Davidson, J., and A. Weersink. What does it take for a market to function? Outline 1) Define the concept of a market and related ideas: efficiency, price, market failure, role of transactions costs and related institutions 2) Examine actual markets - how they evolved in the context of emerging markets in Eastern Europe 3) Summarize principles and necessary criteria

(A) What is a market ? 1) market as a complex web of interactions 2) The market as an institution 3) Market as a geographic sphere - price making forces - law of one price 4) What's a market ? there's a price, many buyers/sellers, a geographic area and a commodity 5) Group of institutions

(B) What is Market Efficiency ? Two fundamental welfare theorems 1) When do you get a Pareto optimum ? a) complete markets b) buyers and sellers - competitive behaviour c) equilibrium 2) Efficiency versus equity What does “PRICE” represent? (Signal) Eugene Fama - Efficient Market Hypothesis (J. of Finance, 1970)

C) Market Failure What does this mean? When does it happen? agents can not equate MRS (consumption and production) exchange is not possible no price to guide decisions, allocation Necessary conditions for the price system to work Sufficient markets Competitive behaviour Equilibrium (S/D) Non-competitive behaviour (e.g. monopoly - welfare not max) Non existent equilibrium - RTS (natural monopoly) Asymmetric information - (George Akerlov - JPE 1970)

D) Role of Transactions Costs (TC) Cost of exchange and enforcement of rights relatively large proportion of GDP Other necessary conditions for a market to exist protection from post exchange opportunism need to define and protect/enforce property rights - this is costly What rights are important ? (4) use, derive income, exclude, exchange Principle: market existence requires low transactions costs TC can kill a market and lead to an externality

E) When is a Market Efficient ? No other institutional arrangement exists with lower transactions costs If you are creating a market - find ways to minimize TC's R. Coase: Exchanges INSIDE or OUTSIDE the firm Make it inside or contract it out ? Cars – GM and Ford Cell phones (Apple, Samsung) University education Modern communications supports this: ecosystem

Elements of Market Design (1) Medium of exchange (money) - to reduce TC - search costs versus barter (2) Trading rules institutional trading arrangements - reduce TC of exchange Evolved from informal to formal Allows the market to expand to include agents who do not know each other trade at a distance Example: Law Merchants (traders) Good reputation – allowed market access Reduced information costs Oversight – private or public ?

Criteria for Successful Market (3) What other aspects of the property right need to be defined? 2) Initial Allocation 1) Definition of property right needs to be exclusive define who owns what - what does ownership mean? what uses of property are OK? What: define the good Where: the physical area When: timeframe Costs to Exchange (TC)? Initial allocation => efficiency TC can be high enough to prevent exchange e.g. native land claims - give resource to natives, or auction ?

3) Exchange of rights A) because of information asymmetries, markets may not give efficient allocation B) system needs an enforcement mechanism What is exchange? 3 elements, all of which involve costs search bargaining contract What is Enforcement? monitor agents involved in exchange - e.g. CBOT market surveillance committee enforcement of contracts - application of penalties cost of enforcement > potential gains from trade => no trade and no market