How Markets Work

Perfect information implies that both the buyer and seller have complete access to the costs of production and perfect knowledge of the product, and no opportunities exist for arbitrage, which is buying low in one place and selling high in another.

Contrast that condition with the experience of buying a car. Chances are the seller has the bulk of information about the cost and specifications of the vehicle, whereas you deal with limited information at best in making your purchase decision.

This also increases the market’s efficiency by allowing the maximum number of buyers and sellers to participate.

Licensing requirements are an example of a barrier to entry. By requiring licenses to sell or produce goods and services, the government limits the potential number of sellers, resulting in less competition and higher prices.

Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship.

Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship.

Price, therefore, is a reflection of supply and demand.

In market economy theories, demand and supply theory will allocate resources in the most efficient way possible.

How? Let’s take a closer look at the law of demand and the law of supply.

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. This means that the higher the price, the higher the quantity supplied.

Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.

On the basis of competition, a market can be classified in the following ways:

1) Perfect Competition
2) Monopoly
3) Oligopoly
4) Monopolistic Competition
5) Monopsony

The government has the capacity to step in and deal with such market failures in a variety of ways.

A good is non-excludable if the producer can’t withhold it from those unwilling to pay for it. Public highways are an example of a non-rival, non-excludable good. (The movie theater is a good example of a non-rival but excludable good.) A private firm has little incentive to produce a public highway at its own cost. There­ fore, it is up to government to provide these types of goods.

Ordinarily, as Adam Smith explained, selfishness leads markets to produce whatever people want; to get rich, you have to sell what the public is eager to buy.

Externalities undermine the social benefits of individual selfishness. If selfish consumers do not have to pay producers for benefits, they will not pay; and if selfish producers are not paid, they will not produce. Thus, a valuable product fails to appear.

Externalities are often blamed for “market failure,” but they are also a source of government failure.

Sometimes the production of a good or service creates a spillover or unintended benefit for someone who is neither the producer nor the consumer. Such a spillover benefit is called a positive externality.

With positive externalities, the benefit to society is greater than your personal benefit.

For example, increased education of individuals can lead to broader society benefits in the form of greater economic productivity and a lower unemployment rate.

Most externalities are negative. Pollution, for example, is a well-known negative externality. A corporation may decide to cut costs and increase profits by implementing new operations that are more harmful for the environment. The corporation realizes costs in the form of expanding its operations but also generates returns that are higher than the costs.

However, the externality also increases the aggregate effect on the economy and society, making it a negative externality.

Externalities are negative when the social costs outweigh the private costs.

Here’s another example:
If you smoke in a crowded room, other people have to breathe in your smoke. This is unpleasant for them and can leave them exposed to health problems associated with smoking.