What Is a Market?

Business people, journalists, politicians, and ordinary consumers talk about markets all the time—for example, oil markets, housing markets, bond markets, labor markets, and markets for all kinds of goods and services. But often what they mean by the word “market” is vague or misleading. In economics, markets are a central focus of analysis, so economists try to be as clear as possible about what they mean when they refer to a market.

It is easiest to understand what a market is and how it works by dividing individual economic units into two broad groups according to function—buyers and sellers. Buyers include consumers, who purchase goods and services, and firms, which buy labor, capital, and raw materials that they use to produce goods and services. Sellers include firms, which sell their goods and services; workers, who sell their labor services; and resource owners, who rent land or sell mineral resources to firms. Clearly, most people and most firms act as both buyers and sellers, but we will find it helpful to think of them as simply buyers when they are buying something and sellers when they are selling something.

Together, buyers and sellers interact to form markets. A market is the collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products. In the market for personal computers, for example, the buyers are business firms, households, and students; the sellers are Hewlett-Packard, Lenovo, Dell, Apple, and a number of other firms. Note that a market includes more than an industry. An industry is a collection of firms that sell the same or closely related products. In effect, an industry is the supply side of the market.

Economists are often concerned with market definition—with determining which buyers and sellers should be included in a particular market. When defin- ing a market, potential interactions of buyers and sellers can be just as important as actual ones. An example of this is the market for gold. A New Yorker who wants to buy gold is unlikely to travel to Zurich to do so. Most buyers of gold in New York will interact only with sellers in New York. But because the cost of transporting gold is small relative to its value, buyers of gold in New York could purchase their gold in Zurich if the prices there were significantly lower.

Significant differences in the price of a commodity create a potential for arbitrage: buying at a low price in one location and selling at a higher price somewhere else. The possibility of arbitrage prevents the prices of gold in New York and Zurich from differing significantly and creates a world market for gold.

Markets are at the center of economic activity, and many of the most interest- ing issues in economics concern the functioning of markets. For example, why do only a few firms compete with one another in some markets, while in others a great many firms compete? Are consumers necessarily better off if there are many firms? If so, should the government intervene in markets with only a few firms? Why have prices in some markets risen or fallen rapidly, while in other markets prices have hardly changed at all? And which markets offer the best opportunities for an entrepreneur thinking of going into business?

1. Competitive versus Noncompetitive  Markets

In this book, we study the behavior of both competitive and noncompetitive markets. A perfectly competitive market has many buyers and sellers, so that no single buyer or seller has any impact on price. Most agricultural markets are close to being perfectly competitive. For example, thousands of farmers produce wheat, which thousands of buyers purchase to produce flour and other prod- ucts. As a result, no single farmer and no single buyer can significantly affect the price of wheat.

Many other markets are competitive enough to be treated as if they were per- fectly competitive. The world market for copper, for example, contains a few dozen major producers. That number is enough for the impact on price to be small if any one producer goes out of business. The same is true for many other natural resource markets, such as those for coal, iron, tin, or lumber.

Other markets containing a small number of producers may still be treated as competitive for purposes of analysis. For example, the U.S. airline industry contains several dozen firms, but most routes are served by only a few firms. Nonetheless, because competition among those firms is often fierce, for some purposes airline markets can be treated as competitive. Finally, some markets contain many producers but are noncompetitive; that is, individual firms can jointly affect the price. The world oil market is one example. Since the early 1970s, that market has been dominated by the OPEC cartel. (A cartel is a group of producers that acts collectively.)

2. Market Price

Markets make possible transactions between buyers and sellers. Quantities of a good are sold at specific prices. In a perfectly competitive market, a single price—the market price—will usually prevail. The price of wheat in Kansas City and the price of gold in New York are two examples. These prices are usu- ally easy to measure. For example, you can find the price of corn, wheat, or gold each day in the business section of a newspaper.

In markets that are not perfectly competitive, different firms might charge different prices for the same product. This might happen because one firm is trying to win customers from its competitors, or because customers have brand loyalties that allow some firms to charge higher prices than others. For exam- ple, two brands of laundry detergent might be sold in the same supermarket at different prices. Or two supermarkets in the same town might sell the same brand of laundry detergent at different prices. In cases such as this, when we refer to the market price, we will mean the price averaged across brands or supermarkets.

The market prices of most goods will fluctuate over time, and for many goods the fluctuations can be rapid. This is particularly true for goods sold in competi- tive markets. The stock market, for example, is highly competitive because there are typically many buyers and sellers for any one stock. As anyone who has invested in the stock market knows, the price of any particular stock fluctuates from minute to minute and can rise or fall substantially during a single day. Likewise, the prices of commodities such as wheat, soybeans, coffee, oil, gold, silver, and lumber can rise or fall dramatically in a day or a week.

3. Market Definition—The Extent of a Market

As we saw, market definition identifies which buyers and sellers should be included in a given market. However, to determine which buyers and sellers to include, we must first determine the extent of a market—its boundaries, both geographically and in terms of the range of products to be included in it.

When we refer to the market for gasoline, for example, we must be clear about its geographic boundaries. Are we referring to downtown Los Angeles, south- ern California, or the entire United States? We must also be clear about the range of products to which we are referring. Should regular-octane and high-octane premium gasoline be included in the same market? Gasoline and diesel fuel?

For some goods, it makes sense to talk about a market only in terms of very restrictive geographic boundaries. Housing is a good example. Most people who work in downtown Chicago will look for housing within commuting dis- tance. They will not look at homes 200 or 300 miles away, even though those homes might be much cheaper. And homes (together with the land they are sitting on) 200 miles away cannot be easily moved closer to Chicago. Thus the housing market in Chicago is separate and distinct from, say, that in Cleveland, Houston, Atlanta, or Philadelphia. Likewise, retail gasoline markets, though less limited geographically, are still regional because of the expense of ship- ping gasoline over long distances. Thus the market for gasoline in southern California is distinct from that in northern Illinois. On the other hand, as we mentioned earlier, gold is bought and sold in a world market; the possibility of arbitrage prevents the price from differing significantly from one location to another.

We must also think carefully about the range of products to include in a market. For example, there is a market for single-lens reflex (SLR) digital cameras, and many brands compete in that market. But what about compact “point-and-shoot” digital cameras? Should they be considered part of the same market? Probably not, because they are typically used for different purposes and so do not compete with SLR cameras. Gasoline is another example. Regular- and premium-octane gasolines might be considered part of the same market because most consumers can use either. Diesel fuel, however, is not part of this market because cars that use regular gasoline cannot use diesel fuel, and vice versa.3

Market definition is important for two reasons:

• A company must understand who its actual and potential competitors are for the various products that it sells or might sell in the future. It must also know the product boundaries and geographical boundaries of its market in order to set price, determine advertising budgets, and make capital investment decisions.
• Market definition can be important for public policy decisions. Should the government allow a merger or acquisition involving companies that produce similar products, or should it challenge it? The answer depends on the impact of that merger or acquisition on future competition and prices; often this can be evaluated only by defining a market.

Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.