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Market Failures and Economic Regulation
Las Fallas de Mercado y la Regulación Económica
Sara Graciela Bravo Loza
Independent legal researcher
City:
Quito
Country:
Ecuador
Johanna Stephany Cabezas Nazate
Independent legal researcher
City:
Quito
Country:
Ecuador
Josué Eduardo Rodríguez Carrillo
Independent legal researcher
City:
Quito
Country:
Ecuador
Giulianna Anahí Sghirla Ayala
Independent legal researcher
City:
Quito
Country:
Ecuador
Karla Daniela Valencia García
Independent legal researcher (correspondent author)
City:
Quito
Country:
Ecuador
Original Article (Miscellaneous)
RFJ, No. 13, 2023, pp. 90 -138, ISSN 2588-0837
ABSTRACT:
A country’s economic dream is to build ideal
markets where suppliers and demanders honestly and
efficiently meet their needs with fair and balanced prices.
DOI 10.26807/rfj.vi.459
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However, in reality, these types of markets are almost nil, since,
with the existence of Information asymmetries, the perspective
changes and from ideal markets, it changes to markets with
failures, since when there are gaps in data, figures, and others,
the participants in these markets do not synchronize with their
parts. Consequently, there is no perfection in their transactions,
and therefore, their activity and performance would not reach
the most convenient standards in the commercialization of
their goods or services since their decisions will not be the most
optimal. With market failures, the State, through its control
bodies, creates market rules and applies regulatory norms to
appeal to any type of failure committed in the market.
KEYWORDS:
Legal system, economic theory, market failure,
regulation.
RESUMEN:
El sueño económico de un país, es lograr construir
mercados ideales, donde los oferentes y demandantes de manera
honesta y eficiente satisfagan sus necesidades con precios justos
y equilibrados, sin embargo, la realidad de cumplir con este
tipo de mercado ideal es muy difícil, ya que con la existencia de
asimetrías de información, la perspectiva sobre los mercados
ideales cambia dando como resultado a los mercados con fallas,
por la presencia de datos vacíos, cifras alteradas, entre otros, los
partícipes de estos mercados no sincronizan con sus partes y
como secuela de esto no existe perfección en sus transacciones y
por ende su actividad y desempeño no alcanzaría los estándares
más convenientes en la comercialización de sus bienes o
servicios ya que sus decisiones no serán las “óptimas”. Con la
existencia de fallas en los mercados, el Estado por medio de
sus órganos de control crea reglas de mercado y aplica normas
regulatorias, para aplacar cualquier tipo de falla que se sete
cometiendo en el mercado.
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PALABRAS CLAVE:
Sistema jurídico, teoría económica, fallos
del mercado, regulación.
JEL CODE:
K, K0
INTRODUCTION
As a theoretical approach to building models aimed
at facilitating analysis and economic governance, abstractions
have been proposed to capture the main characteristics of social
scenarios to contribute to the process of “social optimization”.
This type of engineering and social constructivism exercise,
for example, can be used to evaluate specific moments such as
commercial
and
economic exchange
and, in a critical sense, to
reflect on how to make them happen as efficiently as possible.
It can lead to the study of the optimal allocation of resources,
inspired by the objective of satisfying human needs and
contribute to the theoretical construction of an ideal market,
where supply and demand are “proportional”, and no waste is
generated.
Furthermore, reflecting on this ideal market lucubration
will imply that the information necessary to carry out economic
exchanges is freely accessible. In other words, there should be
no exclusion, to the extent that both the consumer and the
producer “possess” the exact quantities and possibilities of
acquiring or sharing information and that the market process
itself is responsible for self-regulation to reach what is known
as the “equilibrium price”.
However, all these characterizations and assertions of
a perfect context of exchange or price system, without defects,
are based on ideas that could also be considered unrealistic.
Therefore, in the following lines, we will allude to other concepts
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such as the failures in the market (market failures) and ideas
that inform the recipe book of regulations or state intervention
either of a reactive type, proactive or interventionist.
It aims to promote “good practices” and a suitable
environment for socio-economic interaction and the generation
of incentives or disincentives for market agents in a dynamic
context of permanent change and adjustment.
1. MARKET FAILURES AND ECONOMIC REGULATION
When referring to the market, it is necessary to explain
the relationship between law and economics and how these
disciplines influence the market and its dynamics. When
referring to the law, understood as a mechanism that generates
agreements, compliance and coercive mandates within a given
territory. It alludes to the fact that it also manifests itself
through negotiation, processes of conflict resolution generated
by some conflict of interests (public or private). Among the
participating economic agents, whether in the purchase or sale
of a good or service, the law is primarily based on the premise
of self-composition (collaborative and cooperative alternative)
and heater composition (“confronted” agents who were unable
to reach an agreement among themselves).
Concerning “economic law” or “market law”, its scope
lies in the use of the understanding of the mechanisms of the
facts to promote economic activity, and in turn also as a control
entity, regulating activities of consumption, distribution,
planning, creation, among others, of the wealth existing in
society.
On the other hand, an example of the relationship
between law and economics is what happens with market
failures, which cause the market not to function optimally and,
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consequently, give rise to the introduction of “regulations” to
prevent significant adverse effects. In short, law and economics
are two indispensable sciences in managing the market, which
is visibly linked to each other, maintaining a solid interaction.
Proof of this can be found in the Constitution of the
Republic of Ecuador in the section referring to economic
exchanges and fair trade, which establishes the role of the State
in commercial activities:
Art. 335.- The State shall regulate, control and
intervene, when necessary, in economic exchanges and
transactions; and shall sanction exploitation, usury,
hoarding, simulation, speculative intermediation of
goods and services, as well as any form of prejudice to
economic rights and public and collective goods.
