Market failures represent the inability of the market to allocate resources optimally. In the absence of transaction costs optimal allocation would be at the Pareto optimum, that is, where supply and demand meet. Since transaction costs are positive in real life actual trade does not occur at the Pareto optimum. Transaction costs distort market equilibrium diverging thus trade from the optimal point. Either too much or too little is traded of a good. Many economists, including Oliver Williamson and Kenneth Arrow, trace the origin of the different types of market failure to transaction costs. Different types of market failure can be attributed to or associated with different types or levels of transaction costs.

market failure and externalities

The most obvious type of market failure is externalities. Generally, externalities are presumed to be an inefficiency of the price system where prices cannot capture all positive or negative effects of trade. An externality arises when some economic activity affects bystanders or third parties. It is acknowledged in economic literature that there are positive and negative externalities. In the case of negative externalities, the economic activity affects the bystander negatively and is not sufficiently penalized or restricted for causing a negative effect. A famous example is pollution where some production businesses can cause harm to the environment or to society in various ways. Since prices do not capture the magnitude of pollution or do not account for it fully the polluting business remains unpunished. It sells too much of its product at a price too low. There is too much supply of the product causing the externality. Optimal allocation, accounting for the level of harm and pollution, should be on the left of the actual trade. Thus, there is the need to limit negative externalities.

An example of positive externalities

An example of positive externalities is education where those opting for private education invest resources and efforts in gaining education without being sufficiently rewarded. Society benefits from the individual’s efforts to gain education because education is said to create politically savvy individuals. Educated people are believed to better care for their health, be more productive and more contributing to society than uneducated ones. Generally, intelligent people are believed to lead a better life and enjoy greater prosperity than less intelligent ones. The government feels the need to subsidize education at least partly so that to reward individuals who study. The government thus nurtures the positive externality. But the Pareto optimum with positive externalities is on the left of the real-life equilibrium, i.e., too little of the good or service is traded. Transaction costs limit the volume of exchange in the case of positive externalities. With negative externalities transaction costs prohibit limiting the amount of trade. This is because transaction costs cause: 1) an impossibility to define property rights in cases of externalities, 2) technical difficulties in the process of multilateral negotiations when multiple parties to an externality are involved, 3) impossibility to measure the externality in some cases. Thus, externalities of both types can be traced to transaction costs. Indeed, due to positive transaction costs in real life some property rights over economic resources cannot be assigned fully, enforced fully, or evaluated properly. This removes any responsibility from the individual when it comes to the harm he is causing. It is like in the case of a negative externality the individual rides freely on society and the costs it bears due to the harmful activity of the individual or firm. In the case of a positive externality, it is the society which benefits from the actions of the individual taking advantage of his efforts and investments. The hardships of defining property rights might cause substantial transaction costs while it may take substantive resources and time to determine rights and duties.

Market power

Market power is considered another type of market failure. Through organic growth in the competitive process some firm may become more powerful than its competitors. This is an example of naturally grown monopolies which gain significant market power. On the other hand, it is possible for two firms to merge through vertical integration giving thus rise to a bigger firm. The monopoly firm enjoys significant market power. It can set its own price and restrict output to the monopoly level where it is taking the entire market demand. The monopoly price and output hurt consumers considerably. The monopoly price is much higher than the competitive price while the monopoly output much lower than the competitive one. There are natural or artificial barriers to entry with monopoly. Natural monopolies arise out of natural barriers such as economies of scale. Due to the unique technological or other production peculiarities of the industry the firm becomes a sole seller of the good or service. Artificial barriers to entry originate from governmental decisions, i.e., licenses, patents or other designed to limit entry or protect and stimulate inventors.

Monopolies and economic profits

Monopolies achieve excessive economic profits called monopoly rents which deprive consumers of consumer surplus. Monopoly rents are the reason why monopoly is considered an inefficient market structure causing social costs and welfare losses to society. The accumulation of profits allows monopolies to invest in research and development more significantly than other market structures, for instance, monopolistic or perfect competition. Monopolies are also known for price discrimination, an unfair practice where the monopoly can acquire all or part of the consumer surplus enjoyed by customers. With price discrimination the firm charges customers differently based on their: 1) income levels and 2) desire to own the good, and not based on what it costs to produce the good. Thus, a product which costs the same to produce and has the same marginal cost of production may be priced differently for different buyers. The most extreme case is perfect price discrimination where every consumer is charged his reservation price, i.e., the highest price he is able and willing to pay for the good. Since it is difficult for the monopoly to disguise price discrimination practices and charge multiple price levels the monopoly resorts to third-degree price discrimination where consumes are grouped based on their price elasticity. Consumers whose demand for the good is more price-elastic are charged a lower price. Price discrimination allows the monopoly firm to maximize its profit. Therefore, monopoly is often seen as an inefficiency and market power as a market failure.

informational asymmetries

There are informational asymmetries associated with the functioning of the market as well. Examples of such asymmetries are moral hazard, adverse selection, misrepresented quality, etc. Moral hazard is the inclination of economic agents to become negligent and have risky behavior once they get insured against certain economic outcomes. A common example is insurance where insured individuals start behaving hazardously in terms of certain health risks or other. Individuals whose health is insured tend to smoke more heavily than uninsured. Individuals whose house is insured tend to be negligent to its maintenance, etc. The problem of adverse selection is related to that of moral hazard. Prior to concluding a deal one party to the contract has incentives to hide his or her true identity. A potential employee may not reveal his or her true character before signing the employment contract and disguise his features or potential. Once hired, an employee may turn out to underperform, be absent at the job, or lack the skills or features he is expected to have. The employer then has made a bad choice with the employee who acts below the employer’s expectation. This is also a manifestation of the problem of misrepresented quality. One market force, supply or demand, may have more information about the quality and functions of the product than the other. Information thus is asymmetric. The party which has more information has a reason not to reveal it fully so that to take advantage of and expropriate the rents of the other party. Akerlof stresses that misrepresented quality is one of the major problems of contemporary markets since some of them end up in low-end equilibrium. The presence of economic agents who sell low-quality ware as high quality undermines the efforts of the other sellers and erodes the entire market. Asymmetric information can occur on both sides of the market but often it is the seller who has more information than the buyer. Buyers expect cheating to occur and are aware of the low quality in a given market. Akerlof gives the example of the used car market. Buyers eventually stop buying and demand is thus insufficient to meet supply. Mostly “lemon” goods are traded in such asymmetric markets which have the tendency to disappear with the passage of time. Good trade is driven out by bad trade. The market disappears due to quality misrepresentation.

opportunism

Williamson groups all types of information asymmetries under the term “opportunism.” Opportunism is a broader category which incorporates all types of deviant behavior in the market. To Williamson transaction costs are at the core of opportunism which represents the behavioral and transactional failures of the market. Opportunism can take many forms and can occur prior to or after a deal is concluded. Its purpose is to deprive the commercial partner of his rents. Examples of opportunism are the efforts to hide information, disguise the true quality or features of the product, deliver less, delay delivery or payment, pay less than negotiated or steal. Excessive human selfishness is the reason for opportunism to occur in the marketplace.

public goods

Some economists view public goods as a form of market failure. Private agents refuse to supply certain goods which are socially important. It may be that it does not pay to provide these goods and services privately. For instance, orphan drugs for rare diseases are considered undesirable for pharmaceutical producers who are profit driven. This is because the demand for such drugs is rather limited on the market. But the government cannot leave people with rare diseases untreated. Therefore, the government undertakes to produce medication and offer treatment to such individuals. This is only an example of where the market fails to deliver certain commodities. It may be more beneficial for the state to provide those in case of market failures, high transaction costs, or natural monopolies. Another example of a public good which could safely be provided by the state are public utilities which in countries and markets with higher transaction costs are cheaper to operate under the state. The inability of the market to provide all goods and services and the poor market organization of certain activities is the reason why the government has a place in public education, healthcare, defense, military, police, courts, municipalities, etc. The government provides these more cheaply and efficiently than any market.