Deck 9: Transactions Costs, Asymmetric Information, and the Structure of the Financial System

Question 1

Which of the following does NOT represent a way in which financial intermediaries take advantage of economies of scale?

A)paying lower brokerage fees per dollar invested
B)paying lower legal fees per dollar invested
C)purchasing sophisticated computer systems
D)paying lower taxes per dollar invested

Answer 1

paying lower taxes per dollar invested

Question 2

Financial intermediaries emerged

A)to make loans to governments.
B)to provide a market for municipal bonds.
C)to reduce transactions costs for small savers and borrowers.
D)to reduce transactions costs for traders in stocks and bonds.

Answer 2

to reduce transactions costs for small savers and borrowers.

Question 3

How are financial intermediaries able to reduce transactions costs?

Answer 3

Financial intermediaries are able to take advantage of economies of scale, which refers to the reduction in average cost that results from an increase in the volume of a good or service produced.

Question 4

The presence of information and transactions cost result in all of the following EXCEPT:

A)reduced efficiency of financial markets.
B)higher returns for savers
C)some funds not being lent at all
D)borrowers need to pay more for funds

Question 5

The reduction in transactions costs brought about by financial intermediaries benefits

A)small savers, but not small borrowers.
B)small borrowers, but not small savers.
C)both small savers and small borrowers.
D)society through greater economic efficiency; small savers and borrowers do not gain directly.

Question 6

Which of the following is the most likely result of financial intermediaries?

A)increased funds available to borrowers
B)higher transaction costs
C)higher information costs
D)lower information cost but higher transaction costs

Question 7

Information costs

A)are the costs of buying and selling financial claims.
B)include the costs that savers incur to determine the credit worthiness of borrowers.
C)include the costs borrowers incur to discover the best investments to make with the money they have borrowed.
D)are zero in financial markets, but high for transactions carried out through financial intermediaries.

Question 8

Financial intermediaries reduce transactions costs by

A)charging fees to small savers.
B)charging fees to small investors.
C)taking advantage of economies of scale.
D)avoiding risky investments.

Question 9

Financial intermediaries are able to exploit economies of scale since

A)the equipment or expertise necessary for one transaction can be applied to other transactions.
B)they have special licenses needed to perform financial transactions.
C)financial markets fail to do so.
D)they can reduce transactions cost, but not information costs.

Question 10

Transactions costs are

A)zero in financial markets.
B)zero in financial intermediaries.
C)the costs of direct financial transactions.
D)equal to the taxes imposed on financial transactions.

Question 11

Transaction and information costs

A)benefit borrowers at the expense of savers.
B)benefit savers at the expense of borrowers.
C)transaction costs hurt savers while information costs hurt borrowers.
D)create profit opportunities for those who can reduce these costs.

Question 12

What are the various ways that financial intermediaries can take advantage of economies of scale?

Question 13

Small investors face

A)high transactions costs in financial markets.
B)low transactions costs in financial markets.
C)high transactions costs in financial intermediaries.
D)high information costs in financial intermediaries.

Question 14

The reduction in average cost resulting from an increase in the volume of a good or services produced is called:

A)information cost
B)transaction cost
C)diminishing returns
D)economies of scale

Question 15

Economies of scale are

A)charges to savers and borrowers imposed by banks in exchange for reducing transactions costs.
B)the reduction in costs per unit that accompanies an increase in volume.
C)decreases in transactions costs that occur as information costs increase.
D)decreases in information costs that occur as transactions costs increase.

Question 16

The presence of transactions costs and information costs

A)lowers the cost of funds to borrowers.
B)raises the expected return to lenders.
C)lowers the expected return to lenders.
D)increases the efficiency of the financial system.

Question 17

It is generally agreed that

A)the financial system would be more efficient if intermediaries were eliminated.
B)small- and medium-sized firms benefit by the actions of intermediaries.
C)the addition of intermediaries adds to transactions costs.
D)intermediaries should not seek to profit from reducing transactions costs.

Question 18

What are the information costs faced by savers?

