1.  How can economies of scale help explain the existence offinancial intermediaries?

Financial intermediaries can take advantage of economies of scale and thus lower transactions costs. For example, mutual funds take advantage of lower commissions because the scale of their purchases is higher than for an individual, while banks’ large     scale allows them to keep legal and computing costs per transaction low. Economies of scale, which help financial intermediaries lower transactions costs, explains why financial intermediaries exist and are so important to the economy.

2.   Wealthy people often worry that others will seek to marry them onlyfor their money. Is this a problem of adverse selection?

Yes, this is an example of an adverse selection problem. Because a person is rich, the people who are most likely to want to marry him or her are gold diggers. Rich people thus may want to be extra careful to screen out those who are just interested in their money from those who want to marry for love.

3.   What steps can the government take to reduce asymmetric information problems and help thefinancial systemfunction more smoothly and efficiently?

The government can produce information about borrowers and provide it to investors free of charge, it can require borrowers to report honest information about themselves to investors, and it can set and enforce rules that govern the behavior of financial institutions so they do not take on too much risk. These prudential regulations for banks include banning certain activities and asset categories considered too risky, establishing minimum   capital requirements, and requiring disclosure of financial information to regulators and investors.

4.  In December 2001, Argentina announced it would not honor its sovereign (government- issued) debt. Many investors were left holding Argentinean bonds priced at afraction of their previous value. Afew years later, Argentina announced it would pay back 25% of  theface value of its debt. Comment on the effects of information asymmetries on  government bond markets. Do you think investors are currently willing to buy bonds issued by the government of Argentina?

Information asymmetries are also present in government bond markets. Usually investors resort to many information sources about the characteristics of particular governments to assess their ability or willingness to honor their debt. As the Argentinean case illustrates,    sometimes this lack of information results in huge losses for bondholders. In this respect,  the problem is not significantly different from an investor who decides which corporate   bond to buy, although it may be fair to say that information about corporate bonds is more standardized (making it easier to compare firms). After the Argentinean default, investors    were willing to buy bonds issued by its government only at a significant risk premium,  making it very costly for Argentina to raise funds in bond markets.

5.  How does thefree-rider problem aggravate adverse selection and moral hazardproblems infinancial markets?

The free-rider problem means that private producers of information will not obtain the  full benefit of their information-producing activities, and so less information will be produced. This means that there will be less information collected to screen out good from bad risks, making adverse selection problems worse, and that there will be less monitoring of borrowers, increasing the moral hazard problem.

6.   Describe two ways in whichfinancial intermediaries help lower transaction costs in an economy.

Financial intermediaries develop expertise in such areas as computer technology so that they can inexpensively provide liquidity services such as checking accounts that lower  transactions costs for depositors. Financial intermediaries can also take advantage of     economies of scale and engage in large transactions that have a lower cost per dollar of transaction.

7.    Suppose you go to your local bank, intending to buy a certificate of deposit with your   savings. Explain why you would not offer a loan, at an interest rate that is higher than the rate the bankpays on certificates of deposit (but lower than the rate the bank          chargesfor car loans), to the next individual who enters the bank and appliesfor a car loan.

During your visit at the bank you will probably realize that you will receive an annual   interest rate of 1% or 2% if you buy a certificate of deposit, while an individual asking for a car loan will be required to pay an annual interest rate of 7% or 8%. At the beginning, it seems tempting for you to offer an interest rate of 4%, which would make both of you      better off. However, you would probably like to know that individual better, in particular  his net worth (to assess his ability to pay you back), or his credit history (has he or she  defaulted on a loan before?). This process will probably be time consuming and costly for   you. Even if you decide to engage in this transaction anyway, you will probably want to   write a contract to be able to recover your money if this individual does not pay you back.   As before, this will be costly. Your local bank is much more efficient in dealing with the   adverse selection and moral hazard problems created by asymmetric information, so  much so that you are better off by buying a certificate of deposit and avoiding all the        transaction costs associated with making a loan.

8.   How do standardized accounting principles helpfinancial markets work more efficiently?

Standardized accounting principles make profit verification easier, thereby reducing  adverse selection and moral hazard problems in financial markets, hence making them operate better. Standardized accounting principles make it easier for investors to screen out good firms from bad firms, thereby reducing the adverse selection problem in  financial markets. In addition, they make it harder for managers to over- or understate  profits, thereby reducing the principal-agent (moral hazard) problem.

MCQs

1. The "lemons problem" exists because of

A) transactions costs.

B) economies of scale.

C) rational expectations.

D) asymmetric information. Answer:  D

2. A lesson of the Enron collapse is that government regulation

A) always fails.

B) can reduce but not eliminate asymmetric information.

C) increases the problem of asymmetric information.

D) should be reduced. Answer:  B

3. Solutions to the moral hazard problem include

A) low net worth.

B) monitoring and enforcement of restrictive covenants.

C) greater reliance on equity contracts and less on debt contracts.

D) greater reliance on debt contracts than financial intermediaries. Answer:  B

4. Because of the weak systems of property rights in many developing and transition economies, the financial system is unable to use collateral effectively worsening the ________ problem.

A) adverse selection

B) moral hazard

C) principal/agent

D) diversification

Answer:  A

5. A debt contract is incentive compatible

A) if the borrower has the incentive to behave in the way that the lender expects and desires, since doing otherwise jeopardizes the borrower's net worth in the business.

B) if the borrower's net worth is sufficiently low so that the lender's risk of moral hazard is significantly reduced.

C) if the debt contract is treated like an equity.

D) if the lender has the incentive to behave in the way that the borrower expects and desires. Answer:  A

6. Property that is pledged to the lender in the event that a borrower cannot make his or her debt payment is called

A) collateral.

B) points.

C) interest.

D) good faith money.

Answer:  A