The general characteristics of markets and their shortcomings have been discussed above, but there is a particular feature of many markets - rationing - that deserves special attention.
One of the basic assumptions of free markets is 'perfect information'. Buyers have all information about every product and its price, and every potential substitute product and its price, including quality, durability, safety and so on.[143] Sellers have all information about buyers' wishes, including how many of every product they will buy at every possible price. In these circumstances oversupply and undersupply can't occur because sellers produce at exactly the right rate to satisfy buyers. In economic jargon all markets are assumed to clear, meaning that there is no excess production and no shortage. None of us lives in this perfect world however so it is normal for suppliers to misjudge demand, leading either to shortages or to excess production. In reality markets are rationed, either by supply (supply limited - demand exceeds supply - known as sellers' markets where sellers' willingness to sell is less than buyers' willingness to buy), or by demand (demand limited - supply exceeds demand - known as a buyers' markets where sellers' willingness to sell is more than buyers' willingness to buy) (Werner 2005 p27, pp326-331). This can be temporary, for example when suppliers can quickly remedy any excess or shortfall or when supply is interrupted by a strike or minor natural event; or long lasting, for example when it takes a long time for suppliers to respond to excesses or shortfalls, or when a natural resource is running out and it takes time to make substitutes available. Rationed markets are inefficient because products are not allocated to best effect, either there is too much stock with prices so low that suppliers suffer losses and in extreme cases go out of business, or there are unsatisfied buyers because prices are so high that only the better off can afford the products.
In a market that is rationed by demand buyers have the stronger bargaining position because sellers' willingness to sell exceeds buyers' willingness to buy, so the outcome is that the price falls. The reason is that a seller faced with few buyers risks having unsold stock, in which case the costs incurred in making it have been wasted. It is far better to accept a reduced price so that at least some and hopefully all costs are recovered. Competitive sellers therefore reduce prices in order to compete for the few buyers that there are. The same thing happens in reverse with a supply rationed market, and supply rationed markets are greatly favoured by suppliers who go to great lengths to engineer them wherever possible because they then have control and can raise prices considerably. In some cases the government steps in as they did during the Second World War when ration books were introduced to ensure a fair distribution of food and other essentials rather than allow an unfettered market to enrich sellers at the expense of buyers who would have to pay high prices or go without. Nevertheless there was a parallel and thriving 'black market' that operated to give suppliers and wealthy buyers more than their fair share.
It is market rationing that explains some anomalies such as the fact that air, the most valuable thing on the planet, has no exchange value, whereas diamonds, whose value is largely decorative, have enormous exchange value. In the first case air is rationed by demand - there is a much greater supply than there is demand, even though its use value is unlimited, so it is freely available. Diamonds on the other hand are severely limited by supply, so even though their usefulness is superficial they command a very high price. Traditional economics explains the anomaly using marginal utility theory, where, as a buyer continues to buy more of the same product the benefit gained from each additional one (the marginal utility) is less than the one before, but the money paid is the same for all. While the product benefit exceeds the value of money spent products will continue to be bought, but when not there is no further willingness to buy and no further exchanges will be made. Here one additional lungful of air has no exchange value because we already have all the air we need, but one additional diamond has a high value because our stock of diamonds is limited. Both explanations amount to the same thing but I think the rationing explanation is easier to understand.
The diamond/air anomaly is seen as such because it seems logical that the exchange value of an item should increase either as its usefulness increases, or as the time and effort that have gone into making it increases, but usefulness is not the deciding factor for exchange value, and nor is time and effort.
Exchange value depends only on levels of supply and demand, and not on usefulness or time and effort that have gone into making the product.
It used to be thought that an item's exchange value was related to the labour that had gone into producing it. Several early economists subscribed to this view including Adam Smith, Karl Marx and David Ricardo. It is known as the labour theory of value.[144] It was overturned by later economists, notably William Stanley Jevons, Leon Walras and Carl Menger, who independently realised that exchange value was subjectively determined by market participants based on how eager or reluctant sellers are to sell, and how eager or reluctant buyers are to buy.[145] It is summed up nicely in the following quotation:
It is not that pearls fetch a high price because men have dived for them; but on the contrary, men dive for them because they fetch a high price. Richard Whately, Lecture IX of his 'Introductory Lectures on Political Economy' 1831.
However we shouldn't be too quick to dismiss this theory. Although it is true that supply and demand determine prices, products whose labour costs aren't adequately covered by the selling price soon stop being produced, and products whose selling price is greatly in excess of their labour costs soon see their price falling as new suppliers enter the market to enjoy high profits. Therefore we can say that in steady-state market conditions (product supply matching demand) prices do in fact reflect labour costs. The same applies for raw materials that go into making finished products. Raw materials cost nothing prior to extraction. It is the labour costs involved in extraction that, in a steady-state market, determine the price of the material. It is in transient conditions when supply and demand aren't matched - rationed markets - that product prices don't reflect labour costs.
Rationed markets are prominent features of the business cycle - the alternating boom and bust phases that characterise the economy. Housing in particular flips from being rationed by supply during booms when people fight to bid prices up because credit in the form of mortgages is freely available, to being rationed by demand during busts when no buyers can be found because people are short of money or they fear parting with it, or mortgages are harder to obtain. The same thing happens on stock markets where booms are known as bull markets and busts as bear markets.
