The purpose of a market

When we look at the economy as a system, markets are subsystems. From this perspective, the price mechanism describes how some elements of the market system interact with each other. But what is the purpose of a market?

The purpose of an economic system is to resolve the basic economic problem – the allocation of resources – within the boundaries of the earth system, and with the inclusion of all, or: the purpose of an economic system is to allocate resources within the boundaries of the Doughnut. Since markets are subsystems of the economic system, they must somehow contribute to this overall purpose. So how do they contribute? Do they distribute wealth – the inner circle of the Doughnut -, do they contribute to the allocation of resources itself – without crossing the ecological ceiling?

Just writing this down makes me realise that, although markets are very powerful in signalling the relative value of goods and services by means of prices, they may not be best at distributing and sustainability.1

Although I am not yet decided on the purpose of markets, I think you can argue that it could be both: allocating resources through the price mechanism and distributing wealth. How wealth is distributed through markets is normally assessed through analysis of consumer and producer surpluses. Markets that do not function optimally, because of asymmetric information, market power and the like, will not reach their full wealth potential. But when analysing markets from a micro economics perspective, we do not take the fairness, or the equality, of the distribution into consideration. Market systems are not designed for that – yet.

So, I think we can conclude that the purpose to allocate resources with the inclusion of all might not be served best by market systems, simply because it is not geared towards including all. This conclusion does not change that markets do distribute wealth and the outcome of the behaviour of the economy as a whole, results from the behaviour of its parts. I think that is something to think about.2

That leaves us with the other candidate for a market’s purpose: the allocation of resources – without going through the ecological ceiling. The idea behind the market system as a tool for allocating resources, is that people’s willingness to pay for goods and services reflects the utility they draw from it, or, you could say, how the good itself contributes to their welfare. Companies do market research to learn about willingness to pay as input for their pricing policy, or prices are set through a mark up on production cost, or supply is cleared through a real-time auction, and what have you – and anybody not able to earn an income from the resulting prices will withdraw from the market, as do buyers who cannot afford to buy at the market price.

Price is a piece of information that flows from sellers to potential buyers, and is either acted upon – a sale – or not. Price in itself does not reveal much about the underlying information, like research into willingness to pay, cost of production in general, prices of raw materials and labour cost in particular, the compensation for the entrepreneur, fixed cost, and estimates of number of sales, to name a few. It does not tell me how sustainable production was, how revenues were distributed over production factors, to what extent non-renewable resources were depleted, how much production contributed to green house gasses, and what the lifetime of the product is3. So price is actually a very poor bearer of information – for me, as a consumer.

Having said that, I have to conclude that markets are not particularly well suited to serve the purpose of resource allocation – within the boundaries of the earth’s ecosystem. And that is actually a shame, because I love analysing micro-economic graphs and solving supply and demand systems of equations for price and quantity.

I do not claim to have a solution for the shortcoming of markets on the shelf, and I do appreciate the efficiency of markets, but they are certainly not the holy grail.

How can you use this in your lessons?

When approaching markets from a systems’ perspective you can show your students how a market does or does not serve the general purpose of the economic system. You can use the Doughnut Model as a framework. Instead of brushing of market failure as externalities, you can give your students an insight in the challenging questions that lay before them, should they carry on studying economics.

    1. This is called market failure, or system failure. When a system fails its purpose, or the greater purpose of the system which it is part of, it needs to be tuned, redesigned or replaced.
    2. For example, we could think about how money flows in the market system are taxed, and how power is distributed, and how that could be modified to better serve the purpose of the economy as a whole.
    3. I tended to think that higher priced products are of a better quality, but I have learned that this is not necessarily so – nor is it the other way around.