Question by zaar: Explain the two main causes of market failure and give an example of each?
Best answer:
Answer by LucaPacioli1492
One kind is the divorce of market prices from reality: sometimes called “irrational exuberance.” These occasion asset “bubbles” of various kinds that have occurred throughout history. The Dutch Tulip bubble of the 1630s, as do many, envisaged the continual, monotonic increase in the price of tulip bulbs. The fundamental idea that tulips represented an attractive future market ( Holland’s present market for tulips is larger than the total trade in tulips during Tulipomania ) but the prices outstripped any reasonable valuation. More to the point of similarity with other bubbles, the use of credit, leverage and new financial instruments ( such as options contracts, futures, etc. ) allowed unbridled buying that would have been less had it been limited to cash deals. Stock market crashes that are more familiar are 1929, the tech bubble of 2001 and the recent one starting in Summer 2008. The latter was initiated by the asset bubble in housing and, most importantly, the credit expansion that fueled it ( both the low interest rates artificially maintained too long by the Fed, the artificial stimulation provided by government through the Community Reinvestment Act and the provision of unsound credit through the sub-prime (meaning “bad risk”) lending fostered by the CRA. The invention of new financial instruments followed the historical pattern with mortgaged-backed securities ( combined with irrational ratings from agencies ) adding to the innovation of securitization to allow other financial markets to be tapped and the mortgage pool to be reloaded.
Another kind of market failure is when there just isn’t enough liquidity to sustain transactions ( usually where, as a consequence, the bid-asked spread becomes impossibly large.) A recent example of this is the market for “Auction-rate Preferreds” where seven-day paper was touted widely for almost 20 years as an alternative to money-market funds until February 2008 when the auctions failed and those backing these markets just withdrew and the whole market froze into illiquidity.
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