Table of Contents

1.  Introduction.  1

2.  The Presence of Markets  1

3.  The Role of Transaction Costs.  2

4.  The Role of the Government  2

5.  The Requirements for Functioning Markets.  3

5.1.  Information flows smoothly.  4

5.2.  Property rights are protected  4

5.3.  People can be trusted to live up to their promises.  4

5.4.  Side effects on third parties are curtailed.  4

5.5.  Competition is fostered  4

6.  The Role of Modern Information Technology  5

7.  Critique  5

8.  References  6

- 1 - 1.Introduction

In his new Book “Reinventing the Bazaar - A Natural History of Markets, Stanford University economics professor John McMillan tried to demystify economic markets by writing a “rational man’s guide for understanding how they work well in many places, as well as badly in others” ¹ . This book is not comparable to under-graduate economics textbooks to be used for refreshing ones economic knowledge, but a novel. In this book, the reader will not find economic graphs or formulas, but numerous examples of different markets, ranging from the 20-million Aalsmeer tulip market in the Netherlands over local markets in Africa to multi-billion auction markets of spectrum bandwidth for telecommunication and the internet C2C-auctioning platform eBay. By doing so, McMillan notes that there is actually no ‘invisible hand’ as posited by Adam Smith that controls markets. A successful market needs structure which has to be designed to a certain degree by the government. Consequently, this paper will first have a look at markets and the role of transaction costs before focusing on the role of the governments in setting a framework that is required for markets to function properly. Finally, the impacts of modern Information Technology will be considered before summing up the findings.

2. The Presence of Markets

McMillan starts his book with a short look back in history and notes, that “culture developed alongside markets” ² since writing and mathematics were invented about 5000 years ago in the Fertile Crescent in order to allow a more sophisticated buying and selling environment where costs and prices were explicitly compared. In times of transformation and globalization, expectations of buyers and sellers changed, but market mechanisms are still in place. But “unlike God, markets are not omnipotent, omniscient, and omnipresent” ³ because they were created by fallible human beings which can explain why markets sometimes work well or fail severely. Consequently, they can not always achieve a reduction of poverty and increased wealth. Even in separated markets, deregulation and privatization cause changes that have to be adopted by the market. Even though markets can cope with these challenges in some cases, in most cases there is third party action required by institutions which will be focused on in chapter 4.

¹ Lenzner (2002).

² McMillan (2002), p. 4.

³ Williams (2002), p. 33; See: McMillan (2002), p. 8.

- 2 - 3.The Role of Transaction Costs

While Sigmund Freud put his main focus on sex in his studies, economists have transaction costs as their central object of investigation for efficient markets. In a ‘perfect’ economic world without transaction costs and rational actors, decision making is less tricky than in the ‘real’ world where managers have to decide in uncertainty because colleting and evaluating all available information would not allow quick and flexible decisions. There is an immanent risk for buyers paying too much for a certain product because in-formation was unavailable or not considered. McMillan explains this phenomenon by giving the example of a tourist in a bazaar in a foreign country who intends to buy a certain product. ⁴ The principal-agent problem comes in place here, because of asymmetric information. For the seller, this situation is favorable because he will most probably profit from the deal but the buyer will most likely overprice the product. Therefore, in imperfect markets, they have to decide pragmatically.

The trustworthiness of market participants is of high importance to make markets work efficiently. By having high transparency and signaling (e.g. by having a high reputation), the risk of buyers can be reduced. However, the reliability of information given has to be ensured, if possible by using various sources. This can lead to more competitive markets which entail higher efficiency because resources are held by those market participants that can best make use of them. Anyways, participation in markets is completely voluntarily, and in case of doubts, both buyer and seller do not have to perform the transaction. But even in free markets, it is virtually impossible to clarify all aspects of the transaction contract between the parties. Therefore, some exogenous framework is required to ensure basic terms of trade and their compliance.

4. The Role of the Government

The interpretation of the role of the government changed severely in the second part of the 20 ^th century. In the 1950s/1960s, the state still had a steering role in the development process and fostered both structural change and industrialization. Results proved disappointing. In the 1970s/1980s, Neoclassics suggested a withdrawal of the state and believed in the self-healing mechanisms of markets. The Washington Consensus was complied that suggested a decrease of government power and fewer interventions, but only a stabilization-cum-adjustment policy. Since this strategy proved unsuccessful again,

⁴ See: McMillan (2002), p. 41-52.

- 3 - nowadaysthe dichotomy between market and state is to be overcome and the role of governments was strengthened. 5

According to McMillan, the so-called ‘market design approach’ which is a middle way of government intervention between controlled/command economies on the one hand and liberal laissez-faire economies on the other hand. It is essential for the state to provide the society with public goods and infrastructure on the one hand, but also a legal framework is necessary to reduce transaction costs and to show stability and certainty. The state has to be a rule setter on the one hand with sanction power, but also act as a referee if market participants can not come to an agreement. So the government defines the rules of the game that enables the ‘invisible hand’ to work. An absence of governments and institutions leads to dysfunctional and therefore inefficient markets where participants are facing fraud, theft, contract violations, private property loss and copyright infringement. However, the degree of government action varies. But not only a lack of government intervention decreases wealth. Over-regulation also negatively impacts the economy. Two examples mentioned by McMillan are Russia and China. In Russia, a shock-therapy approach was chosen to transform markets from planning economy to market economy whereas in China a graduate approach was favored. Since the process proved successful in China (which is still a dictatorship) and Russia (which moved towards a democracy), there does not seem to be a relationship between the government structure and economic growth as long as the government and its institutions are convincingly and continuously establish and secure elements of functioning markets that are introduced in chapter 5. Consequently, the role of the government can be described as an active design of markets to provide an environment and structure in which efficient markets can work.

