New Horizons in Institutional and Evolutionary Economics series
Chapter 3: How markets work and fail
Markets are claimed to yield the satisfaction of demand in society with an efficient allocation of scarce resources. Efficiency has three dimensions: allocative, productive and dynamic efficiency. In allocative efficiency resources flow to where they best serve the satisfaction of demand. Productive efficiency entails minimum production costs. Dynamic efficiency entails innovation. Whether markets actually satisfy all these expectations is a different matter, which will be analysed later. Among other things, it will be shown that while these three forms of efficiency may indeed arise, they are seldom achieved at the same time. Often, one is achieved at the expense of the other. Markets operate on the basis of decentralized supply and demand, on the basis of private rather than public choice and enterprise. Markets enable prosperity because they enable exchange, which enables specialization in division of labour, which greatly enhances efficiency and variety, which enhance prosperity. Exchange depends on a host of connected conditions of geography and climate, infrastructure, transportation, communication, technology, knowledge, and a variety of institutions. I discuss institutions later. Markets are enabled and constrained by those conditions, which are in turn affected by markets. Mostly, markets work on the basis of price setting or bidding. There is bidding in the case of unique or highly differentiated products such as building projects, transport systems, and events (fairs, festivals, exhibitions, and so on).
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