The State will define a pricing policy to protect national
production and establish sanction mechanisms to
prevent any private monopoly or oligopoly practice
or abuse of market dominance and other unfair
competition practices. (CRE, 2008, art. 335)
Furthermore, the economic activity of a market is closely
subject to the correct performance of all the economic actors
involved in commercial transactions. However, when these actors
are not efficient or honest or do not have precise information,
the consequences will be negative and will influence the costs of
transferring ownership of a good or service.
Therefore, the so-called “market failures” or lack of
harmony among market agents or economic operators affect
their ability to achieve profits and prevent the “level playing
field” understood as an implicit circumstance that falls on them.
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In addition, it introduces disincentives and even uncertainty,
potentially violating the (property) rights of those who act
following the parameters established in the legal system.
Based on the above, market failures are usually defined
as “situations in which the market fails to achieve efficiency
because the individual behaviour of each person trying to
maximize his or her benefits than the assumption of the best
outcome in social terms” (Vidaurre, 2020).
2. CHARACTERIZING THE MARKET
Article 5 of the Organic Law for the Regulation
and Control of Market Power (LORCPM) provides that the
determination of the market will consider the particular
characteristics of the sellers and buyers participating in
such
a market
. Competitors in a market must be comparable,
for which purpose the characteristics of the sales area, the
set of goods offered, the type of intermediation, and the
differentiation with other distribution or sales channels of
the same product will be considered. (LORCPM, 2011). This
“normative” and legal economic consideration forces us to
bring up the following topics.
2.1 Market Structure
“An organized and established market directly
influences the behaviour of its economic agents, who will
determine the price and quantity of goods or services that will
be traded.” (Westreicher, 2019). This structure comprises four
fundamental elements: supply, demand, price and marketing of
a product.
Supply. -
It is defined as “the set of offers made in
the market for goods and services for sale. The supply curve
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captures the location of the points corresponding to the
quantities offered of a particular good or service at different
prices.” (Marshall, 2017)
The purpose of supply in a market is to make goods or
services available in a given period and at a price established by
the economic environment. The competition between different
suppliers in the same territory must occur in an environment of
free participation. The only determining factor for consumers
to choose one or another supplier is fair treatment, represented
by a fair price, unbeatable quality, and optimum service.
Demand. -
It is the overall market value that expresses
consumers’ purchasing intentions. The demand curve shows
the quantity of a specific good that consumers or society are
willing to buy to function the price of the good and disposable
income. (Marshall, 2017)
For Laura Fisher de la Vega (2011), demand is “the
quantity of a product consumers are willing to buy at the market
price”. In addition:
The prices of goods or services in the market depend
directly on the demand variants, i.e. the higher the
consumption, the higher the production and therefore
the higher the economic performance. On the contrary,
the lower the consumption, the lower the production
and the lower the profit. (n. p.)
Price. -
It is defined as “the quantitative estimate
that is made on a product and that, translated into monetary
units, expresses the consumer’s acceptance or not of the set of
attributes of said product, based on its capacity to satisfy needs”
(Muniz, 2021).
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On the other hand, Raquel Valera (2019) makes some
remarks regarding price:
It determines the cost that a product or service has in
the market so that in order to consume such goods and
services, it will be necessary to pay that selling price and
determine the prices of products or services destined
to the market for its commercialization. Several factors
must be taken into account. Among these, we have the
cost of production, fixed costs, variable costs and profit
percentages. (n. p.)
When the customer buys a product in the market,
the product’s price already includes all the costs and benefits
invested in its production, thus being called the selling price.
The price of a good or service for manufacturers or producers
is a decisive factor for decision making focused on their
income since raising the price of a given product will generate
dividends, but the demand will fall. Otherwise, by lowering
the price of a good, its demand will grow and its benefits in
the same way. In economies in crisis almost constantly and
insignificant percentage, the sales tend to fall, and therefore the
price is an important variable that will be defined according to
the parameters established in each company.
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Graph No. 1:
Factors influencing price fixing
Source:
Gonzales (2014, n. p.)
Own Elaboration
As shown in Graph No. 1, the prices set for a given
good or service depend directly on the company’s internal and
external activities to position its product in the market with high-
quality standards to generate demand thus obtain higher profits.
2.2. On the marketing of a product
A given good or service marketing is regulated by
a chain of activities that facilitate its movement from the
manufacturer to the customer, including a series of adjustments
directly linked to promotion, diffusion, distribution, product
projection, mobilization, and storage. “The marketing of a
product or service focuses on marketing, which consists of
putting a product on sale, giving it the necessary commercial
conditions for its sale and providing it with the
distribution
channels to reach the final public” (Caurin, 2018, n. p.).
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Every company dedicated to the commercialization
of its products or services in a market must have
clear and objective strategies for the best use of the
opportunities presented for sale, thus managing a
series of approaches whose challenges are palpable at
the time of the adaptation of a good or service in the
market and whose durability is protected by innovative
methodologies. (Muñiz, 2021, n. p.)
Finally, one of the essential objectives to develop
high-level commercialization in commercial companies lies
essentially in the human talent since it depends on this that
the commercial department contributes with ideas, strategies,
possible solutions to problems presented, and many skills so
that the good or service is placed in competitive standards and
thus continue with the commercialization chain.
2.3. On Market definition
The market is defined as “places where there are, on the
one hand, sellers who offer their goods in exchange for money
and, on the other hand, buyers who contribute their money to
obtain those goods. There is, therefore, a supply and a demand.
What is paid is the price” (Sampedro, 2020, n. p.).
According to the Royal Spanish Academy Dictionary,
the
market is defined as
a set of activities carried out freely by
economic agents without the public authorities’ intervention.
From the perspective of economics, the market is “the
place where suppliers and demanders meet, and it is there
where the prices of goods and services are determined through
the behaviour of supply and demand” (Fisher, 2011, p. 58).
