Pragmatic Pluralism 11: Markets

This chapter provides a map through the complex jungle of economic theories. There are many different theoretical approaches, and each aspect of the economy has been analysed by a number of different ones. However, it is neither feasible nor productive for students to engage with every possible angle for every topic. Hence, the chapters on different topics, together with Building Block 8: Economic Theories, sets out an alternative approach: pragmatic pluralism. Rather than pursuing the extreme of either only focusing on one approach, or including every possible strand of thought for every topic, we propose a pragmatic middle ground: teaching a select number of approaches for each topic. In this way, it is possible to introduce students to the variety and diversity of economic thinking, whilst still having enough time and space to properly discuss each of the insights in detail with them.

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Markets make up much of contemporary economies, organising more and more aspects of our lives. But how do markets function? Is competition between firms more like a gentle process of balancing, or a ruthless war of attrition? Do markets facilitate rational allocation, or are they more often defined by manipulation, norms, and power struggles? And how do markets relate to broader society?

Main opposing perspectives

■ Classical political economy: Competition as a ruthless process

■ Neoclassical economics: Competition as an optimal outcome

Main complementary perspective

□ Cultural approach: Markets are embedded in social structures

Additional perspectives and insights

+ Behavioural economics: People can be manipulated

+ Austrian school: Markets excel at spreading information

+ Field theory: Market stabilisation through social and formal rules

There are two dominant perspectives on market competition. One view sees it as a harmonious outcome and the other sees it as a ruthless process. The static perspective (competition as an outcome) is mainly used by neoclassical and post-Keynesian economists, while the dynamic perspective (competition as a process) is mostly used by classical, Marxian, Austrian, evolutionary and complexity economists, as well as by business scholars. The neoclassical story starts from the Pareto-optimal perfect market, characterised by rationally self-interested behaviour of many buyers and sellers, complete secondary markets, perfect information and factor mobility, no market power, no transaction costs, and no externalities. If any firm is, however, able to acquire more profit than “normal”, then the neoclassical competition-as-end-state view assumes there is some imperfection in the market, otherwise economic “forces” would return the market to a competitive optimal equilibrium. Much of neoclassical economics is, therefore, devoted to solving these market failures, with dedicated fields such as industrial organization, environmental economics, game theory, information economics, organizational economics, and public economics. In the dynamic competition-as-war view, differing rates of profit are not understood as an imperfection, but as an inherent part of the rivalry and fighting between firms, which always creates winners and losers. Equilibrium and arbitrage in this dynamic approach are not realized at one point in time, but over time through periods of under- and overshooting.

Both approaches recognise how market competition can create economic prosperity, but do so in a different way. The static perspective emphasises allocative efficiency, which refers to the maximization of consumer utility. For this products have to be produced at the lowest costs possible and consumed by those who value them most. Neoclassical economists generally argue utility cannot be compared between individuals and therefore assume that the highest bidders are the one’s valuing the product most. The dynamic perspective, instead, emphasises dynamic efficiency, which refers to the reduction of production costs over time. The static perspective thus mainly focuses on consumer demand and elasticities, while the dynamic perspective draws more attention to innovation and the productive processes inside and between firms. 

Within these two broad analytical strands, as well as within the various schools of thought, there are many specific theories about how prices, costs and profits are formed. It is beyond the scope of this chapter, and most courses, to review and summarize each of these (for this see, for example, Dobb, 1975, and chapter 8 in Shaikh, 2016), so we will limit ourselves to a key example for both strands. A recent reformulation of the dynamic approach to understanding markets is provided by Shaikh (2016). He builds a broad range of ideas and research from Smith, Ricardo and Marx to Kalecki, Harrod, and Andrews, among others, and in doing so develops a labour, or cost-of-production, theory of value. Interestingly, he also builds on the insight of Becker (1962) that the key empirical consumption patterns, such as downward sloping demand curves, Engel’s Law, and Keynesian type consumption functions, can be derived without assuming rational utility maximization and only requires two assumptions: that there is a budget constraint and a minimum level of consumption for necessary goods. Most microeconomics textbooks build on the neoclassical utility theory of value to explain prices, costs and profits (examples of microeconomics books). A key difference between the two approaches is whether prices are set so that marginal costs are equal to marginal revenue, profit is maximized and fluctuations in demand cause price fluctuations, as neoclassical economics assumes. Or whether competition forces firms to engage in price-cutting behavior, which is ultimately limited by production costs, as Shaikh argues.

While the above perspectives focus on the internal workings of markets, economic sociologists investigate how markets are embedded in society. Rather than existing in an a-social vacuum, markets are constructed and maintained by socially situated human beings. In this way, markets and the state are not understood as each other’s opposites or enemies, but as building on each other. Markets are social institutions that require government action to be created and expanded. Within economic sociology, social network analysts focus mainly on how social relationships influence market processes, while the cultural approach emphasises how economic practices are shaped by cultural norms and popular ideas. 

A key insight of the cultural approach is that the boundaries and rules of markets are culturally determined. Cultural conceptions and moral values shape what we see as being appropriate to be bought and sold. A famous example of this is that life insurance only became culturally acceptable at the end of the 19th century after a prolonged marketing campaign by companies. Another important insight is that economics itself influences how we think markets should work. For example, auction theory is perhaps just as much about how auctions should work as how they do work. In the real world, auctions have become more like the neoclassical representations of them. This influence on the design of auctions comes either directly through the hiring of economists, or indirectly through the impact these ideas have on the thinking of non-economists. Economics as a discipline has therefore become crucial in various cognitive processes that in turn shape economic processes, creating difficult questions for the philosophy of science.

Beyond these three main perspectives, various schools of thought both inside and outside of economics add to our understanding of markets by providing specific insights.

Behavioural economists, mainly inspired by psychology, focus on studying how people behave in experiments. Here they found that, in contrast to neoclassical theory, people have cognitive limitations and are therefore bounded rational. This implies that we often make decisions which do not optimise our own utility and that we are susceptible to outside influences on our decision-making, whether that is by firms through marketing or by governments through nudging. In this way, behavioural economics is often seen as a ‘positive’ theory of how consumer behavior deviates from the neoclassical “rational maximizing model [which] describes how consumers should choose”, which is taken as (normative) benchmark (Thaler, 1980, p. 39).

The Austrian school argues, on the other hand, that through the price mechanism, markets give us important information for economic coordination. Instead of seeing market decisions as easily misguided and manipulated, the Austrian view of markets is that they allow for collective wisdom. In fact, in this view the price mechanism is the only way in which so much local and subjective information can feasibly be collected and communicated.

Field theory’s approach to markets, sometimes referred to as markets-as-politics and closely related to the cultural approach, focuses on how markets are built and structured through social power struggles. Markets are understood as meso-level social fields, arenas in which the game of jockeying for position constantly plays out. When organising markets it is necessary to create a stable order in which competition does not take destructive forms. This stabilisation generally comes about through an interplay between entrepreneurs and the state, which not only provides a general social and legal order but also is an active participant and regulator.

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