8.2 Transaction Costs, Asymmetric Information, and the Free- Rider Problem #Notebook

 8.2 Transaction Costs, Asymmetric Information, and the Free- Rider Problem #Notebook

Minimum efficient scale in finance is larger than most individuals can invest because most of his or her profits would be eaten up in transaction costs, brokerage fees, the opportunity cost of his or her time, and liquidity and diversification losses. Many types of bonds come in $10,000 increments and so are out of the question for many small investors. A single share of some companies, like Berkshire Hathaway, costs thousands or tens of thousands of dollars and so is also out of reach. 

Most shares cost far less, but transaction fees, even after the online trading revolution of the early 2000s, are still quite high, especially if an investor were to try to diversify by buying only a few shares of many companies. 

Through Scale Economies

They need superfast computers and to engage in large-scale transactions. You can’t profit-making .001% on a $1,000,000,000 trade instead of a $1,000 one.

Making loans directly to entrepreneurs or other borrowers? The time, trouble, and cash it would take to find a suitable borrower would likely wipe out any profits from interest. 

A new type of banking, called peer-to-peer banking, might reduce some of those transaction costs. In peer-to-peer banking, a financial facilitator, like Zopa.com or Prosper.com, reduces transaction costs by electronically matching individual borrowers and lenders. 

Most peer-to-peer facilitators screen loan applicants in at least a rudimentary fashion and also provide diversification services, distributing lenders’ funds to numerous borrowers to reduce the negative impact of any defaults. 

Although the infant industry is currently growing, the peer-to-peer concept is still unproven. Even if the concept succeeds, it will only reinforce the point made here about the inability of most individuals to invest profitably without help.

Financial intermediaries can provide help and achieve minimum efficient scale. Banks, insurers, and intermediaries pool the resources of many investors which allows them to diversify cheaply.

Instead of buying 10 shares of Apple’s $100 stock and paying $7 for the privilege (7/1000 = .007) they can buy 1,000,000 shares for a brokerage fee of maybe $1,000 ($1,000/1,000,000 = .0001). 

Financial intermediaries do not have to sell assets as frequently as individuals because they can usually make payments out of inflows like deposits or premium payments.

Financial intermediaries' cash flow reduce their liquidity costs. Individual investors often find it necessary to sell assets to pay their bills.

Financial intermediaries are experts at what they do, but does not mean that they are perfect. As we learned during the financial crisis that began in 2007.

Asymmetric information makes our markets, financial and otherwise, less efficient and it is possible to make outsized profits by cheating others. 

Financial intermediaries and markets can reduce or mitigate asymmetric information, but they can no more eliminate it than they can end scarcity. 

Financial markets are more transparent than ever before, but at the edges of every rule and regulation yet dark corners remain.

The government and market participants can, and have, forced companies to reveal important information about their revenues, expenses, and more.

What is the precise nature of this great asymmetric evil? Turns out this Cerberus, has three heads: 

1. Adverse selection
2. Moral hazard
3. The Principal-agent problem.