What’s it: A market is where buyers and sellers trade and exchange. It can refer to a physical location such as a store or an abstract location such as in the foreign exchange market.
Transactions can involve goods, services, and money. It usually involves money as a means of payment. However, in bartering, goods and services are exchanged with each other without involving money.
In addition, money can be a commodity to be exchanged, as in the foreign exchange market.
Economists classify the market into three broad groups:
- Factor market
- Products market
- Capital market
Let’s discuss it in more detail.
How the market works
The market works based on supply and demand. Both determine equilibrium, which is the price and quantity traded. In economics, at the equilibrium point, the allocation and distribution of goods and resources occur.
The supply force represents the interests of all sellers or producers in the market. They seek to maximize profits by selling at high prices but low quality.
Meanwhile, the demand force represents the interests of all buyers or consumers. They seek to maximize utility by negotiating low prices and high quality.
You can see, the two forces have opposite interests. The market resolves the interests of both parties and determines how much to trade and at what price.
Markets function efficiently under perfect competition. Neither the buyer nor the seller has more power to put their own interests first.
In perfectly competitive markets, buyers cannot force producers to sell at low prices, which reduces the producer’s profits. Likewise, producers are also unable to charge high prices, which is detrimental to the interests of consumers.
Equilibrium occurs when the quantity supplied equals the quantity demanded at a price given. In a graph, it occurs at the point where the market supply and demand curves intersect. At that point, quantity and price are agreed upon and represent the best interests of producers and consumers.
If the price is higher than equilibrium, market forces (supply and demand) direct the price to move to a lower level. This situation benefits the producers. Therefore, more sellers are willing to supply the goods.
But, on the other hand, the price is too expensive for consumers. It hurts them. They will force producers to lower prices; otherwise, they will not buy.
Finally, the market experiences excess supply, where the quantity supplied exceeds the quantity demanded.
Because fewer people were willing to buy, some producers were willing to lower their prices. Lower price stimulates demand from some consumers. The fall in prices and increases in demand will continue until producers and consumers agree on prices (a new equilibrium is reached).
A similar process occurs when market prices are below equilibrium. At that price, consumers benefit, but producers don’t.
Hence, consumers are willing to demand more than producers are willing to supply. Finally, the market faces excess demand because the quantity demanded exceeds the quantity supplied.
Because it is difficult to find goods, some people are willing to pay high prices. Producers then saw it as an opportunity to increase supply. The increase in supply and price will continue until a new equilibrium is reached.
Market failure occurs when the market is not in the best interests of both buyers and sellers. An increase in the benefits of one party becomes a loss for the other party.
In short, it happens when the market faces a disequilibrium. As a result, resources are not allocated to their best use.
Several factors lead to market failures, including:
- Government intervention such as taxes and price limits
- Lack of public goods
- Asymmetric information
- Abuse of monopoly power
Let’s take a price limit as an example. The government can set it above the equilibrium price (price floor) or below the equilibrium price (price ceiling).
The price floor results in excess supply. Because it cannot go down, it is detrimental to the buyer and beneficial to the seller. Prices are supposed to go down but can’t happen because it’s illegal, violating government policy.
The price ceiling results in excess demand, where the quantity demanded exceeds the quantity supplied. Prices are supposed to go up, but sellers can’t because it’s illegal. Ultimately, it sacrifices the interests of the seller to benefit the interests of the buyer.
Physical vs. non-physical
The physical market was the first to develop. It involves a physical place where the buyer and seller come face to face. It still exists today, for example, a fruit and vegetable market, a fish market, and a livestock market.
However, in modern times, the market does not have to refer to a physical location. eCommerce, for example, sellers and buyers do not have to come face to face in person. You can buy goods in online stores without having to communicate with the seller. This business model is now playing an increasingly important role in trade in goods and services.
Local, national, international
We can also categorize markets based on buyer and seller bases. Local markets serve transactions between buyers and sellers at a specific location. For example, a bakery is a local market if it only sells bread for the area around which it operates and not in other areas within the national boundary.
The auto market and the labor market are usually national markets. Demand and supply originate from various regions but are still within the boundaries of a country.
The commodity market is a good example of the international market. Buyers and sellers come from many countries.
Factors, products, and capital
Product markets trade business’s output. The company acts as a seller. Households and other businesses act as buyers.
Factor markets are markets for factors of production, such as labor and raw materials. Companies buy production factor services from households. They then use it as input to produce goods and services, which will be sold in the product market.
The capital market is a market for long-term financial capital such as bonds and stocks. Here, the company raises funds to purchase capital assets.
Market structure is about the arrangement and relationships between the parts of the market, ultimately determining the competition and profitability. It can be differentiated according to the following criteria:
- Number and size of sellers
- Degree of product differentiation
- Entry and exit barriers
- Selling power over price decisions
- Degree of non-price competition
Economists then divide the market structure into four categories:
- Perfect competition
- Monopolistic competition
The last three we call imperfect competition. Let me briefly detail the characteristics of each.
The characteristics of perfect competition are as follows:
- Many sellers are serving many buyers. Their size is uniform. Thus, they do not have the power to influence market prices through the output they produce.
- Sellers sell a homogeneous product. Thus, there is no reason for consumers to prefer one product, except based on price.
- There are no barriers to entry and barriers to exit. The increase in market profitability encourages new players to enter the market. Market losses force sellers to exit.
- The seller acts as a price taker. They only take the market price as the selling price.
The characteristics of monopolistic competition are:
- Many sellers are serving many buyers in the market. Just like perfect competition, their size is also uniform. Thus, they cannot influence the market by changing output.
- Sellers offer differentiated products through other advertising and non-pricing strategies. They sell similar but not identical products. Unlike perfect competition, products do not act as perfect substitutes but as close substitutes.
- The barriers to market entry and exit are low, much like perfect competition. Players are free to enter and exit in response to profitability in the market.
- The seller has some degree of pricing power. So, they are not price takers because they can sell at a higher price than the market price.
The characteristics of the oligopoly market are:
- There are few sellers but serve many buyers. They can influence the market by changing output, both individually and collectively (collusion).
- The seller may offer a homogeneous product or a differentiated product. As a result, they enjoy substantial pricing power. Under homogeneous products, they compete via price and influence market prices by changing output. Under differentiated products, they compete through non-price elements such as quality, features, and branding.
- The barriers to market entry and exit are significant. It may be structural barriers or strategic barriers. Structural barriers are due to the nature and characteristics of the market, for example, requiring significant fixed costs. Strategic barriers are built by the incumbent, for example, through predatory pricing.
The characteristics of the monopoly market are:
- There is a single seller and serves many buyers. Thus, the monopolist’s supply represents market supply.
- The product has no substitutions. Hence, it is highly differentiable. The buyer has no alternative to purchase.
- Barriers to entry are high. This allows the monopolist to stay as a single-player over time.
- The monopolist has absolute market power. It determines the quantity, quality, and price of the product at will. There are no threats from competitors, product substitutes, or new entrants. For this reason, markets are usually under government regulation to avoid abusing monopoly power.