Insights into market failure

From a market economy perspective, the market and free competition should ideally determine which businesses survive. However, the market does not always work efficiently. When it fails to do so, we call this market failure.

A well-known market failure is referred to as 'external effects'. These effects can be both positive and negative. One example of a positive external effect is a company developing a successful product, such as a drone. The company earns strong revenues from the product for a while, but other companies then copy it, driving down the price of drones. As a result, much of the value created by the product does not benefit the company that invented it. Instead, it improves customer welfare by giving customers access to better, more affordable products from a range of suppliers.

Innovation has significant positive external effects, which individual companies tend to give little consideration. One estimate suggests that innovators capture three per cent of the value generated by new products and processes, while customers, suppliers, competitors and the government receive the remaining 97 per cent. Developing new technology is therefore not necessarily profitable for companies. If everyone waits for others to invest in emerging technology so they can reap the benefits themselves, the transition will not happen.

Pollution is a common negative externality. When pricing its product, a company does not account for the negative impact that its production or product has on society.

Path dependency is a market failure that leaves society in a suboptimal state across an extended value chain. Ship fuel is one example. Ammonia is recognised as a potentially environmentally friendly alternative to the oil used today, but those investing in new ships face a lack of adequate ammonia infrastructure. As a result, investing in this type of technology is not commercially viable. For the same reason, other companies in the value chain do not expect anyone to invest in ammonia-powered ships. This makes the expectation self-fulfilling – and creates a barrier to innovation.

When the public sector initially provided innovation loans to shipyards building electric ferries while supporting several small charging companies at an early stage, Norway developed a well-functioning value chain for electric ferries. None of these companies now need public grants. Instead, they contribute to society by creating value through higher tax revenues, better transport solutions, more jobs and increased Norwegian exports.

A perfect market depends on complete information. However, there is considerable uncertainty for both small, early-stage entrepreneurs and technologically advanced projects in large companies. Can the product or service be brought to market? Will future customers be willing to pay enough to make it profitable? Will cheaper alternatives outcompete us? Will we be able to recruit the people we need to scale up?

The range of potential outcomes for many projects is asymmetric. If the project fails, you will rarely lose more than your investment – for example, a year's income for an entrepreneur. On the other hand, there is virtually no upper limit to how successful a new business can become.

Most people attach little importance to the small chance that the project or business will succeed beyond all expectations. At the same time, they place great emphasis on the high probability of a moderate failure.

Society as a whole reaps many of the benefits of successful development projects through tax revenues, higher wages and better products. This risk aversion – which is entirely rational from the perspective of each individual actor – therefore represents a market failure.

Even where there is genuine uncertainty, the company running the project will have more information about it – and probably about its likelihood of success – than potential investors. Addressing this information imbalance can help unlock many projects that are economically beneficial to society. As the EU and Norway's public support systems have no commercial interests, they can provide reliable quality assurance of the information supplied by the project owner. By 'certifying' uncertain projects for investors, they can reduce this asymmetry.

A well-known market failure is the lack of public goods. In their purest form, these are goods that, once produced, should by their nature be available to everyone. Knowledge can be considered a public good. Much of the work carried out by The Export Centre, the Made in Norway branding scheme, Visit Norway and Invest in Norway can, for example, be linked to this market failure. Keeping track of trade regulations across many countries is challenging, but once this information has been compiled, it should be available to everyone. Joint efforts to promote Norway as a travel destination can also be seen as a public good. Many Norwegian tourism businesses benefit from this promotion, but individually they are too small to fund it.

For more than 170 years, since the establishment of the Norwegian Mortgage Bank in 1851, governments across the political spectrum have considered whether addressing market failures is the right approach – and concluded that it pays off. New businesses turn ideas into new products, services and processes. They can also reduce our reliance on sectors that may be in decline, helping to build a stronger, more resilient economy.