what does it take for a market to function?

Agricultural & Applied Economics Association

What Does It Take for a Market to Function?Author(s): Jeff Davidson and Alfons WeersinkSource: Review of Agricultural Economics, Vol. 20, No. 2 (Autumn - Winter, 1998), pp. 558-572Published by: Oxford University Press on behalf of Agricultural & Applied Economics AssociationStable URL: http://www.jstor.org/stable/1350008 .

Accessed: 25/06/2014 00:13

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

Agricultural & Applied Economics Association and Oxford University Press are collaborating with JSTOR todigitize, preserve and extend access to Review of Agricultural Economics.

http://www.jstor.org

This content downloaded from 188.72.127.159 on Wed, 25 Jun 2014 00:13:10 AMAll use subject to JSTOR Terms and Conditions

http://www.jstor.org/action/showPublisher?publisherCode=oup

http://www.jstor.org/action/showPublisher?publisherCode=aaea

http://www.jstor.org/stable/1350008?origin=JSTOR-pdf

http://www.jstor.org/page/info/about/policies/terms.jsp


Review of Agricultural Economics - Volume 20, Number 2--Pages

558-572

What Does It Take for a Market to Function?

Jeff Davidson and Alfons Weersink

Markets are intricate webs of institutions and social arrangements that have evolved so that transactions can take place at minimum cost. Markets fail to evolve when the uncertainty that surrounds the transaction causes costs to outweigh the benefits of the exchange. If market failure caused by a missing market is to be corrected, the goal of the new market must be to minimize the transaction costs of exchange. The literature offers few suggestions for the conditions necessary for a market to function. The objective of this paper is to specify these necessary conditions by defining what a market really is, identifying characteristics of properly functioning markets, and describing design lessons learned from recent attempts at creating markets in alternative contexts. The paper concludes with a synthesized set of criteria necessary for a market to function.

New markets are being created as eastern European countries make the transition to market-based economies. Markets are being established on the In-

ternet as this new electronic medium becomes a potentially important place to do business. Markets for pollution rights are being viewed by governments as the most efficient solution to a range of environmental problems. These are but a few examples of situations that require an understanding of the necessary elements for a successful functioning market. Any market that functions properly is an intricate web of institutional arrangements that ultimately affect the successful exchange of a commodity within that market. However, rarely do economists define the term "market" despite its importance in a capitalist economy, and when they do, it is typically described as an institution in and of itself (Dorfman, Stigler). Attention has been paid to whether a given market is efficient in terms of least cost allocation (Ledyard), but little effort has been given to the conditions necessary for the market to exist. To address the problems of new markets created for the new mediums, it

M Jeff Davidson is a research assistant, Department of Economics, University of Lethbridge, AB. * Alfons Weersink is associate professor, Department of Agricultural Economics and Busi- ness, University of Guelph, Guelph, ON.



What Does It Take for a Market to Function? 559

is important to recognize what a market really is, why or how markets evolve, and the necessary conditions for a market to be successful.

The purpose of this paper is to define the conditions required to minimize transaction costs when attempting to create a market that has failed to evolve on its own. To determine the conditions necessary for a market to function, the paper contains three sections. Part one defines what a market is by examining the concepts of efficiency, price, and market failure, along with the role of transaction costs and institutions in an efficient market. Part two examines actual markets and how key institutional trading arrangements have evolved to decrease imperfections and lower the transaction costs of exchange. In addition, the factors affecting the transition of state-controlled economies in eastern Europe to a market system are discussed. Part three summarizes the important principles and lists a synthesized set of criteria necessary for a market to function.

What Is a Market? "Two women and a goose make a market" (Hibbard, p. 13). The quote illustrates

why economics is often viewed as a science of common sense. Many concepts that economics explores, including markets, are readily observable. It is easy to oversim- plify and mask a complex system when participation in the system is routine and requires little effort. The weather is an example of a complex system observed every day. After years of observation, a few key variables can be identified to forecast the weather with some degree of certainty. If I wake up and there are dark clouds in the sky, I expect it to rain, so I take an umbrella. Because of the limited amount of information I need to decide whether or not to take an umbrella to work, I could easily mistakenly believe that the weather itself is an easy system to explain.

Like the weather, a market is an intricate web of complex interactions among many variables. As with the decision to bring an umbrella in the morning, the decision to purchase a paper on the way to work requires such a limited amount of information that there is a tendency to be misled into believing that the market process, as with the meteorological example, is very simple. The seventy-five cents you pay conveys information about your tastes and preferences to the seller that then trickles down to the newspaper company, the paper and ink companies, and eventually the pulp mills and the entire forestry industry. In a perfectly competitive world, price is all that is needed to coordinate all of this activity. In a less competitive world, the environmental regulations imposed on the foresters and pulp mills, the reporters' union, and the laws that control the relative size and amount of assets a newspaper company may hold are but a few examples of institutions that have significant effects on the prices that emerge and therefore the resulting activities. Small changes in these institutions can drastically affect the ultimate allocation of resources and the prices that emerge. The following section investi- gates the concept of a market to establish the conditions and institutions thought to be essential variables in the functioning of an efficient market.

