Market Failure

The company of Enron was almost universally known as one of the countries most innovative companies. The company continued to build power plants and operate gas lines, but it became better known for its unique trading businesses. Besides buying and selling gas and electricity futures, it created whole new markets for such oddball "commodities" as broadcast time for advertisers, weather futures, and Internet bandwidth. They were known for going headfirst into the world of e-commerce, At its peak, Enron was worth about $70 billion, its shares trading for about $90 each. However, all of this came to a crashing end when the company admitted to falsifying their financials. They had overstated their equity by a couple of billions of dollars, and had made about a dozen "partnerships" with companies it had created, and it used those partnerships to hide huge debts and heavy losses on its trading businesses. On Dec. 2, 2001, Enron declared bankruptcy. Thousands of people were thrown out of work, and thousands of investors - including most of the company's employees - lost billions of dollars as Enron's shares shrank to penny-stock levels. The company's CFO, Andrew Fastor, as well as many other chief officers and top managers in the company face prison time due to their misdealings. Fastor specifically had embezzled close to $30 million from the company.

The story of Enron reminds us of a serious fact about economics - that markets sometimes fail. Enron was not the only offender when it comes to accounting scandals during the early 2000's. Another example is a telecommunications company called WorldCom that declared bankruptcy in 2002 amid charged of breaking the law. These examples show that a competitive free enterprise economy works best when several conditions, including adequate information, are met. To avoid these problems, we need to know how to identify and deal with the different types of market failure.

Market failure is a condition that causes a competitive market to fail, and occurs whenever one of the conditions necessary for competitive markets does not exist. In market failure, the allocation of goods and services is not efficient. There are five main causes of why we deal with market failure in the economy:

1. Inadequate Competition - a decrease in competition tends to reduce the efficient use of scarce resources. If a company has little to no competition, then why would they need to worry about using their resources carefully? For example, within a monopoly there are companies who could spend their profits on huge salaries and bonuses, private jets, country club memberships, high retirement benefits for employees, etc. One reason that public utility companies are government mandated is so that they do not waste or abuse their resources due to their monopolistic status.
2. Inadequate Information - If resources are to be allocated efficiently, adequate information about must be provided to all parties involved - consumers, businesspeople, and government officials. Without information uneducated decision are made. This leads to mistakes and thus, market failure.
3. Resource Immobility - When land, capital, labor and entrepreneurs do not move to markets where returns are the highest, then this can cause difficulties in the economy. Whenever a large auto assembly plant, steel mill or mine closes, this leaves hundreds of workers without employment. Some workers can find jobs in other industries, but not all can. These employees who need to seek employment in a new town may not be able to sell their homes, or they simply may not want to uproot themselves and move elsewhere.
4. Public Goods - these are goods or services whose benefits are available to everyone and are paid for collectively. Examples of public goods are highways, flood-control measures, national defense, schools, and police and fire protection. Public goods are those goods and services provided by the government because a market failure has occurred and the market has not provided them. All members of society should theoretically benefit from the provision of public goods but the reality is that some need them more then others. For example the wealthy do not need welfare and the elderly still pay for school taxes.
5. Externalities - unintended economic side effect that either benefits or harms an uninvolved third party in the activity that caused it. There are both positive and negative externalities. These are market failures because their costs and benefits are not reflected in the market prices that buyers and sellers pay. These distort the decisions made by consumers and producers, and overall makes the economy less efficient.

This is the beneficial side effect that affects an uninvolved third party. For example, if there is an airport expansion on one side of town, those on the opposite side of town may benefit from the additional jobs created, or restaurant owners may gain more customers with these jobs created. Neither the restaurant owners or employees put in any effort to benefit from this expansion. Other examples: A farmer who grows apple trees provides a benefit to a beekeeper. The beekeeper gets a good source of nectar to help make more honey. If you walk to work, it will reduce congestion and pollution, this will benefit everyone else in the city. The issue with positive externalities is that there tends to be an underconsumption of products in the market.

On the opposite side, a negative externality is the harm, cost, or inconvenience suffered by a third party because of actions by others. Continuing when the example of the airport expansion above, a negative affect would be the values of homes decreasing around the airport due to increased noise and traffic. Another major example is with pollution. Firms have an incentive to pollute, because it would decrease their production costs and lead to higher profits. This then keeps their prices low, encouraging more sales. However, this then just encourages more pollution, and those living in those polluted areas are essentially paying for the cost of production, even if they didn't buy the product.

Student Activity

Investopedia - Invisible Hand part 1

Investopedia - Invisible Hand part 2

Investopedia - Invisible Hand part 3

Miracle of the Market

Case study: The housing market crash

Crisis of Credit Video

Housing Crisis

Case Study: Enron

What happened to Enron?

Sources

• https://www.khanacademy.org/economics-finance-domain/ap-microeconomics/ap-consumer-producer-surplus
• http://www.npr.org/news/specials/enron/