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Unformatted text preview: 21-1Learning ObjectivesAsymmetric InformationAfter reading this chapter, students should be able to:} Understand how adverse selection impacts markets.} Explain the concepts of signaling and screening.} Understand the implications of competitive signaling and screening for resource allocation, and identify implications for government policy.} Explain how moral hazard can impact a trading relationship.} Describe how an incentive scheme can provide a trading partner with incentives to take favorable actions, and some of the potential prob-lems with providing incentives.During the final quarter of 2001, a series of revelations concerning widespread accounting fraud sent Enron Corporation, a highly diversified energy conglomer-ate and once one of the most respected and successful companies in the United States, spiraling toward the largest bankruptcy in history. The value of the companys outstanding stock, valued at roughly $65 billion in August 2000, dwindled to practically nothing over the course of a few turbulent weeks (see Add-On 2A). Yet even as the crisis deepened, Enrons management still held out hope that it could save the company through a merger with Dynegy, another prominent energy conglomerate. According to reports in early November 2001, Dynegy was negotiating to purchase Enron for $7 to $8 bil-lion in stock, and to provide an immediate cash infusion of $1.5 billion to alleviate the short-term crisis. As November progressed, disturbing facts concerning Enron continued to surface. On November 28, Dynegy walked away from the Enron merger. Enron immediately suspended all inessential payments and filed for bankruptcy protection four days later.Why did the merger between Enron and Dynegy fall apart? As Dynegy learned more about Enrons problems, why didnt it simply revise its offer downward to reflect Enrons lower value? With unfolding events eroding the 21ber00279_c21_001-044.indd 21-1ber00279_c21_001-044.indd 21-111/21/07 1:25:37 PM11/21/07 1:25:37 PMCONFIRMING PAGES 21-2 Part III Marketscredibility of Enrons management, Dynegy became increasingly concerned about what it didnt know, and what Enron might still be hiding. Recognizing that Enron had practically no incentive to be forthcoming in its desperation to consummate the deal, Dynegy was forced to assume the worst. The deal unraveled largely because of Dynegys informational handicap.The failed merger negotiation between Dynegy and Enron illustrates the problems that can arise when one party to a potential transaction is less well-informed than another. This chapter is devoted to the study of such informational asymmetries.It covers the fol-lowing four topics.1. Adverse selection.When one party to a transaction has more information than another, the informed party may be more willing to trade precisely when trading is less advantageous to the uninformed party. As a result, the uninformed party may be reluctant to trade. Well see that this reluctance can cause markets to perform be reluctant to trade....
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