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
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.
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