Market Failures 1

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Topic: The impact of information asymmetries and Conflicts of Interest on contractual

relationships.
 Market Failures 2

Introduction

Market failure can be described as the inefficient distribution of both goods and services

in a free market setting. In a free market setting, the prices at which goods and services are

offered and or sold is determined by the supply and demand chain. A change in any one of the

forces leads to a change in price and a change in the corresponding force. These changes create

an equilibrium in the price.

When there is no equilibrium in the market, there is said that a market failure has

occurred. This occurs as a result of a distortion in the market; where the quantity and value of the

services or goods available in the market does not correspond with the quality and or quantity of

the goods or services in demand. Examples of distortions that affects the free market are price

limits, monopoly power, government regulations as well minimum wage requirements.

Intermediation is described and involves the act of matching lenders and savings to the

borrowers who require investment money through an agent or third parties such as financial

institutions1. Information asymmetric is also referred to as information failure. It happens when

a party to an economic transaction has a greater knowledge than the other party. For example, in

a typical transaction, the seller always has a greater knowledge over the product being sold than

the buyer and the vice versa can be true in certain circumstances.

In businesses, conflict of interest entails a scenario where an individual’s personal

interest compromises her or his judgment, actions or decisions in a business transaction. In

1
Geiger S, Gross N. Market Failures and Market Framings: Can a market be transformed from the inside?
(Organization Studies, 2018 (10)):1358
 Market Failures 3

market set-up, conflict of interest majorly occurs where there is an agency relationship; the

interest of the agent may conflict with those of the principal, resulting to what is described in

business transactions as the agency problem.

Information Asymmetric

Asymmetric information refers a specialization as well as a division of knowledge

applied in various forms of trade. For instance, teachers typically are regarded to know more

about education than their students or pupils. Manufacturers as well are regarded to have more

knowledge about products than consumers.it occurs where one of the parties involved in an

economic transaction has greater material knowledge when compared to the other party.

Information asymmetries describes the fact that exists in the real world where

information hardly flows smoothly. Certain individuals have access to information which others

cannot access. For instance, in the business of lending money by financial institutions, banks and

or financial institutions do not know much about the persons or institutions they provide services

to.

In the business of lending, it is very vital to understand the borrower; to track how they

expend the money lent and ensure that the money is spent in a manner that will enable them

repay it; and to ensure that they are tracked to prevent them from disappearing without paying

the loan. Because of all these, financial institutions do not provide loans to every person who is

in need.
 Market Failures 4

Asymmetric information manifests mostly when the seller or provider of goods and

services has greater knowledge than the purchaser; the vice-versa is also true albeit not common.

All economic transactions and or contract depict instances of information asymmetries 2.

Information asymmetry affects the manner in which individuals assess the quality of goods and

services that are available in the market. It also affects how individuals often anticipate on the

intentions of others and agency.

In circumstances where individuals are unable to determine the quality of goods and

services or where they are unable to acquire and or observe information relating to others, then

there is market failure because no equilibrium is produced; prices and transactions therefore

cannot be efficiently coordinated. There are several examples of economic situations where

asymmetric information is exhibited includes the following: in an employment relationship

where employers seek to determine the ability and qualities of their prospective employees

before formally employing them, investors doing everything to determine the true value of a firm

or company before making an investment decision whether to invest ort acquire the said

company.

Individuals normally have their personal information and information regarding their

economic environment which in most circumstances might not be complete and at the same time

different from information of others. Information asymmetries among agents have the effect of

altering the market and its processes; and interfere with the market clearing mechanisms.

2
Crawford GS, Pavanini N, Schivardi F. Asymmetric information and imperfect competition in lending markets
(American Economic Review, 2018 (7)):1669
 Market Failures 5

Therefore, where sellers and buyers do not possess similar information sets when

conducting a transaction, services as well as goods that are of heterogeneous quality often

coexist in the market and as a result of these problems of information the transaction becomes

intertwined together with the selection process over certain hidden characteristics as well as the

process of provision of incentives on hidden behaviors. Where there is asymmetric information,

there is a possibility and chances of bad quality providers entering the market and drive quality

providers out of the market through the lowering of prices. This causes market failure.

