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Market Failure and the Value of Information

The views expressed are those of the author and do not necessarily reflect the views of ASPA as an organization.

By Ben Tafoya
March 7, 2021

An important topic in economics is market failure. In recent weeks there have been some powerful examples of this phenomena that have affected millions of people. In Texas, there has been a widespread disruption of the power grid due to historic storms. This has resulted in extraordinarily high electric bills for consumers. A few weeks prior we saw the spike in stock market activity around equity issues that were subject to intense discussion online such as GameStop, AMC Theatres, Blackberry and more.

Market failure is a situation where the normal operation of a market is interrupted by reason of:

  • Externalities where the market can’t properly allocate costs (pollution) or benefits (K-12 education).
  • Non-excludable goods or services like national defense or public safety.
  • Information asymmetry (quality of the good or service) where one party has critical information impacting the transaction that is not shared with the other party.
  • Market power where particular buyers or sellers (power monopolies) can influence pricing or production.

In Texas, the power grid is fairly insular and as such not subject to serious federal regulation. Moreover, there are options where consumers can buy power at a variable rate. This implies that when power costs are low, so are the rates; but a significant event (like the recent storms) could push prices high, and with the cooperation of Texas regulators there are large and surprising bills. Data is being collected on those who were placed on the risky variable plans, sometimes without their knowledge.

While the system offers consumers significant choice, the system is rather complicated and the uncertainty of what happens makes for a classic case of information asymmetry. A competitive market is based on free entry and exit, but some of those with variable plans may not have known that they were being charged that way and others that tried to change could not move to another provider offering fixed rates.

At the same time we saw on Wall Street the breathtaking events surrounding the little valued and previously lightly traded stocks such as GameStop and AMC Theatres. Bloggers caught the potential for a short squeeze. A short sale is a transaction where traders sell stock now and then buy it later when the price drops, but this can be costly if the price rises instead of falls. By signaling intent to buy, retail investors and then large traders drove the price of GameStop up (it went from a low of $2.57 to a high of $483) forcing the short sellers to buy at a higher price to settle their positions (the squeeze).

A difficulty arose that much of the retail activity was through low-cost brokers, some of whom used other entities to settle their trades. As the trading volume increased, the brokers needed to provide increasing amounts of collateral to satisfy their third-party settlement firms. The need for collateral sapped their resources and led them to interrupt trading for a period. Their restrictions on buying, inhibited those who wanted to sell from completing their trade. The restrictions led to steep price drops and those who had bought into the stocks at higher levels lost significant sums.

In both cases, information proved powerful, and the lack of “perfect” information doomed some market participants to serious financial hits. Certainly, the experts in the Texas energy market and the trading firms knew the risks. But for the average consumer, would they understand the complexity and the risks? Are fine print disclosures enough information for consumers to balance concerns about short term savings or profits and longer-term downside?

Congress has held hearings on the trading fiasco surrounding the spike in retail trading during this period. Members expressed concern about the significant losses experienced by retail traders and discussion ranged from whether the markets should be laissez faire to whether there should be new restrictions on “short selling” to requirements for quicker settlement of trades or restrictions on the internet-based brokers that depict trading like a video game. The major regulator for the exchanges, the Security and Exchange Commission, is also examining tighter rules around short sales. One idea is to require the disclosure of significant “short” positions in the same way that entities must disclose their holdings in firms as their stake hits 5%.

Markets work best when the information flows unimpeded between buyers and sellers. But we know that in the real world, markets are imperfect. The typical reaction to that problem is to put in place regulations to protect the potentially vulnerable. For example, we have significant information about the efficacy and potential side-effects of the COVID-19 vaccines. This transparency increases public confidence in an area where the more people who participate, the better it is for all of us. In the same way, to maintain some measure of public confidence in markets, aggressive action must be taken to improve information and protect the vulnerable from those who have superior information and are able to profit off that imbalance.


Author: Ben Tafoya is an adjunct faculty member at Northeastern University where he earned his doctorate. Ben is the author of a chapter on social equity and public administration in the recently published volume from Birkdale, Public Affairs Practicum. He can be reached at [email protected] or Twitter as @policyben . He has no holdings in any of the firms discussed here. All opinions and mistakes are his alone.

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