rightful owner is deprived of its use. By contrast, an idea can be shared with anyone, without any such deprivation to its original creator. Herein lies the drawback: ‘Once an idea is already in existence, it is wasteful to restrict its use … Granting the monopoly rights to the idea does succeed in rewarding its creator, but only at the cost of making the idea unduly inaccessible. A patent is, literally, a license to overcharge’.

So what are we to make of all this? First, there are no absolute principles of right and wrong here. Or rather, there are two—the inventor ought to be rewarded, but access to their innovation ought not be restricted—and they are in conflict. Intellectual property rights are inherently a compromise; they may either be too weak or too strong. Second, in evaluating intellectual property policy, the threshold question is this: what is its effect on the amount of innovative or creative activity that takes place? If there is none, then there is no economic rationale for the protection.

From this core insight, McMillan extrapolates surprising conclusions. A reason why the computer industry took off in Silicon Valley rather than in Boston was California’s weaker protections for intellectual property, which enabled new ideas to spread rapidly between competing firms. The theft and piracy of an early Microsoft program may have been pivotal in stimulating the development of microcomputing. While the recording industry bemoaned the effect of Napster on sales, McMillan implies the real question should have been its effect on the activities of artists. On balance he concludes Napster’s net effect was likely positive—its benefit to members exceeded the cost to artists—and its shutdown was thus unwarranted.

If this last point should sit uncomfortably, consider how the exact same logic applies to the actions of developing countries in circumventing patents to AIDS drugs. Since the drug companies make most of their sales in the West, the effect on their profits and research activities would have been negligible. The benefit, on the other hand, was potentially millions of lives saved. ‘Unless one believes, religiously, that property rights are sacrosanct, the benefits of overriding the patents in poor countries plainly outweighed the costs. The case for compulsory licensing of AIDS drugs as an emergency measure was overwhelming’.

McMillan’s subtitle, A Natural History of Markets, contains within it a paradox. Far from being a David Attenborough figure, observing events discreetly from beneath the shrubbery, McMillan has been active as an advisor in the development of many of the markets he discusses. A Vice President of Market Design Inc., a consultancy that advises governments and corporations on electronic markets and auctions, McMillan also advised the U.S. Federal Communications Commission in the very first spectrum licence auctions of 1994.

Even where the state is small, its role can be decisive.

The resolution of this paradox is also the central theme of the book and the title of its author’s practice. Although markets are occasionally still observed in their centuries-old ‘natural’ state—most notably in the thriving shadow economies of many developing countries—today’s modern technological economy demands that market rules and processes be carefully designed in order to achieve their full potential. This ‘market design’ can emerge organically from the ‘bottom up’, through the innovations of the market participants themselves, but in some cases it must be imposed from the ‘top down’. McMillan’s approach to the study of markets is to evaluate the detailed strengths and weaknesses of their design, an approach that lends itself naturally to his advisory role. ‘Markets are not magic, nor are they immoral. They have impressive achievements; they can also work badly. Whether any particular market works well or not depends on its design’.

It is in discussing the detail of what works and does not work in the design of specific markets that McMillan is most in his element. The U.S. market in sulphur dioxide emissions trading has not only succeeded in reducing pollution, but also revealed the true cost of abatement to be much lower than previously estimated. By contrast, the failure of electricity deregulation in California is attributed to a flawed market design. Ordinarily, markets respond to high prices by curtailing demand and calling forth increased supply. In California’s wholesale electricity market, neither response was possible. Because retail prices were fixed, end users had no incentive to conserve in the face of a shortage. And because increases in capacity take years to come on line, it made no sense to prohibit long-term forward contracting. Elsewhere, including in Australia, electricity markets have succeeded by avoiding such pitfalls.

A native of New Zealand who completed his PhD in economics at the University of New South Wales, McMillan is doubtless familiar with the ideological battles over states versus markets on both sides of the Tasman. The approach that emerges from his book is a pragmatic one. In primitive economies, it may be possible for markets to function at a small scale without a state, but that is ultimately an impediment to development. In modern economies, there are both upper and lower bounds to the scope of the state, a fact borne out by empirical studies of economic growth. Even where the state is small, its role can be decisive, a point made by analogy to the pivotal effect of key centralised decisions that were made in the very early design of the Internet. ‘Whether intervention is warranted … requires looking into the details of the specific market … It is a technocratic issue, not one of high principle’.

McMillan’s book is not without flaws, although in many cases these are endemic to the profession as a whole. He abhors monopoly and champions competition, but is noncommittal on the number of firms required for competition to be workable. The issue of income redistribution is ducked as a value judgement that is beyond the scope of economics, but this is too glib. What is to be done when market-improving reforms are blocked on account of their perceived effect upon distribution? Similarly, economic growth is promoted as the great hope for developing countries, but there may be significant market design problems in the relations between these countries and Western multinationals that remain unresolved—problems for which a legitimately impartial ‘top down’ authority may be lacking.

It is an inescapable reality that, in Australia at least, the most heralded popular books on economics are those of heretics and critics of the profession. As a result, a crude caricature of ‘economic rationalism’ has been perpetuated in the public imagination. Of course, this is no one’s fault but that of the economics profession itself: in failing to engage popular discourse with a more balanced account it has ceded the ground to outsiders. For this reason alone McMillan’s book is significant. As it turns out, it is also very well done on its own terms. The book will attain greatest acclaim in the markets for which it is intended, namely MBA students and airport-hopping corporate executives. Its real contribution, however, may be in clearing the air over the claims that economists make, and do not make, for the achievements of markets.

Stephen L Cheung teaches economics at The University of Sydney. He is Managing Editor of The Drawing Board.

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