Definition of a Market The term "market" is used at length in economics, often without definition.

Traditional neoclassical economics views the market as an institution in and of itself. Within this exogneously determined market, the invisible hand efficiently



560 Review of Agricultural Economics

directs individual behavior and leads to the Pareto optimal allocation of goods. This view of the market as an institution implies that the role of government is not to intervene in the regulation of the economy, but rather to leave the market alone. Taken to the extreme, this view ultimately means "any government interference in the market will not increase social utility" (Rothbard). The only role for government becomes to ensure that the necessary elements for the market to operate as an institution are in place. These roles include protecting property rights and ensuring enforcement of contracts.

According to traditional neoclassical economists, the market is reduced to the sphere within which price-making forces operate. "A market is the area within which the price of a commodity tends to uniformity, allowance being made for transportation costs" (Stigler, p. 77). The sphere is defined alternatively in terms of price, total number of buyers and sellers, physical area, or commodity. Markets are also commonly defined as an element of time or group of people. Dorfman argues, "the firms and people to whom they sell their product constitute the market for their commodity" (p. 7). The Harper Collins Dictionary of Economics claims that "economists define a market as a group of products consumers view as being substitutes for one another" (p. 321) and presents different classifications of markets depending on the relative number of buyers and sellers. A market has also been viewed as an actual physical area. Blomquist, Wonnacott, and Wonnacott suggest that "in a market an item is bought or sold" (p. 55). A market can be conceptualized by different sectors or commodities such as labor markets, a capital market, or a cotton market. Dolan's general definition of a market is "any arrangement people have for trading with one another" (p. 7).

Although a market is often defined as an institution in and of itself, it is really a group of institutions that act together toward the same purpose. Institutions can be thought of as "the humanly devised constraints that structure political, economic and social interaction" (North 1991, p. 97). The legal system by itself is an example of an institution that contributes to the success (or failure) of a market. A market may not necessarily need to be enforced by law: enforcement can occur through other social institutions, such as the threat of violence. However, a system of laws may contribute to the efficiency of that market. The previous definitions explain markets as institutions in and of themselves with no explanation of their origins. The following definition takes into account that markets are groups of separate institutions and that they evolve, or can be designed, to reduce the transaction costs of exchange.

DEFINITION. A market is a group of institutions which evolves or is designed to facilitate the transfer of rights and titles to ownership in goods, services, and properties.'

Given this definition, we now examine market efficiency concepts and the role of transaction costs within a properly functioning market.

When is a Market Efficient? Whether the allocation of resources in a market is efficient is most often deter-

mined using the first two fundamental theorems of welfare economics. The first details the conditions sufficient for a decentralized economy to achieve Pareto op-




timality. If there are (a) enough markets, (b) producers and consumers who behave competitively, and if there is (c) an equilibrium, then the allocation of resources in that equilibrium will be Pareto optimal. No one can be made better off without making at least one person worse off (Ledyard). The second fundamental theorem of welfare economics separates the concepts of efficiency and equity when redistributing initial endowments. Under the same conditions as the first theorem, a Pareto optimal allocation can be achieved by redistributing the initial endowments and allowing the market to determine the final distribution. Thus, for any initial distribution there exists an associated Pareto optimal allocation. Different assign- ments result in different final and efficient allocations, but nothing is offered as to the equity associated with a redistribution of endowments.

A market is efficient when the resulting allocation of resources equates the marginal rates of substitution (MRS) for all agents. This implies that all gains from trade are exploited. When the conditions for the first theorem are met, exchange in a market is the critical mechanism that allows the agents to reach a state where they can exploit all possible gains from trade. Not only can markets lead to the Pareto optimal allocation of resources, the market is the least costly mechanism to achieve coordination under the above conditions, since prices capture so much information.

What Does Price Represent? A necessary element for exchange between buyers and sellers is an agreed-upon

price for the commodity. Price is the mechanism that governs exchange. It indicates how close a market is to the Pareto optimal allocation where the marginal rates of substitution are equated across all agents. When the market is functioning properly with clearly defined property rights, the value of the traded commodity across interests is reflected in the price. Since price necessarily takes into account each individual's valuation, it drastically reduces the information costs associated with any exchange. Without a price mechanism, agents would be forced to estimate the subjective valuation of others. Price not only provides information about the knowledge of other market participants, but it also forces each participant to take that knowledge and interest of others into account even when they would not otherwise find it in their best interest to do so. Price also forces each to assess the value of his or her own preferences (Hayek). Price, therefore, is the mechanism of exchange with the lowest transaction costs that governs economic association among individuals. This is due to information otherwise difficult to obtain about preferences contained within a price.

Market Failure If a resource becomes scarce and no market exists for that resource, it would be

impossible to achieve an efficient allocation. The agents involved cannot equate their marginal rates of substitution because exchange is impossible, no price exists, and therefore gains from trade cannot be exploited. Understanding the reasons why efficient allocation does not occur is necessary to determine the conditions for a successfully functioning market.

