Question

Select 3 types of market imperfections in the financial system, which can result in market failure

and the need for regulation. Provide examples of each.

Answer 1

Following are some of the market imperfections that lead to market failure:

• Moral Hazard. Such type of imperfection occurs when an individual or an organization take too much risk on the false belief that they are covered under insurance or in case of loss government will stand by them are protect them.
• Asymmetric information. This imperfection occurs when one individual or party has much more information than other party and it can be used for the exploitation of the other party. Finance is a market in information, often a potential borrower (such as a small business) has better information on the likelihood that they will be able to repay a loan than the lender.
• Creation of Monopoly or Market Rigging. This imperfection occurs when there are few firms in an industry and they may merge to become one and create
• Speculative Bubbles. A bubble exists when the price of something is driven well above what it should be, usually due to the behavior of consumers to exploit customers and charge high prices resulting in market failure.Many banking crisis took place because of speculative inflated prices in housing and real estate sector.
• Incomplete Markets. This imperfection exists when the supply of the product is not sufficient to meet the demands of the customers. Only a part of a demand is met. Example Around 2 billion adults worldwide are without a bank account. About 10 million US households, and 1.5 million UK adults do not have a bank account.
• Unstable Markets. Sometimes markets become highly unstable, and a stable equilibrium may not be established. Example Agricultural Markets, Foreign Exchange etc. This volatility requires some intervention.

All these failures call for the need of regulations.

• Price Mechanism can be used. Price of harmful products should be increased by imposing taxation and price of beneficial products should be reduced by providing subsidies. This will result in changing the behavior of consumers and producers.
• Government Regulation and Laws. Strict laws can be made against creation of monopoly. Unstable markets should be controlled by government intervention. Business organizations or individuals causing environment pollution should be penalized. Licensing system should be followed for sale of alcohol.