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Explaining the Puzzles.docx

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Zisimos Koustas

2. Explaining the Puzzles 1.1 Transactions Costs: hinder the flow of funds to people with productive investment opportunities.  Financial intermediaries make profits by reducing transactions cost. This activity explains puzzle #3. Specifically, financial intermediaries reduce transaction costs. a) By taking advantage of economies of scale. Example: mutual funds. b) By developing expertise to lower transactions costs. Example: Commercial Banks. 1.2 Adverse selection It is a symptom of asymmetric information  It applies prior to the transaction  Potential borrowers most likely to produce an adverse outcome are the most likely to seek loans and be selected Financial intermediaries are important in addressing. This problem George Arerlof has shown how adverse selection influences financial structure through his famous “lemons problem” in the used-car market. The lemons problem States of the world Probability Price under certainty State 1 (peach) 0.5 $10K State 2 (lemon) 0.5 $5K The price of a used car under uncertainty-not knowing if the car is a peach or a lemon-is determined by the expected utility of a used car. E(u)=0.5x$10K+0.5x$5K=$7.5K (1) The problem for the functioning of the used-car market is that sellers of good used cars will not sell. Sellers of lemons have a great incentive to sell. Clearly, the used-car market will be dominated by lemons and used-car buyers will be discouraged. 1.2.1 The Lemons Problem in Securities Markets  If an investor cannot distinguish between good and bad securities, she will be willing to pay only the average of good and bad securities v
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