As comfortable as we are with the strengths of market capitalism, we are uneasy and uncertain about its failures: millions of home foreclosures, rising wealth inequality, steady de-industrialization of the US economy, long-term unemployment, threats to the environment, and health care costs that rise without bound.

We can collect conventional mechanisms for market failure into two broad categories: imperfect markets, and misaligned interests.

Figure 1. Common modes of market failure, which often overlap in practice

Imperfect (or Defective) Markets

• Market domination
• Asymmetric information
• Inequity
• Group-think

Monopoly is an example of market failure by market domination. A monopoly can dominate consumers, charging premium prices and creating inefficiencies. A monopsony has a similar effect, dominating suppliers instead of consumers. Wal-Mart is a contemporary example of monopsony.

Asymmetric information is another example of a defective market. Ideally, all buyers and sellers have the same information – no one has insider information. The housing bubble was driven, in part, by sophisticated bankers and loan brokers who persuaded unsophisticated buyers to borrow more than they could afford to repay. Asymmetric information contributed systematically to market failure in the housing bubble.

Markets often produce inequity. Some economists object when they hear inequity characterized as market failure. Rather, they hold that markets are not responsible for fairness. Fairness is a political or social issue, not an economic one. Nevertheless, some market rules magnify inequality while other market rules results in greater fairness.

Group-think is a common condition in human behavior, taking many possible forms. It is the opposite of the behavior assumed in market theory, where all market decision-makers are rational, independent, motivated by self-interest, and everyone shares all known information. Under group-think, markets are subject to asset bubbles and substantial misallocations of capital.

Misaligned interests

• Externalities
• Moral hazard
• Principal-agent problems

Economists believe self-interest drives behavior. Market failure can occur when the public interest is not aligned with the narrow interests of market decision-makers.

Externality is the term used to describe shifting of costs or benefits outside of the market between buyer and seller. For example, carbon dioxide is dumped into the atmosphere, where the public absorbs environmental costs. The producer of carbon dioxide pays nothing for the free use of the atmosphere. The public will pay extraordinary environmental costs sometime in the future – a classic market failure by externality.

The two remaining mechanisms of market failure are similar – one is moral hazard and the other is called principal-agent. In both cases, someone makes a market decision, and someone else pays for it.

One example of moral hazard can occur when a bank lends money, knowing the borrower cannot repay the loan. If the bank knowingly sells the bad loan to an investor, figuring that the problem will fall on someone else’s head, insulating the bank from its poor judgment, then the bank is guilty of moral hazard. The bank and the investor may be complacent, trading the risky loan without due diligence, because they expect a taxpayer bailout if the deal goes bad. They are guilty of moral hazard.

In an ironic twist, the bank and investor then use their political influence to prevent any taxpayer bailout of the original borrower, warning that such a bailout would create moral hazard among borrowers – that future borrowers may behave irresponsibly, anticipating a bailout.

The principal-agent failure mode is similar. For over a century, Goldman Sachs was privately held – owned by its partners. The partners ran the business scrupulously, making decisions optimized for the long-term. As partners, top decision-makers will be more careful, knowing their personal fortunes are at stake.

Goldman Sachs’ partners took the company public in 1999. From that point on, the executives became agents, and the new shareholders became principals. Shareholders will attempt to align the interests of executives with shareholder interests, knowing their wealth may be wiped out if their market goes sour.. However, executives can expect handsome incomes whether the company does well or loses billions. The interests of principal and agent can become misaligned or may even turn contrary to each other.

Stan Sorscher is a member of EOI’s Board of Directors. The views and opinions expressed herein are solely those of the author and do not necessarily reflect those of the Economic Opportunity Institute.