TUTORIAL
CHAPTER 7
1. How can economies of scale help explain the existence of financial intermediaries?
Financial intermediaries can take advantage of economies of scale and thus lower transactions
costs. For example, mutual funds take advantage of lower commissions because the scale of
their purchases is higher than for an individual, while banks' large scale allows them to keep
legal and computing costs per transaction low. Economies of scale, which help financial
intermediaries lower transactions costs, explains why financial intermediaries exist and are so
important to the economy.
2. How do standard accounting principles helps financial markets works more efficiently?
Standardized accounting principles make profit verification easier, thereby reducing adverse
selection and moral hazard problems in financial markets, hence making them operate better.
Standardized accounting principles make it easier for investors to screen out good firms from
bad firms, thereby reducing the adverse selection problem in financial markets.
In addition, they make it harder for managers to over- or understate profits, thereby reducing
the principal-agent (moral hazard) problem.
3. Which firms are most likely to use bank financing than to issue bonds or stocks to finance their
activities? Why?
Smaller firms that are not well known are the most likely to use bank financing. Because it is
harder for investors to acquire information about these firms, it will be hard for the firms to sell
securities in financial markets. Banks that specialize in collecting information about smaller
firms will then be the only outlet these firms have for financing their activities
4. Rich people often worry that others will seek to marry them only for their money? Is this a
problem of adverse selection?
Yes
-Because a person is rich, the people who are most likely to want to marry him or her are gold
diggers.
-Rich people thus may want to be extra careful to screen out those who are just interested in
their money from those who want to marry for love
5. You are in the market for a used car. At a used car lot, you known that the blue book value for the
cars you are looking at is between $20,000 and $24,000. If you believe the dealer knows as much
about the car as you, how much are you willing to pay? Why? Assume that you only care about the
expected value of the car you buy and that the car values are symmetrically distributed.
The expected value of the car values are symmetrically distributed. Since the buyer knows as
much about the used car as the seller, there is no information failure. Therefore, the buyer will
be willing to pay a price that falls between $20,000 and $24,000 as he believes that that is the
current worth of the car. Here, it is assumed that the buyer only cars about the expected value of
the car and not the quality of the car
6. Now, you believe the dealer knows more about the cars than you. How much are you willing to
pay? Why? How can this be resolved in a competitive market?
The buyer desired to pay less than. The seller knows more about the value of used cars than the
buyer, but the buyer does not want to pay more than due to a lack of knowledge.