wk 1 - Info Asymmetry and role of Banks

Question 1

What is Asymmetric Information?

Answer 1

Information that is not equal or even

Question 2

What does asymmetric information lead to

Answer 2

Inefficient outcomes

Question 3

What is adverse selection

Answer 3

A situation where undesirable results occur due to an imbalance of information in a transaction

Question 4

How does adverse selection and moral hazard affect economies

Answer 4

1. The Lemons Problem
2. The principle agent problem

Question 5

What is The Lemons Problem

Answer 5

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

Question 6

What is the Principle Agent Problem?

Answer 6

The problem of motivating the agent to act in the best interests of the principle

Question 7

When does adverse selection occur?

Answer 7

Before the transaction

Question 8

How can you combat Adverse Selection?

Answer 8

1. Information Collection
2. Government Regulation
3. Screening

Question 9

How does information collection reduce adverse selection

Answer 9

Reduces uncertainty and information asymmetry

Question 10

What negative externality arises from information collection?

Answer 10

Free-rider Problem:
A situation where some people benefit from a G/S without paying

Question 11

How does Gov. Regulation reduce Adverse Selection

Answer 11

Can ensure more information is released to increase transparency

Question 12

What is Screening

Answer 12

A strategy to combat Adverse selection where the agent attempts to filter out false information

Question 13

What is Moral Hazard

Answer 13

One party takes on excessive risk because another party will bear some of the burden

Question 14

what is moral hazard in insurance

Answer 14

Where a party’s behavior changes because they feel protected from the risk by insurance
e.g.
Less attentive to precautions
Over consumption

Question 15

How can moral hazard occur in lending

Answer 15

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)

Question 16

how can moral hazard occur in an equity market

Answer 16

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

Question 17

How do markets attempt to overcome the moral hazard problem

Answer 17

Deductible & adjustable premiums
Compensating balances
Corporate board of directors

Question 18

What are Deductibles and adjustable premiums? And how does it combat moral hazard

Answer 18

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

Question 19

How does compensating balances combat moral hazard

Answer 19

A minimum fund a borrower must have in an account to qualify for a loan / credit

Question 20

how does a corporate board of directors combat moral hazard

Answer 20

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.

Question 21

What are the characteristics of a Perfectly Competitive Market

Answer 21

Perfect information
No transaction costs
Free entry and exit
Product is homogenous

In PC the market outcomes are perfectly efficient

Question 22

What is the role of banks in a modern economy

Answer 22

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)

Question 23

What happens if banks do not lend

Answer 23

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.

Question 24

What happens if there are no banks

Answer 24

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

Question 25

What is a Bank Run

Answer 25

When a large number of depositors withdraw money from a bank at one time