The lemons problem also explains why new cars lose so

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The Lemons Problem also explains why new cars lose so much value once they are driven off of the dealer’s lot. New cars provide information about quality that is lost once the car is driven off of the lot. The higher price of new cars shows that consumers are willing to pay quite a bit for that information. The Lemons Problem in Financial Markets How does the Lemons Problem apply to financial markets? Assume a world without financial intermediaries, consisting of borrowers and lenders much like the stick figures without banks in Class 2. Lenders do not know if borrowers are “peaches” or “lemons”, since they lack information about the quality of borrowers. Since lenders lack information about the quality of borrowers, they will assume that borrowers are of no more than average quality. Thus, they will only be willing to offer average and above interest rates. Lenders will not have the information to be able to offer lower interest rates to the highest quality borrowers. Since the safest borrowers are not able to receive interest rates low enough to convince them to borrow, then they are driven from the market. The lemons, or risky borrowers, will dominate the market for loans. Financial intermediaries such as banks provide information in financial markets in much the same way that used car dealers provide information in used car markets. They develop expertise and provide economies of scale in the provision of information, so that lenders can distinguish and attract safe borrowers by offering lower rates or a higher level of financial services. Banks do this in many ways. By developing personal relationships, they can find the safest borrowers in the community. Through advertising, marketing and offering special services such as free checking they are able to attract safe borrowers. And by wearing three-piece suits and working in fancy, ornate buildings, bankers are able to retain such safe customers and encourage them to borrow. Despite financial intermediation, adverse selection will always be a problem in banking. The riskiest borrowers are the ones most likely to ask for loans, and the safest borrowers are unlikely to need a loan in the first place. Moral Hazard Another problem common in financial markets is that of moral hazard. This occurs after the transaction, and is due to the fact that incentives may change after a transaction takes place. Moral hazard occurs when one party to a transaction is able to transfer the costs of that transaction to others. At a minimum, moral hazard increases the verification costs of exchange. At the extreme, moral hazard problems can prevent markets from functioning or lead to financial crises. (I wrote this statement in June 2005!) Moral hazard can occur in two broad contexts. One is debt markets; the other is equity markets. In debt markets, borrowers may not always maximize the likelihood of a loan 75
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Econ 350 U.S. Financial Systems, Markets and Institutions Class 8 being repaid. In equity markets, management may not always act in the best interests of the stockholders.
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