How Markets Work: Transaction Costs and Market-Makers

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Introduction

According to Adam Smith, markets somehow reach equilibrium through an “invisible hand.”  He only used this phrase once in his massive Wealth of Nations.  This is about as close as a Scottish Enlightenment philosopher could come to a mystical interpretation of social behavior.

The basic theory of perfect competition says that small producers of identical products passively accept the market price set by industry-wide supply and demand. The conclusion that they can only adjust output within a narrow range is unrealistic in a modern economy.  Economists don’t even have a realistic model of how this is done or how long adjustments take.  A market is in disequilibrium during the adjustment period.
  
In a world of large corporations and imperfect competition, economic change is a function of decisions made inside firms, not the automatic workings of markets.  Economics should concentrate on firms, not markets.

Markets don’t function because of some invisible hand but because huge resources are developed and deployed to make them function more efficiently. Knowledge is privatized before economic activity begins.

Much of recent economic theory concentrates on how markets do not work smoothly or reach the theoretical equilibrium, due to such factors as transaction costs, asymmetric information and moral hazard.  The general equilibrium model, or Walrasian model, is the limiting case of how markets operate if there are no transaction costs, asymmetric information or moral hazard.
  
Transaction Costs and Market Makers

Much of the discussion about how markets work focuses on transaction costs, the costs companies incur in attempting to use markets.  Transactions costs include finding suppliers, gathering market information, negotiating and contracting with other companies, reducing risk, and monitoring performance of suppliers and customers.  These transaction costs can be very high.  Imagine that if you wanted to buy a pair of Nikes you had to travel to Vietnam, where they are produced (at $4/pair). The total cost to you would be very high. This creates an opportunity for other companies to reduce the transaction costs of bring you together with the manufacturer.  It is market-makers like shipping companies, container trains, trucking companies, wholesalers, distributors, and retailers that make production in Vietnam possible and reduce the total cost to consumers around the world.

In almost every market, there are market-makers between buyers and sellers.  They reduce the transaction costs of using the market to find suppliers and customers along the supply chain and at retail.  They bring buyers and sellers together.

It is estimated that about one-fourth of the value-added in the economy is provided by these companies. (Daniel Spulber, Market Microstructure:  Intermediaries and the Theory of the Firm, 4, 22-26)  Collectively, they are called market-makers.  They include brokers and agents, information providers like Edmonds and Carfax, financial companies, transportation companies (UPS), distributors, wholesalers and retailers (including online retailers and market makers like eBay, Etsy and Amazon).  In addition, many of the employees of manufacturing and assembly corporations in bilateral oligopolies perform the same functions in purchasing and sales departments.

Market-makers expand markets by reducing transaction costs and the price to consumers. Through modern versions of Adam Smith’s famous dictum – “That the Division of Labour is limited by the Extent of the Market” – market-makers also create the profit incentive for producers to invest in expanding output and reducing unit cost as a result of economies of scale. There would not be large corporations in modern economies without market-makers.

Market-makers also overcome the problem of “adverse selection” by providing information to buyers and sellers. 

The Special Role of Retailers

What do large retailers do?
            Forecast sales of a mix of products to actual and potential customers.
            Negotiate net price and sales conditions with suppliers. 
This is a complicated and expensive activity carried out by specialized market makers.
Reduce prices if sales forecasts are too optimistic or they want to clear inventory for new merchandise.  Sometimes “sales” of a percent of a purchased item is built into the expected average margin.  This is a form of price discrimination (different prices for different groups of consumers), higher prices for early buyers and lower prices for later buyers.

Fortunately for consumers, there is tremendous competition among retailers.  They compete partly on their ability to reduce the total cost to consumers in money, time and search.  They are market makers who reduce the transaction costs of consumers.

Digital Platforms as Market-Makers

Digital platforms extend the functions of market-makers. Amazon combines many of the functions of market-makers and then present a huge range of products and services, along with a massive amount of information, warehousing, delivery and easy payment. In addition, Amazon affects demand by accumulating information about each individuals browsing and buying behavior and "suggesting" products and services to buy. 

Companies like Uber and Airbnb go a step further. Their digital platforms are the market. Customers and suppliers find each other and interact through their programs.

Social media platforms are even more complicated. Individuals supply most of the content on the sites. They are also on the demand side, reading other contributors' input. The market price is zero. But the companies collect massive amounts of data about each individual and collectively. This data is used to sell space on the sites to advertisers, who bid for particular spots on the site. Thus, social media companies are auctioning space and access to users.

Amazon
Amazon began as an internet-based seller of books. Its online catalog was larger than the inventory of the largest bookstore. Its site also contained information and description of books and book prices. Customers ordered online. Books were shipped by book wholesalers and specialized fulfillment customers and delivered directly to customers by companies like UPS and FedEx.

This model and its offerings expanded with the technology. Amazon realized that it could vertically integrate all the market-maker functions, adding warehousing and delivery directly to buyers, and potentially profit by eliminating the services of other market-makers.  The company has increased the efficiency of its warehouses by developing specialized robots. The company provided massive amounts of data. This led to a massive data center network, over 900 data centers of which it owned about 460 and leased the rest. The company began to offer data center services to other companies.

Amazon also learned it could monetize the huge amounts of data it collects about its customers. It developed software that started suggesting products to individual customers based on their browsing and buying behavior.  It practices the ultimate in price discrimination, setting and changing prices for individual customers.

It charged suppliers for preferred positions on the top of pages of a product category. Like Costco, it charges an annual fee, which in Amazon's case covers delivery charges and some services like Amazon Prime (which contained advertising). Customers who sign up for Amazon Prime buy substantially more than customers who don't.

Amazon is trying to take its business model a step further with the advent of AI. It foresees a massive new business opportunity by offering data center capacity and services for the development and application of AI.  It is building a global network of massive data centers. In its own company, AI is already being added to Alexa and Siri.

Uber
Uber is another type of internet-based market-maker. It is a company whose only asset is its algorithms that bring together potential riders and independent ride suppliers (technically, contractors). Its platform can change prices depending on changes in real-time variables. Its algorithms and data make it likely it will provide robotaxis itself or in partnership with other companies.


Conclusion

Market makers are often large companies with substantial market power to influence the cost and conditions of transactions.  They exist because they reduce the transaction costs of buyers and sellers in a market.  Often they create or expand the market.  If they did not exist, the transaction costs would be too high for some buyers or sellers.  As much as I like a good Napa cabernet sauvignon, I’m not going to spend $1,000 in air fare and car rental to go to Napa to buy a bottle.

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