The market mechanism is a cornerstone of economic theory that describes the relationship between supply, demand, and price. It seems to be a fairly simple model, but it raises many questions. To start with: Did Adam Smith describe a law of economics akin to a natural law, or is the market mechanism an idealized model that describes an optimal way to produce and distribute goods and services?

When economists refer to price in a market, they try to keep considerations of fairness and justice out of the picture and, analyze price simply as an outcome of the forces of supply and demand. But what are these forces and what determines them? Does the market lead to an optimal distribution of goods and services, or does it create inequalities and exploitation? The following article will first explain the market mechanism in simple terms, and then raise some political and philosophical concerns.

The Market Mechanism Explained

  1. People sometimes refer to prices being “too high” or “too low” as a judgment about the way they think the world ought to be. This is like saying that the weather on a given day is “too cold” or “too hot.” Such judgments reveal something about the preferences of the person expressing the opinion, but they don’t tell you why the price (or the temperature) is actually at the level that it is.

  2. There is a difference between “use value” and “exchange value”. Adam Smith used the diamond-water paradox to describe this difference: Diamonds have high value in exchange, but little value in use. Water has little value in exchange but high value in use. For economists, prices are only about “exchange value”.

  3. Prices are nothing but a relation between supply and demand.

  4. In the market model above, demand and supply have quite specific meanings. Demand is a relationship between quantity demanded and any given price. Demand curves slope down, which shows that quantity demanded tends to fall as price rises. Demand is not the same as quantity demanded. The demand curve above only indicates the relationship between quantity demanded and the range of possible prices; quantity demanded refers to a specific amount demanded at a certain price. The same applies to the supply curve.

  5. Demand for a certain good can shift for a variety of reasons: changes in income, population, tastes, or prices of complement or substitute goods.

  6. Supply is the relationship between quantity supplied and any given price. Supply curves slope up, which means that quantity supplied tends to increase as price rises.

  7. Supply can shift for a variety of reasons, including changes in technology, weather, and prices of key ingredients.

  8. The equilibrium price is where quantity demanded is equal to quantity supplied. Demand and supply determine the equilibrium price, where quantity demanded is equal to quantity supplied. If the price is temporarily above equilibrium, then quantity supplied exceeds quantity demanded, which tends to drive the price down to equilibrium. If price is temporarily above equilibrium, then quantity demanded exceeds quantity supplied, which drives the price up to equilibrium.

  9. The equilibrium price and quantity create efficiency in the sense that extra quantities are not up on shelves, nor are buyers waiting in line.

  10. A shift in demand or supply will lead to a new point of equilibrium. In this way, shifts in demand and supply can explain movements in prices and quantities of goods observed in markets.

  11. The supply and demand model is intended as a framework for discussing how prices and quantities are determined in markets and why they change. The model argues that markets move towards equilibrium and thus efficiency; it does not argue that people are happy with the prices. Typically, buyers will prefer the price to be lower, while sellers would prefer the price to be higher.

  12. Most people don’t think in terms of the demand and supply model. But if consumers look for the goods they prefer at the lowest possible price and firms adjust their production in response to changes in price, then people and firms are acting in accordance with the model.

  13. The test of the supply and demand model is whether it works as a method of understanding the determination of prices and quantities. As a scientific model, it does work for all sorts of products, in markets all over the world, and at different times of history.

Political and Philosophical Reflections

The market mechanism, taught to millions of business and economics students, is not a simple model. Even though it has been studied extensively, the political discussion about the role and applicability of markets often seems confused. A deep fact/value problem distorts the debates about markets and democracy as the cornerstones of Western societies. Is the market mechanism a normative model, a necessary ingredient of efficient economic systems, or does it only refer to a set of scientific laws that describe how a society’s economic activity organizes itself? The following points are food for discussion; I am not advocating a particular economic philosophy.

  1. For a market to function efficiently, the actors have to be free in order to make optimal decisions for themselves. Therefore there is a strong link between market economies and democracy.

  2. It is hard to define the boundary of a single market. Before the Internet and globalization, it was easier to define a market by its geographical size, the number of participants who have access, and other types of access restrictions. Governments can control market boundaries through a variety of means, like licensing, duties and customs, taxes, etc.

  3. Ideal markets require transparency of information, control of insider knowledge, open access, and so on. Competing on elastic markets with open competition and many suppliers does not generate much profit. Market dominance makes individuals rich, but it is bad for consumers. The number of suppliers defines the spectrum of competition.

  4. We can look at the market mechanism as an empirical model of how prices develop over time, but we can also use it as a normative framework. In order to create market efficiency, much external reinforcement and oversight is necessary, because the mechanism does not reward actors to play “fairly”, but rather encourages them to find ways to get an advantage. Actors with privileged positions in the market will make more money through the creation of brands, the formation of monopolies, copyrights, subsidies, tax incentives, or other advantages like insider information, advanced knowledge of market trends, etc. The roles, rights and responsibilities of producers, vendors, customers, and consumers need to be defined and regulated in order to create high-functioning markets.

