The Function of Markets

The most fundamental function of a market is to serve as a convening place that enables buyers and sellers to gather information and trade goods and services. Many believe that a free market system--one largely free of government intervention--is the most efficient and effective mechanism in ensuring that resources are optimally allocated throughout society and being put to their most productive use. The notion of "markets do it best" was first introduced to the mainstream through Adam Smith's metaphorical depiction of markets as having an "Invisible Hand" that, by nature, will guide the self-interested motivations of individuals towards producing what society seeks most. But in order for this theory to hold true, certain conditions must exist. And unlike in textbooks, the world doesn't operate in a chronic state of "ceteris paribus", meaning that these conditions are going to be prone to breakdowns-- two in particular:

Information is abundant-- Even though information is more accessible now than ever before, people are not always able to interpret this information correctly. In addition, obtaining the "best" information requires the ability to decipher and identify what information is relevant, and accordingly, separate and filter the information that is not. Furthermore, information may at times be asymmetric, meaning that one side of a transaction, either knowingly or unknowingly, has more or better information than the other side.

Behavior is economically rational-- This condition is particularly susceptible to failure because individuals are not robots, and as such, are likely to make decisions that stem more from their emotions and less from rationale. Economically irrational behavior can also take the form of people taking on more risk than they otherwise should.

When the financial system began to unravel three years ago, the question about the appropriate balance between reliance on markets and government intervention came back to center stage. And today, there is still ongoing debate regarding who or what was most responsible for lighting the fire that led to the economic meltdown. Those who believe that unregulated markets generally work well express the view that the cause of the crisis can be traced back to the government's interference in the housing market. In contrast, those who hold a more skeptical view about the functioning of free markets believe that the crisis stemmed mainly from the destructive consequences of factors such as information asymmetries in financial markets and distortions to incentives that encouraged excessive risk-taking. In truth, both sides are right, which leaves the mighty challenge in figuring out how where the balance lies between the two.