Markets are places where people come together and where multiple exchanges occur between multiple buyers and multiple sellers with a degree of competition. Institutions are necessary preconditions for markets to work effectively in the long run. Coase emphasises in his Nobel Prize lecture that “without the appropriate institutions, no market of any significance is possible” (Coase, 1992:4). From an institutional perspective, market exchanges are regulated and shaped by laws and regulations as well as local customs and norms. In contrast, in an attempt to find universal principles, classical economists saw the market as a universal mechanism that is not dependent on the conduciveness or even sheer existence of a local institutional setting. The view that institutions play a critical role in market and economic performance has, however, moved to the mainstream of economic thinking over the last three decades (Hodgson, 2008, 2007).
The ‘right’ institutions for functioning markets
Hodgson (2008) in his review of markets in the economic literature finds that the search for the ‘optimal’ rules and institutional forms for markets to work efficiently is difficult or even impossible – a lot depends on the local context. Other scholars, however, have come up with broad categories of institutions that need to be in place for markets to work. These findings should not be seen as hard and fast rules but rather as rules of thumb to better understand market efficiency.
McMillan (2002) found that a workable platform for a market has five specific institutional functions:
- information that flows smoothly
- property rights that are protected
- people must be able to be trusted to fulfil their promises
- side-effects on third parties must be curtailed
- competition in the market must be fostered.
Rodrik (2000:5-10) identifies five non-market institutions that are needed for markets to perform which overlap with McMillan’s institutional functions:
- property rights
- regulatory institutions
- institutions for macroeconomic stability
- institutions for social insurance
- institutions for conflict management
Rodrik and McMillan agree on property rights, although McMillan emphasises that these rights must not be overprotected. Rodrik’s description of regulatory institutions and their functions combines McMillan’s two elements, namely that side-effects on third parties are curtailed and that people can be trusted to fulfil their promises. The description offered by McMillan seems to rely more on social trust than on law enforcement, while Rodrik emphasises the role of laws and courts. Rodrik does not focus so much on information flows as does McMillan, but discusses competition and its importance elsewhere (Rodrik & McMillan, 2011; Rodrik, 2000).
Competition is central to the functioning of markets (McMillan, 2002). Vickers (1995:1) explains that competition is important for productive efficiency because:
- competitive pressure makes organisations internally more efficient by sharpening incentives to avoid sloth and slackness
- competition causes efficient organisations to prosper at the expense of inefficient ones, and this selective process is good for aggregate efficiency
- competition to innovate is the major source of gains in productive efficiency over time.
Not only firms compete. Public organisations compete for scarce resources and political support. Ideologies or political ideas compete for voter support. Countries also compete in global markets and for global support.
Personal and impersonal exchange
While many primitive forms of market can exist through personal transactions where trust is built by social relations only, many countries are held back by an inability to enable more sophisticated markets based on impersonal transactions (Shirley, 2008; North, 2005). Impersonal transactions occur when people transact with those they do not know, do not necessarily relate to, or will never see each other face to face.
Impersonal exchange depends on a range of institutions that protect the rights of suppliers and buyers. For instance, organisations that promote standards, or laws that protect the rights of suppliers and customers, or regulations that shape how goods are sold, exchanged or replaced in case of damage are important to enable impersonal exchange. Societies that are missing these elements will be limited as to the sophistication of transactions that can take place.
While some of the institutions enabling impersonal exchange can be classified as ‘market supporting’, there are many others that may not be directly related yet are critical, for instance, basic education which enables people to read and write and thus enter into contracts.
Shirley states that markets require two broad kinds of institution to be in place to realise gains from impersonal trade (Shirley, 2008:20):
- Institutions that foster exchange by lowering transaction costs
- Institutions that influence the state and other powerful actors to protect private property and persons rather than expropriate and subjugate them.
In conclusion, for a market to work properly as a place where multiple exchanges by multiple buyers take place, a framework of institutions is needed. Competition is central to the functioning of markets. Market transactions, however, do not exist in isolation from non-economic social interactions. Consequently, the social context and culture strongly influence market exchanges.
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HODGSON, G.M. 2007. Evolutionary and institutional economics as the new mainstream? Evolutionary and Institutional Economics Review, Vol. 4(1) pp. 7-25.
HODGSON, G.M. 2008. Markets. In The Elgar Companion to Social Economics. Davis, J.B. & Dolfsma, W. (Eds.), Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 251-266.
MCMILLAN, J. 2002. Reinventing the Bazaar: a Natural History of Markets. 1st ed. New York: Norton.
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VICKERS, J. 1995. Concepts of competition. Oxford Economic Papers, Vol. 47(1) pp. 1-23.