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paratus associated with government, only to the extent necessary to ensure
the maintenance of the conditions of a market system.
A society based on these conditions, starting from a previous state of
individual autarky, without any specialization or exchange, can be seen
as rapidly developing into an intricate exchange system. For such a suc-
cessful development to occur it is however necessary that some commodity
emerge in the market which is a generally accepted medium of exchange.
With exchange confined to direct barter of goods or services for other goods
or services, there can be only a limited scope for market activity. It can be
confidently assumed however that the existence of market activity, even if
limited, will create numerous opportunities for individuals to improve their
positions by engaging in indirect exchange. An individual would give goods
or services in return for goods that he does not himself desire, in hope of
being able to exchange these goods later on for others that he does desire
(but that cannot be had in exchange for his original goods or services).
Widespread activity involving such indirect exchange can in turn aid the
emergence of a commodity generally accepted as a medium of exchange.
THE MARKET: ITS STRUCTURE AND OPERATION 15


Individuals will readily accept this commodity (money) in exchange for
their goods or services, having complete confidence in their ability to use
this commodity whenever they wish, to buy other goods or services at prices
(in terms of the money commodity) more or less definitely known in advance.
For the purposes of the market system analysis undertaken in this book,
we may assume that the system's history includes the evolution of a fully de-
veloped monetary machinery. The market has become completely adjusted
to a system of money; all economic calculation is carried out in terms of
money values, all prices are money prices, and all market transactions are
exchanges of goods or services against money. (Nevertheless, for our pur-
poses, we assume that the market operates exactly as it would operate with-
out the existence of a money supply, but simply enjoys freedom from the
inconveniences connected with direct barter. In other words money is
assumed to succeed in lubricating the wheels of exchange, without itself
actively directing exchange activity into channels other than those that
would in principle be used in the absence of money.) * •

MARKET ROLES
With the conditions governing the market system firmly in mind, we
may turn to observe the different roles within the market process that can
be filled by individual market participants.
Classification of roles as carried out by the economic theorist is quite
different from classifications carried out from other points of view. A
difference between two individuals is significant for the theorist only as
it corresponds to a difference in market function. Market theory is or-
ganized within a conceptual framework that recognizes distinctly several
such market functions.
1. Consumers. At the root of the whole matter lies the concept of
action. Human beings act, we have seen, to improve their positions, so
far as they believe themselves able to do so. Individuals participate in
the market only with this final goal of improving their positions. An
individual may find it necessary to undertake many different activities
within the market, but the ultimate purpose of all these activities will
always be to purchase (or obtain the power to purchase) goods and services
whose possession enables him to enjoy directly an "improvement in his
position." Such goods and services are spoken of as being purchased for
1 It must be emphasized that in a real world, money can never be "neutral." The
introduction of a medium of exchange into an economic system necessarily alters the ac-
tions of market participants because a medium of exchange is always more than just a
medium of exchange. (Tn particular, people may seek to hold money as a particularly
desirable form of asset under conditions of uncertainty.) It is the task of monetary
theory to investigate these complications arising from the use of money in a market sys-
tem. In this book we abstract from these complications.
16 MARKET THEORY AND THE PRICE SYSTEM


consumption. The primary role of every participant in the market, is
thus that of consumer.
The consumer enters the market with money to purchase goods and
services for consumption. This money has come into his possession as
a result of his activities in the market (in some other role). In his role
of consumer, each individual chooses between alternative patterns of con-
sumption spending. He finds numerous opportunities to buy different
kinds and quantities of consumer goods and services, each at its announced
price. His means are clearly insufficient to make it possible to take ad-
vantage of more than a few of these opportunities. As a consumer, he
must choose between the alternatives available to him. In analyzing the
market behavior of men in their roles of consumers, market theory pri-
marily focuses attention on the way consumers react to different possible
patterns of available alternatives.
2. Resource Owners. Consumption goods and services, as a rule, are
not directly available in nature for the taking. They must be produced
from available resources. Raw materials may have to be transformed.
Different materials may have to be combined. Goods may have to be
transported to where they are to be consumed. All these productive ac-
tivities are in general necessary; all such activities have something in
common. They invariably involve the planned combination of the pro-
ductive services of many different resources. The various possible ways
of classifying resources will be considered in a later chapter.2 Here it is
sufficient to notice that in order to produce it is necessary to combine,
say, the services of raw materials, manmade tools and equipment, physical
space, human labor of a number of different varieties, and so on. In a
system based on private property, it is likely that most, if not all, productive
resources are the private property or are under the control of individual
members of the system. These individuals are resource owners.
They are owners of raw materials, men with labor services to sell,
and so on. Resource owners have an obvious role in the market system.
All productive activity must begin with the purchase of the services of
the necessary productive resources. These purchases are made from re-
source owners. Market theory analyzes the way resource owners respond
to the alternative opportunities of resource sale presented to them by the
market and to changes in these opportunities.
3. Entrepreneurs. Under the heading "resources," we have included
everything whose services are necessary to obtain products. There is no
productive service necessary for the production of any desired good or
service that can be purchased from anyone other than the proper resource
owner. And yet there still remains one further role in the market system,