Information asymmetric results in in adverse selection and moral hazards which have

been classified as contributors of market failure. Adverse selection refers to the process where

there is occurrence of undesired results because of imperfect and different information available

to buyers and sellers during a transaction. The indifferent knowledge leads to a shift in the

quantity and prices of goods and services 3. As a result, buyers and sellers select poor or bad

products causing market failure. For instance, if a banking institution set a similar price

applicable to all of its checking account holders there is a risk of the plan being adversely

affected by a low-balance and high activity customers. The individual price therefore would

generate a very low or minimal profit for the banking or financial institution.

Moral hazards results from asymmetric information. A moral hazard refers to a situation

where an individual takes risks because the attendant cost is likely not to be felt by the party

taking the said risk. A moral hazard is likely to occur when the actions taken by one party

changes to the disadvantage of another party soon after completion of a financial transaction. As

3
Glode V, Opp C. Asymmetric information and intermediation chains (American Economic Review, 2016
106(9)):2710
 Market Failures 6

concerns asymmetric information, moral hazards occur where one of the parties to a transaction

is insulated from a risk and has more information available to him or her regarding his or her

intentions and actions than the other contracting party who pays for the negative consequences

associated with the risk. For instance, in employment relationships where employees and the

management is involved; where the company is unable to observe the daily actions of all its

employees and managers, there is a possibility that very selfish and careless decisions would be

made.

Asymmetric information contributes to the downward economic spiral of a company. The

lack of equal information leads to economic imbalances that causes moral hazards and adverse

selection. These economic weaknesses have the capacity to cause market failure.

The problems associated with asymmetric information relates to situations occurring

before and after the contract is entered into. There are hidden characteristics which are associated

with the contracting party or the subject matter of the contract which are normally concealed and

are not known by the principal; the same is concealed ex-ante but often revealed ex-post. Persons

engaged in the negotiation and award of the contract will endeavor and advice the contracting

party prior to the conclusion of the contract on the quality of the organization and service.

In such a process, the weaknesses and faults are concealed so as not to hinder the

conclusion of the contract. As a result of the concealment, there is risk of adverse selection; the

agent however has an incentive to display an opportunistic behavior but on the part of the

principal there is a risk of selecting either unsuitable contractual subject matter or partner. It is

never easy for the principal to identify and discover the intentions of the agent in the first
 Market Failures 7

instance because the aspects of fairness, goodwill and honesty cannot be easily assessed prior to

entering into the contract.

The contractual partner’s intention before the conclusion of the contract forms the basis

of the problem described as hold-up. The hold-up problem affects service providers and the

consumers as well. Both parties are interested in the manner in which the contractual partner

exploits any available chance in order to take advantage of the situation.

After the contract has been entered into. There are certain associated problems that lead

to market failure. Normally, it is not clear and possible to draw any inferences on the amount and

extent of effort invested by the agent based on the result. The result is also based on other factors

that are exogenous. The principal therefore knows the result of the action but is unaware of the

part played by the agent in arriving at the result and how much of it can be attributed to

environmental factors4. This form of asymmetric information is described as hidden information.

The principal though is able to monitor the agent’s actions upon the conclusion of the contract,

he or she cannot in the circumstances evaluate them as a result of lack adequate and special

knowledge. The agent can exploit this asymmetric information to his advantage.

When analyzing contractual negotiations, the problem of hidden information plays a vital

role. The issue that arise is that the service providers may decide to act in concealment especially

when there is information advantage. The service providers then pursue their own goals and fail

to act in the interest of the other contracting party. In a market where there is complete

transparency and contracting done in good faith, the problems of moral hazards and adverse
4
Kopp E, Kaffenberger L, Jenkinson N. Cyber risk, market failures, and financial stability. (International Monetary
Fund, 2017) 47
 Market Failures 8

selection do not arise. Therefore, if measures aimed at increasing transparency or reducing

asymmetric information are vital for solving problems associated with moral hazards and adverse

selection.

