Markets and Knowledge: A different view

I have to take exception to my co-blogger Don's post about information, markets, and valuation. Don writes:

The belief that markets are fundamentally tied to knowledge and the distribution of information is a common belief, but without merit. It is almost certainly a result of a belief in the fallacy of intrinsic economic value, and a belief that a perfect market is one that results in a price that reflects intrinsic value.

The tie in between markets and knowledge is from the merits of both deductive reasoning and empirical observation. In fact, the deduction of the tie between markets and knowledge is based on subjective valuation of economic goods. A belief in a "perfect market" is not required to determine what a "perfect market" would be like and then compare this perfect market with a more realistic free market or a modern mixed economy.

The first problem in coordinating economic activity, such as engaging in trade, is knowing what another values. Since intrinsic value does not exist, we cannot automatically know another's ranking of values. We can get a good idea that a thirsty man in a desert will desire a quart of water more than a large diamond, whereas a woman at a restaurant in a big city will rank the diamond far higher than a glass of water. But we'll have a much more difficult time predicting whether she desires a steak more than the price of the steak. The first thing that markets must do is provide reliable, accurate information about the desires of the participants. Secondly the markets must provide information about the goods that might fulfill those desires. When we desire something we go into the market to find what good will satisfy that desire. We gain knowledge of how the various goods will meet our desire. We also determine what it will cost us to meet that desire, and we decide whether to satisfy that desire or not. This in turn gives information to the other market participants such as how you rank your various desires and whether they can meet your desires. Thus the market is the mechanism for exchanging information so that we can best fulfill each of our desires.

The logic above can be stretched slightly to determine what a "perfect market" looks like. If a market is an exchange of information then a perfect market is a perfect exchange of information. In other words, as soon as we enter the market we gain perfect knowledge of what all other participants want and what they can offer, and they gain perfect knowledge of what we desire and what we can offer. Since everyone knows what everyone wants and in what rank, we can get the greatest amount of good available for all involved, and we get to instantaneous price equilibrium.

Unfortunately, as humans, we are not perfect and thus not able to perfectly communicate our desires or abilities. Add in the fact that there are a few people who not only do not want to communicate, but would rather misinform us as to their desires and abilities and we get to a more realistic free market. Add in the misinformation, distortions, and outright prevention of information exchange caused by government regulations, taxes, and politician's lies and we get our modern mixed-economy with its vaccine and power shortages.

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David, I appreciate your


I appreciate your response, but it seems to me that the state of affairs that you have described cannot be appropriate for any economy larger than a family or a tribe.

At its most fundamental level, a market is not a source of information, but rather a distiller, a refiner, an encoder, of information; a compressing encrypter of the state of the balance of supply and demand. The output of a market is a market price, a single number. This is largely all that is needed by either a buyer or a seller, and all the information that the market has discarded does not have sufficient value in general to be allowed to clog up the information channel. Buyers and sellers must obtain any additional required specific information by other means, importantly including entrepreneurial judgement.

The subjective rankings of individuals have served their purpose when they result in an individual's action or inaction. They have no importance to a seller trying to satisfy mass consumer demand.

Regards, Don

Don, The state of affairs I


The state of affairs I describe is exactly what occurs in most modern markets. I go to the grocery market to purchase fresh oranges. If the quality and quantity of oranges is low and the price is high I know that supply is down and/or demand is up, and that he and/or his suppliers value oranges more than in the past. I have gained information. When I go through the checkout and there are no oranges in my basket the grocer knows that I don't value low quality oranges at his current prices. We have exchanged information even though we did not exchange oranges and dollars. In the stock market I watch bid and ask prices for the stocks I have an interest in. If the prices are rising I learn that many others think that particular stock is worth more than other investments (or consumption goods). Whatever I do, I am telling the other market participants how I value those stocks.

Where the difference between perfect and realistic markets comes in is that much of that information is aggregated into a price. The imperfection is that each participant gains only a portion of the knowledge that goes into the price, the remainder has to be guessed at, thus we end up with prices doing a random walk around the "perfect price".

As to being a source of information perhaps we are using different meanings of the term "market". I suspect that you are using a much narrower meaning, that is where you mean the actual institution (such as NYSE for an equity) and I mean the more general and abstract definition (the sum of all the exchanges, brokers, listed corporations, clearinghouses, buyers, sellers, analysts, and media when dealing with equities).

David, You are correct about


You are correct about my using a narrower definition of market, but wrong about what it is. My definition has nothing to do with institutions, but with the primary market economic function of balancing supply and demand by finding a clearing price.

Inherently, a market must deal with a single good. The identity of a good is determined by the consumer in that any variations are either ignored or they are not. If the quality of a good, (or any other characteristic) is in question, then various qualities must break the good into multiple goods and multiple markets with multiple market prices.

Market prices are what enable the choices of consumer action and the economic calculations of entrepreneurs. They are the starting point, not the endpoint since market prices are only historical records of past actions.

Regards, Don