The Economics of Markets: A Simple Model of the Market-Making Process

Abstract

Markets have played a central role in economic analysis at least since the publication of Adam Smith's Wealth of Nations. Various forms of market organization-pure competition, duopoly, oligopoly, and monopoly-have been considered in great detail in the literature, and virtually every course in macroeconomic theory devotes a substantial amount of time to explaining the nature and implications of these different kinds of markets. The traditional approach in economic analysis has been to assume a particular form of market organization and then to analyze output, price, and cost behavior in the context of the assumed market form. A closely related matter, though one which seems to have received less attention, is the question of where the market comes from in the first place. The process of making a market is, after all, itself an economic activity in the sense that it uses scarce resources. In the usual A simple model involving two traders, each of whom stands to gain by trading, is developed. The traders must expend resources to find each other so that trade can take place. The effects of changing the gains and costs from trading on the amount of marketing effort expended by each of the traders are examined. It is found that increasing the gains from trading need not increase the amount of search expenditures made by the traders and may in fact result in a reduction in the probability that trade occurs. This is because there are external effects that the traders do not take into account when making search decisions that are optimal from their individual viewpoints. These externalities suggest that both traders may gain from the emergence of a middleman who acts as a market maker and takes the externalities into account. * This paper was written for the Rochester Conference on Interfaces between Marketing and Economics, April 7-8, 1978. The author has received several useful comments from members of the Applied Price Theory workshop at the University of Chicago and from the Economic Theory seminar at the University of Toronto. Comments and suggestions from Thomas Borcherding, Dennis Carlton, Jack Carr, Arthur De Vany, George Haines, Albert Madansky, Naser Saidi, and Lester Telser have been particularly helpful. All errors are, of course, the responsibility of the author.