An incomplete market is one where some of the necessary conditions for market formation exist, but not all of them. In the case of incomplete markets, some entrepreneurs may enter the market because profits are possible. However, the firms that do start-up will only satisfy a small proportion of potential demand. In these incomplete markets, total supply is insufficient to meet the needs of consumers. In such cases a market may form, but will fail to develop completely - in other words it is an incomplete.
There are several examples of incomplete markets, including the markets for quasi-public goods and merit goods.
Quasi public goods
The market for quasi-public goods is an important example of an incomplete market. A quasi-public good is one that resembles a pure public good, but lacks some of its characteristics. A free market for pure public goods, like defence, is unlikely to exist at all, but for quasi-public goods, there is a strong possibility that free markets would satisfy a part of total demand.
Quasi public goods are:
Partly-diminishable, and partly-rivalrous, which means that as quasi public good is consumed the stock available for others will diminish, but slowly. Hence some competition between consumers may occur.
Partly-excludable, which means once the goods are supplied some consumers can be excluded from consumption.
Rejectable, which means consumers can reject the good, and they are not forced to consume it.
The example of bridges
Major bridges could be funded by private enterprise because it is possible to operate a toll system, with barriers, and charge each motorist a crossing fee. Gradually, the cost of building the bridge would be covered, and eventually a profit could be made. However, free markets are unlikely to satisfy the need for all river crossings, because the revenue generated would be insufficient.
Bridges are considered to be quasi public goods because some of the conditions necessary for market formation exist, but not all.
Bridges exhibit some diminishability, so that when drivers go over a bridge there are reducing the bridge-space for others.
Some rivalry exists between users of bridges because they often have to queue to cross, as there is an excess of demand over supply at the point of crossing. This indicates scarcity and provides an incentive for firms to because it creates the possibility charging users.
Because the owner of a bridge could put up barriers to stop drivers crossing, the free-rider problem is solved, and non-payers can be excluded.
Crossing a particular bridge to get to a destination can be rejected by drivers, because they can take another route which avoids any toll charges, hence bridges exhibit the characteristic of rejectability.
The formation of a market for using bridges
A market for bridges could emerge in an economy because the conditions for market formation are partly present. For example, although it would be extremely costly to build a bridge across a major river, an entrepreneur could generate revenue by constructing a toll, or turnpike, as they were originally called in the 14th Century. If crossing by this particular bridge, rather than going a different way, creates a positive private benefit for users, in terms of time saved or safety, the entrepreneur can fix a price and charge users. A sufficiently low price can be charged to encourage vehicle owners to use the bridge, especially if the entrepreneur does not expect to make a profit in the short run. A range of prices can be charged to reflect different sizes of vehicles, and different times of crossing.
Some revenue can be set aside for future maintenance of the bridge, and, in most respects, the bridge becomes a private good. However, building a network of toll bridges covering every river in the country would be a very unattractive proposition for a private firm, not just because of the cost of building and maintaining but also because of the difficulty of charging each time the bridge is used.
For example, if a farmer lives on one side of a river and works on the other side, goes home for lunch and makes three round trips across the river and back to deliver his produce, then on any given day the farmer will have to make at least ten trips and ten payments. Without an electronic method of payment, an employee would be needed to collect the money, and this would significantly slow down the traffic flow over the bridge. A much more efficient way to fund such bridges would be to impose a general tax, or rate, on local farmers, and beneficiaries, and build and maintain bridges through as general tax fund. This would avoid the problem of charging for each crossing.
In the UK, turnpikes were an increasingly common way of paying for the maintenance costs of major roads from the early 18th Century. The UK government allowed private companies, known as Turnpike Trusts, to put up tolls (turnpikes) to collect revenue to upkeep and extend the road system. However, by the 1850s railways took over from turnpikes as the most popular method of transport. The complex and fragmented turnpike system was also seen as an increasing barrier to trade across the UK, and it was effectively abandoned in the late 19th Century as control of the building and maintenance of roads and bridges was given to local government, which collected revenue from local rates and received a subsidy from central government. The development and collapse of the turnpike system provides evidence of the difficulty of finding a single and effective way to fund and operate quasi-public goods.
The introduction of new technology can often lead to the formation of new markets, and allows existing markets to become complete over time. This occurs for a number of reasons:
New technology can be used to reduce production costs and make it easier for private firms to break-even.
Technology improves the ability of firms to exclude entry to prevent free riders, such as the use of automatic barriers across bridges. Number plate recognition systems can also be used to track and monitor attempts to avoid payments.
Computer systems can be used to enable suppliers to generate and store more knowledge about travellers and about peak flows, and hence reduce information failure, and increase efficiency. For example, cameras and computers can be used to monitor and measure traffic flows over a bridge.
Finally, new technology allows the possibility of creating fast and efficient payment methods, which can avoid the need to queue to have access to public goods.