1.

1 INTRODUCTION

Before the subject matter is discussed, the paper shall first of all focus on the concept of market
failure, then look at why markets fail (causes of market failure) and later proceed to discuss the
subject matter of this paper which is the discussion of the concept of market failure in relation to
Zambian financial sector.

1.2 THE CONCEPT OF MARKET FAILURE

Market failure has been defined in different ways by various scholars. Booth, P. (2008) defines
market failure as a situation in which the free market leads to misallocation of society’s scarce
resources in the sense that there is either overproduction or underproduction of particular goods
and services leading to a less than optimal outcome. Picard (2013, p.1) refers to it as a
predicament where the market is unable to efficiently allocate resources, especially public
goods’. Further, MacMillan Dictionary (1986) describes market failure as “The inability of a
system of private markets to provide certain goods either at all or at the most desirable or
‘optimal’ level”. Again in this definition, the reference is made to the allocation of resources not
being at the desired or optimal level.

Additionally, Samuelson and Nordhaus (1992:741) define a market failure as “An imperfection
in a price system that prevents an efficient allocation of resources”. In this definition reference is
made to the importance of the price system being able to reflect the true costs and value of a
product, with natural monopoly, imperfect competition, asymmetry of information and
externalities cited as examples of imperfection. In the case where a price system cannot
adequately reflect the true value of the good or service, a market failure may occur because
resources may be allocated inefficiently. Lines et al. (2006:167) explain that market failures are
often visible in the forms of the growth of monopolistic firms and other non-competitive
organizations, and when factors of production stand idle.

Therefore, the reason for market failure lies in the fact that though perfectly competitive markets
work efficiently, most often the prerequisites of competition are unlikely to be present in an
economy. Market failures are situations in which a particular market, left to it-self, is inefficient.
Market failures have two aspects namely, demand-side market failure and supply side market
failures. Demand- side market failures are said to occur when the demand curves do not take into
account the full willingness of consumers to pay for a product. For example, a passerby will not
be willing to pay to view the animals that are by the roadside of Mundawanga National park
along Kafue road because everyone can view them without paying. Supply side of the market
failures happen when supply curves do not incorporate the full cost of producing the product. For
example, a thermal power plant in Maamba that uses coal may not have to include or pay
completely for the costs to the society caused by fumes it discharges into the atmosphere as part
of the cost of producing electricity.

Therefore, from the above definitions the understanding is that when there is a market failure in
an economy it indeed does not mean that the market is not functional, as it may sound, rather it is
just a “situation whereby the market does not organize production or goods allocation
effectively”.

1.3 ACTUAL CAUSES OF MARKET FAILURE

The pertinent question here is why do markets fail? Market failure is the mostly results of
ignorance of the consumer, natural monopolies, allocation of resources in times of emergencies,
speculation, inequalities in the distribution of income and wealth, restrictions on imports,
optimization of the rate of savings, provision of humanitarian services and so on. Traditional
reasons of market failure that have special relevance to financial services efficiency include
incomplete or non-existent property rights, externalities, and absence of relevant information,
moral hazard, speculation and market bubbles, and market rigging. Other study show that causes
of market failures include common property resource management, non-competitive markets and
the assignment and defense of property rights (Bohm and Russell, 1985). The following section
discusses some identified causes of market failures in detail;

1.3.1 Lack of competition and market rigging

The lack of competition in a particular segment of an economy means that there is relatively
small number of financial institutions dominating particular financial markets which usually
encourages market players to collude and undertake cartel-like behaviour. Collusive behaviour
may extend to market ‘rigging’, where asset prices, or other aspects of the market, are fixed by
the dominant firms.

This is what happened in the Libor scandal (Libor is the London Interbank Offered Rate) which
involved fixing interest rates and exchange rates. A Libor rate is an average interest rate (or
exchange rate) calculated through submissions by major global banks. In terms of interest rates,
the Libor rate is then used globally to fix rates on a variety of loans – from mortgage rates to
student loan rates.