2 See Ch. 8, p. 150.
THE MARKET: ITS STRUCTURE AND OPERATION Ì7

without whose successful fulfillment production would be hopelessly in-
efficient. This is the role of the entrepreneur. The entrepreneur's role is
to decide what resources should be used, and/or what goods and services
should be produced; he makes the ultimate production decisions. These
decisions must involve speculation concerning an uncertain future, since
in its pure form an entrepreneurial decision is an act of purchase followed
by a subsequent act of sale of what was previously purchased.
Among market roles, the entrepreneurial role is the least simple to
grasp. The source of its elusiveness lies in the fact that some element
of the entrepreneur's speculative function is exercised whenever human
beings act. In fact we must recognize that in theorizing about the making
of decisions, we may be concerned with two analytically distinct kinds of
decisions. First, there is the decision between definite alternatives. Here
the adoption of any one definitely known objective is accompanied by
the sacrifice of a no less precisely known set of alternative potential ob-
jectives. This kind of decision making is clearly never possible in the real
world of uncertainty (in which we wish our market system to have its
setting). In a world of uncertainty men must invariably make a second
kind of decision, one choosing between courses of action whose outcomes
are quite uncertain, being susceptible to numerous possible unforeseeable
modifications by external events. Although we can never expect to find
actual instances of the first kind of decision, we may sometimes theorize
concerning decisions of the second kind by temporarily reasoning as if
the outcomes were not clouded by uncertainty. In reasoning in such a
way the economist is abstracting from the speculative or "entrepreneurial"
element in the making of the particular decision.
In speaking, however, of a distinct entrepreneurial role to be filled
by hypothetical agents to whom we assign the name entrepreneurs, we
are drawing attention to a unique class of decisions that it is essential for
market theory to distinguish. In a system where specialization and di-
vision of labor have been carried to a fairly advanced stage, there is room
for a class of decisions for which uncertainty is of the essence (thus to speak
about such decisions as if they were made in a world without uncertainty
would be self-contradictory). In such a specialized market system, it is
possible to purchase all the productive services necessary for the produc-
tion of a proposed good, at a definite total money cost. Similarly, when
the good has been produced, it too can be sold in the market for a definite
sum of money. By itself, a decision simply to buy a group of resources,
or their productive services, involves no essentially speculative element;
neither does a decision to sell a finished product, once it has been produced.
But the decision to buy a bundle of productive resources at one price in
order to resell "them" (that is, the finished product for whose production
these productive services suffice completely) later at a higher price, is
18 MARKET THEORY AND THE PRICE SYSTEM


essentially speculative. In a market there is constant opportunity for
this kind of decision to be made, and we distinguish the "pure" function
of making this kind of decision by referring to it as the role of the en-
trepreneur. The entrepreneur must simultaneously make the decisions
concerning which good he will produce and which resources he will use
in its production, under the condition that he can expect only an un-
certain price for the product when it will be sold. The entrepreneur
makes one such speculative decision out of innumerable possible specu-
lative decisions.
Of course, we must immediately point out that in a market system any
one person is likely to fulfill more than one of these three "market roles."
All resource owners and entrepreneurs are also consumers. We have
already noticed, too, that a decision by an individual in his role of con-
sumer or resource owner invariably involves an entrepreneurial element.
Similarly, an individual whose activities are primarily entrepreneurial is
likely to combine with them activities belonging to one or both of the
other possible market roles. A producer may be contributing his own
capital, and will quite probably be directly supplying supervisory labor
services to the production process. In this way, he is acting in part as
a resource owner. A producer may engage in entrepreneurial speculation
not only in order to secure profits, but also because he obtains a peculiar
thrill from taking bold risks. In this way, he is acting in part as a con-
sumer. The resolution by the theorist of the integrated activities of a
market participant into the three general, distinct, functions is purely a
matter of analytical expedience. We understand the market process more
fully, we will find, because we understand that individuals perform a variety
of functions that are susceptible to a separate theoretical "explanation."

