Chapter 11

Question 1

Two major impediments of Specialization & Exchange

Answer 1

-Transaction costs: Financial institutions play a huge role in reducing these.

• Information Asymmetry:
  
  • -Adverse Selection: Occurs before selection, Deception and assumptions lead to adverse selection.
  • -Moral Hazard: Occurs after the selection. Nothing beforehand that indicated the moral hazard.

Question 2

Roles of Financial Institutions

Answer 2

• Price economic resources and allocate them in productive uses.
• Seek out info, to reduce risk.
• Pool savings
• Provide liquidity
• Diversify Risk

Question 3

Adverse Selection

Answer 3

• A situation where sellers have information that buyers don’t (or vice versa) about some aspect of product quality.
• Usually the “lemons” are sold, or the least creditworthy are the ones applying for funds.

Question 4

Lenders and investors can decrease adverse selection by:

Answer 4

• Collecting and disclosing information on borrowers.

- Requiring borrowers to post collateral and show sufficient net worth.

Question 5

Moral Hazard

Answer 5

The risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

Question 6

Financial Intermediaries Reduce Moral Hazard, and adverse selection by:

Answer 6

• Monitoring the borrowers that have funds. (Moral hazard)

- Collecting info on borrowers and screening them for their creditworthiness. (Adverse Selection)

Question 7

Economies of scale

Answer 7

Cost advantages for larger production. (expound on this idea.)

Question 8

Principals (owners) want to maximize

Answer 8

Wealth

Question 9

Managers may want to maximize

Answer 9

Leisure, wealth, recreation, power, etc.

They may take advantage of their position.

Question 10

4 ways to curb Moral Hazard of managers

Answer 10

• Monitor: Audits, managers oversee managers.
• Incentivize: Set up environment to align intentions of principal and agent.
• Short leash on management: Increase their debt or bring up dividends.
• Entertain any take-over offers, keep company appropriately priced.

Question 11

STUDY PYRAMID PICTURE OF HOW INFORMATION ASYMMETRY CONTRIBUTED TO THE FINANCIAL CRISIS.