CH 8 Study Questions-Answers

CHAPTER 8 STUDY QUESTIONS
1. How can economies of scale help explain the existence of financial intermediaries?
2. How do standard accounting procedures help financial markets work more efficiently?
3. Would you be more willing to lend to a friend if she put all of her life savings into her business
than you would if she had not done so? Why?
4. Rich people often worry that others will seek to marry them only for their money. Is this a
problem of adverse selection.
5. The more collateral there is backing a loan, the less the lender has to worry about adverse
selection. Is this statement true, false, or uncertain? Explain your answer.
6. How can a stock market crash provoke a financial crisis?
7. How can a sharp rise in interest rates provoke a financial crisis?

Chapter 8
An Economic Analysis of Financial Structure
1. 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. Financial intermediaries develop expertise in such areas as computer technology so that they can
inexpensively provide liquidity services such as checking accounts that lower transactions costs for
depositors. Financial intermediaries can also take advantage of economies of scale and engage in
large transactions that have a lower cost per dollar of transaction.
3. No. If the lender knows as much about the borrower as the borrower does, then the lender is able
to screen out the good from the bad credit risks and so adverse selection will not be a problem.
Similarly, if the lender knows what the borrower is up to, then moral hazard will not be a problem
because the lender can easily stop the borrower from engaging in moral hazard.
4. Standard accounting principles make profit verification easier, thereby reducing adverse selection
and moral hazard problems in financial markets, hence making them operate better. Standard
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
mangers to understate profits, thereby reducing the principal-agent (moral hazard) problem.
5. The lemons problem would be less severe for firms listed on the New York Stock Exchange because
they are typically larger corporations that are better known in the market place. Therefore it is easier
for investors to get information about them and figure out whether the firm is of good quality or is a
lemon. This makes the adverse selection–lemons problem less severe.
6. 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
the financial markets. Banks that specialize in collecting information about smaller firms will then be
the only outlet these firms have for financing their activities.
7. Because there is asymmetric information and the free-rider problem, not enough information is
available in financial markets. Thus there is a rationale for the government to encourage information
production through regulation so that it is easier to screen out good from bad borrowers, thereby
reducing the adverse selection problem. The government can also help reduce moral hazard and
improve the performance of financial markets by enforcing standard accounting principles and
prosecuting fraud.
8. Yes. The person who is putting her life savings into her business has more to lose if she takes on too
much risk or engages in personally beneficial activities that don’t lead to higher profits. So she will
act more in the interest of the lender, making it more likely that the loan will be paid off.
Part Three: Answers to End-of-Chapter Problems 69
9. Yes, this is an example of an adverse selection problem. 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.
10. True. If the borrower turns out to be a bad credit risk and goes broke, the lender loses less, because
the collateral can be sold to make up any losses on the loan. Thus adverse selection is not as severe a
problem.
11. The free-rider problem means that private producers of information will not obtain the full benefit of
their information-producing activities, and so less information will be produced. This means that
there will be less information collected to screen out good from bad risks, making adverse selection
problems worse, and that there will be less monitoring of borrowers, increasing the moral hazard
problem.
12. The separation of ownership and control creates a principal-agent problem. The mangers (the agents)
do not have as strong an incentive to maximize profits as the owners (the principals). Thus the
managers might not work hard, might engage in wasteful spending on personal perks, or might
pursue business strategies that enhance their personal power but do not increase profits.
13. Because one information resource can be used in providing the several services, thus lowering the
cost for each.
14. Conflicts of interest arise because higher profits might arise in providing one kind of service if the
provider misuses information, provides false information, or conceals information when providing
another kind of service.
15. Conflicts of interest lead to a substantial reduction in the quality of information so that asymmetric
information problems become worse, which prevents financial markets from channeling funds into
productive investment opportunities. The result is that financial markets become less efficient.
16. (1) Research analysts in investment banks might distort their research to please issuers of securities
so underwriters in the investment bank can get their business. (2) Investment banks might engage in
spinning, a form of kickback in which they allocate hot, but underpriced IPOs to executives in return
for their companies’ future business.
17. Spinning makes financial markets less efficient because it might influence executives not to use the
lowest-cost investment bank when issuing securities. The result would be a higher cost of capital and
hence lower efficiency.
18. (1) Clients may be able to pressure auditors into skewing their opinions in order to get fees for other
accounting services. (2) Auditors may be auditing information systems or structuring (tax and
financial) advice put in place by their non-audit counterparts within the firm, and thus may be
reluctant to criticize this advice or systems. (3) Auditors may provide overly favorable opinions in
order to solicit or retain business.

CH 8 Study Questions-Answers

Uploaded by

Copyright:

Available Formats

CH 8 Study Questions-Answers

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH 8 Study Questions-Answers

Uploaded by

Copyright:

Available Formats

CHAPTER 8 STUDY QUESTIONS

6. How can a stock market crash provoke a financial crisis?

7. How can a sharp rise in interest rates provoke a financial crisis?

You might also like