THE STRUCTURE OF THE MARKET SYSTEM:
VERTICAL RELATIONSHIPS
The analytical isolation of the various possible market roles leads
directly to the perception of a unique structure of human actions within
the market system. The recognition of market structure is in turn the
indispensable step toward the understanding of market operation.
In asserting that there is a structure in the decisions made in the
market place, we mean simply that the decisions belonging to each of
the various market roles are linked in a stable pattern of relationships.
Decisions of resource owners, for example, are conditioned on the one hand
by the urge to gain money income, and on the other hand by the different
alternatives offered by various entrepreneurs. The decisions of consum-
ers are conditioned on the one hand by his own tastes and income, and
on the other hand by the different alternatives offered to him by various
19
THE MARKET: ITS STRUCTURE AND OPERATION

entrepreneurs. The decisions of the entrepreneur, in turn, are conditioned
by a simultaneous appraisal of the various alternatives offered to him by
those he is able to buy from, and of the various alternatives offered to him
by those he may be able to sell to; and so on.
In this section we notice, first of all, markets related to each other
"vertically." A vertical relationship can be said to exist between two
markets when goods or services bought in one of the markets are sold
(either alone or in combination with other goods or services) in the other
market. The simplest possible notion of vertical structure within the
market system may perhaps be obtained from Figure 2-1. The figure

Resource
\
Owners


Market for
Productive Services



Entrepreneurs
)


Market for Products



Consumers



Figure 2-1

shows here that the market system consists of two markets; a market for
products (in which entrepreneurs are the sellers and consumers are the
buyers), and a market for productive services (in which resource owners
are the sellers, and entrepreneurs are the buyers).3 The structural rela-
tionship between the markets is seen, for example, by noticing that the
prices consumers are willing to pay for particular products in the product
market will determine the prices entrepreneurs can offer for particular
resources in the market for productive services (also termed the resource
market or the factor market).
A more realistic view of the vertical structure of a typical market
system would recognize that the activities of the entrepreneur may result
in the production not only of goods for the consumer, but also of produced
goods that can provide productive services with which other producers may
3 Later in this chapter, the legitimacy of speaking of separate "markets" within the mar-
ket system is discussed. In reality, of course, there is only one market where all participants
meet.
20 MARKET THEORY AND THE PRICE SYSTEM


produce goods or services for the consumers. The Austrian economist
Menger introduced the concept of the "order" of a good to express this
kind of complexity. A good demanded for consumption is a good of
"lowest order." The goods required for the production of goods of lowest
order are goods of second order, those required for the production of second
order goods are the third order goods, and so on. The point is that entre-
preneurial activity will be possible wherever there are two "vertically
adjacent" markets; one market for a particular good, and another market
in the goods of higher order with which the particular good can be pro-
duced. The complex vertical structure of a developed market system can
now be glimpsed more fully. There are not merely the two markets whose
relationship is indicated in Figure 2-1; there are likely to be numberless
markets related vertically to each other in such a way. Between each pair
of adjacent markets, there will be entrepreneurial activity. The entre-
preneur will buy in the one market, produce, and sell in the market
"below" it. (Here again, incidentally, the entrepreneurial role is closely
integrated with that of resource owner. The initial decision to buy and
sell in the different markets is an entrepreneurial one; but once the
entrepreneurial decision has been made, and the good of higher order has
been produced, the entrepreneur finds himself selling in the "lower"
market just as any other resource owner.)
Moreover, although the vertical relationship between two markets may
appear to stamp one of them as being "higher" than the other, there may
be some other equally valid point of view from which the order of relation-
ship is reversed. For example, iron ore is used in the production of steel
which in turn is used in the production of equipment which plays a part
in the mining of iron ore. The decisions of entrepreneurs buying iron
ore in order to produce steel will be influenced in part by the decisions
of those to whom they sell; that is, the entrepreneurs engaged in the pro-
duction of mining equipment. But these latter decisions will clearly be
partly influenced by the decisions of those buying this equipment”the
miners of iron ore.
There are certainly strands of a vertical relationship existing between
the market for iron ore, and the market for mining equipment, where
the latter market is the higher; but there are, no less clearly, other strands
of a vertical relationship between the two markets where the market for
iron ore is the higher.

THE STRUCTURE OF THE MARKET SYSTEM:
HORIZONTAL RELATIONSHIPS
Two markets may be said to bear a horizontal relationship with one
another, either when the goods or services sold in each of the separate
THE MARKET: ITS STRUCTURE AND OPERATION 21