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On the other hand, it is considered that “The purpose
of the market study is to determine the number of goods and
services coming from the new production unit that, under
certain conditions of price and quantity, the community would
be willing to acquire to satisfy its needs” (Miranda, 2012, n. p.).
The market (see Graph No. 2) comprises two consumers:
actual consumers, who buy your products or services regularly,
and potential consumers who could probably be interested in
an offer.
Graph No. 2:
The Market
Source:
Fisher (2011, n. p.).
Own Elaboration
A market originates when there is a need or lack of a
good or service, and it is here where the capacity of producers
to offer suitable products that comply with the characteristics
established according to the consumption habits of the
demand and with accessible prices intervenes. Thus, fulfilling a
harmonic satisfaction between beneficiaries and suppliers, it is
worth mentioning that the clients’ acquisition is exclusively for
their consumption and not commercialising them.
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The indicator that positions a market to be competitive
against its adversaries is to externalize information records,
which will be the key for the actors involved in the commercial
negotiations of goods or services. Then, making clear and
concise decisions with optimal marketing strategies, allowing
them to position themselves with high-quality standards and
whose effort is reflected in their economic environment.
The main objective in a market economy is to achieve
the highest levels of performance, but when this for some
reason presents shortcomings, it is said that there are market
failures.
From the point of view of the typical customer, the
markets are distributed in four essential groups. The first is
related to the demand market and is nothing more than obtaining
the good or service intended solely for personal consumption.
A second concerns the supply or producer market, which is
the one that transforms the raw materials to obtain the final
product and can market it. The third is related to the reseller
market, which acquires the good through a sale from the initial
producer and resells it at higher costs, obtaining a profit; and the
last refers to the state market, which is responsible for acquiring
goods to provide services to its government departments and
for works in the community (Fisher, 2011).
Economic science, through the construction of models,
has made it possible to differentiate between two types of
market: the perfect market, which is the utopian construction
of an exchange space that has reached maximum efficiency, and
the real market, which is the actual and practical situation of
economic exchanges.
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2.4 Market typologies
a. Idealized or perfect market
The idealized market is:
Where no participant can individually influence prices
or quantities, it is also assumed that everyone is fully
informed of what is offered or demanded at available
prices. Under these conditions, any buyer can choose
with certainty what suits him best and at the best price
available. Therefore, it is claimed that the consumer is
the king of the situation and that the market gives him
the freedom of choice. (Sampedro, 2020, n. p.)
For Gregory Mankiw (2012), author of the book
“Principles of Economics”, a market is “a group of buyers and
sellers of a given good or service. The buyers jointly determine
the demand for the product, and the sellers” (n. p.).
The fact that there is perfect competition means that
each competitor does not have power in the market, i.e. does
not influence the optimal functioning of the market (Durán,
Quirós & Rojas, 2009).
It is a
market where suppliers and demanders share clear
and
essential
information
, so that the transfer of ownership
of a good is homogeneous, producing an economic scenario,
without overpricing, with free competition, with similar
products, with no barriers to entry and exit, without unfair
competition, with similar conditions for potential competitors
and thus, promoting an ideal balance between all the actors
involved in this marketing process.
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In other words, it is a place where everyone can access
in the same way and the same amount of information, which
will facilitate the making of reasoned decisions, and this means
that those who want to produce a good and those who want to
acquire it have access to the data, which consequently will allow
them to interact in the market. On the other hand, the ideal
market is a space that regulates itself, i.e. the quantity of the
product demanded and the product offered to reach a certain
point of exchange, known as the equilibrium price, without the
intervention of any factor that alters this result.
Graph No. 3:
Idealized market - the break-even point
Own Elaboration
As shown in Graph No. 3, the quantity demanded
coincides with the quantity supplied of the same good or
service, generating the equilibrium point or equilibrium price,
which (as mentioned above) results from the self-regulation of
the perfect market.
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b. Real Market
It comprises a group of people who need a good or
service, who possess the necessary financial means
to cover it and are interested in acquiring it. The
primary objective of the real market has always been
the exchange of goods at a realistic market price,
determined by the combination of supply and demand.
(García, 2014, n. p.)
Based on this, the real market is understood as space
where situations do not happen as ideally planned due to many
factors known as market failures. One of them is that there
is much hidden information. In addition, it is noted that not
everyone has the same access to information and that people
do not process it in the same way. Therefore, producers and
consumers are not usually in a position of the equality of
conditions, but someone will always know more than others.
This means that there cannot be parity between demand and
supply, thus generating an imbalance that does not reach an
equilibrium price, as in the ideal market.
This situation triggers phenomena such as waste
or scarcity. In the first case, there is more supply than is
consumed, and there is excess production, and in the second
case, supply does not meet demand, so there are unsatisfied
needs. This is why the real market is not self-regulating; it needs
the intervention of a regulating entity to operate in the best
possible way.
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Graph No. 4:
Market Failures - Actual Market
Own Elaboration
Graph No. 4 shows that the lack of information directly
affects the demand with products or services that are scarce
for use and the supply with excess production, causing waste
in their sales and directly generating an impact on the price,
clearly detecting a market with failures.
Segmentation of a real market. “Market segmentation is
a process by which a group of homogeneous buyers is identified,
i.e., the market is divided into several segments according to the
different purchasing desires and requirements of consumers”
(Fisher, 2011, p. 61).
The need to segment a market lies in classifying
consumers according to their consumption preferences, and
with these guidelines, manufacturers will be able to target
consumers by facilitating transparent and strategic processes
safely. Proper market segmentation requires effective measures
to match goods and services perfectly to the needs of each
individual.
c. Types of market segmentation
There are four types of segmentation in the market, and these
are:
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I.