Rate submissions are supposed to be based on actual bank data, but investigations in the USA
showed that five major banks – Citicorp, JPMorgan Chase, Barclays, the Royal Bank of Scotland
and UBS AG – colluded over a number of years to set exchange rates in their favor. Other
investigations revealed widespread rate fixing across global financial markets.

1.3.2 Incomplete or Non-existent property rights

Incomplete or non-existent property rights make it hard for the markets to take all the costs of
production into account. De Soto (2000) and Prahalad (2005) explain that the lack of access to
formal property systems is a barrier to market entry for poor people, who cannot gain access to
the formal capital markets without property rights. De Soto (2000) and Prahalad (2005)
emphasize how dependent the modern world is on the existence of formal property rights and
explain the links between property rights, poverty, innovation, wealth and progress.

For instance, property often allows a person to gain access to financial resources without
requiring that person to sell the property. Thus owning a house allows a person to get a credit
card or overdraft facility more easily, using the house as collateral. There are many more assets
than houses that one may use to gain access to financial resources.

1.3.3 Incomplete Information

Complete information is an important element of competitive market. Perfect information

implies that both buyer and sellers have complete information about anything that may influence
their decision making. However, this assumption is fully satisfied in real markets due to the
following reasons;
 i. Often the nature of products and services tend to be highly complex e.g. cardiac surgery,
financial products (such as pension products, mutual funds etc.).
ii. In many cases consumers are unable to quickly /cheaply find sufficient information on
the best prices as well as quality for different products. Sometimes they misunderstand
the true costs or benefits of a product or are uncertain about the true costs and benefits
iii. People are ignorant or not aware of matters in the matter. Generally or incomplete data
and consequently make potentially wrong choices / decisions.

Information failure is widespread in numerous market exchanges. When this happens

misallocation of scarce resources takes place and equilibrium price and quantity is not
established through price mechanism. This results in market failure.

1.3.3.1. Asymmetric Information

This is a more intractable information problem which has to do with quality of goods rather than
price. With this type of characteristic of market failure, consumers are often at a disadvantage
compared to producers. Economists call this the problem of asymmetric information, where one
party to the transaction (usually, but not always the seller) has much better knowledge of the
product than the other party. Persuasive and misleading advertising can add to this problem.

The classical example of asymmetric information is when the landlady knows more about their
properties than the tenants, a borrower knows more about their ability to pay a loan than the
lender, a used car seller knows more about a vehicle quality than a buyer and some traders may
possess inside information in financial markets. These are situations in which one part to a
transaction knows a material fact that the other part doesn’t know. This phenomenon which is
sometimes refers to as lemon problem is an important source of market failure. With asymmetric
information lower quality goods can drive high quality goods out of the market.

1.3.4 Natural Monopoly

William Baumol (1977) stated that a natural monopoly is “an industry in which multiform
production is more costly than production by a monopoly”. A natural monopoly occurs when the
most efficient number of firms in the industry is one. A natural monopoly will typically have
very high fixed costs meaning that it is impractical to have more than one firm producing the
good.
An example of a natural monopoly is water distribution. It makes sense to have just one
company providing a network of water pipes and sewers because there are very high capital costs
involved in setting up a national network of pipes and sewage systems. To have two different
companies offering water wouldn’t make sense as the average cost would be very high compared
to just one firm and one network. There would also be the inconvenience of having two firms dig
up the road to lay a duplicate set of water pipes.

