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Chapter 8

Chapter 8 EC223.docx

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Angela Trimarchi

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
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