Geographic segmentation divides the market into
geographic units, such as nations, states, regions,
provinces, cities or neighbourhoods that influence
consumers. The company can operate in one or several
areas; it can also operate in all of them, but paying
attention to local variations. In that way, it can adjust
marketing programs to the needs and desires of local
groups of customers in trade areas, neighbourhoods,
and even individual stores.
(Kotler & Lane Keller, 2012,
p. 214)
II.
Behavioural market segmentation is one of the leading
market division techniques. These four
market
segmentation
techniques represent the fundamental
tools to support a good marketing and communication
plan in distributing products and services. (Argudo,
2017)
III.
In demographic segmentation, the market is divided
by age, family size, family life cycle, gender, income,
occupation, education level, religion, race, generation,
nationality and social class. One of the reasons why
demographic variables are so popular among marketers
is that they are often associated with consumer needs
and wants.
(Kotler & Lane Keller, 2012, p. 216)
IV.
Psychographic segmentation is effective, and when
associated with other segmentation criteria (geographic,
behavioural, demographic, among others), it becomes
an essential tool for the correct adaptation of the
marketing mix (price, place, promotion and product)
to the target audience, i.e., it allows the company to
position its product more coherently in the market.
(Ciribeli & Miquelito, 2015).
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c. Imperfect competition
It is a market situation in which sellers or companies
competing in the market have some control over price because
they offer differentiated products and limit supply. In addition,
there is incomplete market information and emotional
buying behaviour in this type of market, so companies use
the promotion to inform, persuade or remind their target
market of the characteristics and benefits of their products
(Thompson, 2005).
This phenomenon produces:
a)
Low degree of concentration of companies: The
number of companies that form this type of market
is reduced, contrary to what occurs in a market of
perfect competition (Jiménez, 2012).
b)
Sellers influence price: In most cases, sellers
significantly influence price, thus contradicting the
spirit of the free market advocated by Adam Smith
with his metaphor of the “invisible hand” (Jimenez,
2012).
c)
Product differentiation: Companies in this type of
market are perceived as different by the consumer.
Characteristics such as design, use or usefulness are
different from one product to another (Jiménez,
2012).
d)
There is incomplete information in the market:
Buyers and sellers have different information about
the product. Cases of asymmetric information in
which the seller has much more information about
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the product than the buyer are expected in this type
of market.
(Jiménez, 2012)
e)
High prices and low production levels: This is because
sellers can control the price of their products to
some extent, which results in a decrease in demand.
(Jiménez, 2012)
f)
Existence of high barriers to market entry: The main
barriers to entry that prevent or hinder the entry of
new companies into the market are cost advantages,
product differentiation and the high capital investments
required to enter the market. (Jim
é
nez, 2012)
In other words, there is an imbalance between demand
and supply, so the market cannot regulate itself. In a scenario
of imperfect competition, some situations can be distinguished
that, based on the amount of supply or demand, trigger
consequences such as monopoly and monopsony, which are
extremes that directly affect the price of market products (see
Graph No. 5).
A monopoly is defined as “a market that has only
one seller, but many buyers” (Pindyck & Rubinfeld, 2009, p.
395). Market failure occurs when there is a single supplier in
the market that, through opportunism, in terms of supposed
efficiency, seeks to maximize its price, i.e. it has total control of
the market section to which it belongs and can impose the price
it considers best on the goods it produces.
To obtain more profits, the monopolist must first
investigate the types of demand existing in the market since
this information is essential for the company to make financial
decisions and thus decide on the quantity it will produce and
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sell. In other words, the monopolistic company determines the
price and quantity it will sell. (Pindyck & Rubinfeld, 2009)
A Monopsony “is a market that has many sellers, but
only one buyer” (Pindyck & Rubinfeld, 2009, p. 395). That is, it
is a single person, the consuming or demanding party; however,
variants such as duopsony and oligopsony, which are small
groups of buyers, can also be found; these together cause prices
to fall to a minimum value and consequently the supply must
produce more to offset the cost of production. “When there
is only one buyer, monopsony power influences the product’s
price by allowing the buyer to purchase the good at a lower price
than in a competitive market”. (Pindyck & Rubinfeld, 2009).
Another failure is an oligopoly, which is understood as
a “market in which only a few firms are competing with each
other, and the entry of new firms is impossible”. (Pindyck &
Rubinfeld, 2009, p. 507).
In specific oligopolistic factories, firms collaborate,
but in others, they do not, becoming rivals, even if this
means lower profits. To understand why it is necessary
to know how these industries manage their production
and pricing decisions. The measures are complex since
each company must act with planned methodologies,
and when it makes a decision, it must deduce the likely
reactions of its rivals always to be one step ahead of
them. In oligopolistic markets, economic performance
is very high because there are barriers to entry for new
companies forced to give up because of barriers to
entry. (Pindyck & Rubinfeld, 2009, n. p.)
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On the other hand, another flaw is the oligopsony, which
refers to “a type of
market
where there are few demanders,
although there may be a large number of bidders. Therefore,
control and power over prices and transaction conditions
reside with the buyers” (Cabello, 2016, n. p.). The dominance
identifies this type of market failure it has over the market,
and its profits are enormous. These companies have policies of
reciprocal dependence with the same economic purpose.
Graph No. 5:
Type of market failures - Imperfect Competition
Own Elaboration
For a more detailed example, Table 1 shows some
situations of imperfect competition and the degree of control
they exert on price:
Table No. 1:
Market structures and degree of price control
Market
Structure
Number of
Bidders
Degree of
control
exercised over
the price.
Example
Monopoly
One
Bidder
Complete
Control
Drinking-Water
Service
Oligopoly
Few
Bidders
Exercises little
control
Vehicle
Manufacturing
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Monopsony
Single
Claimant
Complete
Control
Public Works
Oligopsony
Few
Claimants
Exercises little
control
Large
Distributors
Source:
Fuenmayor (2017, n. p.)
