How markets emerge

Kenneth Arrow (1969) was perhaps the first to point out that markets are not a fixture of the economy, but are the results of decisions made by private economic agents and government agencies. Private agents will establish a market in a particular good only if the costs of doing so are more than met by gains. Such markets are open. Gains are the expected markup over the price paid to owners or producers of the good. Setup costs may be present because there are costs of organization which are independent of scale. These include administration, exclusion, information gathering, and dissemination.

A market for a particular commodity will fail to exist when private calculations show that there is no profit in its existence. No price is quoted and no transactions can take place. Such markets are closed. Market failure arises when private calculations dictate a closed market, but a social calculation shows that a gain is possible through exchange. Government action can make profitable the establishment of a market when there is market failure.

Externality is a case in point: Exclusion is either too costly under existing modes of organization or impossible because property rights have not been established. See Arrow (1969). An auction market in pollution rights could be farmed out to an entrepreneur, if property rights were established, and monitoring mechanisms were sufficiently cheap.