Question 19

Individual investors can reduce transactions costs by

A)buying common stock rather than bonds.
B)combining their purchases through an intermediary.
C)common stocks directly, rather than through a mutual fund.
D)making loans directly, rather than depositing funds in a bank.

Question 20

Which of the following is NOT an example of transactions costs?

A)high interest rates
B)lawyers' fees
C)brokerage commissions
D)minimum investment requirements

Question 21

The "lemons problem" is overcome in the used car market by

A)strict government regulation of private deals between individual buyers and sellers of used cars.
B)most used cars selling for well below their true values.
C)"lemon insurance" policies being offered by insurance companies.
D)the existence of used car dealers who are concerned about maintaining their reputations.

Question 22

Adverse selection and moral hazard are examples of:

A)transaction costs
B)information cost
C)symmetric information
D)financial market efficiency

Question 23

Which of the following is NOT true of moral hazard?

A)It would not exist in a world of perfect information.
B)It arises because borrowers typically know more than lenders.
C)It describes a lender's problem of distinguishing the good-risk applicants from the bad-risk applicants.
D)It describes a lender's problem in verifying borrowers are using their funds as intended.

Question 24

The "lemons problem" exists in the market for goods because

A)sellers tend to try to take advantage of buyers.
B)buyers tend to try to take advantage of sellers.
C)differences in the quality of the goods being exchanged.
D)of moral hazard.

Question 25

You own a 2007 Ford Explorer. Although it has high mileage, you have maintained it very well. You want to sell it, but after checking the prices other owners of 2007 Ford Explorers are able to get for their cars in the used car market, you decide the prices are too low and you decide not to sell. This is an example of

A)the "lemons problem."
B)moral hazard.
C)economies of scale.
D)low information costs.

Question 26

If there were no adverse selection problems in the stock market,

A)some well-run firms would pay more to raise funds.
B)some poorly-run firms would pay less to raise funds.
C)the willingness of savers to invest in the market would be increased.
D)the volume of new stock issues would be lower.

Question 27

Which of the following is NOT an example of adverse selection?

A)A family with a home ten feet from a large river buys flood insurance.
B)A company uses the proceeds of a new stock sale to build an unnecessarily luxurious new headquarters.
C)A terminal cancer patient buys life insurance.
D)A company in serious financial trouble offers to pay you 30% on a loan.

Question 28

One method that lenders use to mitigate the adverse selection problem is to

A)charge higher interest rates to less creditworthy borrowers.
B)monitor closely the behavior of borrowers after a loan is made.
C)ration credit.
D)provide default insurance.

Question 29

Credit rationing refers to

A)the increase in the interest rate that occurs when the demand for credit increases.
B)the increase in the interest rate that occurs when the supply of credit increases.
C)the increase in the interest rate that occurs when the supply of credit decreases.
D)a restriction in the availability of credit.

Question 30

Generally, when there is asymmetric information

A)a lender will only lend to the government.
B)a lender will only lend to well-known borrowers.
C)practical solutions are devised to allow lending to take place.
D)a lender will cease all lending activities.

Question 31

The company that manufactures Screaming Chocolate Zonkers breakfast cereal finds that its sales collapse, it is forced into bankruptcy, and it defaults on its bonds, as a result of information on the filthy conditions in its factory, which had long been known to management, leaking out to the general public. This incident is best thought of as an example of

A)symmetric information in the financial markets.
B)asymmetric information in the financial markets.
C)moral hazard in the financial markets.
D)the generally poor state of sanitation in the food-processing industry in the United States.

Question 32

Which of the following is an example of adverse selection?

A)A homeowner with a large fire insurance policy allows the wiring in her house to deteriorate.
B)A woman with a large life insurance policy takes up sky diving.
C)Your brother-in-law borrows $20,000 from you to open a pizza parlor, but spends it gambling at the racetrack instead.
D)A man with a bad heart condition buys a large life insurance policy.

Question 33

The "lemons problem" in the used car market arises from

A)the difficulty U.S. producers have in making reliable cars.
B)the difficulty buyers have in distinguishing good cars from lemons.
C)the tendency of buyers of used cars to pay for them with bad checks.
D)the reluctance of many car dealers to handle used cars.

