wk 1 - Info Asymmetry and role of Banks Flashcards
What is Asymmetric Information?
Information that is not equal or even
What does asymmetric information lead to
Inefficient outcomes
What is adverse selection
A situation where undesirable results occur due to an imbalance of information in a transaction
How does adverse selection and moral hazard affect economies
- The Lemons Problem
- The principle agent problem
What is The Lemons Problem
Market failure arising from asymmetric information about a P/S. Good and bad products become mixed and buyers become unwilling to pay a fair price
What is the Principle Agent Problem?
The problem of motivating the agent to act in the best interests of the principle
When does adverse selection occur?
Before the transaction
How can you combat Adverse Selection?
- Information Collection
- Government Regulation
- Screening
How does information collection reduce adverse selection
Reduces uncertainty and information asymmetry
What negative externality arises from information collection?
Free-rider Problem:
A situation where some people benefit from a G/S without paying
How does Gov. Regulation reduce Adverse Selection
Can ensure more information is released to increase transparency
What is Screening
A strategy to combat Adverse selection where the agent attempts to filter out false information
What is Moral Hazard
One party takes on excessive risk because another party will bear some of the burden
what is moral hazard in insurance
Where a party’s behavior changes because they feel protected from the risk by insurance
e.g.
Less attentive to precautions
Over consumption
How can moral hazard occur in lending
When a borrower engages in risky behaviors that are not in the best interest of the lender:
e.g.
Not repaying loan when able to
Using the loan for risky activities (lottery ticket)
Providing false info (about assets, credit, etc)
how can moral hazard occur in an equity market
through asymmetric info, one party can take risks that will negatively effect another party
e.g.
Employees taking risks to increase bonuses
Insured firms taking more risks
How do markets attempt to overcome the moral hazard problem
Deductible & adjustable premiums
Compensating balances
Corporate board of directors
What are Deductibles and adjustable premiums? And how does it combat moral hazard
A deductible is a minimum payment the policy holder must pay before an insurance company will cover the claim
An adjustable premium is a monthly payment to an insurance company that can change over time
How does compensating balances combat moral hazard
A minimum fund a borrower must have in an account to qualify for a loan / credit
how does a corporate board of directors combat moral hazard
Can offer incentives to encourage risk-taking parties to act responsibly
Create policies to discourage immoral behavior, and make it punishable
Can regularly monitor at-risk parties to ensure they aren’t being taken advantage of.
What are the characteristics of a Perfectly Competitive Market
Perfect information
No transaction costs
Free entry and exit
Product is homogenous
In PC the market outcomes are perfectly efficient
What is the role of banks in a modern economy
Provide liquidity
Reduce transaction costs (e.g. search costs)
Block Lending (gather together lots of small savings into one big bundle to then lend to borrowers)
What happens if banks do not lend
Credit Crunch: A reduction in the availability of credit (e.g. risk aversion / regulatory requirements / low interest rates)
Banks can also be concerned about the future of the economy or because banks are already experiencing a decline in the market value of their assets.
What happens if there are no banks
Lending doesn’t occur
money supply does not increase
Economic activity does not increase (most important)
If there is a lack of economic activity, unemployment may increase, and businesses fail
What is a Bank Run
When a large number of depositors withdraw money from a bank at one time
