FIN 324 Financial Institutions in Hong Kong and Global Banking Week 1 Introduction: Financial System and Financial Intermediation Mishkin (2012): Chapter 2 Overview of the Financial System Additional notes: Asymmetric Information Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Additional notes: Asymmetric Information: A situation where one party to a market transaction has much more information about a product or service than the other. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Moral Hazard Problem: There is a tendency of one party to a contract to alter his/her behaviour in ways that are costly to the other party. Adverse Selection Problem: Information known by the first party to a contract is unknown to the second and, as a result, the second party incurs major costs. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Used Cars: The Market for “Lemons” A new car loses much of its market value as the buyers drives it off the sales lot. The question is, why? Copyright © 2009 Pearson Prentice Hall. All rights reserved.

One explanation relates to inadequate information about used cars, some are good and some are “lemons” of poor quality. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Consumers cannot distinguish the good from the defective, so a single price emerges for used cars, which roughly reflects the average-quality car. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

This leads to an adverse selection problem This leads to an adverse selection problem. Owner of lemons have an incentive to sell their cars because the average price is above that for the low-quality car they own. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Therefore, there will be proportionately more low-quality cars offered than good-quality cars whose owners hold onto them rather than offer them at the average-quality price. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

At the extreme, only lemons would appear on the used-car market, but even without the extreme, this theory offers one explanation of the pricing of used cars. Copyright © 2009 Pearson Prentice Hall. All rights reserved.