Question 34

When interest rates in the bond market rise,

A)adverse selection problems increase.
B)adverse selection problems are mitigated.
C)moral hazard problems increase.
D)moral hazard problems are mitigated.

Question 35

Which of the following is NOT true of adverse selection?

A)It would not exist in a world of perfect information.
B)It arises because borrowers typically know more than lenders.
C)It describes a lender's problem of distinguishing the good-risk applicants from the bad-risk applicants.
D)It describes a lender's problem in verifying borrowers are using their funds as intended.

Question 36

To help offset the costs from loan defaults, the First National Bank of Gotham decides to increase the interest rate it charges on its business loans. As a result of this increase in the interest rate, the creditworthiness of Gotham's loan applicants is likely to

A)improve.
B)deteriorate.
C)be unchanged.
D)be unchanged, unless the economy enters a recession at the same time as the interest rate is increased.

Question 37

Which economist is credited with having been the first to discuss the "lemons problem"?

A)George Akerlof
B)Milton Friedman
C)Robert Shiller
D)James Tobin

Question 38

Why do higher interest rates increase adverse selection problems in the loan market?

A)Higher interest rates reduce the gains from economies of scale.
B)As interest rates rise, the creditworthiness of the average loan applicant declines.
C)Higher interest rates reduce information problems in the loan market.
D)At higher interest rates fewer investment projects are profitable.

Question 39

The assumption of asymmetric information means that

A)borrowers and lenders have the same information.
B)borrowers and lenders have perfect information.
C)borrowers know more than lenders.
D)lenders know more than borrowers.

Question 40

Why is adverse selection more likely in financial markets when interest rates rise?

A)The remaining borrowers are more likely to be risky.
B)Higher interest rates are likely to hurt the economy.
C)If firms have to pay higher interest rates, they may choose to use the funds differently than they first intended.
D)Banks eliminate risky borrowers by raising interest rates.

Question 41

The free-rider problem faced by private information-collection firms results in their

A)usually going out of business within a few years.
B)collecting less than all the available information about the firms they investigate.
C)being plagued by lawsuits.
D)charging fees higher than can be justified by market conditions.

Question 42

Moody's Investors Service is able to make a profit because

A)most investors are irrational.
B)of the existence of adverse selection problems.
C)fluctuations in interest rates make default risk on corporate bonds difficult to gauge.
D)small investors like the mutual funds they sell.

Question 43

Private information-collection firms fail to eliminate the adverse selection problem because

A)the law does not allow them to disclose private information about the creditworthiness of firms.
B)they do not monitor borrowers after loans have been made.
C)some investors who do not pay for their services will still profit from them.
D)most companies refuse to provide them with any information.

Question 44

All of the following are consequences of adverse selection on good firms EXCEPT

A)the cost of external financing increases.
B)firms need to rely more on internal funds.
C)firms need to rely more on accumulated profits.
D)firms will only be able to attain financing from the government.

Question 45

Acme Widget tells investors it wants to build a new widget factory and sell investors $10,000,000 in bonds to finance it. Once they have raised the $10,000,000 the owners of Acme Widget use the funds to finance a trip to Atlantic City to try out a new scheme they have devised to win at blackjack. This is an example of

A)the adverse selection problem in financial markets.
B)the moral hazard problem in financial markets.
C)the difficulty lenders have in distinguishing good from lemon firms.
D)the problems with using rational expectations in financial markets.

Question 46

A firm's principals are its

A)shareholders.
B)management.
C)values.
D)customers.

Question 47

Which of the following agencies has established standardized accounting principles for reporting corporate earnings?

A)The Securities and Exchange Commission
B)The Federal Trade Commission
C)The National Accounting Board
D)The Fair Reporting Commission

Question 48

When there's asymmetric information, who tends to have the better information?