Own Elaboration
Monopoly power causes the costs of a good to be
higher and the quantity produced to be lower; in the case of
monopsony power, the buyer’s capacity will influence the price
of the good so that it will be lower than that which would be in
force in a market.
c.1 On Commercial Regulation
This is done to prevent this imbalance between demand
and supply from significantly harming the price of the goods
offered and prevent fraudulent or evil faith actions that could
harm the proper development of the market.
Two solutions are proposed to avoid this situation: the
first is to set the price as if it were in perfect competition, which
means that the price is in equilibrium. Graph No. 6 shows this:
Graph No. 6:
Price in perfect competition
Own Elaboration
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The second solution proposed is to set a price
proportional to the total cost of production; however, the
long-term problem is that the producer, seeing himself with a
fixed income, may lower the quality of the goods he offers to
maximize his profits.
c.2 On the Regulatory Framework
The application of norms and rules established in the
Constitution is of vital importance since they are created to
avoid unfair and restrictive practices, distorted data and others
that may affect healthy competition and transparency in the
economic activities of the market.
These control measures are typified in
the Constitution
of the Republic of Ecuador (2008) approved in 2008,
where
it states “That, Article 304 paragraph 6 of the Constitution
establishes that trade policy will aim to prevent monopolistic
and oligopolistic practices, particularly in the private sector,
and others that affect the functioning of markets” (art. 304.6).
It should also be noted that
in 2011, the National Assembly
enacted the Organic Law of Regulation and Control of Market
Power (LORCPM), and in 2012, the Superintendence of Control
of Market Power (SCPM) was created as a control entity to
regulate and sanction all those economic agents that are not
aligned under the law.
c.3 Asymmetric Information Considerations
Information asymmetry (see Graph No. 7) constitutes
a market failure because it contributes to an unequal state
among market players. This occurs when one party has more
knowledge than the other regarding the good or service to be
exchanged in a negotiation. Without information, the decisions
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to be made are imprecise and can benefit or detriment an agent
in the transaction.
In the context of an “economy with asymmetric
information, the more informed agents displace the less
informed ones in the market” (Perrotiní, 2002, n. p.).
When the asymmetry of information originates in the
negotiation of a good or service, tacitly, the market equilibrium
disappears, and the negotiator with more information is placed
in a privileged situation causing the other negotiating party
to be in a vulnerable situation generating erroneous decisions
and thus placing itself in inefficient situations in the market
(McGraw-Hill, 2019)
.
Asymmetric information leads to market failure since
it induces the buyer to be at a disadvantage without knowing
it, acquiring a good or service of dubious quality at high prices,
so this dishonesty should be sanctioned in the regulations of
the Organic Law of Regulation and Control of Market Power
(LORCPM).
One of the causes that give rise to the appearance of
information asymmetry in the market is the poor allocation
of the few information resources among the economic
participants, which restricts the companies without this tool
to function better, causing this inefficiency to become an
economic problem since decision making will be complex and,
in some cases, erroneous.
The failure of information is frequent, and its effect
acts as a limiting factor in the exercise of goods or services,
generating conflict and discouraging suppliers and demanders
from participating in the market.
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A market with few buyers and few sellers is sometimes
called a thin market. Conversely, a market with many
buyers and sellers is called a dense market. When
imperfect information is severe, and buyers and
sellers are discouraged from participating, markets can
become extremely thin as a relatively small number
of buyers and sellers attempt to communicate enough
information for them to agree on a price. (Gonzales,
2020, n. p.)
Figure No. 7:
Information asymmetry - practical example
Own Elaboration
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Information asymmetry
also results in the following problems:
a.
Adverse Selection. -
The quality of a good or service
depends directly on the asymmetry of information. When one
of the participants in the transaction has clear and concise
information and does not share it with the other party or
provides distorted information, tacitly both parties are affected,
since their production levels will not be optimal and with the
risk that these goods or services do not offer the quality offered
or worse still cannot even be exchanged.
In an economy with asymmetric information Akerlof
(1970) (The economics of asymmetric information: micro-
foundations of imperfect competition) “the more informed
agents (borrowers, sellers in second-hand markets) crowd out
the less informed agents in the market, and, as a result, the
“bad” product crowds out the “good” product” (n. p.). Akerlof
extended the famous Gresham’s Law to the case where agents
cannot distinguish between the high-quality sound and the low
quality good due to the presence of asymmetric information”;
the assumptions of his model are:
i.
The offer of an indivisible good that is presented
in two qualities, the low quality good and the high
quality good;
ii.
The offer is made in fixed proportions, and
respectively;
iii.
consumers cannot recognize a priori the qualitative
differences of the product due to “private” or
“hidden” information held by the seller;
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iv.
In the absence of market regulation, the same dual
quality good (high and low) will be traded in only
one market, and consumers will not be able to
identify this qualitative duality, giving rise to the
phenomenon of adverse selection.
In a scenario where the conditions of information
asymmetry give rise to a problem of adverse asymmetry, the
seller of a high-quality product should not simply tell his
customers but demonstrate it, and a clear sign of this is the so-
called manufacturing guarantees of a good or service.
This failure in the market of adverse asymmetry harms
everyone, both buyers who, in good faith, acquire products
thinking that they are of good quality and that only in their
consumption will prove otherwise; as well as sellers who will get
bad publicity and who knows even complaints about misleading
advertising and deception. The different guarantees existing in
a market are a reflection of the quality of each of its products.
