1.8.6 Market Imperfections

Imperfect and Asymmetric Information

A key assumption of perfect market efficiency is perfect/symmetric information, where buyers and sellers have equal, complete knowledge.

In reality, information gaps and asymmetric information are common.

Information gaps: a situation where one party lacks the information needed to make an informed decision.

Asymmetric information: a situation where one party in a transaction has more or better information than the other.

These can distort decision-making and lead to market failure.

Consequences of Asymmetric Information

Information gaps: can cause consumers to over/under-consume goods and services, leading to a misallocation of resources and market failure.

For example: a consumer may underconsume healthcare check-ups due to lack of information about their benefits, including the long-term value of preventive care such as catching cancers early.

Asymmetric information: can lead to consumers making poor decisions, such as purchasing low-quality goods or services.

For example: a consumer may purchase a used car without knowing about defects that the seller is aware of and hiding, leading to a loss of utility.

Result: Market Failure

Asymmetric information causes a misallocation of resources.

Markets may over-provide low-quality or harmful goods because buyers are unaware of defects.

Markets may also under-provide high-quality or beneficial goods because buyers cannot identify them.

This results in a loss of allocative efficiency.

Monopoly Power

Monopoly power is the ability of a firm to set prices above the competitive level due to a lack of competition. Any firm with 25% or more market share is considered to have monopoly power.

Pure Monopoly: a market structure where a single firm is the sole producer of a good or service with no close substitutes. Pure Monopolies have complete monopoly power and can set prices without concern for competition.

Consequences of Monopoly Power

Firms with monopoly power can set prices above the competitive level, leading to a loss of consumer surplus and a transfer of wealth from consumers to producers.

This can also lead to a reduction in output and a loss of productive efficiency, as monopolies may not have the same incentives to minimise costs as firms in competitive markets.

Monopolies may also engage in rent-seeking behaviour, such as lobbying for government protection or subsidies, which can lead to a misallocation of resources and a loss of economic efficiency.

Immobility of Factors of Production

Factor immobility refers to the inability of factors of production (land, labour, capital, and entrepreneurship) to move freely between different uses or locations.

Factor immobility can lead to a misallocation of resources and market failure, as resources may not be used in their most productive use.

For example, if workers are unable to move to areas with higher wages due to housing costs or family commitments, this can lead to a shortage of labour in certain industries and a surplus in others, resulting in a misallocation of resources and a loss of economic efficiency.

Labour Immobility

Labour immobility is the most common form of factor immobility and can be caused by two main immobilities:

• Geographical immobility: when workers are unable to move to areas with higher wages due to housing costs, family commitments, or other factors.
• Occupational immobility: when workers are unable to move between different occupations due to a lack of skills or qualifications.

Both forms of labour immobility can lead to a misallocation of resources and a loss of economic efficiency, as workers may not be able to move to areas or industries where they are most needed, leading to shortages and surpluses of labour.