Market failure in the financial sector

Question 1

Main types of market failure

Answer 1

Assymetric information
Moral hazard
Market rigging
Externalities
Speculation and market bubbles

Question 2

Asymmetric information in the financial crisis example

Answer 2

Bankers knew much more about their adjustable rate mortgages than the people they were selling them to.

Bankers also knew far more about banking than the financial regulators who were meant to be monitoring their behaviour.

Question 3

Speculation and market bubbles

Answer 3

Speculated house prices increase>More subprime mortgages -> Increased demand for houses -> Increases house prices -> More profit from selling houses when people default -> More subprime mortgages -> Increased demand for houses -> Increases house prices -> Housing bubble

Question 4

Negative externalities

Answer 4

After the financial crisis, banks stopped lending money to people or businesses. Firms couldn’t borrow money, so they had to make cutbacks, which meant that millions of people became unemployed. There was therefore a decrease in real GDP. This is a negative externality because the people who lost their jobs were outside the price mechanism in the financial sector. Furthermore $700bn of taxpayers money was used to bail banks out

Question 5

Moral hazard

Answer 5

After the 2008 financial crisis, the US spent about $700 billion of taxpayers’ money in order to stop the banks from going bankrupt. They are too big to fail

Question 6

Market rigging

Answer 6

Firms unfairly try to control prices which distorts the price mechanism . One of the most famous examples of market rigging is LIBOR rate, where barclays lied about their interest rates to benefit them