The conditions necessary for the system of prices to function properly and result in a Pareto optimal allocation of resources are (a) sufficient markets, (b) competitive




behavior, and (c) the existence of an equilibrium. When one or more of these conditions are violated, market failure occurs. The first condition is violated if a market does not exist for the exchange of the right to a good or obligation, even though some would be willing to pay for it. Without a market and a corresponding price, participants cannot inform each other about potential exchange that would leave both parties better off. The missing markets for many natural resources are a classic example where the first condition is violated, and the Pareto optimal allocation of resources are not achieved. One obvious solution to the problem of insufficient markets is to create the markets that are missing through a reassignment of property rights or a system of Pigouvian taxes. But adding more markets can affect the other two sufficient conditions of the first theorem of welfare economics (Ledyard).

The second condition of the first theorem is violated if the actors in the market do not behave competitively. Competitive behavior implies that consumers maximize preferences subject to budget constraints and producers maximize profits as if unable to affect prices. The classic example of noncompetitive behavior is the existence of a monopoly where an agent acts as a price maker rather than a price taker. A monopoly agent may be able to make itself better off by restricting supply and increasing prices, but the resulting allocation will be inefficient. One solution to the problem of noncompetitive behavior is to ensure that all agents are both resource- and informationally small relative to the market, but it is difficult to do so without creating too shallow a market (Ledyard).

The final requirement for an allocation of resources to be efficient is that an equilibrium exists. The existence of a natural monopoly is an example of a non- existent equilibrium. When there are increasing returns to scale in production, a fixed setup cost, and a constant marginal cost to produce, a firm will produce either nothing or an infinite amount. Because there is no price at which supply equals consumer demand, an equilibrium does not exist (Ledyard). Other examples leading to market failure include external diseconomies and informational asymmetries. These examples of nonexistence of equilibrium tend to lead to noncompetitive behavior (Wilson).

The Role of Transaction Costs and Institutions in an Efficient Market Even if the conditions for the fundamental theorems of welfare economics are

satisfied, successful exchange within a market depends upon the necessary conditions being in place to facilitate the transaction as outlined in the earlier definition of a market. A commitment is necessary that enables both parties exchanging in a market to be protected from posttransaction opportunism (Miller). Whether institutional arrangements evolve to ensure that commitment and permit exchange depends on transaction costs. It takes resources to define and exchange control over property rights (North 1990). The extent of these costs directly affects the gains attainable from trade. The most successful markets are those that have assisted in minimizing transaction costs.

The existence of an externality is an example where markets can fail to produce the efficient allocation of resources. An externality exists if there is an opportunity for a mutually beneficial exchange that fails to materialize. The externality created by firms over polluting can be solved by internalizing the costs of pollution they are presently not bearing through either taxes or pollution rights. However, we




would never observe the phenomenon of pollution levels above that socially optimal if transaction costs did not play such an important role in markets. In the absence of transaction costs and the given initial distribution of resources, a high level of pollution maybe the efficient solution, and if it exists, it is optimal. Otherwise, agents would pay the polluter to reduce pollution. It is the very existence of transaction costs that prohibit the market from forming and allowing exchange to occur. If an alternative institutional arrangement exists, such as to reduce the transaction costs so that exchange can occur, then the current market structure is inefficient. If this is not the case, the present allocation is efficient. Thus, standards for efficiency should account for the costs of the transaction when solving the problem of market failure.

By excluding information and transaction costs, the neoclassical approach is limited to describing the ability of a market to achieve an equilibrium allocation of resources that is Pareto optimal. If a market needs to be created that facilitates reduction of transaction costs so that trade can occur (where it was not possible before), the efficiency rule established by the first two fundamental theorems of welfare economics needs to be adjusted to include an element of transaction costs. Market efficiency analysis should thus consider all costs associated with participation in a market. North (1990) divides these costs into two types: transformation costs and transaction costs. Transformation costs are those with which economists typically deal. These costs include the costs of production, or of transforming inputs into outputs. Transaction costs are defined by North (1990) as the costs of exchange that include "defining, protecting and enforcing the property rights to goods (the right to use, the right to derive income from the use of, the right to exclude, and the right to exchange.)" (p. 26).

The inclusion of only transformation costs in the efficiency analysis ignores the allocative effects caused by the existence of transaction costs. Because incorporation of transaction costs within a general equilibrium model has not yielded simple and robust general results, tractability has been obtained by assuming that transaction costs are relatively small compared to transformation costs. Transaction costs, however, are now being shown to be much larger than originally suspected. For the U.S. economy, Wallis and North (1986) estimated the size of transaction costs had changed from roughly a quarter of GNP in 1870 to one half in 1970.2 These transaction costs thus appear to be significant and should be included when determining the efficient allocation of resources.