A)lender
B)borrower
C)intermediary
D)equally likely to be the borrower or the lender

Question 49

Requirements for information disclosure for firms that desire to sell securities in financial markets

A)are very common in industrialized countries, including the United States.
B)are common in other industrialized countries, but have not yet been adopted in the United States.
C)have been adopted in the United States, but have not yet been adopted in other industrialized countries.
D)have yet to be adopted in the United States or other industrialized countries.

Question 50

Which of the following is NOT a company that collects information on individual borrowers and sells it to savers?

A)Moody's Investor Service
B)Value Line
C)NASDAQ
D)Dun and Bradstreet

Question 51

Suppose one person buys a copy of Consumer Reports and gives away free copies to all who request one. This is an example of

A)free rider problem.
B)moral hazard.
C)adverse selection.
D)economies of scale.

Question 52

Government regulations requiring firms that desire to sell securities in financial markets to disclose all available information

A)eliminate the adverse selection problem (when rigorously enforced).
B)increase the difficulty that young firms may have in raising funds.
C)eliminate the moral hazard problem in securities markets.
D)fail to eliminate the adverse selection problem, in part because they do not greatly reduce the difficulty that young firms have in raising funds.

Question 53

Lenders prefer to lend to firms with high net worth because

A)such firms are usually willing to pay higher interest rates.
B)the owners of such firms have more to lose if the firm defaults on a loan.
C)the government requires most bank loans to be made to such firms.
D)such firms usually are unable to raise funds directly through financial markets.

Question 54

Moral hazard problems arise when

A)lenders have difficulty in distinguishing between good and lemon firms.
B)when a downturn in economic activity makes repaying loans difficult for borrowers.
C)borrowers default on loans.
D)borrowers have an incentive to conceal information.

Question 55

Moral hazard arises from

A)the difficulty of distinguishing good-risk borrowers from bad-risk borrowers.
B)the likelihood that bad-risk borrowers are more likely to accept a loan than are good-risk borrowers.
C)savers' difficulties in monitoring borrowers.
D)borrowers' difficulties in locating savers.

Question 56

Suppose some members of Enron's board of directors are aware of the company's true financial condition, information that is not available to most investors. This is an example of

A)lemon problem.
B)moral hazard.
C)adverse selection.
D)asymmetric information.

Question 57

One reaction of firms to the adverse selection problem is to

A)rely on internal funds to finance investment.
B)use the stock market rather than the bond market to raise funds.
C)use the bond market rather than the stock market to raise funds.
D)borrow long-term rather than short-term.

Question 58

Moral hazard problems arise when

A)lenders have difficulty in distinguishing between good and lemon firms.
B)when a downturn in economic activity makes repaying loans difficult for borrowers.
C)borrowers have an incentive to act in ways that do not reflect the lender's interests.
D)borrowers default on loans.

Question 59

A firm's net worth is equal to the value of its

A)assets minus the value of its liabilities.
B)liabilities minus the value of its assets.
C)common stock minus the value of its outstanding bonds.
D)outstanding bonds minus the value of its common stock.

Question 60

Symmetric information

A)is the same as perfect information.
B)holds under the assumption of rational expectations.
C)is true only in efficient markets.
D)means that savers and borrowers have the same information.

Question 61

The use of collateral

A)allows banks to charge higher interest rates on loans.
B)makes it more costly for borrowers to take advantage of their asymmetric information.
C)makes it more costly for lenders to take advantage of their asymmetric information.
D)has important tax implications for both borrowers and lenders.

Question 62

With debt financing

A)moral hazard problems are eliminated.
B)moral hazard problems are reduced but not eliminated.
C)adverse selection problems are eliminated.
D)firms reduce the risk that they will become bankrupt during a recession.

Question 63

In the United States the stake of top management in firms' ownership usually is

A)less than 5%.
B)more than 25%.
C)more than 50%.
D)more than 75%.

Question 64

The main reason why banks are the leading source of external finance for businesses is

A)the interest rates on bank loans are usually lower than interest rates on corporate bonds.
B)banks have an information-cost advantage in reducing adverse selection problems.
C)interest paid on bank loans is deductible against the corporate income tax, whereas interest paid on corporate bonds is not.
D)government regulators encourage small businesses to obtain funding from banks.

