Information Economics flashcards, diagrams and study guides
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the cost of a trade or a financial transaction; for example, the brokerage commission charged for buying or selling a financial asset
the costs that savers incur to determine the creditworthiness of borrowers and to monitor how they use the funds acquired
the reduction in average cost that results from an increase in the volume of a good or service produced
The problem of asymmetric information that an employer faces in hiring a new employee is that a large amount of trust is involved. An employer is trusting that the employee was honest in his or her interview, that the information provided on their resume and application materials was accurate, and that their references are giving good insight on the employee. Employers run the risk of being disappointed by their hires. They may not perform as expected or work out in ways that the employer had anticipated. To try to avoid this problem, employers should try to collect as much information as they can before they make the decision to hire someone. After hiring, conducting probationary periods where employees may be easily terminated is one way to try to solve this problem. This problem is more severe for employees on a fixed salary. If an employee is not working hard, a fixed salary does not offer any incentives or motivation for the employee to try to perform better. An alternative would be to give salaries based on performance. Even giving a lower base salary with commission would be more effective.
Bernard Madoff ran a Ponzi scheme. Investors lost money because Madoff wasn't investing their money like they had intended it to be invested. He knew more about what was going on than the investors that were giving him money. The investors didn't have all of the information and Madoff wasn't monitored properly, which was why he got away with cheating so many investors for so long. The problem associated with asymmetric information was a moral hazard problem.
Economies of scale: when the average cost of producing a good or service falls as the quantity produced increases. Financial intermediaries can take advantage of economies of scale by using the same standardized forms for obtaining information from potential borrowers when they are in the process of determining whether they qualify for a loan.
Direct finance: -The bond market. -The equity market. Indirect finance: -Financial intermediaries such as banks, insurance companies, pension funds, etc.
-Banks are critical providers of financing around the world. -Banks decide the size of a loan and interest rate to be charged. -Markets determine which firms can access the stock and bond markets. -Reflecting these markets, securities firms set the volume and price of new stocks and bond issues when they purchase them for sale to investors.
1. Pooling the resources of small savers. 2. Providing safekeeping and accounting services, as well as access to payments system. 3. Supplying liquidity by converting savers' balances directly into a means of payment whenever needed. 4. Providing ways to diversify risk. 5. Collecting and processing information in ways that reduce information costs.
What is the difference between moral hazard and adverse selection? "______ occurs when bad risks are more likely to seek/accept a financial contract than are good risks. ______ occurs in financial markets when borrowers use borrowed funds differently than they would have used their own funds.
The "lemons problem"
How does the lemons problem lead many firms to borrow from banks rather than from individual investors? (Check all that apply.)
AI: One party to a transaction has relevant information that another party does not have. One party knows more than another regarding some important variable. (A type of uncertainty) Two types: 1) Hidden characteristic: - a FACT about a person or thing that is known to one party but unknown to others. 2) Hidden action: - occurs when one party to a transaction cannot observe important ACTIONS taken by another party
A more-informed party may exploit the less-informed party, engaging in opportunistic behavior: taking economic advantage of someone when circumstances permit. Two problems of opportunistic behavior arise from asymmetric information: 1) Adverse selection: - due to hidden characteristics 2) Moral hazard: - associated with hidden actions.
The problem of adverse selection arises when one party to a transaction possesses information about a HIDDEN CHARACTERISTIC that is unknown to other parties and takes economic advantage of this information, LOW QUALITY ITEMS DOMINATE THE MARKET IN THAT THEY ARE OVER-REPRESENTED IN TRANSACTIONS Adverse selection may prevent desirable transactions from occurring, possibly eliminating a market entirely. Two examples studied: 1) AS in insurance markets 2) AS in products of unknown quality
the tendency for people to enter into agreements in which they can use their private information to their own advantage and to the disadvantage of the uninformed party.
a market in which the buyers or sellers have private information.
the risk that a borrower, also known as a creditor, might not repay a loan.
Everyone is equally knowledgeable or equally ignorant about prices, product quality, and other factors relevant to a transaction.
One party to a transaction has relevant information that another party lacks.
Hidden characteristics - an attribute of a person or thing that is known to one party but unknown to others. Hidden actions - an act by one party to a transaction that is not observed by the other party.
1. Stocks are not the most important sources of external financing for businesses 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations 3. Indirect finance is many times more important than direct finance 4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. 5. The financial system is among the most heavily regulated sectors of the economy 6. Only large, well-established corporations have easy access to securities markets to finance their activities 7. Collateral is a prevalent feature of debt contracts for both households and businesses. 8. Debt contracts are extremely complicated legal documents that place substantial restrictive covenants on borrowers
Property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments
also known as collateralized debt - automobile = collateral for your auto loan - house= mortgage