One of the solutions to this market failure is the one
developed by the governmental entity, by issuing within the
constitution the so-called
Organic Law of Regulation and
Control of Market Power
(LORCPM), which
protects the
interests of buyers, sellers, customers, suppliers, consumers,
users, distributors and
other actors that are part of the market,
through mechanisms that guarantee a free competition system
avoiding and sanctioning bad commercial practices if necessary,
and thus having efficient, transparent, competitive, productive,
technological and fair markets. (Constitution of the Republic of
Ecuador, 2008)
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Within the guidelines for the application of the
conducts contained in the Organic Law of Regulation and
Control of Market Power (LORCPM) (2020), we find article 1,
which determines:
The purpose of this Law is to avoid, prevent, correct,
eliminate and sanction the abuse of economic operators
with market power; the prevention, prohibition and
sanction of collusive agreements and other restrictive
practices; the control and regulation of economic
concentration operations; and the prevention,
prohibition and sanction of unfair practices, seeking
market efficiency, fair trade and the general welfare of
consumers and users, for the establishment of a social,
supportive and sustainable economic system. (art. 1)
This phenomenon can be better understood from the
following example (see Graph No. 8):
Graph No. 8:
Information asymmetry - adverse selection
Own Elaboration
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b.
Moral hazard. -
Ex post in terms of exchange decision.
Moral hazard is a problem derived from the asymmetry of
information (see Graph No. 9 and Graph No. 10), where one
of the parties generates its benefit without considering that the
other party cannot observe it or be aware of its movements.
For
Krugman
(2017) “moral hazard refers to any
situation in which one person decides how much risk to take,
while another person bears the cost of things going wrong”
(n. p.)
For another author, moral hazard is:
The incentive of a person A to use more resources than
he would otherwise have used, because he knows, or
thinks he knows, that some other B will provide some
or all of those resources. What is important is that this
occurs against B’s will and that B is unable to approve
of this appropriation immediately. (Hülsmann, 2008,
n. p.)
This type of market failure occurs because the economic
agents participating in a transaction are uninformed about the
reality of some consequence given by one of the parties. This
asymmetry of information operates in activities generally in
insurance contracts, in auditing companies, in banking entities
towards their clients, among others.
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Graph No. 9:
Market Failure - Moral Risk
Source:
Guido (2008, n. p.)
Own Elaboration
As can be observed, moral risk arises once a contract has
been accepted, with all its terms and conditions. The contractor,
due to some adversity in the environment of the contracted
agent, cannot verify whether such calamity occurred due to
imprudence or not of the contractor, so the contractor claims
its rights established in the signed document, thus obtaining
a favourable situation with the execution of such agreement,
which the contractor omitted information or distorted it.
Finally, asymmetric information leads to a moral
hazard caused by the scarcity of informative data due to the
concealment of information for convenience, as detected in
confirmed cases in the market.
According to Rodriguez (2013), market failures
corresponding to information asymmetry influence the
behaviour of economic agents since it allows them to decide
which action to take is the most appropriate for their commercial
benefit within a business market, implying short-term
consequences that will only generate situations of
inefficiency
and loss of consumer welfare.
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The existence of asymmetric information justifies
an immediate intervention to correct or mitigate its effects.
Therefore, a market must correct itself with regulatory strategies
and radical approaches to mitigate information asymmetry.
This problem must be overcome through natural
incentives and strategies by all the intervening agents in the
economy, who suffer from market failures due to the lack of
information reflected in their productive activities.
A direct measure to stop the lack of information in
current times is that digital technology, which develops, notifies
and transmits information instantaneously and at a low cost.
Concerning manufacturers of high and low-quality
products, another natural incentive mechanism in the face
of lack of information is to offer guarantees to consumers,
reducing the uncertainty they have at the time of acquiring
a good or service and whose reward will influence the price,
obviously the manufacturers of dubious quality will have little
encouraging scenarios before their adversary. This incentive is
significant even in monopolistic markets.
Chain advertising is another natural tool that facilitates
the marketing of a product, and this occurs when satisfied
consumers recommend the product to their relatives and these
to the rest.
Other sources of information acquired innately are
provided by retailers as they comment on their work practices
to other consumers. Moreover, finally, we find the digital
information, which, through computers, tablets, and cell
phones, provides us with all kinds of valuable content across
borders and with basic costs for its use.
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Figure No. 10:
Example of the type of market failure -
Information asymmetry - moral hazard
Source:
Rodriguez (2013, n. p.)
Own Elaboration
It is necessary to take into account for improving
information asymmetry, measures based on regulatory
standards, which should include standardization of parameters,
in order to manage information more accurately, as well as to
improve reputation concerning market research and supply and
demand behaviours in order to interact in an honest manner
and with efficient results.
Finally, it is pointed out that information asymmetry is
a market failure caused by the lack of regulation since it is the
interaction between the legal system and the economic reality.
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c.4 “
Externalities”
considerations
By definition, an externality is an overflow, and it is a
positive impact (in which case we speak of “external”
benefits) or a negative impact (“external” costs) on
another party not directly involved in an economic
transaction. In such cases, prices do not reflect the total
costs or benefits of producing or consuming a product
or service. Consequently, producers and consumers in
a market do not bear all the costs or reap all the benefits
of economic activity. (Bou, 2009, n. p.)
There is a cost or benefit to a third agent outside
the interaction with the market. For example, during the
production or manufacture of the product or good, side effects
occur that were not planned within the cost of production and
are assumed by agents who are not involved in the exchange.
According to Bou (2009), externalities in an economic
market are made visible by the excessive production of a
product whose purpose is to satisfy demand.
The internal costs that a manufacturer generates for
the elaboration of a particular good or service for society’s
consumption are retributed in its profit. However, external
costs are generated during the transformation of raw materials
to the final product because they affect third parties. From the
producer’s point of view, they do not have any interference in
the productive phase, and these costs are called contamination,
destruction, pollution, originating the so-called negative
externalities (Bou, 2009, n. p.). These costs are shown in
Graph No. 11.
