Chapter 9

An article in the Economist magazine​ observes: ​"Insurance companies often suspect the only people who buy insurance are the ones most likely to​ collect." ​Source:​ "The Money​ Talks," Economist​, December​ 5, 2008. What do economists call the problem being described​ here?

Adverse selection.

The author of a newspaper article providing advice to renters observes that​ "landlords will always know more than you​ do." ​Source: Marc​ Santora, "How to Be a Brainy​ Renter," New York Times​, June​ 3, 2010. Part 2 Do you agree with this​ statement? If​ so, what do landlords know that potential renters might​ not?

Agree; Landlords know more about the quality of the property, and hence its true value, than renters.

In what ways is the market for rental apartments like the market for used​ cars?

In both​ markets, the owner knows more than the potential renter or buyer.

If we lived in a world in which everyone was perfectly​ honest, would the difference in the transactions costs faced by financial intermediaries when they make loans and those faced by small savers when they make loans​ disappear?

No; while information costs might decrease there are still significant legal and other transaction costs involved in matching savers and borrowers.

What is the most important method of debt financing for​ corporations?

The bond market.

What is the most important source of funds for small to​ medium-sized firms?

The​ owners' personal funds and profits

Why​ don't these firms rely on external funds to the same extent as large firms​ do?

Transactions costs and information costs are much higher for smaller firms.

If everyone were perfectly​ honest, would there be a role for financial​ intermediaries?

Yes

Financial intermediaries take advantage of _____, which refers to the _____ in average cost that results from _____ in the volume of a good or a service produced.

economies of scale; reduction; an increase

If insurance companies are correct in their​ suspicion, it will increase the price of insurance.

increase

The shift to keeping all records on computers has increased the opportunities to achieve economies of scale by replacing labor cost with technology cost.

increased; labor; technology

Describe some of the information problems in the financial system that lead firms to rely more heavily on internal funds than external funds to finance their growth. Do these information problems imply that firms are able to spend less on expansion than is economically​ optimal?

Asymmetric information makes information costs for external funds higher than for internal​ funds, but these costs do not necessarily imply that firms are able to spend less on expansion than is economically optimal.

If the article is correct about what was happening in the Chinese banking​ system, what problems might arise as a​ result?

Banks will make riskier and riskier loans over time.

Which of the following is a correctly explained key feature of the financial​ system? ​(Check all that​ apply.)

Debt contracts usually require collateral or restrictive covenants. The purpose of the collateral is to reduce moral hazard. The stock market is a less important source of external funds to corporations than is the bond market. This is because there is less moral hazard involved with bonds than with stocks. Loans from financial intermediaries are the most important external source of funds for​ small- to​ medium-sized firms. Financial intermediaries can reduce the transaction costs of borrowing for small firms.

If the statement is​ correct, what are the implications for the market for rental​ apartments?

Landlords will attempt to charge a higher price than they otherwise would receive in the absence of this information asymmetry.

What is the most important source of external funds for these​ firms?

Loans from financial intermediaries

In what ways is it​ different?

The landlord is not selling the​ apartment, merely renting​ it, while the buyer of a used car makes an irreversible deal.

Consider the possibility of income insurance. With income​ insurance, if a person loses his job or​ doesn't get as big a raise as​ anticipated, he would be compensated under his insurance coverage. Why​ don't insurance companies offer income insurance of this​ type? ​(Check all that​ apply.)

The problem is moral hazard​ (once insured, you​ won't work as​ hard). The problem is adverse selection​ (people who are more likely to be fired or get low raises would be more likely to buy such​ insurance).

An article in the Wall Street Journal discussed the fact that the Chinese government often intervenes to keep banks that make many bad loans from failing. The result was​ "moral hazard, or​ risk-taking based on the belief that someone else will pick up the tab if things go​ wrong." Do you agree with the​ article's definition of moral hazard in this​ context? This is an example of moral hazard because the article mentions that the government often intervenes to bail out banks making bad​ loans, therefore, banks are taking risks knowing they will not bear the entire burden when loans fail

is an example; taking risks knowing they will not bear the entire burden when loans fail

At the​ time, banks achieved little economies of scale as the amount of labor required to maintain such records was the same for every​ transaction, regardless of the size of the bank.

little; the same; regardless