After an agreement has been entered into, there is a risk related to opportunistic behavior

based on hidden information and action. The act of observing the behavior of the agent by the

principal is referred to as monitoring. Monitoring can involve the introduction of a quality

management and control system. This process of monitoring does not however involve the

investment of too much time or finances. When this monitoring function is delegated, it creates

an agency relationship involving a principal and agent and causes conflict because third parties

act as agents because the said agents also need to be supervised.

How to overcome asymmetric information

In order to avoid a market failure resulting from asymmetric information, it is important

to devise ways that ensure that any form of asymmetric information is avoided so as to ensure

and create a perfect market. Asymmetric information can therefore be remedied as discusses

below.

Investment on the business-give signals is one way of overcoming asymmetric

information. In a contract involving the selling of a car for instance, if the car is being purchased

from a one-off private buyer, there are chances for the buyer to be suspicious about the car’s

quality. However, where a second-hand car dealer invests in advertising as well as a large

property, it portrays the firms’ intention to be in the market for the foreseeable future. In the
 Market Failures 9

latter case, the firm has great incentive to sell very reliable cars and to avoid costs to the

reputation.

Giving warranties is another way of overcoming asymmetric information. A warranty

would act as a window for the buyer to examine the goods purchased such that where any defects

are noticed, the same can be returned for replacement within the warranty period.

In insurance business for example, awarding no claims bonuses is a way of overcoming

asymmetric information. Insurers normally give huge discounts based on no claims as the best

way of gaining more and better information on unlucky and careful customers.

Engaging an expert examiner to examine every good before it is sold is another method

of overcoming the problem of asymmetric information. This arrangement can be done even by

the purchasers. For instance, if one wants to buy a second-hand car worth $5000, it would be

reasonable to spend at least $100 to engage a qualified mechanic to run the said car through tests

to ensure that the same is free of any mechanical defects.

Advantages of asymmetric information

Even though asymmetric information has been linked with market failure, it has certain

advantages as enumerated below.

Asymmetric information enables experts in a particular field or trade to become more

productive and as a consequence, they tend to provide better services and add greater value to

experts in another field or trade. For instance, a stockbroker can assist investors from other fields

with investing money in the stock market.

Market Failures 10

However, there is also a disadvantage with asymmetric information. Asymmetric

information can have very fraudulent consequences including adverse selection. In insurance

business for instance, adverse selection leads to and creates the probability of very extreme and

huge loss as a result of the risk that the policy holder failed to disclose at the time of taking up

the policy

Conflict of Interest

Conflict of interest arises where an individual or an entity suddenly becomes unreliable

because there is a clash between one’s personal interests and professional duties or

responsibilities5. The said conflict happens when an entity or an individual has some vested

interest which may include but not limited to financial, knowledge, status, reputation or

relationship which has the effect of putting into question whether the actions or judgment or

decision-making can turn out to be unbiased. Where such situations arise, the party should

excuse themselves from engaging in the performance of the duty or contractual obligation as the

case may be.

In the world of business and contractual obligations, conflict of interest often arises in

situations where an individual chooses to pursue personal gain over his or her duties to the

principal or employer or in an organization where he or she has a stake or in other words exploits

the position they hold for personal benefit.

5
Mazzucato M, Penna CC. Beyond market failures: The market creating and shaping roles of state investment
banks (Journal of Economic Policy Reform, 2016 (4)):315
Market Failures 11

In a company or firm, all the board members or directors have a fiduciary relationship

with the company on one hand and the shareholders on the other hand. They therefore owe a

duty to act in good faith and for the benefit of the company and the shareholders. If one or any of

the directors chooses an action or decision that benefits them directly or indirectly to the

detriment of the company, they harm the interests of the company and the shareholders due to

the exhibited conflict of interest. For instance, a board member of say a property insurance

company who casts a vote on the reduction of lower premium rates for companies which own

fleets of vehicles when the said companies own trucks. Even if the act of instituting lower

premiums does not amount to bad business for the insurer, it can be considered to amount to

conflict of interest because the said board member can be said to have certain special interest in

the outcome.