Question 65

All of the following are benefits of securitization EXCEPT

A)risk sharing.
B)reduced interest rates that borrowers pay on loans.
C)increased liquidity.
D)fewer adverse selection problems.

Question 66

Compared to CDs and money market funds, crowd funding

A)provides higher expected returns with increased safety
B)provides lower expected returns in exchange for increased safety
C)is likely to result in lower returns due to higher volatility
D)provides opportunities for higher returns but also significant losses

Question 67

Restrictive covenants

A)generally require that firms use debt finance rather than equity finance.
B)generally require that firms use equity finance rather than debt finance.
C)put restrictions on the use of borrowed funds.
D)were outlawed under the Civil Rights Act of 1964.

Question 68

A firm's agents are its

A)shareholders.
B)management.
C)marketing department.
D)customers.

Question 69

Which of the following is NOT true of restrictive covenants?

A)They sometimes require borrowers to maintain the value of collateral offered to the lender.
B)They increase the marketability and liquidity of loans.
C)They sometimes require a borrower to maintain a certain minimum level of net worth.
D)They sometimes limit a borrower's risk taking.

Question 70

Crowd funding can best be described as:

A)raising funds in a very large market
B)raising small amounts of money from large numbers of people
C)many firms competing for the same source of funds
D)making funds available for a large number of business start ups

Question 71

Venture capital firms attempt to overcome the principal-agent problem by

A)investing only in industries with high profit rates.
B)charging high interest rates on loans.
C)holding large equity stakes in the firms they invest in.
D)avoiding investing in common stock.

Question 72

Banks require collateral for loans in order to

A)ensure that borrowers have significant amounts of their own funds invested in their businesses.
B)charge higher interest rates on loans.
C)reduce their tax liability on the interest they collect on loans.
D)reduce the total amount they are obliged to lend to any one borrower.

Question 73

A part of the Jumpstart Our Business Startups (JOBS)Act:

A)banks were required to provide special financing for start ups
B)differences between qualified and unaccredited investors were removed
C)the SEC is no longer is allowed to regulate funding of business start ups
D)Congress removed some of the restrictions on using crowd-funding to allow small investors to buy equity in start-ups

Question 74

Moral hazard is not eliminated in debt financing because

A)borrowers have an incentive to assume greater risk than is in the interest of the lender.
B)firms with a great deal of debt often go bankrupt.
C)principal-agent problems are greater with debt financing than with equity financing.
D)the use of restrictive covenants tends to increase moral hazard.

Question 75

When managers do not own very much of the net worth of the firm, then

A)there may be a principal-agent problem.
B)the firm will usually have to raise most of its funds in financial markets.
C)the firm will have to rely more on equity financing than debt financing.
D)the firm will have to rely more on debt financing than equity financing.

Question 76

Many economists and policymakers have raised concerns about crowd funding due to the existence of:

A)information costs facing small investors
B)information costs facing business start ups
C)transaction costs facing business start ups
D)increased competition for banks in funding business start ups

Question 77

Banks deal with problems of adverse selection by

A)charging high interest rates.
B)gathering information about the default risk of borrowers.
C)making only short-term loans.
D)making only long-term loans.

Question 78

The existence of adverse selection results in:

A)reduced market efficiency
B)an increase in the likelihood of moral hazard
C)increase market transactions
D)higher transaction costs

Question 79

Financial intermediaries are able to act as delegated monitors for individual savers because

A)other investors are unable to gain a free ride on their monitoring efforts.
B)borrowers consider this role to be traditional for financial intermediaries and are willing to put up with it.
C)the federal government has granted them waivers from laws protecting privacy.
D)they employ a vast network of private detectives to carry out their monitoring role.

Question 80

In effect, banks are able to charge

A)depositors for banks' superior information about borrowers.
B)borrowers for banks' superior information about depositors.
C)the government for banks' superior information about borrowers and depositors.
D)interest rates that are in fact above those legally allowed.