im11 - Chapter 11 Reducing Transactions Costs and...

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Chapter 11 Reducing Transactions Costs and Information Costs Overview This chapter explains how financial markets and financial intermediaries deal with the problems of transactions costs and information costs. In most competing texts these questions are not dealt with as directly as they are here. The result is that recent occurrences—such as the corporate accounting scandals —are treated as isolated episodes. The unifying theme of the chapter’s discussion is the idea that many aspects of the financial system evolved to deal with the costs that arise from asymmetric information. The main problems arising from asymmetric information—moral hazard and adverse selection—are discussed at length. Although adverse selection and moral hazard are initially unfamiliar to most students, they usually are readily grasped—particularly if good use is made of examples, such as the many contained in the chapter. When students grasp these ideas, recent developments in the financial system become clearer. The chapter discusses the role of financial intermediaries in reducing adverse selection and moral hazard problems. In performing this role financial intermediaries provide a source of funds for firms that would have difficulty financing their operations through financial markets. Through this discussion students can begin to understand better the crucial role of intermediaries in the financial system. The approach in this chapter is more satisfactory than the usual, more descriptive discussion, which tends to leave students with the vague idea that financial markets provide funds to large firms and intermediaries provide funds to small firms, but with no understanding of why this might be true. The long case study that appeared at the end of the chapter in the second edition has been moved to the web page. Outline I. Obstacles to Matching Savers and Borrowers A) Transactions costs are the costs of buying and selling a financial instrument. 1. Brokerage commissions, minimum investment requirements, and lawyers’ fees are all examples of transactions costs. 2. Financial intermediaries reduce transactions costs by exploiting economies of scale . B) Information costs are the costs that savers incur to determine the credit-worthiness of borrowers and to monitor how borrowers use the acquired funds. 1. Asymmetric information describes the situation in which one party in a transaction has better information than the other. 2. Adverse selection refers to a lender’s problem of distinguishing the good-risk applicants from the bad-risk applicants before making an investment. 3. Moral hazard refers to a lender’s verifying that borrowers are using their funds as intended.
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56 Hubbard • Money, the Financial System, and the Economy, Sixth Edition II. Adverse Selection A) The “lemons problem” refers to the situation where asymmetric information in a market leads to adverse selection problems, with the result that trading becomes costly. B)
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im11 - Chapter 11 Reducing Transactions Costs and...

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