Lecture 2 Market Failures PDF

Lecture 2 Market failures Diego Valiante, Ph.D. Views are strictly personal and LEIF Master Programme cannot be attributed in any way 87507 - FOUNDATIONS OF RISK to the European Commission....

Lecture 2 Market failures Diego Valiante, Ph.D. Views are strictly personal and LEIF Master Programme cannot be attributed in any way 87507 - FOUNDATIONS OF RISK to the European Commission. REGULATION IN FINANCIAL MARKETS  Agenda The Robinson Crusoe’s economy Coase Theorem and its evolution Key market theories Efficient Market Hypothesis (EMH) Market failures 1. Information asymmetry 2. Public good provision 3. Negative externalities 4. Knightian uncertainty 5. Market power (e.g. natural monopoly or cartel) 6. Bounded rationality (next lecture) © Valiante Diego - 2  Definition A market failure can be described as a situation in which the allocation of resources obtained through the market economy is not efficient in a Kaldor-Hicksian perspective, and this can lead to the loss of economic value. © Valiante Diego - 3  Study questions What are key sources of market failures? What are examples that we can identify from financial markets and banking practice? What are the main remedies for such failures? © Valiante Diego - 4  Market failures and potential remedies © Valiante Diego - 5  Transaction costs A transaction cost is generally defined as any (direct or indirect) friction to parties’ negotiation. – “The cost of exchange” (Cooter-Ulen) Opportunism (self-interest) is central in the study of transaction costs. Three main categories: 1. Search costs High for unique goods/services and low for standard ones 2. Bargaining costs Not all information is public (to establish the other party’s reserve value for a good or service) The more private information the higher the cost More parties creates collective action problems Behavioural biases, hostility, etc.. 3. Enforcement costs Simultaneous exchange or not Complexity Multiple agents ‘Transaction-specific’ and ‘non-transaction specific’ (Williamson 1975) Transaction costs can lead to vertical integration (Williamson 1979) © Valiante Diego - 6  Sources of Transaction costs Main sources of TCs that can lead to market failures in financial markets: 1. Information asymmetry 2. Public good provision 3. Negative externalities 4. Knightian uncertainty 5. Bounded rationality 6. Market power (e.g. natural monopoly or cartel) © Valiante Diego - 7  Information asymmetries © Valiante Diego - 8  1. Information asymmetries Information asymmetry refers to all those situations in which one party to a transaction has an informational advantage over the other. Knowledge of given benefits and costs (or reserve prices) is private information. Three main sources of informational asymmetries in financial services can lead to targeted market failures: 1. Credence nature of financial services Market failure: Structural mispricing (adverse selection). 2. Withheld private information Market failure: Opportunism/strategic behaviour (moral hazard). 3. Transaction-specific investments (TSIs) features Market failure: Lock-in effect and underinvestment (hold-up). © Valiante Diego - 9  1. Information asymmetries Information asymmetry refers to all those situations in which one party to a transaction has an informational advantage over the other. Knowledge of given benefits and costs (or reserve prices) is private information. Three main sources of informational asymmetries in financial services can lead to targeted market failures: 1. Credence nature of financial services Market failure: Structural mispricing (adverse selection). 2. Withheld private information Market failure: Opportunism/strategic behaviour (moral hazard). 3. Transaction-specific investments (TSIs) features Market failure: Lock-in effect and underinvestment (hold-up). © Valiante Diego - 10  Credence goods (Darby & Karni 1973) Search goods – Quality can be ascertained to a great extent before the purchase, during the search process (e.g. pen, book, table, style of a dress) Experience goods – Quality can be ascertained only after the use, costlessly (e.g. durable goods like a car) Credence goods – Quality cannot be ascertained even after normal use (e.g. financial products, car repair services) – Assessment requires additional costly information In the case of financial products, the investor frequently has to buy advice or other risk signalling mechanisms to understand more about quality. – Due to structural contract incompleteness, specification costs are very high (so TCs) © Valiante Diego - 11  Credence qualities – The traditional example of the car repair and investment advice Owner of good car is D.05 so he performs better than the 95% of the car owners, but he may be induced to believe that he is Dm instead (i.e. average performance). Credence qualities can lead to ‘churning’ in investment advice – “excessive buying and selling of securities in your account by your broker, for the purpose of generating commissions and without regard to your investment objectives” (SEC) – It is a misuse of the fiduciary role between intermediary and customer, due to the lack of monitoring by the latter (e.g. due to information asymmetry) Financial advisors who are paid commissions may find it easier to increase revenues through churning when customers already have a bias towards excessive trading. © Valiante Diego - 12  Adverse selection © Valiante Diego - 13  Adverse selection Pre-contractual information asymmetry – Risk/quality assessment costs (Inability to evaluate risk) Outcome: Market breakdown (worst scenario in the spectrum) Key conditions: 1. Unobserved characteristic of product/service/individual 2. Divergence of interest between parties (i.e. advantage by withholding information) 3. Some gainful exchange among parties Two main implications: – Misselling – Deterioration of market quality Market forces unable to reach a clearing price where demand meets supply © Valiante Diego - 14  Adverse Selection – The market for Lemons (Akerlof, 1970) Car dealer and buyer The buyer can be sold a lemon or a good car Buyer is unable to assess quality – Value of good car is 100 with probability q – Value of the bad car is 20 with probability (1-q) – q