1.4 MARKET FAILURE IN THE CONTEXT OF ZAMBIAN FINANCIAL SECTOR

Kenton, W, (2021) describes financial sector as a section of the economy made up of firms and
institutions that provide financial services to commercial and retail customers. In any economy,
the financial sector is the hub of productive activity (Rajan, 2010). The sector is one of the major
systems of economic life, a cornerstone and aid to legitimate national and global commerce, an
ardent participant in both formal and informal financial sectors, and a catalyst of the market
economy. Rey-Stiglitz (2012) likens the financial sector to the brain of the economy. He posits
that it is central to the management of risk and the allocation of capital. It runs the economy’s
payment mechanism. It intermediates between savers and investors, providing capital to new and
growing businesses. Therefore, when it does its functions well, economies prosper; when it does
its jobs poorly, economies and societies suffer resulting in what is called market failure (Rey-
Stiglitz 2012).

On the other hand, Economics-online, (2020) defines financial market failure as a situation in a
market where financial markets fail to operate efficiently, causing lost economic output and
reductions in the value of national wealth. This implies that when the market fails, not only will
the sector's profits be lower than they would otherwise have been, but the performance of the
entire economic system may be impaired.

Zambian financial system comprises institutional units and markets that interact for the purpose
of mobilizing funds for investment and providing facilities including payment systems, for the
financing of commercial activity. According to IMF, (2018) the sector is largely dominated by
banks which account for about 67 percent of total financial sector while nonbank financial
institution (NBFI) sector is dominated by pension funds, of which the government-run National
Pension Scheme Authority (NAPSA) accounts for about three-quarters. Microfinance institutions
(MFIs) comprise 8 percent of total nonbank financial sector, and insurance companies 12
percent. Other nonbank financial institutions (NBFIs) include building societies, leasing
companies, development finance institutions, and FX bureaus. There is also a stock exchange,
with 19 listed and nine quoted companies (IMF, 2018).

On one hand, the primary role of financial institutions-units in the system is to intermediate
between those that provide funds and those that need the funds, typically transforming and
managing risk.

On the other hand, financial markets provide a forum within which financial claims can be traded
under established rules of conduct (BoZ, 2021).

To effectively contribute and foster sustainable economic development, it is essential to have a

stable and efficient financial system in the country. In this regard, the Financial Stability function
of Bank of Zambia endeavors to achieve a financial system that is resilient to shocks and is able
to smoothly conduct its core tasks (BoZ report, 2021).

The financial sector in Zambia is still relatively undeveloped as regards its potential and as
reflected in limited financial intermediation, however, its overall performance and condition has
remained largely satisfactory despite the adverse macroeconomic environment compounded by
external and internal factors (IMF, 2018).

This is in stark contrast with the late 1980s and early 1990s, when the sector was volatile and had
many bank failures following the reforms in financial sector in 1995 (Manenga N, et al, (2009).
During that period, banking sector experienced some failures resulting in closure of several
banks like Meridien Bank of Zambia Limited; this was followed by the closure of African
Commercial Bank and Commerce Bank later in the same year. The instability experienced in the
financial sector as a whole had a severe impact on the financial system, resulting in the failure of
four more banks in 1997 and one in 1998 (Manenga N, et al, (2009). As of 31st December 1999,
the African Commercial Bank, Credit African Bank and Manifold Investment Bank, Meridien
(BIAO) Bank and prudence bank were in liquidation, while First Merchant Bank was undergoing
reorganization. The cost of these failures to the Bank of Zambia (BoZ) was high, both financially
and in terms of its reputation and credibility as the regulator and supervisor of the financial
sector. Its 1997 Annual Report indicated that the overdrawn accounts for banks in liquidation as
of 31st December were in excess of US$30 Million (BoZ, 1997).

Since the last market failure in 1997/8, the Zambian financial sector has been shielded from
experiencing another failure due to its resilience to shocks (Manenga N, et al, (2009). This is in
spite of the global economic crises in 2008 where many financial markets and large financial
institutions collapsed in much of the industrialized world (Rajan 2010).

According to BoZ, (2009), the Zambian financial sector was not directly adversely affected by
the credit crunch as reflected in the continued stability of the banking sector with most banks
being adequately capitalized and the inter-bank market operating as before, due to the sector’s
limited integration into the international financial markets. Further, the financial sector had no
exposure to toxic assets, which led to the credit crunch in most developed markets (Caleb, 2009).

