to try to offset individual supplies or demands. The quantities depicted in Figure 4 and Figure 5 differ greatly, which happens in the common market scenario when the number of buyers greatly exceeds the number of producers. Once they are aggregated, however, they are directly comparable, by focusing only on the combined amounts rather than the quantity of entities involved.
The very core of the workings of the market model is that market demand and market supply meet each other at the marketplace. All the entities who want to buy a product meet all the entities who want to sell it. As a result, the market demand and the market supply can be graphically depicted with the same set of coordinates, and their interaction can be observed, as in Figure 6.
Figure 6 The market supply and demand of hamburgers during an average week in Marketville.
Demand is the quantity that buyers want and are able to buy at each price point, while supply is the quantity the sellers want and are able to sell for each price. The price value ($5) of the intersection in Figure 5 is called the equilibrium price. When the price on the market equals the equilibrium price, it means that buyers want to buy exactly the same number of goods that the sellers are willing to sell. This amount is known as the equilibrium quantity. When the price is the equilibrium price, all the products brought to the market by the producers will be bought by the buyers, and all the buyers who want to buy products at that price will be able to do so. The market effectively “clears” itself of goods, and all the demand is satiated, thus equilibrium price is also called market-clearing price.8
Markets tend to move toward equilibrium under certain circumstances. Those circumstances include: 1) The entities are rational. That is, they realize their own self-interests and always follow them, 2) the markets are competitive, meaning that the buyers and sellers are relatively numerous and similar in size, so no single one of them can exert undue influence on what is happening on the market, and 3) perfect information ensures that all buyers and sellers are familiar with all of the relevant information regarding the product. When a market exhibits these traits, it is a perfectly competitive market or perfect competition.
In a perfect competition, the behavior of individual buyers and suppliers ensures that the market converges towards equilibrium. Consider the situation depicted in Figure 7. The equilibrium price is still 5, but for some reason, the current price on the market is only $4. At that price, the suppliers are only willing to provide 1,000 hamburgers, but the buyers want to purchase 2,000 leading to a hamburger shortage. Out of the 2,000 units in demand, buyers are only able to purchase half that amount.
Figure 7 Disequilibrium in Marketville.
In the short run, non-market rationing solutions spring up nearly immediately. People will queue up for hamburgers, and those who arrive early will be able to buy the product, while latecomers will not. Eventually, sellers will realize that they are able to charge more. They will raise the price to $5, hire more employees to expand their production, and maybe even open new restaurants, increasing the total supply of hamburgers to 1,500. Seeing the price increase, consumers could decide to eat something else—or still purchase hamburgers, but eat less of them.9 This reduction of the quantity demanded to 1,500 hamburgers means that all consumers will get to have a hamburger, which might eliminate the lengthy queuing for it.
When the price is higher than the equilibrium price, similar mechanisms can be seen. In that case, the quantity supplied exceeds quantity demanded, leading to surplus production (or as economists euphemistically call it, unintended inventory investment). In practice, this means that sellers can’t get rid of their stock (or in case of the hamburger example, only a few consumers come in to eat them). Seeing the products pile up (or the dearth of consumers), producers will organize a “sale”—which is literally a reduction of price, potentially moving the market towards equilibrium.
Market Efficiency and Failures
A perfectly competitive market achieves two kinds of efficiencies: distributive efficiency and allocative efficiency. Distributive efficiency is an effect of goods and services being received by those with the greatest need, if need is defined as willingness to pay the most for a product.10 The market mechanism ensures that everyone whose reservation price is greater or equal than the market price will be able to buy the product, while those whose reservation price is below the market price will not be able to do so. This also ensures that all the sellers combined can extract the highest total amount of payments from the buyers.
Allocative efficiency exists when the goods and services produced in the economy match consumer preferences. This occurs when the unit produced provides a marginal benefit to consumers equal to the marginal cost of production. Companies that use fewer resources (thus using the resources more efficiently) will be able to offer their products (and turn a profit) at lower prices.11 The market mechanism ensures that every single firm that is profitable at a price below market price will produce goods, while those firms that require higher prices in order to be profitable will instead produce something else.
Market Failures
A market failure occurs when the allocation of goods and services is not efficient in the manner described above. There are two kinds of market failure in law: 1) those which the courts regulate and 2) those which the courts leave to market participants to resolve.
A competitive market requires many buyers who purchase relatively small quantities compared to the quantity demanded. There are many sellers who all produce relatively small amounts of the good compared to the quantity demanded. There is no way to distinguish between goods of the sellers. Courts generally do not regulate markets to add buyers or sellers or to standardize goods.12
A market failure can occur when participants are either unaware of their self-interest or act contrary to it. Again, courts are hesitant to question to the motives of market participants.13 Market efficiency assumes that market participants have perfect information in that all material information about their products is known. Courts are willing to step in on this point in both contracts for services and contracts for the sale of goods as noted in Chapters 4 and 5.
Transaction Costs
Transaction costs are all the costs associated with the purchase that have to do with making sure the purchase actually happens. Legal fees associated with lawsuits are the transaction cost most commonly discussed in this volume. Searching costs involved in finding the right employee are explored in Chapter 7.
An additional cost is information gathering. In the age of the Internet, an overabundance of information makes it hard to determine what is reliable, creating additional transaction costs for information validation efforts.
Bargaining is a transaction cost in the process of coming up with the actual details of a given transaction. Bargaining involves the process of finding terms (usually those other than price and quantity) that are necessary in order to close the deal. Some terms worth bargaining for are described in more detail in Chapters 4–6.
Enforcement