5. The Requirements for Functioning Markets

Markets, no matter whether they are big or small, are an intricate system and only if they are properly designed and well-structured, they can be successful. According to McMillan, markets develop from bottom-up over time by trial-and-error. But they will “never attain their fullest potential without a soupcon of government intervention when age-old procedures need to be formalized and authority given to enforce the results“ ⁶ .

⁵ See: Ahrens (2002), p. 23-35.

⁶ Kirkus Reviews (2002), p. 387.

- 4 - McMillandiscovered the following five elements ⁷ as essential for functioning markets:

5.1. Information flows smoothly

As stated in chapter 3, rational decisions can only be made if all information is available and considered. That is why uneven distribution of information hinders transactions and negotiations because of difficult contracts to reduce risks. While information retrieval on a bazaar is quite difficult, the internet makes it easy to retrieve and compare information and prices in global markets.

5.2. Property rights are protected

Property rights have to be guaranteed by the state because they incorporate usage rights and risks of goods. In order to have a competitive market, investments in innovations have to be protected, but only to a certain degree. Corruption is infringing property rights and has to be reduced not to cause inefficiencies in governmental institutions.

5.3. People can be trusted to live up to their promises

Buyers have to trust on the quality promises and eventually hidden product characteristics of sellers whereas sellers have to trust on the payment morality of buyers, especially in long-term contracts. In Mexican shoe markets, there were private institutions to create trust but in more complex or global markets, it is the government that has to ensure basic rules to avoid market failure like in the Indian milk market where consumers lost trust.

5.4. Side effects on third parties are curtailed

The state has to ensure, that opportunistic behavior of companies does not negatively impact competitors that stick to the rules. This is very important to avoid free-rider practices and use of public goods. McMillan’s example with the pollution ratios shows the success of such regulations if the state has legitimate power to sanction unfair behavior.

5.5. Competition is fostered

By competitive market structure which has to be supervised by the government, innovations and quality improvements are encouraged. Products are sold almost at marginal costs maximizing consumer’s wealth. However, it is the government’s responsibility to equally distribute wealth amongst rich and poor people to lower poverty.

As a conclusion it can be stated that “markets coordinate the economy better than any centralized alternative” ⁸ but if selfregulating markets are left to themselves, they can fail.

⁷ See: McMillan (2002), Preface.

⁸ Warsh (2002).

- 5 - 6.The Role of Modern Information Technology

McMillan regards internet auction platform eBay as a “high-tech flea market” ⁹ which linked buyers and sellers of formerly local markets in a global cross-border market at lower transaction costs. This is expressed by the statement that “the bazaars of today’s global village are on the internet” ¹⁰ . In the internet with its high transparency, exchange mechanisms work better and gains can be generated from trade, so eBay is regarded as the high tech version of a bazaar. However, McMillan notes that the internet can not be seen as the reason for ‘reinventing’ the markets, because they markets always existed.

7. Critique

The book ‘Reinventing the Bazaar’ by John McMillan is an easy-to-read book opening the black box of economic markets explaining cohesions using simple examples. The assumptions made are comprehensible, but sometimes a bit simplified. By examining five constitutive elements of efficient markets, McMillan shows issues that governments have to address in order to create a structure that allows efficient markets to work successfully. Government interventions often cause disruptions or even lead to market failure, but without any government markets will not work. Informal rules can only substitute government rules to a certain degree in simple markets, but in complex and global environments, they are inefficient. It is the concur between the government and market participants that ensures success. However, the critical reader might miss some more thoughts about the impacts of market design on politics and vice versa. In addition, governments are supposed to set right game rules, but there is no explanation what these rules actually entail. The impact of Information Technology and advances in global logistics are immense and caused dramatic changes in markets and people’s expectations. Nevertheless, markets existed ever since but varied over time. Therefore, it might be possible that the actual role of the state is just the best solution for today’s challenges but not for the future as the stop-and-go approach shown in chapter 4 illustrates. Finally it can be concluded, that when markets “do work, it’s through institutions, procedures, customers and some minimal regulation” ¹¹ so “free markets work best when they aren’t so free” 12

⁹ McMillan (2002), p. 20.

¹⁰ McMillan (2002), p. 5.

¹¹ Williams (2002), p. 33.

¹² Lenzner (2002).

- 6 - 8.References

AHRENS, Joachim (2002): Governance and Economic Development - A Comparative Institutional Approach, Cheltenham/Northampton.

LENZNER, Robert (2002): Reinventing the Bazaar,

, Published 16.09.2002, Accessed: 12.12.2003.

McMILLAN, John (2002): Reinventing the Bazaar - A Natural History of Markets, New York/ London.

WARSH, David (2002): The Storyteller of Markets,

, Published 26.05.2002, Accessed: 10.12.2003.

WILLIAMS, Mark: Markets demystified, in: Red Herring, Issue 113, 05/2002, p. 33.