Including transaction costs in assessing market efficiency implies price will equate the marginal rates of substitution not at the point where all gains from trade are realized, but rather at the point of maximum gains from trade less the transaction costs of that trade. Thus, a market is efficient when no other institutional arrangement exists with lower transaction costs. As Bakken notes, no perfect markets exist, so the best that can be done is to strive toward greater efficiency in performing the tasks of exchanging commodities or obligations from one to another.

The solution to a market failure still remains to correct for conditions of too few markets, noncompetitive behavior, or nonexistence problems. However, devices for the creation of a market must consider the institutional framework that minimizes the transaction costs associated with that market. This will ensure that we come as close as possible to a Pareto optimal solution that exists in a world of zero transaction costs.




Market Design The previous section examined the elements of a market in our attempt to es-

tablish the necessary conditions for a successful market. The next section of the paper examines two actual markets and how key institutions have evolved to decrease imperfections and lower the transaction costs of exchange. The first illustrates how institutional trading arrangements have changed. The second examines the transition of eastern European countries to market-based economies. Lessons from these case studies will be used along with the previous section to assemble a list of elements necessary for a successful market in the paper's final section.

The Evolution of Institutional Trading Arrangements Gains from exchange are reduced by transaction costs incurred as a result of

costs and asymmetries associated with information held by the parties involved. Because human interaction is subject to limited information and computational ability of market participants, rules exist to reduce the costs of human interaction (North 1990). These rules or institutional trading arrangements evolve to decrease the interaction costs. The very existence of the potential to recover more of the gains from trade is the driving force behind the evolution of market institutions in society and in the process permitted the expansion of markets (North 1991).

In the simplest example of a trading arrangement, where a double coincidence of wants occurs between three people, all would benefit from using a medium of exchange because it reduces the information costs that need to be incurred before exchange takes place (Blanchard and Fischer). To trade directly with another person without a medium of exchange, it is necessary to determine not only what that person wants but to find someone who is willing to accept what I have in order to get it. Thus, a medium of exchange allows for more transactions than a barter economy because it avoids the necessity of direct exchange and drastically decreas- es the amount of information necessary for indirect exchange.

The medium of exchange is often used to help describe the jump from barter economies to more complex trading environments, but a quick glance at the evolution of the types of mediums used also shows how the evolution is a result of an attempt to decrease transaction costs. The evolution of money started with the lightest object in multiple exchanges, thereby reducing the transportation costs of the transaction. The object was a recognizable symbol representing the intention to trade. The next step was to coins so that the medium of exchange could be recognizable in an entire community, rather than within a small group of organized traders. Various forms of currency then emerged to reduce the probability of coun- terfeit and to reduce the resources involved in making it. The increasing use of debit cards is also due to the transaction cost savings associated with activities, such as not having to count bills or balance the till and fewer trips to the bank. The evolution of exchange mediums from a barter economy to a cash-free debit card economy has been driven by the ability to decrease transaction costs.

The use of a medium of exchange in trade that began with informal trading agreements has developed over time into more formal trading rules. Informal rules include everything that governs individual behavior, including taboos, customs, and traditions. These constraints are imposed by people on themselves to give structure to their dealings with others (North 1990). This structure reduces the




costs of daily interaction. Without formal rules, informal constraints arise to elim- inate conflicts of interest by defining what it is people can expect from others (Colson). Informal constraints are part of a culture that do not solve every problem, but exist to simplify life. Consequently, these informal rules can reduce the transaction costs associated with getting or needing information and with enforcing commitment. The importance of informal rules can be shown when two different outcomes are often observed as a result of the same formal rules operating in two different areas subject to different social and cultural norms (North 1990). Formal rules are easier to identify because they include legal rules, political rules, economic rules, and individual contracts. A hierarchy of these legal rules exists as well. For example, it is more costly to change constitutional law than statute law, and a statute is more costly to change than individual contracts (North 1990).

The combinations of these two types of rules form the guiding principles that shape behavior in any society. Over time, as societies grew in size, the rules that govern behavior moved from informal to formal (North, 1990). It has become more difficult (costly) to control behavior using informal constraints in an increasingly complex society with ever larger groups of people in immediate contact, so the movement toward formal rules is inevitable. Small villages that relied on hunting and gathering could function with the threat of violence being sufficient as a de- terrent to breaking contracts (North 1991). However, Western society has evolved over time from a semicommercialized agricultural society with confined local interaction to one in which all participants are extremely specialized and depend on a vast network of other specialists to provide an entire array of goods and services. The subsequent move from informal rules and constraints to formal rules and constraints can be explained as a response to decrease the transaction costs of coordinating larger impersonal markets.

