3.6 Competitive Markets—And Others
Early in this chapter, we defined a competitive market and explained that the supply and demand framework is a model of competitive markets. But we took a rain check on the question of why it matters whether or not a market is competitive. Now that we’ve seen how the supply and demand model works, we can offer some explanation.
To understand why competitive markets are different from other markets, compare the problems facing two individuals: a wheat farmer who must decide whether to grow more wheat and the president of a giant aluminum company—say, Rio Tinto Alcan—who must decide whether to produce more aluminum.
For the wheat farmer, the question is simply whether the extra wheat can be sold at a price high enough to justify the extra production cost. The farmer need not worry about whether producing more wheat will affect the price of the wheat he or she was already planning to grow. That’s because the wheat market is competitive. There are thousands of wheat farmers, and no one farmer’s decision will have any impact on the market price.
For the Rio Tinto Alcan executive, things are not that simple because the aluminum market is not competitive. There are only a few big producers, including Rio Tinto Alcan, and each of them is well aware that its actions do have a noticeable impact on the market price. This adds a whole new level of complexity to the decisions producers have to make. Rio Tinto Alcan can’t decide whether or not to produce more aluminum just by asking whether the additional product will sell for more than it costs to make. The company also has to ask whether producing more aluminum will drive down the market price and reduce its profit, its net gain from producing and selling all its output.
When a market is competitive, individuals can base decisions on less complicated analyses than those used in a non-competitive market. This in turn means that it’s easier for economists to build a model of a competitive market than of a non-competitive market.
Don’t take this to mean that economic analysis has nothing to say about non-competitive markets. On the contrary, economists can offer some very important insights into how other kinds of markets work. But those insights require other models, which are studied in microeconomics.
Good Exchanges Make Great Cities
Around the world, commodities are bought and sold on “exchanges,” markets organized in a specific location, where buyers and sellers meet to trade. But it wasn’t always like this.
The first modern commodity exchange was the Chicago Board of Trade, founded in 1848. At the time, the United States was already a major wheat producer. And St. Louis, not Chicago, was the leading city of the American West and the dominant location for wheat trading. But the St. Louis wheat market suffered from a major flaw: there was no central marketplace, no specific location where everyone met to buy and sell wheat. Instead, sellers would sell their grain from various warehouses or from stacked sacks of grain on the river levee. Buyers would wander around town, looking for the best price.
In Chicago, however, sellers had a better idea. The Chicago Board of Trade, an association of the city’s leading grain dealers, created a much more efficient method for trading wheat. There, traders gathered in one place—the “pit”—where they called out offers to sell and accepted offers to buy. The Board guaranteed that these contracts would be fulfilled, removing the need for the wheat to be physically in place when a trade was agreed upon.
This system meant that buyers could very quickly find sellers and vice-versa, reducing the cost of doing business. It also ensured that everyone could see the latest price, leading the price to rise or fall quickly in response to market conditions. For example, news of bad weather in a wheat-growing area hundreds of miles away would send the price in the Chicago pit soaring in a matter of minutes.
The Winnipeg Grain Exchange, later called the Winnipeg Commodity Exchange, opened in 1887 and operated in much the same manner as the Chicago Board of Trade. It helped make Winnipeg one of the fastest growing cities in North America in the early 1900s, earning it the nickname “The Chicago of the North.” Its head office building, opened in 1907, was one of the largest office buildings in the British Empire for more than twenty years. By 1911, assisted by the thriving business of selling and shipping commodities, Winnipeg had grown to become the third largest city in Canada. Just as the Chicago Board of Trade was integral to the rise of Chicago, so also did the Grain Exchange have a central role in Winnipeg’s rapid growth. Establishing a successful market, it turns out, is very good for business indeed.
QUESTIONS FOR THOUGHT
Question 3.6
In the chapter we mention how prices can vary in a tourist trap. Which market, St. Louis or Chicago, was more likely to behave like a tourist trap? Explain.
Question 3.7
What was the advantage to buyers from buying their wheat in the Chicago pit instead of in St. Louis? What was the advantage to sellers?
Question 3.8
Based on what you have learned from this case, explain why eBay is like a commodity exchange. Why has it been so successful as a marketplace for second-hand items compared to a market composed of various flea markets and dealers?
