Price discovery

The reason markets exist is to allow trade and the reason we trade is because we have different marginal valuations of scarce goods. This video shows how demand and supply both originate from the concept of value.

I like using this video because it shows two really important things. The first is that middlemen don’t add costs to market exchange; rather, competition between middlemen reduce transactions costs and thus improve the efficiency of a market. And secondly, as Brian Albrecht has said:

“There’s no such thing as supply. It’s demand all the way down.”

brian albrecht

We can define transaction costs, as those involved in using the price mechanism. They could be as simple as the petrol it costs to get to the market, or as abstract as the knowledge required to find other sides of the market. The middleman specializes in reducing transaction costs, because they find ways to convert dead weight loss (potentially efficient trades that aren’t being made) into the realm of profit. This doesn’t mean that middlemen will always make consumers and producers better off. But it’s the purpose of the market to balance out the costs of trading directly versus the costs of trading indirectly. Middlemen are like bridges – they increase value by linking traders together. In a competitive market they are optional, and therefore we will only use them if they make our lives easier.

This argument is controversial, because it’s common practice to view middlemen as a source of additional costs. But that’s only if you’re comparing them to the hypothetical idealized state where transaction costs are zero. In the real world they are likely to reduce the costs of exchange.

It’s competition between middlemen that reduces transaction costs, and converts dead weight loss into captured value.

Here’s more on transaction costs: