According to Fama (1970), market efficiency refers to “a market in which prices always ‘fully reflect’ available information.” In discussing market efficiency, three sets of information are considered and include historical prices, publicly available information, and private information. Market inefficiency therefore refers to a condition in which current prices of common stocks and similar securities do not reflect all the public information about a market. This theory opposes the efficient market hypothesis. Market inefficiency is also used to refer to a market that is not operating efficiently, for example, low-volume stocks traded over the counter represent an inefficient market when contrasted with blue chip stocks.
Market failure is becoming increasingly important to economists. Market failure refers a situation where, in any given market, the quantity of a good demanded by the consumer fails to match the quantity provided by suppliers. It is a situation in which free markets fail to allocate resources efficiently. Markets will not be able to efficiently allocate resources if they are not competitive or when property rights are not fully defined and fully transferable. To this end, market failure occurs under natural monopoly, public goods, externalities, asymmetric information, moral hazard, and transaction cost. All these conditions legitimize regulation of markets.
Under what conditions do markets fail to efficiently allocate scarce resources?
It is difficult for the modern market to meet the stringent requirements for a perfectly competitive market. The existence of monopoly power has been associated with potential for market failure calling for intervention measures to correct some of the welfare consequences of monopoly power. Classical economics holds that under monopoly, the prices are much higher and the output is low as compared to competitive market (Young, 2010). In some cases, monopoly can exist where there is one supplier, for example, in markets with only two firms controlling the larger market share. As defined in the 1998 Competition Act, abuse of dominant power implies that a firm can ‘behave independently of competition pressure’ (). In an attempt to control mergers, regulators in the UK consider that if two firms merge to create a market share of 25% or more of a particular market, the merger in question may be ‘referred’ to the Compensation Commission, and may result into its prohibition.
Activities of the private market create spillovers or externalities. These include any benefit or cost not accounted for in the price of goods or services. Externalities are potential causes of market failure. Externalities take two forms, positive and negative (Popp, 2006). A positive externality occurs when a producer is not able to estimate all the benefits of the activities it has undertaken. For example, research and development project that yields benefits to the society such as employment that the producer is not able to capture. The main problem here is the absence of a clearly defined property rights for the producer which may make them under-invest in the activities unless the government intervenes. This calls for government intervention in defining property rights so as to avoid market failure. Conversely, negative externalities occur when the producer is not charged for all the costs including impacts such as pollution from manufacturing plants. Since the external cost is excluded from the calculation that producers make, the producer supplies more of the good than is socially beneficial. Both positive and external externalities call for some kind of regulation to make it more efficient.
It has been proposed that taxing activities that produce negative externalities is the best solution in ensuring that the cost is paid (Mankiw, 1998). An example of this approach is emission taxes on factories to ensure that they pay for polluting the environment. Another policy includes regulating the level of activity permitted with the introduction of laws prohibiting loud parties after a particular time. The problem created by externalities is that companies do not fully measure the economic cost of their actions. They are not forced to minus these costs from their revenues, which means that he profits inaccurately depicts company’s actions as positive. This results into inefficiency in the allocation of resources. Since neither the private individuals nor the market can be given the responsible of preventing this inefficiency in the economy, the government must come in. the major goal of the government is to force companies to internalize externality cost (Popp, 2006). To this end, if a company’s pollution results into economic cost (for example medical cost undergone by a patient who gets sick due to pollution), then the government will force that company to cover the cost. In order to achieve such goals, the government can use any of the following regulations; tax companies for polluting, pollution limits, or gives out tradable pollution permits.
Lack of information or asymmetric information among buyers and sellers at the time they act may make the markets not to perform efficiently. The lack of information means that the demand prices do not reflect all the benefits associated with the good or the supply price does not reflect all the opportunity cost of production (Shogren and Taylor, 2008). This implies that consumers might be willing to pay more or less for a good because they are not aware of the true benefits associated to it. On the other hand, sellers might be willing to accept less or more for a good than the true opportunity cost of production. In most instances, suppliers have better information about a good than buyers because they own and have direct contact with the good. In contrast, buyers have less familiarity with the good except for the information given by the supplier.
When participants in a market have incomplete information, the markets may not function efficiently. This may call for mandating provision of information through government legislation. However, regulation may not be warranted in all situations involving asymmetric information. In addition, information has value implying that it has demand attached to it. For example, when buying a used car, the potential buyer might take the car to a mechanic for inspection to come up with appropriate value.
Another cause of market inefficiency is moral hazard. This refers to the presence of incentives that gives people a reason to incur costs they do not have to pay (Young, 2010). For example, provision of flood insurance funded by the federal government may encourage people to live in flood-prone area which leads to socially inefficient local decision. Similarly, individuals with medical insurance have unlimited demand for medical care, since they do not have to bear the cost of care they receive. Regulation serves as an attractive response to moral hazard problems, but it can also cause moral hazard thereby making regulation itself less effective. An article written by Peltzman argued that safety regulation for drivers induce them to take more risk, which therefore reduces effectiveness of compulsory safety standards (Mankiw, 1998).
Lastly, costs resulting from market transactions can result into market failures. To that end producers and consumers incur costs in the process of getting information about market opportunities and completing market transactions. Regulations are brought into place to reduce these costs in order to improve market efficiency (Shogren and Taylor, 2008). For example, the global emissions standards for the auto industry can enhance efficiency since auto makers will not have to produce different models for different countries.
In conclusion, the government has come up with regulation of production, consumption, and exchange decision undertaken by the private sector. In other terms, the government sets the rules of the game, a duty undertaken for the wellbeing of the society, but in this case, specifically directed toward ensuring efficient market. An example includes government actions aimed at restricting the amount of emissions from a particular production activity. Government regulations requiring producers to provide information to consumers is a means of addressing market failure of asymmetric information. Government intervention to avert market failure include pollution taxes to correct externalities, regulation of oligopolies, taxation of monopoly profits, direct provision of public goods such as defense, policies to introduce competition into markets, and price control for recently privatized utilities.
Fama, E., 1970. Efficient Capital Markets: A Review of Theory and Empirical Work, Journal of Finance 25, 383-417.
Mankiw, N.G., 1998. Microeconomics, Volume 1. Amsterdam: Elsevier.
Popp, D., 2006. R&D Subsidies and Climate Policy: Is There a "Free Lunch?" Climatic Change 77, 311-341.
Shogren, J., Taylor, L., 2008. On Behavioral-Environmental Economics. Review of Environmental Economics and Policy 2, 26-44.
Young, P., 2010. Innovation Diffusion in Heterogeneous Populations: Contagion, Social Influence, and Social Learning. American Economic Review 99, 1899-1924.