The litmus test of a well-functioning market is a flexible price that adjusts quickly whenever the quantity demanded differs from the quantity supplied. When people want to buy more gasoline than the oil companies want to supply at the going price, a higher price for gasoline will guarantee the restoration of market equilibrium (that is, when quantity demanded is equal to quantity supplied).
But imagine that the price of gasoline is fixed, possibly because of a government regulation, as it was in fact by price controls agaiinst inflation in the early 1970s (see Figure 4.1).
Figure 4.1 A market with inflexible prices
After the price controls are imposed the quantity voluntarily supplied drops sharply, from Flexible-Price Quantity Supplied to Priced-Controlled Quantity Supplied. Because the price of gasoline is fixed at Controlled Price, the quantity demanded, of course, remains the same. The result is a lasting disequilibrium, a shortage. Concretely, this will mean long lines in front of gasoline stations.
The disequilibrium shortage in the market cannot be resolved by an adjustment of the price. All adjustment takes place through the quantity sold. People line up to get gasoline that they now would value at Shadow Price Under Controls, if they could pay it. Actually, they can. They can throw away time queuing up at the gasoline stations, or bribe the owners to let them jump to the head of the line, or spend time driving to stations far away that they hear have gasoline. The amount they "spend" in such non-money ways will be exactly the difference between the Controlled Price and the---higher---Shadow Price Under Controls. Buyers are filling to pay more for the last gallon of gasoline they get than they would under flexible prices. It's wrong to think that price controls reduce prices. They increase the full price, including the value of time in lines and the value of bribes, that is the shadow price.
But even when the government is not directly involved, you find inflexibilities in prices. Your local all-night deli will not change its posted price for an Italian sub whenever the demand goes up or down a little bit. The price for a sub is more or less set for some time - a year, perhaps, and anyway certainly over the course of a day. In the meantime all the adjustment is in the quantity supplied. The deli will try to supply whatever its customers demand at the going price. But at 12:00 noon the place is jammed, and the customers are paying a higher shadow price, if you include the time in line, compared with the price at 2:00 a.m.
Concept Check 1: On St. Patrick's Day there is a long, long line in front of your favorite Irish pub. You want to get inside the pub immediately, even if a $20 cover charge were imposed. Instead the cover charge is zero and you stand in line for two hours. What's the market failure here? Chicago-School supplement: Is it really a market "failure," or just the way markets work, considering that changing prices hourly or daily or even weekly is itself costly in resources, and anyway is irritating to customers?
The exercise of market power by a few
In a perfect market no single buyer or seller is supposed to have the power to influence the price. Just think of your own powerlessness in, say, the market for computers. Suppose you are upset by the repeated crashes and the exposure to hacking on your Microsoft Windows program. You withdraw your business, refusing to buy anything more from Bill Gates. What are the effects? None. Nobody will notice your gesture. One order less will not change Microsoft's bottom line. The effect on the market price of Microsoft Windows will be nil.
Market power is the ability of a buyer or a seller (or an organized group of buyers or sellers) to affect the market price
In a market with many buyers and sellers on both sides, no one has any market power.
Of course you and others can beat the invisible hand of the market if you band together into a Microsoft consumer movement. In that case you would organize a visible hand to exert direct pressure on Microsoft, with press conferences and mass demonstrations and above all the power to cut the demand facing the company enough to make the company take notice. You exercise both the power of "voice" in complaining and the power of "exit" in not buying. As a single person you have neither.
It's nothing like always bad to try to exercise such a power collectively. During the Montgomery Bus Boycott, for over a year from December 1, 1955, started by Rosa Parks and led by Martin Luther King, Jr., African Americans in Montgomery, Alabama refused to ride the city buses. The goal was to gain equal access with whites to any seat-front, back, or middle. The protestors, in the face of legal and illegal harassment, succeeded in gaining much more. The boycott became the model for a nationwide and then worldwide civil rights movement. In such cases your group has market power.
The Montgomery Bus Boycott of 1955-1956, led by Martin Luther King, Jr., is an example of a desirable visible hand. In the United States the movement thus sparked culminated in the Civil Rights Act of 1964. In South Africa it culminated in 1994 in the end of apartheid, the segregation by law of blacks from whites.
Similar attempts to seek market power are apparent everywhere. Commonly they are not so public-spirited as a consumer pressure or civil rights group. The most well-known instance of market power is the large corporation: General Motors, General Mills, General Dynamics, Sony, Shell. Whereas consumer organizations distort the ideal market story on the demand side of the market, large corporations do it on the supply side. The big airlines and auto manufacturers have in some markets highly visible hands in the sense that they can influence the price for air travel and cars.
In some cases one single company controls the entire supply or demand in a market. Think of the company that delivers your electricity or of the lone gasoline station in the middle of the Mohave Desert. Both have the power to set their prices higher than a competitive market would have allowed, and both get higher profits than companies facing mere competition.
Notice that you do not need to be enormous international corporations to have market power on the supply side. In fact, being a super-big company is not no guarantee that you won't face vigorous competition. MacDonald's is big, but so is Wendy's and Burger King. And Alice's Fine Food Restaurant competes with MacDonald's, too. A little company like Joe's Last Stop Gasoline Station at the edge of the Mohave can have local market power. And to take the extreme case, within a single household each person can have, in effect, significant market power, going on kitchen strike, say, if the others don't help with the dishes. A small fish can be a big force if the pond is small enough.
Caption: Courtesy of Gordon Parks, Farm Security Administration, and the Library of Congress.