Conflict of interest can lead to legal ramifications. But in a scenario where there is

perceived conflict of interest and the individual is yet to commit a malicious act, it is possible to

isolate and remove the individual from the conflicting situation.

The most common form of conflict of interest is self-dealing. Self-dealing refers to a

situation where a fiduciary act in his or her interest in a transaction instead of acting in the

interest of their employer, principal or clients. Self-dealing can take several forms such as the use

of the company funds to act as personal loan, the assumption of a deal and or an opportunity, or

the use of insider information in the stock market trade or transaction. Self-dealing involves

many individuals who operate under the fiduciary guidelines. They include attorneys, trustees,

board members, corporate officers and financial advisors.

Market Failures 12

The act of issuing gifts is another common form that conflict of interest takes. It occurs in

situations where a corporate officer or manager solicits and accepts a gift from a contracting

party or any other similar person. Companies have put up regulations that prohibits the giving

and soliciting of gifts but the practice is still common, those who do not give the gifts are not

assured of securing the contracts.

Where in the course of undertaking professional duties an individual collects private and

confidential information; if such information is used for personal gain for instance by an

employee presents a huge situation of conflict of interest. This is generally described as insider

trading and has a great impact on contractual relationships.

Conflict of interest is real in financial intermediation. In a market setting with a perfect

competition in in the absence of asymmetric information, the exploitation of conflict of interest

cannot occur. Therefore, sufficient conditions on agency costs that accrue from conflict of

interest exploitation revolve around information and market imperfections. The larger the

financial intermediaries, the greater the existing agency problems that are associated with the

exploitation of the concept of conflict of interest.

The exploitation of conflict of interest has been associated with banks, insurance

companies, security firms as well as asset managers who get involved in a acts said to be abusive

to retail markets by acting as intermediaries and principals simultaneously hence facilitating

corporate abuses, the misuse of private information e.t.c, a suggestion that market imperfections

exists even in markets that boast of a highly developed financial system.

Market Failures 13

There are generally two forms of conflicts of interest that firms have to deal with

especially in the financial services industry6. The first form of conflict of interest is in a firm’s

economic interests and those of its clients, that is usually reflected in the mispriced transfer of

risk or in the extraction of rents. Other than the direct firm-clients conflicts, indirect conflict

could as well involve collusion between the company and a fiduciary who acts as an agent for

ultimate firm’s clients. The other form of conflict of interest is that which exists between the

clients of a firm, or between various types of clients which has the result of placing the firm in a

position where it tends to favor one client over others.

Conflicts of interest arises in professional activities that are conducted in wholesale as

well as in activities that involve retail clients. The difference between the two market domains is

vital due to the role that information and transaction costs, which vary between the main two

types of participants in the market. The vulnerability of the two domains to conflict-exploitation

varies and the measures that have been designed to remedy the scourge in one domain may not

be appropriate when applied to the other domain.

Conflict of interest in wholesale markets

In wholesale markets involving professionals, corporations and investors, the competitive

conditions and asymmetric information to be exploited are not important per se. however, there

are several types of conflict of interest that arises nevertheless.

6
Olaniyi C. Asymmetric information phenomenon in the link between CEO pay and firm performance (Journal of
Economic Studies. 2019) 78
Market Failures 14

In the case of principal transactions, there might be the involvement of a fiduciary

intermediary and having a stake in the transaction where he or she acts as a lender, adviser or

underwriter.

This creates an incentive to try and put his or her own interest in front of the clients and

or other trading parties. The company is also likely to engage in an act of misrepresentation that

way far beyond the reach and ability of the clients to be able to uncover.

