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Week 10: Tutorial.

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Presentation on theme: "Week 10: Tutorial."— Presentation transcript:

1 Week 10: Tutorial

2 Q1: Explain what is meant by the phrase ‘in equilibrium, the rental price of capital equals the marginal product of capital’. To maximize profit, the competitive, profit-maximizing firm hires capital up to the point where the value of the marginal product of capital equals the rental price of capital. VMPK = Rental Price of Capital The value of marginal product curve is the demand for capital curve for a competitive, profit-maximizing firm. In maths Π = PQ(K, L) – wL – rK Maximise profits P∂Q/∂K – r = 0 So MPK = r

3 Q2: Give three examples of moral hazard.
Moral Hazard: the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behaviour Travel agent (provide less accurate information) Employer-employment (shirk) Insurance (Drive faster)

4 Q3: Give three examples of adverse selection.
Adverse selection is where a principal knows more about their situation than the agent, leading to the agent preferring not to do business with the principal. -Insurance: The person seeking insurance has more information about his/her condition than the insurance company -Banking industry: the borrower- the lender -Market for used cars: the buyer and the seller

5 Q4: If deregulation was a major factor in the development of the financial crisis can you explain why re-regulation is not a “free lunch”? Regulation can prohibit multiple financial service provision by financial intermediaries Regulatory capture : regulatory agents may issue regulations that advances politician concerns

6 Q5: Explain why in many countries in the wake of the crisis Governments have moved to restrict or eliminate bonus payments to decision-makers in the financial sector. First, bonus payments may have encouraged risky behaviour by decision-makers and/or may have discouraged decision-makers from closely supervising the behaviour of people working for them. The risk chosen by the decision-maker may have been too high from the perspective of the firm and the rest of the economy, because although bonus payments are tied to some measure of returns (so there is an incentive to generate high returns which are riskier), the decision-maker can influence how returns are captured in accounts and hence whether the bonus is paid out. The bonus payments are also much less affected by a really negative outcome. For example, if the firm goes bankrupt, then the former decision-maker can still look for a job at another firm. So bonus payments could be too blunt a tool to incentivise decision makers in a manner consistent with economic efficiency. Second, cutting bonuses is a form of cutting costs and potentially raising profits, which is especially relevant for a government that has bailed out some banks and is trying to recover its bailout funds. Third, since financial firm bailouts (including bonus payments) have been financed through general taxation, high bonus payments are much more difficult to justify politically. So the restriction or elimination of bonuses are considered for equity reasons and could be seen as an alternative to a rise in top income tax rates.

7 6. Should governments make it easier for poorer people to borrow money?
Your answer can be either “should” or “should not” -Should not: A greater possibility of default. -Should: It is important to support the poorer group in order to provide them opportunities to change their lives. We can do so by lending in a small amount of money and based on the purpose of the loan (Microfinance). Also, we should monitor how they send their loans in order to reduce the moral hazard.

8 7. What kind of regulatory changes in banking structures might reduce the probability of a repeat of the recent financial crisis? Here are some of the regulatory changes that have been in discussion or are starting to be implemented: Separate different types of financial services (retail banking, mortgages, investment banking) into separate firms or separate parts within firms, which can be monitored separately. In the case of a bank failure, only parts of a firm could be bailed out, while the other is allowed to go bankrupt and its creditors have to shoulder the losses. This lowers the risk that a bank is “too big to fail” and, therefore, may reduce moral hazard. Restrict gearing and require higher capital ratios (capital asset ratios), so that banks are in a better position to survive a sudden change in the value of their assets (e.g. their loans). Expand regulatory objectives to include the monitoring of systemic risk posed by the behaviour of each individual bank. - Systemic risk (the possible impact of an adverse event on the entire financial system as opposed to the effect on the bank directly affected Regulators need to be empowered to supervise the behaviour of banks with a view to systemic consequences rather than simply to the implications for a particular bank’s balance sheet. For example, even if a bank had plenty of room to lend to the property sector, the regulator might need to be able to restrict such lendning by reference to overall lending to that sector Restrict the size of firms and encourage a higher number of competing firms, i.e. do not allow some mergers and acquisitions in the financial sector to go ahead. This may lower the riskt hat a bank is “too big to fail”. Change the bonus culture; see the previous question.

9 Q8: A bank obtains funds by accepting deposits, selling bonds and issuing shares. Depositors, bond-holders and even share-holders can be seen as “creditors” of a bank. Why should Governments guarantee depositors, but not the others, against a bank failure? The reason for not guaranteeing any creditors against the failure of a firm (whether it is a bank or not) is that it discourages the creditors from lending wisely, i.e. lending to those firms that have the best prospects given the risk. So creditors may decide to lend to riskier firms than they would do if there was no guarantee in place. The guarantee also means that creditors have less of an incentive to monitor the behaviour of the firm and penalise the firm (by not extending the credit) if the firm is not acting in the best interest of the creditors. The reason for guaranteeing some of the creditors of banks i.e. depositors, is that it is difficult (very costly) for an individual depositor to find out which bank has the best prospects and to monitor the bank after making a deposit. A small individual shareholder may also face difficulties in selecting the best bank and monitoring its progress, except that there are financial intermediares acting on behalf of the individual small shareholder. But there are fewer intermediaries helping us as depositors to decide where to open a bank account and telling us when to switch banks, so that we can penalise a bank which is mismanaging our funds. Yet depositors are needed for the financial system to work and to lend to other parts of the economy. If deposits are not guaranteed and there is a potential risk of bank failure, then households and firms have a greater incentive to keep funds outside of the financial system (at home under the mattress or in the office safe). By insuring depositors at least in part against bank failure, the government raises the level of trust in the financial system, so deposits held in banks increase and more funds (a larger money supply) is available to the economy.


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