An interesting case study of the Law Merchant in medieval Europe by Milgrom, North, and Weingast illustrates the evolution of informal, private enforcement rules for exchange to a more formal system. Informal arrangements based on reputation can support honest behavior provided the gains from establishing a continuing relationship are greater than the immediate gains from dishonest behavior that would sever the relationship. Although the value of the relationship may serve as an adequate bond between two pairs of traders who come together frequently, the reputation mechanism may not promote honest exchange if there are a large number of traders who rarely meet and thus find it too costly to obtain information on the other trader. Milgrom, North, and Weingast contend that the Law Merchant enforcement system is an example of a formal institution that evolved to encourage honest trade over a wide area by making it unprofitable for merchants to renege on promises. Fairs brought traders from a wide geographic area but only allowed entry to those in good standing. Thus, any merchant within the fair could be assumed by all to have a "good reputation." Merchants developed their own private code of laws (the Law Merchant) with disputes settled by a judge. The judge had limited powers to enforce judgments, but the process provided members of the trading community information on the conduct of individual merchants necessary for the effectiveness of a reputation system. Thus, the formal laws of the Law Merchant system arose to economize on the collection and dissemination of information on potential traders and thereby reduce the transaction costs of exchange.3

Not only did institutions evolve to overcome informational asymmetries between




individual merchants, and as a consequence promote exchange, but trading arrangements also changed between the merchants and rulers of the trading centers where merchants met. Grief, Milgrom, and Weingast detailed how merchant guilds emerged in the late medieval period to prevent the person and property of visiting merchants to be abused by the state. Although the problem of the ruler's commitment to posttransaction opportunism could possibly have been overcome by an informal reputation mechanism in which the cheated traders refused to come back, Grief, Milgrom, and Weingast argue that the ruler-merchant arrangements were governed by merchant guilds. Guilds were an institution that supervised the overseas operation of merchants of a particular region and held certain regulatory powers within that region. They served as a coordinating organization for merchants that would supplement the operation of a multilateral reputation mechanism by permitting collective action by the merchants. The powers of the state to violate contractual obligations were similarly addressed by institutional constraints in England during the early eighteenth century that permitted the development of modern financial markets (North and Wiengast). In both examples, informal and formal institutional trading arrangements evolved to reduce the transaction costs of trade, enabling trade to be expanded for the benefit of both the traders and the state.

The need for the Law Merchant system of judges and merchant guilds to secure merchants' rights declined with the development of state enforcement. Rather than depend on decentralized informal reputation mechanisms (albeit enhanced by institutional developments), enforcement could be obtained by punishing dishonest behavior with fines or jail terms (Milgrom, North, and Weingast). The costs of state enforcement of contracts relative to decentralized reputation mechanisms decrease as the number of traders increase and state systems develop. The evolution toward third-party enforcement of legal codes by the nation state as a means to reduce the transaction costs of exchange given changing parameters such as technology is discussed by North and Thomas.

Lessons from Emerging Markets (Eastern Europe) A number of countries within the sphere of the former Soviet Union began the

process of transforming from centrally planned economies to more market-based systems in the 1989-1991 period. For the previous seven decades, these economies had been characterized by a hierarchical structure of authority with a desire to maximize resource use and equity through rigid centralized planning of production, distribution, and prices (Ericson). Although such a system was effective in gathering resources to meet a few, clear objectives, significant economic inefficien- cies resulted from the focus on incentives oriented toward commands of superiors who lacked information on relative scarcity and use values (Bergson). Without proper incentives to allocate resources, these countries were marked by low productivity and income levels, overinvestment in obsolete infrastructure, and insol- vent state-owned enterprises (Svenjar).4 The relative poor performance of centrally planned economies led to a desire for economic reform.

Elements of reforming a socialist economy toward a market-based economy require action in four areas, according to Fischer and Gelb; (a) macroeconomic sta- bilization and control to reduce budget and trade deficits; (b) price and market




liberalization to provide information on resource values; (c) restructuring and privatization of enterprises to permit flexible responses to incentive changes; and (d) redefinition of the role of the state from being all-encompassing to one with adequate legal and information accounting systems to support markets. Although there is consensus on the general nature of the reforms, their sequencing and speed of implementation vary with the state depending on its present political and economic situation.

Murrell discusses the changes that have occurred for the 29 countries of eastern Europe and the former Soviet Union undergoing transitions toward a market economy. Many have established the institutional underpinnings of a democratic process, but significant uncertainty in those arrangements remain within the former Soviet Union countries. In these states, institutional changes defining the role of elected leaders, the legislature, and the bureaucracy are often lacking. Most countries have enacted laws, such as constitutional protection of property rights and antitrust statutes, to promote exchange, but the instruments to enforce these laws are generally missing. These political and institutional changes tend to be related to the degree of economic liberalization that has proceeded quickly for input markets (reflecting the end of centralized intervention), but less progress is evident in privatization of state-owned enterprises.

Differences in the types of reforms implemented along with the initial economic, political, and social situation have resulted in significant variations in growth rate increases and budget deficit reductions. Murrell finds relative economic performance measures decline as one moves east from central Europe. The reforms have increased prosperity in the Czech Republic, Hungary, Poland, and Slovenia but adjustment costs in the form of recessions and large increases in poverty are evident in many of the former Soviet Union states. The institutional changes required to support democratic and economic freedoms necessary for economic development were greatest in these regions. Although dramatic changes in policy may be needed, there are greater political costs to implement such transition reforms.

