As we learned earlier in the book, in a market economy decisions about production and consumption are made via markets. In fact, the economy as a whole is made up of many interrelated markets. Up until now, to learn how markets work, we’ve been examining a single market—the market for used textbooks. But in reality, consumers and producers do not make decisions in isolated markets. For example, a student’s decision in the market for used textbooks might be affected by how much interest must be paid on a student loan; thus, the decision in the used-textbook market would be influenced by what is going on in the market for money.

We know that an efficient market equilibrium maximizes total surplus—the gains to buyers and sellers in that market. Is there a comparable result for an economy as a whole, an economy composed of a vast number of individual markets? The answer is yes, but with qualifications.

When each and every market in the economy maximizes total surplus, then the economy as a whole is efficient. This is a very important result: just as it is impossible to make someone better off without making other people worse off in a single market when it is efficient, the same is true when each and every market in that economy is efficient. However, it is important to realize that this is a theoretical result: it is virtually impossible to find an economy in which every market is efficient.

For now, let’s examine why markets and market economies typically work so well. Once we understand why, we can then briefly address why markets sometimes get it wrong.

Economists have written volumes about why markets are an effective way to organize an economy. In the end, well-functioning markets owe their effectiveness to two powerful features: property rights and the role of prices as economic signals.

By property rights we mean a system in which valuable items in the economy have specific owners who can use, rent, or dispose of them as they choose. In a system of property rights, by purchasing a good you receive “ownership rights”: the right to use and dispose of the good as you see fit. Property rights are what make the mutually beneficial transactions in the used-textbook market, or any market, possible.

To see why property rights are crucial, imagine that students do not have full property rights in their textbooks and are prohibited from reselling them when the semester ends.² This restriction on property rights would prevent many mutually beneficial transactions. Some students would be stuck with textbooks they will never reread when they would be much happier receiving some cash instead. Other students would be forced to pay full price for brand-new books when they would be happier getting slightly battered copies at a lower price.

Once a system of well-defined property rights is in place, the second necessary feature of well-functioning markets—prices as economic signals—can operate. An economic signal is any piece of information that helps people make better economic decisions. There are thousands of signals that businesses watch in the real world. For example, business forecasters say that sales of cardboard boxes are a good early indicator of changes in industrial production: if businesses are buying lots of cardboard boxes, you can be sure that they will soon increase their production.

But prices are far and away the most important signals in a market economy, because they convey essential information about other people’s costs and their willingness to pay. If the equilibrium price of used books is $30, this in effect tells everyone both that there are consumers willing to pay $30 and up and that there are potential sellers with a cost of $30 or less. The signal given by the market price ensures that total surplus is maximized by telling people whether to buy used books, sell used books, or do nothing at all.

Each potential seller with a cost of $30 or less learns from the market price that it’s a good idea to sell her used book; if she has a higher cost, it’s a good idea to keep it. Likewise, each consumer willing to pay $30 or more learns from the market price that it’s a good idea to buy a used book; if he is unwilling to pay $30, then it’s a good idea not to buy a used book.

This example shows that the market price “signals” to consumers with a willingness to pay equal to or more than the market price that they should buy the good, just as it signals to producers with a cost equal to or less than the market price that they should sell the good. And since, in equilibrium, the quantity demanded equals the quantity supplied, all willing consumers will find willing sellers and vice versa.

Prices can sometimes fail as economic signals. Sometimes a price is not an accurate indicator of how desirable a good is. When there is uncertainty about the quality of a good, price alone may not be an accurate indicator of the value of the good. For example, you can’t infer from the price alone whether a used car is good or a “lemon.” In fact, a well-known problem in economics is “the market for lemons,” a market in which prices don’t work well as economic signals. (We’ll learn about the market for lemons in Chapter 20.)

As we’ve seen, markets are an amazingly effective way to organize economic activity. But as we’ve noted, markets can sometimes get it wrong. We first learned about this in Chapter 1 in our fifth principle of interaction: When markets don’t achieve efficiency, government intervention can improve society’s welfare. When markets are inefficient, there are missed opportunities—ways in which production or consumption can be rearranged (reallocated) that would make some people better off without making other people worse off. In other words, there are gains from trade that go unrealized: total surplus could be increased. And when a market or markets are inefficient, the economy in which they are embedded is also inefficient.

Markets can be rendered inefficient for a number of reasons. Two of the most important are a lack of property rights and inaccuracy of prices as economic signals. When a market is inefficient, we have what is known as market failure. We will examine various types of market failure in later chapters. For now, let’s review the three main ways in which markets sometimes fall short of efficiency.

First, markets can fail when, in an attempt to capture more surplus, one party prevents mutually beneficial trades from occurring. This situation arises, for instance, when a market contains only a single seller of a good, known as a monopolist. In this case, the assumption we have relied on in supply and demand analysis—that no individual buyer or seller can have a noticeable effect on the market price—is no longer valid; the monopolist can determine the market price. As we’ll see in Chapter 13, this gives rise to inefficiency as a monopolist manipulates the market price in order to increase profits, driving the price higher, which thereby prevents mutually beneficial trades from occurring.

Second, actions of individuals sometimes have side effects on the welfare of others that markets don’t take into account. In economics, these side effects are known as externalities, and the best-known example is pollution. We can think of the problem of pollution as a problem of incomplete property rights; for example, existing property rights don’t guarantee a right to ownership of clean air. We’ll see in Chapter 16 that pollution and other externalities also give rise to inefficiency since with spillovers, market prices do not fully account for the social cost of the good.

Third, markets for some goods fail because these goods, by their very nature, are unsuited for efficient management by markets. In Chapter 20, we will analyze goods that fall into this category because of problems of private information—information about a good that some people possess but others don’t. For example, the seller of a used car that is a “lemon” may have information that is unknown to potential buyers. With private information, a high price need not signal good quality. In the used car market, asking for a higher price than a car is worth hides the fact that it is secretly worth less!

In Chapter 17, we will encounter other types of goods that fall into the category of being unsuited for efficient management by markets—public goods, common resources, and artificially scarce goods. Markets for these goods fail because of problems in limiting people’s access to and consumption of the good; examples are fish in the sea and trees in the Amazon rainforest. In these instances, markets generally fail due to incomplete property rights.

But even with these caveats, it’s remarkable how well markets work at maximizing the gains from trade.