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The economy shows that with the appearance of
negative externalities, disastrous results are generated from
the social point of view since the most harmed are not even
aware of this situation. In other words, businesspeople
pollute the air with the production of certain products. Their
machinery generates the emission of gases that contact nature
cause an environmental impact, and the surrounding people
unknowingly inhale. Moreover, it is here where the State must
apply corrective measures for these cases and charge monetarily
for the negative impacts caused. (Bou, 2009)
As opposed to negative ones, positive externalities
provide many benefits, as is the case of pollination, which
generates benefits in the development of plants and these, in
turn, produce fruit and the honey nectar produced by the bees.
These activities help clean the environment and regenerate
it, so they should be encouraged with economic support to
promote this activity.
The existence of externalities creates an essential flaw
in the operation of a market by creating diseconomies, which
provide incorrect signals to companies and consumers and
result in inefficient prices and goods. (Bou, 2009)
Faced with this problem of market failure, the
central government should focus on applying a tax (negative
externality) and a subsidy (positive externality) to mitigate
some of the damage caused to the environment and reward the
benefits caused to it. (Bou, 2009)
It should be clarified that judicially, the problem to be
solved is the negative externalities that, whether premeditated
or not, are not part of the production costs of the causers; and,
consequently, these are assumed by society, so mechanisms
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must be established to rectify these costs through penalties,
fines, fees, taxes, among others.
With externalities, the premise of the perfect market is
broken precisely because of the cost of the damage caused, and
it is necessary to be aware of the damage caused to third parties
so that this behaviour can be minimized through behavioural
terms to achieve market equilibrium.
Graph No. 11:
Example of the type of market failures –
externalities
Own Elaboration
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c.5 Public Property Considerations
Public goods are those that do not have a rivalry, which
“means that the consumption of such good or service by one
person does not reduce the amount available to others” (Tansini,
2003), nor exclusion, which implies that “it is impossible or
prohibitive to prevent people who do not pay for such good
or service from using it” (Tansini, 2003). To contribute to the
definition of “public goods,” we can paraphrase the author
Alberto Benegas-Lynch (1998), who states that public goods
produce effects for subjects that do not participate in an
economic transaction, equivalent to generating externalities
that cannot be internalized.
The doctrine recognizes two types of public goods:
pure public goods and impure public goods. Now, what are
pure public goods? A public good is pure when it is of total
enjoyment, that is, when it exhibits no rivalry or exclusion in
its use by the citizens, a clear example is street lighting, since
everyone uses it and its use by one subject does not represent
an impediment or detriment to the use of another (it can be
enjoyed at the same time and without exception). On the other
hand, impure public goods are those that have degrees of non-
rivalry or joint consumption, but not absolutely; they are rivals,
but the exclusion of their consumption is not efficient or is
impossible, and they are not rivals, but it is possible to exclude
people from their consumption (Filgueira & Lo Vuolo, 2020).
Another part of the doctrine affirms that any good
and service continuously varies within the spectrum between
public and private classic absolute constructions (exemplified
in Figure 1). Since “strictly speaking there would be no goods
and services, no matter how rivalrous or excludable they may
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be, that do not generate some public externalities” (Filgueira
& Lo Vuolo, 2020). For example, a perfume, which although
it can only be used by the person who acquired it (through an
economic exchange), can be perceived (and enjoyed or not)
by all those who are in its periphery, or a tree, the exclusive
property of the person on whose land it is located, which
provides shade to the neighbouring house.
Graph No. 12:
Characteristics of public and private assets
Own Elaboration
Other attributions of public goods are presented by the
author Pimiento (2019), who states that:
To simplify the legal regime of public property (...)
it should be noted that: a) all public property (fiscal
and public use) is imprescriptible; b) public use
property and fiscal property destined to the provision
of public service, provided by a decentralized entity
or its concessionaire, are unseizable; and c) public
use property and fiscal property determined by the
constituent of the legislator are inalienable. (n. p.)
It is also necessary to cite the definition of public goods
(or national goods) in the Ecuadorian civil code:
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Art. 604.- National assets are those whose domain
belongs to the Nation as a whole. If, in addition, their
use belongs to all the inhabitants of the Nation, such as
streets, squares, bridges and roads, the adjacent sea and
its beaches, they are called national goods of public use
or public goods. Likewise, the perpetual snow-capped
mountains and the areas of territory located more than
4,500 meters above sea level. The national goods whose
use does not belong to the inhabitants are called State
goods or fiscal goods” (CC, 2005, art 604).
In the perspective of the perfect market model, which
implies property rights transactions for the satisfaction of
needs, public goods represent a market failure. According
to Bagattin (2018) and as a result of the non-rivalry of these
goods, they produce the phenomenon above;
For a price equal to zero that maximizes social
benefit, there will be no provision under a market
scheme unless the producer could obtain resources
by alternative means to the sale of the good or service
in the market. On the other hand, if the marginal cost
is zero, any favourable price implies a reduction in
efficiency and the additional need to implement some
form of exclusion. (emphasis added) (n. p.)
Adding to this phenomenon the inability of these
goods to be excluded, it is unlikely that there will be private
participation in this type of market.
On the other hand, according to Benegas-Lynch (1998),
the public nature of public goods (redundancy aside) implies
the existence of “free-riders”, i.e., individuals who benefit from
the externalities (generally positive) of such goods without
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having been part of a transaction. This implies an economic
waste since the good, service or externality was not enhanced
or maximized.