The first lesson or criteria critical to creating markets, which can be learned from the transition of state-controlled economies, relates to the importance of the initial allocation of property rights. Eastern European countries are faced with redistributing private property rights previously held by the government to create a functioning market within their region. Brada describes the mix of methods required to effectively privatize state assets including restitution to original owners, sale of state property, mass or voucher privatization, and the growth of the private sector from below through the formation of new firms. Ingrained in agriculture from the previous set of property rights was a focus on quantity rather than profit. Farms were expected to provide more at all costs with the government absorbing any potential losses (Brooks). Consequently, wages were subsidized, and for workers' income to be maintained in the shift to private ownership, increased investment, increased risk, and increased hours were required (Brooks). Workers will perceive that they are bearing significant costs as the redistribution to private ownership occurs. The challenge becomes to allocate property rights efficiently in the face of extreme political complications. Initial allocation and subsequent definition of property rights are the limiting factors to how well the market functions. The ways in which land is allocated, for example, affect how the price mechanism reveals the value of that land. The two critical elements of ensuring that the property right is




as clear and certain as possible are (a) striking a balance between securing tenure of established users and allowing entry of new users and (b) balancing how permanent a right is while maintaining flexibility so that the rights can be adjusted if a mistake occurs.

Although privatization and the issues surrounding the initial allocation of rights are important, Bromley argues that the key criteria necessary for revitalizing the Russian food system is the development of institutional arrangements permitting competitive input and output markets. Bromley notes that the economic systems of Russia and other former Soviet Union nations described above could be characterized by the presumption of prohibition, in which activity was prohibited unless stated. In contrast, market-based economic systems assume the presumption of permission, which allows an activity unless expressly prohibited. The bounds of acceptable behavior for market participants exchanging rights to a good or service are determined by the social and legal foundations of the society. With institutions to define and enforce these bounds, the costs of transactions can be reduced and flexible, impersonal trade facilitated.

Litwack also stresses the importance of commitment to private property rights or economic legality, which he defines as a mutually consistent set of laws the populace believes will be enforced. Setting laws for acceptable behavior is not sufficient for allowing markets to function; people must be willing to follow them. Bromley and McDowell provide examples for Russia and Albania, respectively, where the political entity and public support are not developed to support the legal foundations of a market. Rapaczynski notes that an enforceable system of property rights cannot simply be created by government laws but adds that such a system is endogenously determined by economic forces. These forces create self- enforcing mechanisms that often arise before the legal arrangements to property rights and hence are often more effective.

Criteria for a Successfully Functioning Market The previous sections have examined the elements of a market and reviewed the

evolution and development of market institutions. This material provides the necessary background to address the purpose of this paper, which is to identify the necessary criteria for a market to function. Three components are identified as being of utmost importance if exchange is to occur within a market: (a) the definition of the original right, (b) the initial allocation of the right, and (c) the exchange of the right. The definition of the right needs to be specified in a manner so that the right is as exclusive as possible. The allocation of the right must function to reduce the uncertainty surrounding the establishment of a new right. Finally, institutions, either formal or informal, must be in place to guide the exchange of the right and to ensure its transferability and enforcement. The three components are based on those commonly defined as the requirements for a nonattenuated system of property rights. Ideally, a set of nonattenuated property rights completely spec- ifies the right to a good and delivers exchange at the least cost. As you move away from a system of nonattenuated property rights, transaction costs increase, as does the potential for market failure.




Definition of a Property Right One reason for market failure described earlier occurs when the rights over a

good or service are not properly specified. Property rights help identify the proper relationships among people regarding the use of goods and services and the pen- alties associated for violation of these proper relationships (Randall). Consequently, the bundle of rights associated with a particular resource affects the owner's choices and uses of that resource, because it determines the consequences of the owner's actions (De Alessi). As discussed previously, the development of eastern European countries is correlated to the extent to which property rights are defined and se- cured.

A clear definition of property rights over a good or service must account for several elements of the right. For instance, the physical area over which the right is valid must be specified to avoid conflicting claims. Similarly, accurate and sufficient data must be obtainable to define the good. Also, the right needs to be permanent or specified over a specific time so that the value of the resource is discounted over the appropriate period. If any of these conditions are not met, the value of the right will be adjusted to reflect the uncertainty involved.

Initial Allocation of Rights The initial allocation of rights has no effect on the efficient allocation of resources

when transaction costs are zero but become of paramount importance to resource allocation when there are costs to negotiating and enforcing exchange (Coase). As we have discussed, institutional arrangements evolve to minimize the transaction costs of exchange. Yet these costs, which are partially a function of initial endowments, may be high enough to prevent exchange. Thus, initial allocation of rights can determine the form and extent of markets exchanging those rights.

Privatizing state-owned enterprises in eastern Europe and the allocation of pollution permits represent examples where a new market is being established and an initial allocation of rights has to be determined. The basis for the initial allocation depends on a theory of fairness. In a theory of natural rights, the agents who possessed the right first would be allocated the right, whereas in a utilitari- anism system, rights would be assigned on the basis of which allocation results in the maximum production value. Ultimately, a balance must be struck between ex- isting users and those who demand use after the market has been formed. The goal is to allow the resource to move toward its highest value use while recognizing that previous users have an established right. The allocation must also balance flexibility with predictability. At the same time, if the right is not viewed as permanent, the value the right acquires will be affected.

