Missing market
Encyclopedia
A missing market is a situation in microeconomics
where a competitive market
allowing the exchange
of a commodity
would be Pareto-efficient, but no such market exists.
A classic example of a missing market is the case of an externality
like pollution, where decision makers are not responsible for some of the consequences of their actions. When a factory discharges polluted water into a river, that pollution can hurt people who fish in or get their drinking water from the river downstream, but the factory owner may have no incentive to consider those consequences.
Coordination failure can also prevent market formation. Again considering the pollution example, downstream residents might seek to be paid by the factory owner to pollute their water, but because of the free rider problem
it may be difficult coordinate.
Another barrier to pollution markets could be technology. If the river has several factories along its banks, it may be difficult or impossible to monitor which factory is responsible for downstream pollution.
High transaction costs might also deter market formation. It may be the case that both sides could benefit from an exchange of goods, but that setting up such an exchange is prohibitively expensive.
Markets can also be missing if there is a failure of trust or information. In non zero-sum
interactions, it is possible that the Nash Equilibrium
for individuals acting independently will be sub-optimal, in that both parties could benefit from cooperating, but on their own will choose not to. An example could be a shortage in footwear, where one person would like to open a factory to make shoes, and the other would like to produce socks, but because they are complementary commodities, neither has incentive to start producing unless he knows that the other will do the same (see also: prisoner's dilemma
). The same applies to alternative automotive fuels: few filling station owners will be interested in offering the fuel until alternate-fuel cars are on the road, but people will not buy alternate-fuel cars until filling stations exist to service them.
. In cases of information failure, futures markets can help to signal willingness to cooperate. An ownership solution is for one party to integrate into both activities, thereby internalizing the benefits, or to use the surplus generated on one side of the market to subsidize transactions on the other (see two sided markets).
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...
where a competitive market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
allowing the exchange
Trade
Trade is the transfer of ownership of goods and services from one person or entity to another. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and...
of a commodity
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
would be Pareto-efficient, but no such market exists.
Examples
A variety of factors can lead to missing markets:A classic example of a missing market is the case of an externality
Externality
In economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...
like pollution, where decision makers are not responsible for some of the consequences of their actions. When a factory discharges polluted water into a river, that pollution can hurt people who fish in or get their drinking water from the river downstream, but the factory owner may have no incentive to consider those consequences.
Coordination failure can also prevent market formation. Again considering the pollution example, downstream residents might seek to be paid by the factory owner to pollute their water, but because of the free rider problem
Free rider problem
In economics, collective bargaining, psychology, and political science, a free rider is someone who consumes a resource without paying for it, or pays less than the full cost. The free rider problem is the question of how to limit free riding...
it may be difficult coordinate.
Another barrier to pollution markets could be technology. If the river has several factories along its banks, it may be difficult or impossible to monitor which factory is responsible for downstream pollution.
High transaction costs might also deter market formation. It may be the case that both sides could benefit from an exchange of goods, but that setting up such an exchange is prohibitively expensive.
Markets can also be missing if there is a failure of trust or information. In non zero-sum
Zero-sum
In game theory and economic theory, a zero-sum game is a mathematical representation of a situation in which a participant's gain of utility is exactly balanced by the losses of the utility of other participant. If the total gains of the participants are added up, and the total losses are...
interactions, it is possible that the Nash Equilibrium
Nash equilibrium
In game theory, Nash equilibrium is a solution concept of a game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his own strategy unilaterally...
for individuals acting independently will be sub-optimal, in that both parties could benefit from cooperating, but on their own will choose not to. An example could be a shortage in footwear, where one person would like to open a factory to make shoes, and the other would like to produce socks, but because they are complementary commodities, neither has incentive to start producing unless he knows that the other will do the same (see also: prisoner's dilemma
Prisoner's dilemma
The prisoner’s dilemma is a canonical example of a game, analyzed in game theory that shows why two individuals might not cooperate, even if it appears that it is in their best interest to do so. It was originally framed by Merrill Flood and Melvin Dresher working at RAND in 1950. Albert W...
). The same applies to alternative automotive fuels: few filling station owners will be interested in offering the fuel until alternate-fuel cars are on the road, but people will not buy alternate-fuel cars until filling stations exist to service them.
Solutions
In many cases of missing markets, it may be possible for the government or another actor to create circumstances that make market exchange possible. In the case of pollution, one popular solution is for the government to assign property rights in order to allow Coase BargainingCoase theorem
In law and economics, the Coase theorem , attributed to Ronald Coase, describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are no transaction costs, bargaining will lead to...
. In cases of information failure, futures markets can help to signal willingness to cooperate. An ownership solution is for one party to integrate into both activities, thereby internalizing the benefits, or to use the surplus generated on one side of the market to subsidize transactions on the other (see two sided markets).