Can a market failure occur when there is a high amount of risk leading producers and consumers to avoid the market?

Ask an Economist

Can a market failure occur when there is a high amount of risk within the market leading producers and consumers to avoid the market?


To answer this question, it is critical to agree on the definition of "market failure." In what follows, by "market failure" we will mean a situation where a free market fails to provide an efficient allocation of goods and services (i.e., risk in this particular example). Hence, if the market fails, it is possible to conceive an alternative allocation of risks so that at least one market participant could be made better-off without making anybody else worse off.

Given such a definition of market failure, whether a large amount of risk can lead to a market failure or not depends on the nature of the risk involved. More specifically, a large risk may lead to a market failure if it is associated with informational asymmetries; otherwise, it does not. Informational asymmetries occur when one of the parties to a transaction has "private" information, so that s/he is better informed about the good/service being transacted than the other party. Asymmetric information leads to two types of problems for free markets, namely, adverse selection and moral hazard.

Adverse selection arises when people use their private information to their own benefit when entering a contractual arrangement, to the detriment of the less-informed party. A classical example of adverse selection is health insurance, because a person typically knows more about his/her own health than the insurer. Thus, everything else equal, the people more likely to buy insurance at any given premium are the ones posing the greatest risks. Anticipating adverse selection, insurers tend to adjust their premiums upward. In the end, adverse selection leads to higher premiums and fewer insured people than if there were no informational asymmetries.

Moral hazard occurs when people take advantage of their private information (to the disadvantage of the less-informed party) after entering a contractual arrangement. Health insurance provides a good example of moral hazard as well, because people have more incentives to enter into riskier behaviors (e.g., practice extreme sports, spend less on preventive care, etc.) once they have secured insurance. If insurers cannot prevent moral hazard, they will adjust premiums upward accordingly. As a result, the presence of moral hazard increases premiums and reduces the number of insured people compared to a situation without private information.

Absent information asymmetries, there is no reason for large risks to cause a market failure. Take for example the case of a perfectly competitive commodity producer facing large price risks due to uncertainties in weather, export demand, and the like. In the absence of private information, such a producer would face the same uncertainty as anybody who might be willing to take on his/her risk. Unlike standard goods, risk is a "bad;" therefore, its owner (in this instance the commodity producer) must pay rather than be paid to get rid of it. Quite possibly, the commodity producer may not find anybody willing to take on his/her risk for the amount of money he/she is willing to pay. If such a situation arises, however, it would not be a market failure. This assertion is true because it would be analogous to a seller of a standard good being unable find any buyers at a specific price he/she would like to charge. While this situation means that transactions fail to occur, it does not represent a market failure as defined above.

Answered by:
Dr. Sergio Lence
Professor and Marlin Cole Chair of International Agricultural Economics