Now, it is pertinent to delve into the concept of “free
riders”, these are subjects within a group that grants a certain
degree of anonymity and, upon receipt of a benefit, do not
contribute to remedying production costs. This behaviour
responds to a limited rational behaviour of satisfaction of
individual interests or, in the words of Bagattin (2018):
For the group of individuals when they contribute to
sustaining the cost of the public good whose provision
places all of them in a situation of greater welfare than
in the case where it is not provided, but it will be the
most profitable condition for each rational individual
to obtain the benefits by leaving others to assume the
costs. (emphasis added) (n. p.)
The solution to the problem of public goods is directly
related to technological evolution since it provides producers
with methods to generate rivalry and exclusion over goods and
thus profit from their production. This gradual privatization
of goods can be exemplified in the encryption of frequencies
(for telephone, television and radio services) limiting access to
them. It is also directly related to the development of research
methods that identify non-internalized externalities.
From the legal perspective, state interventionism is
proposed (and justified), i.e., that the State (in the absence of
private providers) should provide these goods and services
in exchange for taxes. In this way, there would no longer be
“free-riders” (unless tax obligations are not complied with,
legally sanctioned), and the costs of services and goods would
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be covered. Alternatively, the State could incentivize the
production of these goods through the exchange of taxes for
the investment in public facilities and other related types of
infrastructure.
In Ecuador, direct State intervention has a constitutional
hierarchy, as it is enshrined in the following articles of the
Constitution of Ecuador (2008):
“Art. 285.- The specific
objectives of the
fiscal policy
shall be as follows:
1. The financing
of services, investment and public goods (...)” (art. 285).
Art. 315.- The State shall constitute public enterprises
for the management of strategic sectors, the provision
of public services,
the sustainable use
of natural
resources or
public goods
and the development of
other economic activities. (CRE, 2008, art. 315)
This normative solution is currently applied to regulate
the failure of public goods, but this does not mean that it is
not subject to criticism. Benegas-Lynch (1998) questions the
coercion applied by this type of regulation because from an
economic perspective. The consumer is forced to pay for a good
or service that he may or may not use. For example, a blind
person does not benefit from public lighting, but part of his
taxes will cover the costs of this service.
Other authors claim that public goods regulation policies do
not “work according to Walrasian general equilibrium models”
(Filgueira & Lo Vuolo, 2020) and that it would be unreasonable
to try to create regulation policies based on this system, as it
would result in many public goods and services not having a
place in this perfect market model.
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CONCLUSIONS
By way of synthesis, it is possible to affirm that
Economics and Law are closely related. For:
The Law, when it is put into operation, takes the basic
social relationship (whether economic, political, family,
among others,) [...] to inscribe it in public and general
sphere of Law” (Ost, 2017).] to inscribe it in public and
general sphere of Law. (Ost, 2017, n. p.)
In other words, Law adopts (generally in the normative
legal system) situations of public interest and grants them legal
consequences, which in turn creates obligations, which are
enforceable and with non-compliance punishable by the state
power; in other words, the function of Law is to regulate (with
general, public and binding rules) interpersonal relationships,
among which are economic exchanges.
Moreover, it can be argued that law plays a particular
role within the market, and that is to facilitate its organization,
regulation (of economic failures) and coordination. Therefore,
it promotes rules that seek to model the behaviour of market
actors so that the “real market” develops as close as possible
to the “ideal market”, i.e., so that the market is as efficient as
possible. Furthermore, an exercise of social engineering is
promoted where the efficiency of these rules (norms) will have
its foundations in a system of incentives and disincentives,
which “use” the desire to maximize the benefit (or otherwise
minimize the loss) so that the agent (according to his limited
rationality) is prone to make decisions according to ends in
harmony with the legal system.
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It should be noted that the market is a space in which
human interactions take place, the purpose of which is the
satisfaction of needs through the transaction of goods and
services (which in the end constitutes an exchange of property
rights). Also, in which there are constantly conflicting interests
since the subject prioritizes his or her benefit over the common
good. It is because of this individualistic eagerness inherent to
the human being that straightforward rules are necessary.
On the other hand, market failures are products of
reality in which the real market disagrees with the perfect
market paradigm. These are a) information asymmetry, which
arises from the factual inequality between agents in terms of
their capacity to acquire and process information; b) non-
internalized externalities, which third parties must assume; c)
public goods, which despite being necessary, violate the logic
pursued by the ideal market; and d) imperfect competition,
which in short means that the parties are not on equal terms,
resulting in price manipulation by the dominant participant.
However, although the paradigm of the perfect market is helpful
in approximate an ought to be, it is merely referential and
cannot be used as a tool to justify irrational collective action.
Social engineering has limits and requires that these limits be
set to avoid overlapping “state failures” when attempting to
correct “market failures”.
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R
eceived:
05/05/2022
Approved:
01/12/2022
Sara Graciela Bravo Loza:
Independent legal researcher
City:
Quito
Country:
Ecuador
Email:
rfj@puce.edu.ec
ORCID:
https://orcid.org/0000-0001-6629-8231
Johanna Stephany Cabezas Nazate:
Independent legal
researcher
City:
Quito
Country:
Ecuador
Email:
johannac202@mail.com
ORCID:
https://orcid.org/0000-0001-7211-8073
Josué Eduardo Rodríguez Carrillo:
Independent legal
researcher
City:
Quito
Country:
Ecuador
Email:
josuejocho@gmail.com
ORCID:
https://orcid.org/0000-0002-6487-2719
Giulianna Anahí Sghirla Ayala:
Independent legal researcher
City:
Quito
Country:
Ecuador
Email:
giuliannasghirla@gmail.com
ORCID:
https://orcid.org/0000-0003-1607-4824
Bravo, G.; et al.
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Karla Daniela Valencia García:
Independent legal researcher
City:
Quito
Country:
Ecuador
Email:
karlivale2013@gmail.com
ORCID:
https://orcid.org/0000-0002-2236-7431