  5. The demand and supply model is somewhat misleading, because it just describes an ideal situation for one single market (one product.) In establishing a price for one item, we assume that the prices for all other goods and services in the economy are constant. But if those prices fluctuate, the demand and supply curves of X are impacted, which means that the equilibrium price is also dependent on external factors. All other prices depend on demand and supply in their own respective markets, and even the cost of money (interest and exchange rates) is subjected to a supply and demand curve. Therefore, in reality there are many markets which influence each other; they are interlocking and interdependent and form a complex network. Market participants, on the other hand, just want to know the prices for specific services and products, and want to have a simple tool for forecasting future trends.

  6. Since there is never only one market, but many interlocking markets, we always face an open and dynamic market system. This aggregate of all markets creates a complex system. A system is complex if its agents meet four criteria: diversity, connection, interdependence, and adaptation. For instance: There is a diversity of producers and business agents, and they compete for similar or overlapping market segments. This means that they react to each other and learn from each other, which makes their actions interdependent. They adapt to the environment as well as to each other.

  7. Markets “spread,” they morph, evolve, differentiate, and change through product differentiation, innovation, or other company activities like branding, copyrights, customer service and support, warranty or financing conditions. Markets can also become platforms for new markets, for instance in smartphones, TV’s, computers, cars, or houses.

  8. The markets mechanism balances supply and demand through the price, but in reality there is also a fair amount of speculation, depending on the type of market. Financial markets like the stock market are examples. To what degree are markets, like casinos, based on gambling? How do you distinguish between the operation of a market and speculation, or action based on a perceived future? Furthermore: is this distinction even useful?

  9. How do market bubbles fit into the traditional model of market equilibrium? In the classical model, markets move towards equilibrium. In practice, they are sometimes determined by crowd behavior – prices go up, more people buy because they go up, eventually it crashes. Markets can be manipulated by clever distortion of the rules, through information politics, and through the utilization of mass psychology.

  10. The price is only a function of supply and demand; it does not reflect a “real” value. Once a product enters a capitalistic market, its price is not based on production cost, or other value considerations like its ecological role, historical importance, or sentimental importance. it is simply a function of supply and demand, which separates the product and its history from its valuation.

  11. Price can also be interpreted as information. From this point of view, it is a signal to suppliers and consumers. But is the current price a clear reflection of all available information? Is it reflective of everything the market knows about the product at this time? The efficient market hypothesis (EMH) is an economic theory that claims that market prices fully incorporate information that is known now and that new information is incorporated very quickly into market prices. Therefore, prices are reliable, and attempts to outperform the market must fail in the long run. It also implies the markets are rational; they are not functioning in erratic ways, at least not in the long run.

  12. Profits can be dramatically increased through market manipulation. So why should players be fair? Is there not in implicit conflict between profits and ethics? Is it true that ethical behavior also coincides with better business practices, and thus more profit? This type of conflict between long-term benefits versus short term profits appears often in discussion of business ethics; it indicates an intrinsic problem with open economic systems where participants can enter and leave at will.

  13. If markets are self-correcting, or if the EMH is correct and markets are rational, why do we need additional constraints, in the form of business ethics, or corporate social responsibility demands (companies as citizens), in order to improve the business world?

  14. Is the concept of an underlying “demand” even sustainable? Is the behavior of participants only based real demands? What is demand, and how do we distinguish it from desires, or fears, that also motivate decisions? If markets are mostly driven by desires, they begin to rely on the stimulation of consumer interest, and the marketing and advertising campaigns become integral to the products themselves. Consumers get more and more “hooked” on certain products, and an addictive commercial realm floods all aspects of the social sphere. People begin to identify with commercial objects and express themselves through their possession, and this process begins to shape the very formation of identity.

  15. Companies aim for profits; but the total economic activity may cost more to society as a whole than the consumer pays for it. This is known as a “negative externality.” A negative externality occurs when a company produces a good or service but does not have to pay the full cost for it, for instance by polluting the air, or causing medical problems for the consumer later on. If a good has a negative externality, then the cost to society is greater than the cost the consumer is paying for it. Since the price does not reflect the full cost of the product, negative externalities result in market inefficiencies. The resulting costs are passed on to society. How should these costs be calculated, when the pricing mechanism itself excludes it?

  16. Finally, there is a related problem known as the “tragedy of the commons.” public goods get destroyed through over-use, because the benefits of using common property goes to economic actors who are only interested in their own profits. This affects especially our relationship to nature. Goods that are supposed to be free and available to all, like clean water and fresh air, become contaminated or scarce through commercial activity that operates like a cancer. Mountains of garbage, the ecological cost of destroyed forests, polluted oceans without fish, or widespread ecological destruction through over-use: Can these problems ever be solved within an economic paradigm that is based on profit, and that relies on competing economic actors that can move freely in a globalized world?