Types of Financial Market Failure - Speculation, Bubbles, Asymmetric Info, Externalities & Rigging

Market Failure Overview

• Market failure occurs when the allocation of goods and services by a free market is not efficient.

• There are several types, with special focus on:

  • Excessive risk leading to speculation and market bubbles.

  • Collusion and price fixing among financial market agents.

Types of Market Failure

1. Excessive Risk and Speculation

• Speculation defined: Purchasing assets at a low price to sell at a higher price for profit.

• Risk of price decline: If asset value decreases after purchase, speculators face losses, especially in leveraged deals.

Leveraged Deals

• Normal Deal Example:

  • Investment of £10,000 to buy assets worth £11,000, generating a profit of £1,000.

• Leveraged Deal:

  • Borrowing additional funds (e.g., £990,000) to invest in assets, dramatically amplifying gains or losses.

  • After selling for £1,100,000, costs (loan repayment, interest) total £1,010,000, leaving a profit of £90,000, which may seem attractive.

• Problem of Asset Bubbles:

  • Over-leveraging can inflate asset prices beyond their intrinsic value, leading to market bubbles. The withdrawal of demand exposes inflated prices, triggering panic selling and crashes, risking insolvency for investors and banks involved.

2. Asymmetric Information

• Moral Hazard: When banks take risks knowing the consequences will be borne by third parties (government bailouts).

• Adverse Selection: The most risk-prone individuals are often the ones who seek out loans or insurance, arising from gaps in information between buyers and sellers.

Health Insurance Example

• Health insurance premiums attract unhealthy buyers while healthy individuals opt out due to high costs, resulting in unsustainable models for insurers, risking their solvency due to overwhelming claims.

3. Negative Externalities

• Commercial banks ignoring the broader socioeconomic effects of their risky behavior leads to:

  • Costs to taxpayers for bailouts.

  • Loss of savings, jobs, and economic growth due to systemic financial issues.

4. Market Rigging

• Collusion among financial institutions to fix prices and distort markets, leading to:

  • Major scandals in mechanisms like LIBOR and Forex rates.

• Entities involved (e.g., Barclays and JP Morgan) manipulate essential market indicators affecting savings and borrowing rates.

• Ongoing risks from weak enforcement of regulations can perpetuate these behaviors.

Conclusion

• Four specific types of market failures highlight the complexities within the financial system, underscoring the significance of regulatory oversight to prevent excess risk-taking and ensure market integrity.