Nevertheless, the global financial crisis, had adversely affected Zambia, like most global
economies, mainly through: reduced revenue earnings from mineral resources; job losses,
particularly in the extractive industry; lower foreign capital inflow (both foreign portfolio
investment (FPI) and foreign direct investment (FDI)); rising domestic inflation driven by pass-
through effects of the depreciation in the exchange rate of the Kwacha against major currencies;
and declining number of foreign tourists (BoZ, 2009).

Despite not experiencing the market failure to an extent where the performance of the entire
economic system may be impaired, there have been some reminiscent instances of failure
reflected through an incomplete property rights. As earlier alluded to, not having full and
complete property rights may create failure as this is a barrier to market entry for most of poor
people, who cannot gain access to the formal capital markets without property rights. For
instance, many small farmers and macro, small and medium enterprises (MSMEs) in rural areas
especially do not gain access to funds from most of either the banks or financial lending
institutions because their lands are not recognized as collateral (FinScope Zambia Small
Business Survey (2020).

According to FinScope Survey (2020), 85 percent of micro, small, and medium enterprises
(MSMEs) in rural areas have no access to financial services” compared with 15 percent in urban
areas. The survey further reveals that access to finance for micro, small, and medium enterprises
(MSMEs), including in agriculture, is limited due to structural constraints, such as informality,
high collateral requirements, and inadequate bank lending tools.

In addition, the Survey reveals that many commercial banks have focused on corporate clients
due to instability of the country’s monetary policy rate (MPR). The monetary policy rate (MPR)
keeps fluctuating ostensibly in the quest to quell inflation by increasing the cost of borrowing
(Sean, 2021).

Therefore, any adjustment of monetary policy rate (MPR) by the Bank of Zambia, which is
responsible for monetary and supervisory policy and regulating of banks and other financial
service institutions, either upwards and downwards, results in commercial banks and
microfinance institutions adjusting the loans’ rates accordingly thereby making it difficult for
either micro, small, and medium enterprises (MSMEs) or smaller farmers especially in rural
areas to have access to financial services. As a result there are minimal dedicated micro, small,
and medium enterprises (MSME) lending windows with results in failure.

Further, according to Christabel, (2019) the complication in understanding financial services,

such as mortgages and life insurance by many Zambians has contributed in having a small
number of people who are able to access the services resulting in failure. Due to lack of
knowledge, some people take it on trust that banks and other financial institutions will act with
integrity when they sell them these products, while others are compelled to use the services of
financial advisor or broker to help them choose appropriate products. Again the problem here is
that the advisor and principal may not necessarily have the same interests. The advisor may seek
to persuade the client to take out a particular mortgage policy because he (the advisor) will earn a
large commission. Again this is a case of asymmetric information (the advisor knows more than
the client) and it can lead to market failure and misallocation of resources.

In insurance sector, the effect of information failure has resulted in only 2.8 percent of adult
Zambians being insured (Insurers Association of Zambia report (2019). The low insurance
penetration in Zambia has been attributed to lack of knowledge about the insurance services by
majority Zambians (Christabel, 2019).

1.5 CONCLUSION
In conclusion, it is ostensive that market failure is effectively caused by some of the factors that
support the market. Thus addressing market failure it could be about getting these platforms to
perform more efficiently or optimally in the way that resources are allocated or decisions made
regarding the production of goods and services. Whenever one or more of the prerequisites for
markets to perform are missing, it leads to a market failure. However, market failure in relation
to Zambian financial sector is not evident in that the sector has performed largely satisfactorily
since its first financial market failure that happened in 1997/8 which resulted in closure of
several banks. The limited integration of the sector into the international financial markets
shielded it from being adversely directly affected by the global economic crises in 2008 where
many financial markets and large financial institutions collapsed in much of the industrialized
world.