Exchange of Property Rights By relaxing the assumption of perfect information, activities related to the ex-

change of rights give rise to transaction costs. Differences in the information possessed by market participants can be used to the advantage of the more knowl- edgeable individual and possibly at the expense of efficiency. Asymmetric information and the resulting transaction costs imply that completely decentralized markets may not result in efficient allocation (Murrell). A functioning market has compatible incentive mechanisms and institutions that permit the transferring of




rights to a good or service and that avoid postexchange opportunism by ensuring that the transfer is enforced.

Transferability Three exchange activities related to the transferring of a right are described by

Eggertson. First is the search for information about the distribution of the good's price and quality, for potential buyers and sellers, and for relevant information about their behavior and circumstances. Second is the bargaining that is needed to find the true position of buyers and sellers when prices are endogenous. Third is the making of contracts. If a market needs to be created, it is because uncertainty drives the costs associated with these activities so high that they prevent a market from evolving on its own. When this is the case, an institution that reduces the search and bargaining costs needs to be established. In addition, this institution serves to protect the industry from the threat of market power due to the thinness of the market and assists in specifying the contracts by providing information and reducing uncertainty.

Enforcement Eggertson also outlines the three enforcement activities that directly influence

the transaction costs of exchange. First, contractual partners are monitored to see whether they abide by the terms of the contract. Second, contracts are enforced and damages are collected when partners fail to observe their contractual obligations. Finally, property rights are protected against third-party encroachment. The greater the degree of uncertainty surrounding potential enforcement with respect to these activities, the more time is spent specifying a detailed contract (possibly even the creation of new laws); hence, the larger are the transaction costs that cut into the possible gains from trade. If the costs of enforcing compliance are large relative to the gains from trade, exchange will not occur (North 1990). As evident from the experiences in eastern Europe, legal responses are not sufficient to ensure enforcement. A properly functioning market requires both formal and informal institutions that provide an incentive to self-enforcement.

Summary Markets are intricate webs of institutions and social arrangements that have

evolved so that transactions can take place at the least cost possible. When markets fail to evolve, gains from trade cannot be realized because the uncertainty that surrounds the transaction gives rise to costs that outweigh the benefits of the exchange. If market failure caused by a missing market is to be corrected, the goal of the new market must be to minimize the transaction costs of exchange. The literature offers few suggestions for the conditions necessary for a market to function properly in this framework. This paper represents an attempt to outline these conditions by defining what a market really is and what conditions are necessary to have a properly functioning market, providing examples of how market institutions have evolved to reduce exchange costs, and designing lessons from recent attempts to create markets in eastern Europe.

Transaction costs can be minimized by properly specifying and allocating the




right and then providing institutions that decrease the costs of exchanging for that right. Uncertainty surrounding a potential exchange is reduced when the property right is defined clearly, allocated without discrimination, and transferred and enforced easily. The fundamental conditions necessary for a market to exist include ensuring that property rights of the good to be exchanged are defined properly and that the institutions are in place to ensure its allocation. Knowledge of these elements is necessary in the numerous situations where new markets are being created.

Acknowledgments The authors thank Danny LeRoy, Michael Ivy, Glenn Fox, Cal Turvey, and Trevor Dick for their

helpful suggestions.

Endnotes 'This is based largely on Henry Bakken's definition of a market as follows: "In the judgment of the

author(s), a market is an institution designed to facilitate the transfer of legal rights and titles to ownership in goods, services and properties."

2 It should also be noted that Eggertson refers to the same study and suspects that this number is underestimated since it only includes transaction resources which are bought or hired. This excludes transaction costs borne by individuals, such as waiting in lines or search costs for information.

3 Grief describes how informal and formal rules evolved between merchants and overseas agents to permit the benefits of using such agents in the Mediterranean region during the eleventh century.

4 Agriculture in Eastern bloc countries before the transition was typical of most sectors in the economy, characterized by large, inefficient farms with high costs of production; a high level of food con- sumption relative to market economies of comparable prosperity; and pervasive monopoly in food pro- cessing and distribution (Braverman, Brooks, and Csaki).

5 Randall outlines four elements of a system of nonattenuated property rights: (a) specification, (b) exclusively, (c) transferability, and (d) enforceability.

References Bakken, H. Theory of Markets and Marketing. Madison WI: Mimir Publishers, 1953. Bergson, A. "The USSR Before the Fall: How Poor and Why." J. Econ. Perspect. 5, 4(1953):29-44. Blanchard, QJ., and S. Fischer. Lectures on Macroeconomics. Cambridge MA: The MIT Press, 1988. Blomquist, A.,

P. Wonnacott, and R. Wonnacott. An Introduction to Microeconomics. Toronto, ON:

McGraw-Hill Ryerson, 1987. Brada, J.C. "Privatization is Transition--Or Is It?" J. Econ. Perspect. 10, 2(1996):67-86. Braverman, A., K. Brooks, and C. Csaki. The Agricultural Transition in Central and Eastern Europe and

the Former USSR, Washington DC: The International Bank for Reconstruction and Development, The World Bank, 1991.

