Market distortion is an economic scenario that occurs when there is an intervention in a given market by a governing body. The intervention may take the form of price ceilings, price floors, or tax subsidies.
Breaking Down Market Distortion
Market distortions create market failures, which is not an economically ideal situation. Market distortions are often a byproduct of government policies that aim to protect and raise the general well-being of all market participants. Regulators must make a tradeoff when deciding to intervene in any given marketplace. For this reason, analysts and lawmakers try to seek a balance between the general well-being of all market participants and market efficiency in the formulation of economic policy. Although an intervention may create market failures, it is also intended to enhance a society's welfare.
For example, many governments subsidize farming activities, which makes farming economically feasible for many farmers. The subsidies paid to farmers create artificially high supply levels, which will eventually lead to price declines if the government does not subsequently purchase the goods or sold to another nation. Although this type of intervention is not economically efficient, it does help ensure that a nation will have enough food to eat.
Causes of Market Distortions
Government actions aren't solely responsible for all market distortions. Several types of events, actions, policies, or beliefs can bring about a market distortion. For example, a market may become distorted when a single business holds a monopoly or when other factors prevent free and open competition. This distortion causes problems for consumers as well as for private sector businesses following standard procurement procedures. A lack of competition typically means higher prices. A monopoly may exist because of a lack of competition or not enough strong competitors.
For example, almost all types of taxes and subsidies, but especially excise or ad valorem taxes/subsidies, can cause a market distortion. In addition, asymmetric information, uncertainty among market participants, or any policy or action that restricts information critical to the market can cause a market distortion.
Inaction on the part of governments may also result in a market distortion. For instance, government failure to provide a stable currency, enforce the rule of law, protect property rights, or regulate non-competitive or anti-competitive market behavior can also cause market distortion.
Other Possible Causes of Market Distortions
- Criminal coercion or subversion of legal contracts,
- Lack of liquidity in the market (lack of buyers, sellers, product, or money),
- Collusion among market participants,
- Mass non-rational behavior by market participants,
- Price supports or subsidies,
- Stifling or corrupt government regulation.
- Nonconvex consumer preference sets
- Market externalities
- Natural factors that impede competition between firms, such as occurs in land markets