markets were both bought, in part (directly or indirectly), in the same
"higher" market, or when the goods or services bought in each of the
separate markets is to be sold (in combination with other resources) in
the same "lower" market. Thus the market where washing machines are
bought and sold, is related horizontally to that where automobiles are
bought and sold, since the entrepreneurs in either of these markets will
be bidding against one another in the same higher market”that for steel.
Similarly, the labor market is related horizontally to the market where
labor-saving machinery is bought and sold, since buyers in each of these
markets are likely to be selling their products in the same lower market.
Or again, the market in skilled labor for the production of automobiles
is related horizontally to that for steel, because the resources sold in both
these markets are combined and sold jointly in the automobile market;
and so on.
Clearly, the decisions of buyers or sellers in any such markets will have
to be between alternatives that are conditioned, not only by the decisions
of competing buyers or sellers in the same market, but also, in part, by
the decisions of buyers or sellers in the horizontally related markets. The
price of steel to producers of washing machines will be determined partly
by the strength of the demand for automobiles; the price that a skilled
automobile worker can obtain for his labor will be determined in part
by conditions in the steel market; and so on.
It should be clear from our discussion of the complexity of vertical
market relationships that horizontal relationships, too, may be far from
straightforward. Two markets may be related by different strands of
connectedness, some of which may be vertical, others horizontal, in charac-
ter. For example, sellers in the iron-ore market and sellers in the steel
market may both buy the services of unskilled labor in the same labor
market.
Several points of great importance ought to be made at this stage
concerning the division of the market system into separate "markets." It
must be recognized that any such division is quite arbitrary and is made
by the market theorist only as a matter of convenience. Moreover, there
are significant problems where the theorist finds it convenient to stress
the lack of such watertight divisions. The fact is that in the most impor-
tant sense, the entire market system is one market. Each market participant
is a potential customer for each good offered for sale and a potential en-
trepreneur in the production of every conceivable product. There is inter-
connectedness between every single market decision and every other single
market decision made in the system. The price paid for a shoeshine at
one end of the country is connected, however tenuously, with the prices
paid for the rental of high-speed computers at the other end of the coun-
try, so long as both points are within a single market system. Nevertheless,
22 MARKET THEORY AND THE PRICE SYSTEM


there are clearly various degrees of connectedness. The price of computer
rentals is obviously more directly sensitive to changes in the attitudes of
buyers and sellers of computers than to changes in the tastes or incomes of
customers for shoeshines. Thus, the theorist finds it convenient to mark
off arbitrarily different "markets" within which the connectedness of de-
cisions is more direct than is the case between decisions in different markets.
In pointing to various structural patterns between the markets that make
up the market system, the theorist is indicating the less direct, more subtle”
but over the long run no less powerful”influences that different markets
exercise over one another.

THE ANALYSIS OF HUMAN ACTION IN THE MARKET:
THE CONCEPT OF EQUILIBRIUM
With the mutual influences that may be operative between markets
well understood, it is desirable to consider what goes on inside a market.
This is, after all, the kernel of market theory”the logical tracing through
of the consequences within a market of given sets of data that impinge
upon it.
A market process can be defined as what goes on when potential buy-
ers and potential sellers are in mutual contact. We have seen that the
market system as a whole can be treated as a single market, or that it may
be treated for convenience as consisting of a number of interconnected
markets. Within any market, however conceived, the theorist recognizes
that at any one time each participant has definite attitudes concerning
what is being bought and sold. At a given point in time, each participant
has a particular eagerness to buy or to sell; for each participant there is
on his "scale of values" a unique position assigned to each quantity of
the commodity to be bought or sold. When a large number of such
potential market participants come into contact with one another, many
find opportunities for gainful action. Some buy at the going price, others
sell; some find it gainful to bid prices higher than those currently quoted;
some find it gainful to offer prices lower than the current prices.
The theorist usually attacks the problem of market analysis in the
following way. He takes the attitudes of the various market participants,
as they are assumed for any one date, and imagines that these attitudes
are maintained continuously over an indefinite period of time. He may
then describe a pattern of actions for the various participants that, if
actually adopted, would not have to be revised. For example, the theorist
may suppose that milk suppliers come daily to market with a continuous
and constant supply of milk (concerning which their selling attitude is
assumed to continue unchanged), and that prospective milk consumers
similarly maintain, from day to day, an unchanged degree of eagerness
THE MARKET: ITS STRUCTURE AND OPERATION 23


concerning the purchasing of milk. The theorist may then describe terms
on which suppliers might sell and consumers buy milk, that, if actually
put into practice, would leave no opportunity for any market participant
to improve his position in the future through a change in his actions.
This fictional construction of the economic theorist is known as the state
of equilibrium. The prices the milk is sold at, and the quantities of milk
bought at these prices, are equilibrium prices and quantities.
Should the market participants (whose attitudes are assumed to be
maintained without change) take actions that do not correspond to those
that characterize the equilibrium market, then pressures will emerge on
the participants that will lead them to alter their actions. Should, for
example, the sellers of milk offer their milk at a price higher than the
equilibrium price, then some sellers will find that milk sales are so low
that it would be profitable for them to undercut the existing price. The
non-equilibrium price would generate economic forces that would ensure
that subsequent prices are different; and so on.
The state of equilibrium should be looked upon as an imaginary sit-
uation where there is a complete dovetailing of the decisions made by all
the participating individuals. Every single supplier of milk, for example,

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