Economics Chapter: Market Failures and Transaction Costs

Market failures

• A market failure occurs when the allocation of resources from the market is not efficient and leads to a loss of economic value
• Transaction costs include any barrier preventing parties from negotiating effectively
• Examples of market failures include information asymmetry, public goods provisioning, negative externalities, and market power

Transaction costs

• Key aspects of transaction costs are search costs, bargaining costs, and enforcement costs.
• The higher the amount of private information, the higher the cost of bargaining.
• Transaction costs can lead to vertical integration within a firm.

Information asymmetries

• Information asymmetry exists when one party in a transaction has more information than the other party.
• Information asymmetries in financial services lead to market failures through the credence nature of financial services, withheld private information, or transaction specific investments (TSI).

Credence Goods

• Search goods can be easily assessed for quality before purchase.
• Experience goods can be assessed after purchase, but credence goods are difficult to assess for quality even after use.
• The quality of financial products can be difficult to understand even after purchase.
• Assessing credence goods requires costly information.

Adverse selection

• Pre-contractual information asymmetry leads to market failure through adverse selection.
• Adverse selection occurs when buyers are unable to assess the risk/quality of the product or service they are purchasing.
• Adverse selection makes market participants reluctant to participate, leading to potential market breakdown.

Market Failures

• Market failure occurs when resource allocation through the market is inefficient, causing a loss of economic value.

Transaction Costs

• Transaction costs represent any friction (direct or indirect) hindering negotiations between parties.
• Opportunism is central to understanding transaction costs.
• Categories of transaction costs:
  • Search costs: High for unique goods/services, low for standard ones.
  • Bargaining costs: Higher when private information is involved, as the other party's reserve value can be difficult to determine. Complex negotiations increase costs.
  • Enforcement costs: Depend on the complexity of the transaction and the number of parties involved.

Sources of Transaction Costs

• Transaction costs that contribute to market failures in financial markets:
  • Information asymmetry
  • Public good provision
  • Negative externalities
  • Knightian uncertainty
  • Bounded rationality
  • Market power (natural monopoly or cartel)

Information Asymmetries

• One party to a transaction has more information than the other; knowledge of costs and benefits is private.

Information Asymmetries in Financial Services

• Information asymmetries impact financial services in three ways:
  • Credence Nature of Financial Services: Quality is difficult to evaluate even after using the service, leading to structural mispricing.
  • Withheld Private Information: The party with more information can use it strategically, leading to opportunism and moral hazard.
  • Transaction-Specific Investments (TSIs): One party invests in a specific asset or relationship, making them vulnerable to hold-up (higher prices) and underinvestment.

Credence Goods:

• Search goods: Quality is easy to evaluate before purchase (example: pen, book).
• Experience goods: Quality can be assessed after use (example: durable goods like a car).
• Credence Goods: Quality is difficult to assess even after use, requiring additional information (example: financial products, car repairs).

Adverse Selection

• It occurs when a party has private information, creating an imbalance in the transaction (example: buyers with private knowledge about their risk profile or quality of product, leading to mispricing).
• Key conditions for adverse selection to occur:
  • Unobserved characteristics of the product or individual
  • Divergence of interests between parties

Churning

• Excessive buying and selling of securities by a broker (often without the client's best interest in mind) to generate commissions, occurring because of information asymmetry.
• It represents a misuse of the fiduciary role between the financial advisor and the client.

This quiz explores key concepts in economics, focusing on market failures, transaction costs, and information asymmetries. Understand how these elements can lead to inefficiencies in resource allocation and economic value loss. Test your knowledge on examples and implications related to credence goods and public goods.