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MTSU Econ 3210 - Chapter 9

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Stuart Fowler

on 20 October 2014

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Transcript of MTSU Econ 3210 - Chapter 9

Chapter 9, Asymmetric Information & Transactions Costs in the Financial System
What is Asymmetric Information?
Tree on left is symmetric (equal parts). Tree on right is asymmetric (no equal parts).
Information can also be asymmetric; seller (borrower) usually knows more information than the buyer (lender).
Q: who has more information?
What are Transactions Costs?
Def: Transactions costs are the cost of a trade or exchange.

Ex: The brokerage commission charged for buying or selling a financial asset.

Note: Transactions costs may be related or caused by asymmetric information
Why Should we Care about Asymmetric Information and Transactions Costs?
Q: What information is asymmetric. What are the transactions costs?

A: Be around to service machine, to pay, third party's ability.
Transactions costs include time spent reading and verification of financials, time spent finding 3rd party, cost of hiring 3rd party
The Costs of Asymmetric Information
The Costs of Transactions Costs
TC and AI have the negative effect of raising borrowing costs. This results in:
less borrowing/saving.
drive out "good" borrowers and leaving "bad" borrowers.
The Market for Bonds
Ex Suppose that you purchased a 3yr 5% coupon bond with par value of 1000at a price of 950. What is your expected return if you think you will sell next year for 925? 1+i=(50+925)/950=1.026 or 2.6%

Q: What happens to your expected return on the bond if there is now an expected selling fee of $20? (50+925-20)/950=1.0052 or .52%

Q: Draw the effects of the fall in expected return on the bond market.
Note the fall in price means higher borrowing costs
Fall in quantity means less loans made!
Def: Information costs are the costs that savers incur to determine the creditworthiness of borrowers and to monitor how they use the funds acquired. These result from AI.

There are two types of InfoCosts that arise from Asymmetric Info:
Def: Adverse selection is the problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment. Additionally, the odds of unknowingly lending to a high-risk borrower is relatively higher.

Ex: In insurance, the problem that those most likely to buy insurance are also most likely to file claims.

Ex: The lazy coworkers of Dilbert will most likely pay to get a good evaluation but are least deserving of a raise.
Def: Moral hazard is the risk that people will take actions after they have entered into a transaction that will make the other party worse off. Moral hazard occurs if a party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk.

Ex: Dilbert and his coworker. His coworker may not give him a good eval once he is paid.

Ex: in financial markets, the problem investors experience in verifying that borrowers are using their funds as intended.
Q: Why is this a picture of moral hazard?
Consequences of Adverse Selection
The "bad" products or services are more likely to be selected.
The Lemons Problem:

consumers cannot tell the quality of a product and are willing to pay only an average price for it,
this price is more attractive for sellers who have bad products than to seller who have good products (hence the term adverse selection). Consequently, more bad products (i.e., lemons) will be offered than good products.
if consumers are rational, they should anticipate this adverse selection and expect that at any given price, a randomly chosen product is more likely to be a lemon than a good product.may lead to a complete break down of the market.
Moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

The Insurance Problem:

In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer, since the insured party no longer bears the full costs of that behavior.
Consequences of Moral Hazard
Adverse Selection
Moral Hazard
Lemons (AS) in Securities & Bond Markets
Adverse selection is present in the bond market as well:

As interest rates on bonds rise, a larger fraction of the firms willing to pay the high interest rates are lemon firms.
Attempts to Reduce Adverse Selection
Can lead to credit rationing where the lenders restrict credit such that borrowers cannot obtain the funds they desire at the given interest rate.
I: Use public information such as disclosures to the SEC reduces the information costs of adverse selection, but it doesn’t eliminate them for three reasons:

Some good firms may be too young to have much information for potential investors to evaluate.

Lemon firms will try to present the information in the best possible light so that investors will overvalue their securities.

There can be legitimate differences of opinion about how to report some items on income statements and balance sheets.

II: Use private firms collect information about firms

Information is collected from sources such as firms’ income statements, balance sheets, and investment decisions.
III: Use collateral assets that a borrower pledges to a lender that the lender may seize if the borrower defaults on the loan.

IV: Develope relationships.
The information advantage banks gain from relationship banking allows them to reduce the costs of adverse selection and explains the key role banks play in providing external financing to firms.
Moral Hazard (MH) in the Financial System and Solutions
Two types of behavior can change.

I: ex ante moral hazard. In this case, insured parties behave in a more risky manner, resulting in more negative consequences that the insurer must pay for.

For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurer.

II: ex post moral hazard. In this case, insured parties do not behave in a more risky manner that results in more negative consequences, but they do ask an insurer to pay for more of the negative consequences from risk as insurance coverage increases.

For example, without medical insurance, some may forgo medical treatment due to its costs and simply deal with substandard health. But after medical insurance becomes available, some may ask an insurance provider to pay for the cost of medical treatment that would not have occurred otherwise.
To reduce moral hazard of managers pursuing their own interests rather than those of shareholders.

I: the SEC requires managers to issue financial statements.

II: Boards of directors use incentive contracts to align the goals of managers with the goals of shareholders. Compensation tied to the firm’s profits, however, may lead managers to undertake risky investments.
To reduce moral hazard in bond markets:

I: investors insert restrictive covenants into bond contracts, a clause in a bond contract that places limits on the uses of funds that a borrower receives.

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