There are also instances of misuse of fiduciary relationships. In the financial services

sector for instance, a mutual fund manager who is in competition for pension funds may be

reluctant to cast a fiduciary vote on shares that is against the management of such a company to

the detriment of the company’s shareholders7. The other scenario is where the asset management

department of an institution may succumb to pressure from a corporate banking customer to vote

shares in the company for the management’s position where there is a contested corporate action.

The likelihood of deriving gain or attempts to avoid loss in the banking business is attained at a

cost.

In a banking transaction or relationship, there can be instances of misuse of private

information. The bank obtains private information of its customers and such information may be

used by the bank in a manner that harms the interest of the customer. For example, the private

information may be used by the investment unit of the banking institution in the pricing and

subsequent distribution of securities to a different customer in breach of the interest of the

former.

7
Vandenberg P, Chantapacdepong P, Yoshino N. SMEs in developing Asia: new approaches to overcoming market
failures (Asian Development Bank Institute, 2016) 97
Market Failures 15

Conflict of interest in Retail business contracts

Asymmetric information actively drives conflict of interest exploitation in retail contracts

more than it does in wholesale contracts where the interests of the seller or service provider are

set against those of the retailers 8. Misleading reporting and disclosure is an example of conflict

of interest in retail contracts. Financial firms for instance may be unwilling to report an

unfavorable investment performance to their customers if by so doing acts as a threat that

induces outflow of assets under management.

Eliminating market failures

Several strategies can be adopted and implemented in order to eliminate elements that

cause market failure. The first strategy is to enact a legislation. The government can manage and

control market failures through the implementation of a legislation that alters and changes

behavior. For instance, the government can pass a legislation that bans cars form operating

within the town centers or one that imposes very high penalties on businesses that engage in the

selling of alcohol to children that are underage in order to control unwanted behavior.

The other strategy that can be adopted to eliminate market failure is price mechanism.

Price mechanisms have been designed to assist in changing the behavior of both the producers

and consumers. For products that are considered as having the effect of causing harm to the

consumers, the government can discourage their consumption through increasing the payable

taxes. For instance, taxes levied cigarettes and or alcohol are always increased so as to

8
Von Kriegstein H. Professionalism, agency, and market failures (Business Ethics Quarterly, 2016 (4)):455
Market Failures 16

discourage their use and consumption so as to reduce the harmful effects that do not relate to

third parties.

Conclusion

In conclusion therefore Market failure can be described as the inefficient distribution of

both goods and services in a free market setting. In a free market setting, the prices at which

goods and services are offered and or sold is determined by the supply and demand chain. A

change in any one of the forces leads to a change in price and a change in the corresponding

force. Market failure is attributable to information asymmetries and Conflicts of Interest as the

two aspects affects the parties’ abilities to perform their respective obligations on contractual

relationships.
Market Failures 17

References

Crawford GS, Pavanini N, Schivardi F. Asymmetric information and imperfect competition in

lending markets (American Economic Review, 2018 (7)):1659-701.

Geiger S, Gross N. Market Failures and Market Framings: Can a market be transformed from the

inside? (Organization Studies, 2018 (10)):1357-76.

Glode V, Opp C. Asymmetric information and intermediation chains (American Economic

Review, 2016 106(9)):2699-721.

Kopp E, Kaffenberger L, Jenkinson N. Cyber risk, market failures, and financial stability.

(International Monetary Fund, 2017).

Mazzucato M, Penna CC. Beyond market failures: The market creating and shaping roles of state

investment banks (Journal of Economic Policy Reform, 2016 (4)):305-26.

Olaniyi C. Asymmetric information phenomenon in the link between CEO pay and firm

performance (Journal of Economic Studies. 2019)

Vandenberg P, Chantapacdepong P, Yoshino N. SMEs in developing Asia: new approaches to

overcoming market failures (Asian Development Bank Institute, 2016).

Market Failures 18

Von Kriegstein H. Professionalism, agency, and market failures (Business Ethics Quarterly,

2016 (4)):445-64.