Bromley, D.W. "Revitalizing the Russian Food System: Markets in Theory and Practice." Choices, Fourth Quarter 1993, pp. 4-8.

Coase, R. "On the Problem of Social Cost." J. Law and Econ. 3, 1(1960):1-44. Colson, E. Tradition and Contract: The Problem of Order. Chicago: Adeline, 1974. De Alessi, L. "Development of the Property Rights Approach." The New Institutional Economics. E.G.

Furubutn and R. Richter, eds., pp. 62-71. College Station TX: Texas A&M University Press, 1991. Demsetz, H. "Toward a Theory of Property Rights." Amer. Econ. Rev 57, 2(1957):347-59. Dolan, EG. Basic Economics. New York: CBS College Publishing, 1998. Dorfman, R. Prices and Markets. Englewood Cliffs NJ: Prentice Hall, 1972. Eggertson, T. Economic Behaviour and Institutions. Cambridge MA: Cambridge University Press, 1990. Ericson, R.E. "The Classical Soviet-Type Economy: Nature of the System and Implications for Re-

form." J. Econ. Perspect. 5, 4(1991):11-28. Fischer, S., and A. Gelb. "The Process of Socialist Economic Transformation." J. Econ. Perspect. 5,

4(1991):91-105. Grief, A. "Contract Enforceability and Economic Institutions in Early Trade: The Maghribi Traders'

Coalition." Amer. Econ. Rev 83, 3(1993):525-48.




Grief, A., PR. Milgrom, and B.R. Weingast. "Coordination, Commitment and Enforcement: The Case of the Merchant Guild." J. Polit. Econ. 102, 4(1994):745-76.

Harper Collins. Collins English Dictionary, 3rd ed. Glasgow: Harper Collins Publishers, 1991. Hayek, E "The Use of Knowledge in Society." Amer. Econ. Reu 35, 4(1945):519-30. Hibbard, B.H. Marketing Agricultural Products. New York: Appleton, 1921. Ledyard, J.O. "Market Failure." The New Palgrave: Allocation, Information and Markets. J. Eatwell, M.

Millgate, and P. Newman, eds., pp. 185-90. New York: Macmillan Press, 1989. Litwack, J.M. "Legality and Market Reform in Soviet-Type Economies." I. Econ. Perspect. 5, 4(1991):

77-90. McDowell, G.R. "How Far From Central Planning to a Market Economy? A View From Albania."

Choices, Second Quarter 1997, pp. 13-20. Milgrom, PR., D.C. North, and B.R. Weingast. "The Role of Institutions in the Revival of Trade: The

law Merchant, Private Judges and the Champagne Fairs." Econ. and Polit. 1, 1(1990):1-23. Miller, G.J. "The Impact of Economics on Contemporary Political Science." J. Econ. Lit. 35, 3(1997):

1173-1205. Murrell, E "How Far Has the Transition Progressed?" J. Econ. Perspect. 10, 2(1996):25-44. North, D.C. "Institutions." J. Econ. Perspect. 5, 1(1991):97-112. - . Institutions, Institutional Change, and Economic Performance. Cambridge MA: Cambridge Univer-

sity Press, 1990. North, D., and R. Thomas. Rise of the Western World. Cambridge MA: Cambridge University Press,

1973. North, D.C., and B.R. Weingast. "Constitutions and Commitment: The Evolution of Institutions

Governing Public Choice in Seventeenth Century England." J. Econ. Hist. 49, 4(1989):803-32. Randall, A. Resource Economics: An Economic Approach to Natural Resource and Environmental Policy.

Columbus OH: Grid Publishing, 1986. Rapaczynski, A. "The Roles of the State and the Market in Establishing Property Rights." J. Econ.

Perspect. 10, 2(1996):87-103. Rothbard, M. Toward a Reconstruction of Utility and Welfare Economics. New York: Centre for Libertarian

Studies, 1977. Stigler, G.J. The Theory of Price. New York: Macmillan Publishing, 1971. Svejnar, J. "Microeconomic Issues in the Transition to a Market Economy." J. Econ. Perspect. 5,

4(1991):107-22. Wallis, J.J., and D.C. North. "Measuring the Transaction Sector in the American Economy, 1870-

1970." Long Term Factors in American Economic Growth, vol. 51 of The Income and Wealth Series. S. L. Engerman and R.E. Gallman, eds. Chicago: University of Chicago Press, 1986.

Wilson, R.B. "Exchange." The New Palgrave: A Dictionary of Economics, Allocation, Information and Mar- kets. J. Eatwell, M. Milgate, and P. Newman, eds., pp. 83-93. New York: The Macmillan Press, 1989.



what does it take for a market to function?

Documents