Chapter 8 Mishkin Notes Essay

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An Economic Analysis of Financial Structure Why do Financial Institutions Exist? (Why is Indirect Finance so Important?) Chapter 8 Chapter Preview W e take a closer look at why financial institutions exist and how they promote economic efficiency. Topics include: • A Few Basic Facts About Financial Structure • Transaction Costs • Asymmetric Information: Adverse Selection and Moral Hazard Chapter Preview (cont.) • The Lemons Problem: How Adverse Selection Influences Financial Structure • How Moral Hazard Affects the Choice Between Debt and Equity Contracts • How Moral Hazard Influences Financial Structure in Debt Markets 1 Basic Facts About Financial Structure Throughout the World • The chart on the next…show more content…
Occurs when one party has an incentive to behave differently once an agreement is made between parties 2. After transaction occurs 3. Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won't pay loan back 6 Health Insurance • Symmetric Information: Suppose, if you get sick, drugs cost $10,000/year • Everyone has a 1/10 chance of getting sick • Solution - Insurance will be offered at $1,000 per year Health Insurance – Symmetric Information continued • Suppose 10% of the population (2 out of 20) is sickly and has a 50%(1/2) chance of getting sick - independent. • Other 90% (18 people) only has 1/18 chance of getting sick. • This information in known to everyone. • How do you price the insurance? Health Insurance – Symmetric Information continued • Sickly types pay? • Healthy types pay? 7 Health Insurance - Asymmetric Information Adverse Selection • Same as previous example, but one’s type (sick or healthy) is private information. Suppose insurance company
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