Market Imperfection

Market

Market imperfections

Ramon P. DeGennaro1

SunTrust Professor of Finance, The University of Tennessee, Knoxville, and Visiting Scholar, Research Department, Federal Reserve Bank of Atlanta

Abstract

This paper provides a taxonomy of market imperfections built around the economic forces underlying them. Market imperfections affect virtually every transaction in some way, generating costs which interfere with trades that rational individuals make, or would make in the absence of the imperfection. Understanding these costs gives us insight regarding the total costs of transactions, where to place them, or whether to undertake them at all. Market imperfections also generate profit opportunities for entrepreneurs. Institutions or individuals that can lower costs that trace to imperfections have a competitive advantage and can earn economic rents — at least until competing firms adapt. Imperfections can and do change over time, but they collectively never go to zero. Identifying and solving the underlying business problems linked to these imperfections remains an ongoing challenge — and opportunity.

1

I would like to thank Paula A. Tkac and James T. Moser for useful comments and discussions that clarified several points. The views expressed here are the author’s and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any errors are the author’s.

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Market imperfections

What comes to mind when we hear ‘market imperfections’? Most of us think first of financial markets, and would name taxes and transactions costs. Although these are obvious examples, market imperfections are legion and affect virtually every transaction in some way. Taxes, for example, influence not only financial decisions but also decisions to trade everything from shirts to real estate. Nor must the imperfection be a monetary cost: We sometimes must stand in line to pay a lower price. New businesses must charge lower prices than...