Reinventing the bazaar (McMillan, Book Review)

Table of Contents

1. Introduction

2. The Presence of Markets

3. The Role of Transaction Costs

4. The Role of the Government

5. The Requirements for Functioning Markets
5.1. Information flows smoothly
5.2. Property rights are protected
5.3. People can be trusted to live up to their promises
5.4. Side effects on third parties are curtailed
5.5. Competition is fostered

6. The Role of Modern Information Technology

7. Critique

8. References

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 differ- ent 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 tele- communication 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 de- gree 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 devel- oped 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 en- vironment 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 omni- present”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, deregu- lation 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.

3. The Role of Transaction Costs

While Sigmund Freud put his main focus on sex in his studies, economists have transac- tion costs as their central object of investigation for efficient markets. In a ‘perfect’ eco- nomic 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 cer- tain 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 volun- tarily, and in case of doubts, both buyer and seller do not have to perform the transac- tion. But even in free markets, it is virtually impossible to clarify all aspects of the trans- action 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 20th 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 disap- pointing. In the 1970s/1980s, Neoclassics suggested a withdrawal of the state and be- lieved in the self-healing mechanisms of markets. The Washington Consensus was com- plied that suggested a decrease of government power and fewer interventions, but only a stabilization-cum-adjustment policy. Since this strategy proved unsuccessful again,

nowadays the 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 pro- vide 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 govern- ments and institutions leads to dysfunctional and therefore inefficient markets where participants are facing fraud, theft, contract violations, private property loss and copy- right 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 to- wards 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 con- vincingly 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 mar- kets 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.

[...]

¹ Lenzner (2002).

² McMillan (2002), p. 4.

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

⁴ See: McMillan (2002), p. 41-52.

⁵ See: Ahrens (2002), p. 23-35.

⁶ Kirkus Reviews (2002), p. 387.