Macro A2 - Market Failure In The Financial Sector Flashcards
Asymmetric information
one party in a transaction has more or better information than the other.
How does Asymmetric information cause market failure in the financial sector?
Adverse selection: When one party in a financial transaction has more information than the other, the party with the better information can take advantage of the other. This can result in a market failure
Moral hazard: When one party in a financial transaction has more information than the other, the party with the better information may engage in risky behavior that they would not engage in if they had full information.
Externalities
Positive externalities refer to the benefits of an economic activity that spill over to others and are not reflected in market prices
Negative externalities refer to the costs of an economic activity that are imposed on others and are not reflected in market prices
How do externalities cause market failure in the financial sector?
Market inefficiencies: Externalities can result in market inefficiencies, as the true costs and benefits of financial activities are not reflected in market prices
Financial institutions can engage in risky behavior that generates negative externalities in the form of systemic risk. For example, a financial institution may take on excessive risk in pursuit of profits, but if that risk leads to a financial crisis, it can impose costs on the broader economy, such as increased unemployment and reduced economic growth.
Market inefficiencies: Externalities can result in market inefficiencies, as the true costs and benefits of financial activities are not reflected in market prices.
Moral hazard
Moral hazard refers to a situation in which one party’s behavior changes in a way that is detrimental to another party, because the first party is insulated from the consequences of its actions
how does moral hazard cause market failure in the financial sector?
Adverse selection: Moral hazard can also result in adverse selection, as market participants with higher risk profiles may be more likely to take advantage of the reduced incentives to act responsibly.
Market inefficiencies: Moral hazard can result in market inefficiencies, as market participants are not fully exposed to the costs and benefits of their actions. This can result in an overproduction of goods and services with negative externalities.
Systemic risk: Financial institutions may engage in risky behavior because they are insulated from the consequences of their actions. This can increase systemic risk, as a financial crisis at one institution can have a ripple effect throughout the financial system.
Speculation
speculation refers to the act of buying and selling financial assets, such as stocks, bonds, commodities, or currencies, with the expectation of making a profit from price changes.
How does speculation cause market failure in the financial sector?
Volatility and instability: Speculation can lead to rapid buying and selling of financial assets, which can contribute to volatile and unstable financial markets
Market inefficiencies: Speculators may have an incentive to engage in behavior that is detrimental to other market participants, such as front-running or insider trading
Excessive risk-taking: Speculation can encourage excessive risk-taking, as speculators may be willing to invest in risky assets in pursuit of high returns.
Market bubbles
A market bubble is a period of rapid and unsustainable increases in the price of an asset or a group of assets, such as stocks, real estate, or commodities. During a bubble, prices can become detached from their underlying fundamentals, such as earnings or income, and can be driven higher by a combination of speculation, optimism, and herd behaviour.
How do market bubbles cause market failure in the financial sector?
Financial losses: When a market bubble bursts, it can result in significant financial losses for investors, which can harm their financial security and reduce consumer and business confidence
Misallocation of resources: Market bubbles can result in the misallocation of resources, as investments are made based on expectations of further price increases, rather than on fundamentals such as earnings or income
Reduced confidence: Market bubbles can reduce confidence in financial markets and the broader economy, as investors may become less willing to invest in the wake of a bubble burst.
Rigging markets
Market rigging refers to the illegal manipulation of market conditions for the purpose of profit or to give an unfair advantage to one or more market participants. It can take many forms, including insider trading, price manipulation, wash trading, spreading false information, and more.
How does rigging markets cause market failure in the financial sector?
Misallocation of resources: Rigged markets can lead to mispricing of assets, which can cause resources to be allocated inefficiently and in a way that does not reflect their true value. This can result in suboptimal outcomes and reduce overall economic growth.
Decreased trust and confidence: When markets are rigged, investors lose trust in the market and become less confident in the integrity of financial institutions. This can reduce the flow of capital into the financial sector and reduce overall investment.
Increased volatility: Rigging can cause sudden and large price swings, which can increase market volatility and result in financial instability. This can have a ripple effect throughout the economy, causing further damage to other financial markets and institutions.
Reduced transparency: When markets are rigged, it can be difficult for investors to determine the true value of an asset. This can reduce transparency in the market and make it harder for investors to make informed decisions.