Unequal distribution of information
"Knowledge is power," people say. It's true in markets. Knowing where and when to buy, and where and when to sell, can really count. Klamer told an art-dealer friend that he was going to Bologna in Italy and on his way would stop in Amsterdam in the Netherlands. "That's perfect," exclaimed the art dealer. "Do me a favor and visit Jan van Dyck in Amsterdam. Have a chat and then tell him that I want to buy his statue for $25,000. He will know what you are talking about and will give it to you. Then go to Giovanni Botticelli's shop in Bologna. Tell Giovanni that you want to see some paintings of his. Pretend you're interested. Then, as though by the way, show him the statue. Ask $45,000. He will probably give you $40,000. We'll split the profit." Klamer did as he was told except for two alterations in the plan: he asked $50,000 and got $45,000---though being honest he felt compelled to tell his art-dealer friend about what he did, and divided the profit fairly. People are like that: on the whole they do not want to be cheats or crooks. Justice intervenes in market-based prudence. But observe anyway the power of information. The friend and art dealer in Bologna knew that the man in Amsterdam did not know of the interest of the other art dealer in Bologna for his statue, and stood to gain significantly from this informational advantage.
But information can be unequally distributed to the point that those with the right information can be considered to have an unjust advantage. Your mother may be in on a deal in which a company is taking over another, struggling company. Knowledge of that deal could mean a sizable profit in the stock market. She could herself buy shares in the struggling company, and tell you and her friends to do so. All that is left to do is watch the price rise when the takeover deal is announced and then sell the shares at a big profit. The information on which your mother is trading, however, is called "insider" information, and is illegal in the United States.
Concept Check 2: On December 27, 2001, Martha Stewart avoided about $51,000 in loss by selling thousands of shares of ImClone stock, one day before the stock tanked in value. Stewart and her broker had learned from an insider, it seems, that ImClone's founder was about to sell. Stewart went to jail on the jury's conviction. Is Martha Stewart an entrepreneur who is trying to make mutually beneficial deals in stock and retail trade? Does Martha's search for good deals in better food and homemaking mean she is a scoundrel?
Unequal distribution of information --- "informational asymmetry," it's called --- is very common. It's characteristic of markets for, say, labor services, and for used cars. A new job and a new-to-you used car contain hidden costs that should be figured into the calculation of the contract price. You know more about your abilities as a worker than your potential employer does. You can tell her that you're a great worker. But she has no way to know whether or not you're lying. That's why she insists on seeing your objective qualifications, such as your university graduation, or the grade you got in your economics course.
A used car can be a "lemon," a bad-'un. The dealer knows that the car has been in a big accident---he's seen the weld marks on the underbody---and that it will never quite drive right. But you don't. Remember the comic scene in "Breaking Away" in which the son gives a money-back guarantee on a clunker from his father's used-car lot. The father, who thought he had gotten rid of the thing to some unsuspecting buyer, is outraged. The used-car company CarMax has done well by trying to eliminate the rampant informational asymmetry in the used car market. If you take your old car to CarMax a mechanic very carefully inspects it, and the salesperson offers you the standard, "Blue Book" price or thereabouts. No casual offers from a Western-Avenue dealer in a shiny suit of $2000 for your six-year old Toyota Avalon. No, the $5500 Blue Book price, thank you very much---if it turns out your claim that the car had not been in a major accident checks out.
The instability of markets
Even when prices are flexible, and no individual buyers or sellers have excessive power, and everyone has the same information. . . the market may still not function perfectly from everyone's point of view. The invisible hand does not guarantee that the world will be heaven, only that it will not be a certain kind of inefficient hell.
Price instabilities, for example, often cause problems for both individuals and businesses. Whenever the prices on the stock market fall sharply, as they did on October 19, 1987, newspapers will be full of stories about the instability of markets. Sharp movements in market prices tend to make the market participants nervous, and often poor. And making plans becomes difficult when you don't know what the price will be next week, or tomorrow. Of course, instabilities like this at the micro, market level can often be insured against. People do, in markets for insurance such as the "forward" market in wheat and corn and stocks. But insurance markets do not always exist, for one reason or another: informational asymmetries are a big one. Or politics---onions to this day do not have a forward market in which wholesale buyers of onions could "hedge" (in effect, insure) against price changes, so that they could predict how much their onion soup was going to cost. In 1958 the onion producers of Michigan, because they mistakenly believed that trading in onion futures increased rather than reduced price instability, got Congress to make trading in such insurance illegal. You can buy and sell wheat, the Japanese yen, all sorts of things for future delivery. But to this day not onions.
Instability is also reflected in sharp changes in the quantity that is traded on a market. When there is excess supply in the car market, the prices drop, but so will production and employment in the car factories. That can be a macro instability. Market adjustments take the form of factory shut-downs and big lay-offs, affecting the economy as a whole---hence, "macro." Knowing that this is "how the market works" is very nice. The personal experience of being laid-off is quite another, and not pleasant.
Pro-market economists argue that adjustments will be quick either through the arrival of new industries or the moving away of the unemployed to other areas with better job opportunities. They point out that in the long run it is not so that unemployed people keep piling up in places with declining industries. If it were so, no one by now would have a job, since job losses have been happening since the economy began---around 50,000 B.C.! Other economists, with less faith in the market, argue that such adjustments take too long and therefore cause more pain than is warranted. They argue that micro- and macro-instabilities are problems requiring the visible hand of the government.