8.3 Adverse Selection #Notebook

 8.3 Adverse Selection #Notebook

Without Discovering The Truth

The seller has superior information and indeed has an incentive to increase the asymmetry by putting a Band-Aid over any obvious problems. As a result, hapless buyers learn that he has overpaid after they discover the truth.

Sometimes, the sellers can’t credibly inform buyers.

The market for used car dealers may be too competitive, leading to many failures, which gives dealers incentives to engage in rent-seeking (ripping off customers) and disincentives to establish long-term relationships. 

In recent years, many used car salesmen have cleaned up their acts from the likes of AutoNation, CarFax.com, and similar companies have reduced asymmetric information by tracking vehicle damage using each car’s unique vehicle identification number (VIN), making it easier for buyers to reduce asymmetric information without the aid of a dealer.

Adverse selection for insurance

Safe risks are not willing to pay much for insurance because they know that the likelihood that they will suffer a loss and make a claim is low. 

Risky firms, by contrast, will pay very high rates for insurance because they know that they will probably suffer a loss. 

Financial facilitators and intermediaries seek to profit by reducing adverse selection. They do so by specializing in discerning good from bad credit and insurance risks, it's called screening.

Potential lenders want to know if your income minus expenses is large and stable enough to service the loan.

Potential insurers want to know if you have filed many insurance claims in the past because that may indicate that you are clumsy, or worse, a shyster who makes a living filing insurance claims.

However, financial intermediaries often make mistakes....

Insurers like State Farm, for example, underestimated the likelihood of a massive storm like Katrina striking the Gulf Coast. 

Subprime mortgage companies that lend to risky borrowers and miscalculated the likelihood that their borrowers would default since competition between lenders and insurers induces them to lower their screening standards to make the sale.

Another way of reducing adverse selection is the private production and sale of information. Companies like Standard and Poor’s, Fitch’s, and Moody’s used to compile and analyze data on companies, rate the riskiness of their bonds, and then sell that information to investors. 

However, the free-rider problem killed off that business model. The free riders had to pay only the variable costs of publication; the rating agencies had to pay the large fixed costs of compiling and analyzing the data.

In the mid-1970s, the bond-rating agencies began to give their ratings away to investors and instead charged bond issuers for the privilege of being rated. The new model greatly decreased the effectiveness of the ratings. Moreover, instead of pleasing investors, the agencies started to please the issuers....

Due to the free-rider problem inherent in markets, banks and other financial intermediaries have incentives to create private information about borrowers and people who are insured.

Governments can no more legislate away adverse selection than they can end scarcity by decree. However, do them favors. 

In the United States, for example, the Securities and Exchange Commission (SEC) tries to ensure that corporations provide market participants with accurate and timely information about themselves, reducing the information

asymmetry between themselves and potential bond and stockholders.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.

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.