Why markets exist

Published July 5, 2021
The writer is a financial markets professional and a teacher.
The writer is a financial markets professional and a teacher.

GEORGE Akerlof won the Nobel Prize in economics in 2001. His paper, The Market for Lemons, is a seminal work in the discipline. He wrote it in 1967 as a fresh assistant professor at Berkeley, having completed his PhD at MIT in 1966. The paper was rejected by three prestigious journals, by two on the grounds of triviality and by the third on the grounds that it would upend the then prevailing understanding of economics. It was finally published by the Quarterly Journal of Economics, in 1970. The Market for Lemons is about markets and transactions. In Akerlof’s own words “It concerns how horse traders respond to the natural question: ‘if he wants to sell that horse, do I really want to buy it?’”

Akerlof uses the example of the used car market to illustrate the point. In any given market, some cars will inevitably be of bad quality (lemons, in the slang) and some of good quality (peaches).

Any seller, as the current owner of the car, always has better information about the quality and inherent value of the car than any buyer. A buyer contemplating a purchase does not know if the car is a peach or a lemon. Let us say the fair value of a peach is Rs2,000,000 and that of a lemon Rs1,000,000. The buyer, under the circumstances, can expect equally to get either a peach or a lemon and will therefore offer an average of the two prices ie Rs1,500,000. At this price the owners of the lemons will be happy to sell but the owners of the peaches will withhold their cars from the market since the price offered is less than the fair value. There is thus a market malfunction.

We can take it a step further. If a certain number of peaches are withheld by the sellers, buyers will revise their expectations of the average proportion of lemons to peaches and will bid even lower than Rs1,500,000. The malfunction intensifies. The root cause of the problem is of course the existence of unequal information. Economists have a fancy phrase for it — information asymmetry.

Information asymmetry may make the investor hesitant and therefore the transaction less likely.

Any market malfunction is serious because it results in a loss of economic efficiency — transactions which could have added value to both parties do not happen. In response, markets — the institutions, rules and regulations which govern them — have evolved over time to become more efficient with positive repercussions for economic growth and development.

Let us take a leap from the used car market to financial markets to see this more closely. Financial transactions are highly susceptible to information asymmetries because of their inherent complexity. Financial markets, for all of their considerable sins, offer insights into the nature and role of markets in general by virtue of their size, scope and sophistication.

Financial markets, at their most basic, provide a mechanism to move money from those who have a surplus to those who have a productive need for money but do not have a surplus. Financial markets, as any other market, are a central meeting place for buyers and sellers (of funds). These meeting places can be physical or — increasingly — virtual. The presence of a large number of participants ensures that buying and selling is easier. Liquidity — the quantum and value of transactions that take place — is an important aspect of markets. The more liquidity you have, the more efficient the market.

Transparency is another key factor. Transactions in financial markets are recorded and the information disseminated. Information asymmetry is to a large extent mitigated. Since each transaction takes place at a certain price at a certain time, markets give critical information about the value of traded assets. This information is more valuable since it is arrived at, not in isolation, but as the net result of the aggregate buying and selling decisions of multiple participants. Economists have a fancy phrase for this too — price discovery.

Let us take a basic financial transaction. Say there is an entrepreneur who is looking to sell shares in her company to outside investors for fresh capital. The entrepreneur will always possess more information on the health of the company than any potential investor will. The position is exactly the same as the seller and buyer in the used car example. The entrepreneur may offer the shares of her company at a certain price. The potential investor has no way to judge the fair value. The information asymmetry may make the investor hesitant and therefore the transaction less likely.

Let us now contrast this with a share transaction at a formal financial market like the Pakistan Stock Exchange. Any company listed on the PSX is required by law to disclose certain information publicly. This includes quarterly financial results, an annual audited result, and all material information which can have an impact on the business and its value. The requirement for information disclosure and its mandatory dissemination by the exchange mitigates the information asymmetry problem. It enables investors to make informed investment decisions.

Furthermore, the share price information is publicly available, indeed during PSX trading hours it is available in real time. There can be no disagreement between a buyer or seller over its price at a given time. The buyer and seller may differ on whether the price is a fair valuation, in which case either may decide not to do the transaction. However, this will not be due to a lack of information.

Markets promote greater economic activity. If markets are non-existent or inefficient, such activity is starved, with consequences for economic development. This holds true for financial markets, goods markets and commodity markets. The latter are a particularly vexatious issue at present in Pakistan, their malfunction due largely to government intervention. One of the historical lessons from centrally planned economies — and why they failed — is that there were no markets and thus not enough information to make optimal economic decisions.

The writer is a financial markets professional and a teacher.

Twitter: @samirahmed14

Published in Dawn, July 5th, 2021

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