Before we proceed further, we want to clarify the definition of trade we used in last week’s posts. We chose to regard trade as synonymous with exchange, but in most economic texts you’ll find exchange being used in context of ‘trade between individuals’ whereas trade is reserved for ‘trade between countries’. It’s not a big difference in our opinion but we thought it is an important one to clarify.
We have mentioned markets quite a number of times in the previous posts. You’d have probably realised by now that this isn’t the supermarket or wet market down the road from your house that we are referring to. This is a more abstract concept.
A market exists whenever two or more individuals are prepared to enter into an exchange transaction.
Here you go — the definition of markets. As you can see it’s not that complicated. Markets denote exchange/trade. And exchange is what we have studied extensively in last week’s series of post.
Who are the individuals?
In economics the most common dichotomy you will come across is that of consumers (or households) and producers (or firms). This is a simplistic characterisation but it helps us better understand who the key decisions makers in any given market are. One thing to note is that these roles are not fixed, and can change depending on which market you are referring to — for example, business owners are producers in their specific markets and a consumer in every other market.
Both households and firms have their own objectives — which we typically assume to be self-interest. In addition, we assume that these agents are rational, which means they will make the choices that maximise these objectives.
Taken together, these assumptions imply that economic agents will do their best to maximise self-interest.
These are the people who purchase final goods and services from markets. Everyone is a consumer at some point. And when we wear the consumer hat, we are assumed to seek satisfaction. Our only constraint is the income that we have, which we have earned by selling our goods and services in other markets. For most of us, the income is wages and the service we provide is labour.
The firms produce and supply the goods and services in the market. Companies like Apple, Walmart and Tesla are classified under this category. The objective of firms is profits, which is defined here as revenue minus costs. Later on we will see how this definition helps us to simplify the firm’s decision making process.
The Third Wheel?
A market can exist with just producers and consumers. But governments tend to be necessary for a fundamental reason — they help to enforce laws that protect property rights. No one would want to produce if they might get robbed at any moment.
But beyond that, governments can play a larger role of ensuring that the market is functioning at the optimal level. Their objective is to maximise society’s welfare. This translates into ensuring efficiency (allocative and productive efficiency) AND improving on distributional outcomes in markets.
In conclusion, markets denote exchange between individuals — who are typically classified into consumers and firms. Economic agents are assumed to want to maximise self-interest — satisfaction for consumers and profits for firms. Governments play a fundamental role in capitalism, but beyond that they can assist in improving market outcomes — efficiency and distribution.
Question of the Day
Answers will be given tomorrow.
What are the objectives of firms, consumers, and governments in markets?
- Why should governments concern themselves with distribution if achieving Allocative Efficiency already suggests that society’s welfare is maximised? (Hint: It has to do with the assumptions made when allocative efficiency is defined.)
Google: What is revenue and what is cost?
Must the objective be self-interest? Can we assume it to be altruism (i.e. others’ interest)? Would that make outcomes better or worse?
To maximise satisfaction, we buy stuff. But is more always better?
We look forward to seeing your responses in the comments section below!
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Till next time, dream economics.
All great achievements require time