The business cycle is examined in more detail later - see chapter 52.
Rationing shows the benefits of bigger markets. A supplier selling into a large market has a much greater level of demand, so demand isn't rationed to the same extent that it often is in small markets. Similarly consumers buying from a large market have a greater level of supply, so supply isn't rationed to the same extent as it often is in small markets. Bigger markets also allow for more specialisation: in traditional products where there is a bigger workforce employees can specialise to a greater degree, and in specialised products where there are buyers that wouldn't exist in sufficient numbers in small markets. With specialisation comes greater expertise and therefore greater efficiency - more wealth out for a given level of wealth in - which benefits everyone. These benefits provide the drive to expand both domestic and international markets as widely as is possible. Globalisation in terms of expanded trade in goods and services is a very good thing, but the manner in which it is managed leads to some very bad outcomes, especially for poor countries, as will be seen in Part 3.
It is important to understand the implications of an item's exchange value depending only on relative levels of supply and demand, and not on usefulness or on time and effort that have gone into its production. The relationship between time/effort and exchange value is efficiency. It is possible to spend lots of time and effort in producing something of very limited value, as suppliers do when they overestimate the level of demand, and in these cases the time, effort and the producer's money are largely wasted, which is inefficient. Conversely efficiency was increased when Worker A in the simple economy invented the knife and the harvesting of food required only half the time that was needed before. When wheelbarrows came along efficiency improved a further three times.
Efficiency is at the heart of modern wealth creation. Producers in a competitive private-enterprise environment seek improvements all the time, and when they succeed their profits go up, which means that they are able to expand production by paying workers more than their competitors, and they can capture more of the market by reducing prices below their competitors (remember that wealth use is as important as production, it is no use expanding production if use can't also be expanded - see chapter 16), and still keep some of the additional profits for themselves. In this way wealth production naturally gravitates towards the most efficient producers, and less efficient producers then also have to improve, go out of business, or suffer much lower profits. In this way competition promotes efficiency, which is good for more efficient producers and consumers because both gain from the improvements - higher profits and lower prices. It isn't necessarily good for workers because more efficient production methods often require fewer workers, so some might lose their jobs. Over time some of these workers move to more efficient producers, whereas others can remain unemployed for long periods. Also, competition between producers by utilising labour from low wage countries or just the threat of doing so allows domestic wages to be driven down to much lower levels. This is one of the reasons why the income of the general population hasn't risen much in real terms since the 1970s whereas the income of the already well paid - those who benefit from improved workforce competition - has soared, see Figs 20.1 and 20.2. The fact that higher efficiency improves overall benefits means that displaced workers should be compensated fairly for their loss because they too deserve a fair share of the benefits, but the firm that profits rarely compensates them except to the extent that the law forces them to make redundancy payments.
Note that we are talking about genuine competition here - where new suppliers can easily enter the market and are free to do so - not the contrived competition favoured by governments intent on privatising public enterprises and services. That isn't real competition and doesn't promote efficiency; it promotes self-seeking opportunities for profit maximisation from the public purse, opportunities for cost cutting by exploitation of the workforce, and neglect of service recipients - see chapters 91 and 92.
Conversely lack of competition in private enterprise stifles efficiency, because monopolies can sell their products and still make handsome profits regardless of how inefficient the process. This hurts consumers and users considerably, because not only are they paying much more for products than they would be in a competitive environment, the products themselves will be of lower quality because the supplier has no incentive to improve them.
Competition in a private enterprise environment promotes efficiency, and lack of competition stifles it.
It all comes down to incentives. People seek to minimise costs and effort, and maximise profits and benefits, and if an incentive exists to achieve either or both of these then people will respond to it. Hence in a competitive environment the incentive is to apply effort to innovate to achieve lower costs, higher profits and hence benefits, and also (unfortunately) to apply effort to finding ways to drive down wages and to limit competition and extract more money from buyers - see chapter 29. In a monopolistic environment the incentive is to maintain or extend the monopoly so as to maintain high profits. With monopolies there is little or no incentive to apply any effort to innovation because profits and benefits are already as high as the market will stand without it.
People respond to incentives.
Neoliberalism elevates one incentive above all others - money. There is no doubt that money is indeed a powerful incentive, and if a company sets the accumulation of money as its highest goal then that single-mindedness will rub off on its staff and their approach to work and life. It represents a one-dimensional outlook and misses so much else. People are motivated by much more than just money, for example pride in the job, being reliable, being knowledgeable, serving the public good, being loyal, winning the trust of workmates, and so on. In fact as far as money is concerned people are motivated and demotivated much more by their relative pay with respect to colleagues and others in the same profession than by absolute levels of pay. Relative pay and relative wealth are discussed further in chapter 99. In Maslow's hierarchy of needs[146] money can only satisfy the two most basic ones - physiological (survival needs) and safety, the higher ones involve relationships and realising one's potential. This recognises that people are multidimensional and a company that recognises that is much more likely to provide a pleasant place to work than one that doesn't, regardless of its profitability. The problem is that a pleasant working environment doesn't appear on the balance sheet, though it is a very significant asset nonetheless.