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Chapter 7

Chapter 7 Econ 2035 (98% on the test)

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ECON 2035
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Chapter 7Asymmetric Information in the Financial System SECTION71ADVERSESELECTIONAdverseselection thoseleastdesirablearethemostwillingtomakeadealisaproblemthatarisesin manytypesofmarkets ofirstdescribedbyGeorgeAkerlofin1970 proven by asymmetricinformationoEx usedcars bad Lemons problem good PeachTheuninformedbuyerswouldinitiallyequatethepriceofausedcarasagoodindicationoftheaveragequalityofthecar Ownersofbetterqualitycarswouldnotbewillingtoselltheircarsforalowerprice Onlyownersofthelowerqualitycarsthelemonswouldwanttosellthecar BuyersrealizingthiswoulddemandlessusedcarsandthepriceofusedcarswouldfallandthemarketwouldfailoEx 2 firms Investment project 100Firm 1 safe return125 Firm 2 risk 23 return 150 13 return 0Saver Another asset return 110 Expected payment on bondpromised payment x probability of project success Expected payment needs to be at least 110 Saver knows probability but doesnt know which is risky and which is safe Future oSafe promise110 Profit15oRisk expected return23150100firm will not sell bonds Dont sell because promise110 then need return of 11023 165 Probability of success probability if getting paid 123256 Expected payment 110 Promised payment11056132 oSaver will not sell bond oRisk bond will sell bond so all thats left is risk firms Promise payment then turns to 11023165now risk firms wont sell AdversetofinancialmarketsoStockmarketsPricesofstocksare basedontheexpectedfutureearningsofthefirm Ifthefirmwantstoraisefundsviastocksandthepublicforecastoftheirfutureearningsarelowthenthevalueoftheirstockwillbeundervalued Theoppositeistrueforfirmsthathavepublicforecastsoftheirearningsthataretoohightheirstockisovervalued Thefirmsthathaveovervaluedstockwillbemorewillingtoraisefundsviastocks oSaversknowingthiswillactaccordinglyandstockpriceswillfallAdverseselection inbondmarkets defaultriskishighoFirmswhosedefaultriskishigherthanthepublicthinksmorewillingtoissuebondsoFundsraisedbybondsalesusedtofinanceriskyprojectsadverseselectionproblemgetsworse SECTION72MORALHAZARDMoralhazardis aprobleminmanymarkets oOccurswhentheactionsofotherscantbeobservedoTerm comesfromtheinsuranceindustryInsurancecompaniesfacemoralhazardfromthepeoplewhotheyinsure
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