EC223 Chapter Notes - Chapter 8: Financial Intermediary, Moral Hazard, Adverse Selection

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26 Jan 2013
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EC223 Chapter 8 An Economic Analysis of Financial Structure Week 7
Transaction Costs
-Transaction costs are a major problem in financial markets
How Transaction Costs Influence Financial Structure
-Because you have only a small amount of funds available, you can make only a restricted number of
investments, because a large number of small transactions would result in very high transaction costs
you have to put all your eggs in one basket, and your inability to diversify will subject you to a lot of risk
How Financial Intermediaries Reduce Transaction Costs
-Financial intermediaries have evolved to reduce transaction costs and allow small savers and borrowers
to benefit from the existence of financial markets
Economies of Scale
-Bundle the funds of many investors together so that they can take advantage of economies of scale, the
reduction in transaction costs per dollar of investment as the size of transactions increases
-The presence of economies of scale in financial markets helps explain why financial intermediaries
developed and have become such an important part of our financial structure
-A mutual fund is a financial intermediary that sells shares to individuals and then invests the proceeds
in bonds or stocks
-Economies of scale are also important in lowering the costs of things such as computer technology that
financial institutions need to accomplish their tasks
Expertise
-Financial intermediaries also arise because they are better able to develop expertise to lower
transaction costs
-Their expertise in computer technology enables them to offer customers convenient services like being
able to call a toll-free number for information on how well their investments are doing and to write
cheques on their accounts
Asymmetric Information: Adverse Selection and Moral Hazard
-Because adverse selection increases the chances that a loan might be made to a bad credit risk, lenders
may decide not to make any loans even though there are good credit risks in the marketplace
-Moral hazard arises after the transaction occurs: the lender runs the risk that the borrower will engage
in activities that are undesirable from the lender’s point of view because they make it less likely that the
loan will be paid back
-Because moral hazard lowers the probability that the loan will be repaid, lenders may decide that they
would rather not make a loan
-The analysis of how asymmetric information problems affect economic behaviour is called agency
theory
The Lemons Problem: How Adverse Selection Influences Financial Structure
-The owner of a used car is more likely to know whether the car is a peach or a lemon if the car is a
lemon, the owner is more than happy to sell it a the price the buyer is willing to pay, etc.
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