Question

• Select a financial institution or market and discuss the causes of asymmetric information. Describe real-world examples of adverse selection and moral hazard problems for your institution/intermediary or market. Evaluate the impacts of adverse selection and moral hazard problems on your financial institution/intermediary or market. Discuss a principal-agent problem in your financial institution/intermediary or market. A principal-agent problem is a moral hazard problem between managers and shareholders. Analyze whether your financial institution/intermediary or market can reduce the adverse selection and/or moral hazard problems.

Answer 1

As per the Chegg Policy, answering the first four parts

Problem of asymmetric information arises when one party involved in a transaction has more information at hand than the second party.

Let's consider the Securities Market where an investor wants to make a decision of investing his money in the high profit marking firms.

If there is asymmetric prevails in this firm, then following shall be the consequences:

- If one party has more information and that party knows that their securities are undervalued, then they would not sell the securities at the investor's willingness to pay price. Consequently, only loss-making firms would be selling the securities risking the investor's money.

- Problems of Moral Hazard or Adverse Selection will occur where either of one party may get involve in the risky ventures without letting the other party know.

Real World Example of Adverse Selection:

Adverse Selection arises before the transaction has been taken place. In the case of the securities market, the investor does not have complete information regarding good and bad profit making firms. So, there is a high change that he might choose bad firm over good firm leading to an adverse selection problems.

Moral Hazard problem arises after the transaction has been taken place. The bad profit-making firms may use the investor's money somewhere else where there are high changes of money getting lost. The firm is then said to be morally hazard to the investor's money

Impact of such problems on market:

- Market will consist of only bad profit making firms selling their low quality securities. Good profit making firms will get wiped out completely from the market.

- High risk of money getting lost and the revenue from the transaction become zero or may be negative due to high searching and opportunity cost involved.

- As firms will cheat, they will be willing to sell the securities at much lower price. This may lead to over-selling of securities in the market.

Principal-Agent Problem in the market:

Principals are called the owner of the business and the company. Agents are individuals who hold stocks into that business.

The Agents here are the bad profit making firms who has less "skin in the game". Investors are the principals. Now, the agents may indulge in moral hazard and work against the interest of the investors. This problem arises due to separation of ownership.