2. TYPES OF MARKETS

Analysts must understand the demand and supply model of markets because all firms buy and sell in markets. Investment analysts need at least a basic understanding of those markets and the demand and supply model that provides a framework for analyzing them.

Markets are broadly classified as factor markets or goods markets. Factor markets are markets for the purchase and sale of factors of production. In capitalist private enterprise economies, households own the factors of production (the land, labor, physical capital, and materials used in production). Goods markets are markets for the output of production. From an economics perspective, firms, which ultimately are owned by individuals either singly or in some corporate form, are organizations that buy the services of those factors. Firms then transform those services into intermediate or final goods and services. (Intermediate goods and services are those purchased for use as inputs to produce other goods and services, whereas final goods and services are in the final form purchased by households.) These two types of interaction between the household sector and the firm sector—those related to goods and those related to services—take place in factor markets and goods markets, respectively.

In the factor market for labor, households are sellers and firms are buyers. In goods markets: firms are sellers and both households and firms are buyers. For example, firms are buyers of capital goods (such as equipment) and intermediate goods, while households are buyers of a variety of durable and non-durable goods. Generally, market interactions are voluntary. Firms offer their products for sale when they believe the payment they will receive exceeds their cost of production. Households are willing to purchase goods and services when the value they expect to receive from them exceeds the payment necessary to acquire them. Whenever the perceived value of a good exceeds the expected cost to produce it, a potential trade can take place. This fact may seem obvious, but it is fundamental to our understanding of markets. If a buyer values something more than a seller, not only is there an opportunity for an exchange, but that exchange will make both parties better off.

In one type of factor market, called labor markets, households offer to sell their labor services when the payment they expect to receive exceeds the value of the leisure time they must forgo. In contrast, firms hire workers when they judge that the value of the productivity of workers is greater than the cost of employing them. A major source of household income and a major cost to firms is compensation paid in exchange for labor services.

Additionally, households typically choose to spend less on consumption than they earn from their labor. This behavior is called saving, through which households can accumulate financial capital, the returns on which can produce other sources of household income, such as interest, dividends, and capital gains. Households may choose to lend their accumulated savings (in exchange for interest) or invest it in ownership claims in firms (in hopes of receiving dividends and capital gains). Households make these savings choices when their anticipated future returns are judged to be more valuable today than the present consumption that households must sacrifice when they save.

Indeed, a major purpose of financial institutions and markets is to enable the transfer of these savings into capital investments. Firms use capital markets (markets for long-term financial capital—that is, markets for long-term claims on firms’ assets and cash flows) to sell debt (in bond markets) or equity (in equity markets) in order to raise funds to invest in productive assets, such as plant and equipment. They make these investment choices when they judge that their investments will increase the value of the firm by more than the cost of acquiring those funds from households. Firms also use such financial intermediaries as banks and insurance companies to raise capital, typically debt funding that ultimately comes from the savings of households, which are usually net accumulators of financial capital.

Microeconomics, although primarily focused on goods and factor markets, can contribute to the understanding of all types of markets (e.g., markets for financial securities).