Chapter 3 Tx Asymmetric Info I Obstacles to matching savers and borrowers a Binging savers and lenders lend funds and borrowers borrow funds together are the role of the financial system b The financial system is complex because there are obstacles that can make it difficult for saver to find borrowers that willing able to lend to and for borrowers to find saver are willing to make loans c The problems obstacles facing small investors i Can be divided into 2 categories transaction cost and asymmetric info ii Because of transaction costs and information costs savers receive a lower return on their investment and borrowers must pay more for the funds they borrow 1 Sometimes these costs can cause funds to be never lent or borrowed at all iii Transaction Costs the cost of a trade or exchange the cost of making a direct financial transaction such as buying stock or a bond or making a loan 1 Ex the brokerage commission charged for buying or selling a financial asset 2 Lawyers and licenses 3 High transaction cost reduce the probability of transaction occurring a Flat fees fee that everyone pays for a something i High for small investment amounts 4 5 Insufficient money for high dollar investments Insufficient money to diversify iv Information cost the cost that savers incur to determine the creditworthiness of borrowers and to monitor how they use funds required 1 How credit worthy are you will money be spent as intended v Transaction cost and information costs reduce the efficiency of the financial system they also crate a profit opportunity for individuals and firms that can reduce these costs d How financial intermediaries reduce transaction costs i High transaction costs individuals savers less likely to lend directly to borrowers ii Small medium size firms that need to borrow money so banks reduce their transaction cost 1 If bank doesn t provide funding then they will sell part ownership of the firm to raise funds a They do this because it is unlikely to find individuals willing to invest in them because of risks and illiquidity situations 2 As a result small investors small to medium size firms turn to financial intermediaries commercial banks mutual funds to meet their financial needs a For example a mutual funds can sell shares to individual investors and use the funds to invest in a diversified portfolio of stocks and bonds While an investor with 500 dollars would have difficulty buying a diversified portfolio without incurring substantial transaction cost i Mutual funds provide diversification with low transactions costs b Another example an investor could purchase a certify ate of deposit from a commercial bank and the commercial bank then could use the funds to make loans to households and business borrowers 3 Intermediaries and technology a Are naturally involved via services they provide providing information product innovation b Reduce information costs c Reduce transaction cost to meet the needs of savers and buyers and still make a profit i They can do this because of Economies of scale the reduction in average cost that results from an increase in the volume of a good or service produced Economies of scale 1 Lower diversification costs 2 Access to high dollar investments a Examples i ATMs Computer systems within banks ii Mutual fund pensions diversification ii Specialization 1 Defined as one person doing a task a doctor specializes in treating patients only being a lawyer too a Defined as processing loans efficiently through repetition reducing time required and ultimately reducing cost per loan b Process standardization which allows the costs to produce a loan ex a contact is spread over many loans II The problems of adverse selection and moral hazard a When savers lend to borrowers a key consideration is the financial health of the borrower i Savers don t lend to borrowers who are unlikely to pay back 1 Borrowers w poor financial health have an incentive to hide it from lenders b Asymmetric information i Define as a situation in which one party to an economic transaction has better information than the other party 1 Typically lender has more information knowledge than borrower ii 2 problems that arise from asymmetric information 1 Averse selection the problem investors experience in distinguishing low risk borrowers from high risk 2 Moral Hazard This is the risk that people will take actions after they have entered into a transaction that borrowers before making an investment will make the other party worse off a In financial markets the problem is that investors can experience difficulty in verifying that borrowers are using their funds has intended iii Cost arising from asymmetric information can be so great that the investor will lend only to borrowers who are Financial markets or financial intermediaries lower the cost of information needed to iv A solution of the problem transparently low risk such as the federal government make investment decisions v To mitigate asymmetric information 1 Investors get info a Private info gathering firms costly 2 Borrowers advertise receive rewards good reputation III Averse selection in depth a Lemon bad cars firms etc take advantage of knowing more about the true value of the selling object than buyer investor i Ex people who are more likely to buy insurance or more likely to file claims 1 There are mitigating factors in insurance they are risk based premiums and distance to fire stations b Ex USED CAR MARKET analyzed by George akerlof restrictive covenants driving records etc i Seller of a car will have more true information than buyer ii Problem buyer cant tell if it is a good car or not iii Expected value is used in this market 1 Expected value probability car is good value if good probability if car is bad lemon value of lemon 2 This value will help determine if it is good car or lemon a Value offer good b Value offer lemon iv To Reduce cost of adverse selection car dealers act as intermediaries between buyers and sellers by 1 Maintaining good rep dealers are less willing to take advantage of private information about quality of car as result dealers sell lemons and good cars at true value plus government regulation s require to disclose all car information to consumers a Information problems reduce economic efficiency in a market 2 Recommendations 3 Government regulations 4 Warranties certified vehicles v Adverse selection in car market causes bad car to push good cars from the market c Example lemon problems in financial
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