Week 9 - Information and Markets Flashcards
What is asymmetric information?
When one party in a transaction has more information than the other.
What is it when one party in a transaction has more information than the other?
Asymmetric information
What is assumed in an idealised market?
Both buyers and sellers have perfect information about prices and the quality of the good
What is adverse selection?
Sellers of poor-quality products have more incentive to be in the market.
Sellers of high-quality products have an incentive to signal their quality (e.g. via garentees) but this may not be possible.
What is adverse selection in terms of health insurance?
If individuals have better information about their health than the insurance company the buyers of private health insurance are likely to be sicker-than-average
This drives up the cost which in turn encourages the healthier not to buy it, making those with the insurance even sicker and hence the price even more expensive..
This is one reason we often see publicly-provided or compulsory health insurance
What is the interbank market?
Before the crisis, banks often lent to and borrowed from each other when they were either short of cash or had a bit too much of it
The interest rate I will lend to you at depends on how much risk there is that you will not pay me back
What happened in the run-up to the financial crisis?
In the run-up to the financial crisis in 2007 some banks funded long-term mortgage lending using short-term interbank borrowing
What happened in the financial crisis as a result of the run up?
In 2007/8 fears that some of these sub-prime mortgages were not going to be paid back meant that the affected banks were viewed as more risky so could no longer borrow in the interbank market
Unable to borrow these banks went bankrupt
This then became a loss for the banks who had lent to them so now no-one wanted to lend to these banks
What was the informational problem in the financial crisis?
Nobody knew which banks had lent to which other banks
No bank wanted to lend to any other bank for fear that the other bank was in financial difficulties
Trying to borrow in the market was taken as a sign that the bank had financial difficulties
The market collapsed and we all suffered the consequences – and still are 10 years later
What happened after the informational problem?
Central banks e.g. the Federal Reserve, the Bank of England had to step in to lend to banks in financial difficulties
But confidence has still not returned to these markets and they are still not working well
Informational problems are an important part of the problem
What is the moral hazard?
When the behaviours of one party to a contract cannot be trusted to fulfil the terms of the contract
For example, someone with car insurance may drive less carefully because they will not pay all the cost of damage if they have an accident
What was the moral hazard in the financial crisis?
Bankers can take risks knowing they will not bear all the costs of any losses.
Before 2007 many banks made very risky loans
When the risky loans went well, the bankers got the profits.
When the risky loans went badly, the banks had to be bailed out by the taxpayer who paid for the losses.
What are some possible solutions to moral hazard problems?
More Regulations to limit undesirable behaviour
E.g. on capital adequacy of banks
More monitoring
E.g. watching the riskiness on banks’ lending
It is still very much up in the air how best to regulate banks
