Question 1

A lesson of the Enron collapse is that government regulation

Accepted Answer

The Enron collapse revealed the problem of asymmetric information between the company and its investors. While government regulation cannot completely eliminate this problem, it can reduce it through requirements for transparency and disclosure. Therefore, option B is the best choice.

Question 2

External financing by ________ should be more important in developing countries than in industrialized countries because information about private firms is more difficult to collect in developing countries.

Accepted Answer

Financial intermediaries, such as banks and microfinance institutions, are better equipped to gather information and assess the creditworthiness of businesses in developing countries where information is less readily available. Bond and stock markets may be less accessible, and direct lending may be too risky without adequate information.

Question 3

Equity contracts

Accepted Answer

Equity contracts represent ownership in a company and entitle the holder to a portion of the business's profits and assets. Debt contracts, on the other hand, represent loans made to a company and must be repaid with interest, but do not confer ownership. Equity contracts may suffer from the moral hazard problem, as owners may be tempted to take excessive risks knowing that they will reap the rewards if successful, while debt contracts have the advantage of being easier to verify and monitor. Equity contracts are not used more frequently than debt contracts to raise capital; the choice of financing depends on the company's specific needs and financial situation.

Question 4

Analysis of adverse selection indicates that financial intermediaries,especially banks,

Accepted Answer

Financial intermediaries, especially banks, have advantages in overcoming the free-rider problem, which is one reason why indirect finance is more important than direct finance for businesses. This is because intermediaries can pool resources and conduct in-depth analyses that individual investors might not undertake due to the costs involved, thus mitigating adverse selection issues.

Question 5

Moral hazard in equity contracts is known as the ________ problem because the manager of the firm has fewer incentives to maximize profits than the stockholders might ideally prefer.

Accepted Answer

The principal-agent problem refers to the potential conflict of interest between the principal (the shareholders) and the agent (the manager) in a firm, where the agent has less incentive to act in the best interest of the principal. This is because the manager may prioritize their own interests, such as job security or personal gain, over maximizing profits for the shareholders. This leads to moral hazard, where the manager may take actions that benefit themselves but are detrimental to the company and its shareholders.

Question 6

The concept of adverse selection helps to explain all of the following except

Accepted Answer

Adverse selection is the tendency for the riskiest borrowers to be the ones most likely to seek out loans or funding, which can make it difficult for lenders or investors to determine the true risk of an investment or loan. This can lead to higher interest rates or reluctance to lend. Adverse selection does not explain why direct finance is more important than indirect finance, as this is influenced by a range of factors including regulatory frameworks, market structure, and investor preferences.

Question 7

The free-rider problem occurs because

Accepted Answer

The free-rider problem occurs when people who do not pay for a good or service still benefit from its provision. In the case of information, non-paying individuals can still use and benefit from it, even if they did not contribute to its production or distribution. This creates a situation where it may not be profitable to produce or provide the information, since not everyone is paying for it.

Question 8

Adverse selection is a problem associated with equity and debt contracts arising from

Accepted Answer

Adverse selection occurs when there is an asymmetric information between the lender and borrower. In this case, the lender lacks information about the borrower's potential returns and risks, which may lead to them offering a higher interest rate to compensate for the risk.

Question 9

How does collateral help to reduce the adverse selection problem in credit market?

Accepted Answer

The answer of How does collateral help to reduce the...

Question 10

Net worth can perform a similar role to

Accepted Answer

Net worth can serve as collateral for loans and other financial transactions. It represents the value of the assets owned by an individual or company minus the liabilities owed. This provides a measure of financial stability and a potential source of security for lenders.

Question 11

The problem of adverse selection helps to explain

Accepted Answer

The problem of adverse selection occurs when borrowers with higher risk are more likely to apply for loans than those with lower risk. This makes it difficult for lenders to distinguish between high-risk and low-risk borrowers, which can result in lending to risky borrowers who may default. This is why firms are more likely to obtain funds from financial intermediaries who can screen borrowers and reduce adverse selection. Securities markets are more prone to adverse selection as it is difficult to screen and monitor individual investors.

Question 12

That most used cars are sold by intermediaries (i.e.,used car dealers)provides evidence that these intermediaries

Accepted Answer

The fact that most used cars are sold through intermediaries suggests that these intermediaries are able to prevent potential competitors from free-riding off the information that they provide. This implies that information asymmetry is a significant problem in the used car market and that intermediaries are necessary to solve it. It does not necessarily indicate that intermediaries have been afforded special government treatment, that they have failed to solve adverse selection problems, or that they have solved the moral hazard problem.

Question 13

The concept of adverse selection helps to explain

Accepted Answer

Adverse selection refers to a situation where sellers have information that buyers do not, or vice versa, about some aspect of product quality. In the context of financial markets, this can lead to market failure as bad credit risks are more likely to seek loans than good credit risks, prompting lenders to protect themselves. This problem is a key reason financial markets are heavily regulated, to ensure information is disclosed and to protect against market failures caused by information asymmetries.

Question 14

That only large,well-established corporations have access to securities markets

Accepted Answer

Indirect finance is crucial for businesses, especially smaller ones, because direct access to securities markets is often limited to larger, well-established corporations. This makes banks and other financial intermediaries key sources of external funds for these smaller entities.

Question 15

Government regulations require publicly traded firms to provide information,reducing

Accepted Answer

Government regulations requiring publicly traded firms to provide information help to reduce the adverse selection problem. This is because investors have access to more accurate and reliable information about the company's financial performance and prospects, which helps them make better investment decisions. The other options are not directly related to the provision of information by publicly traded firms.

Question 16

A problem for equity contracts is a particular type of ________ called the ________ problem.

Accepted Answer

The correct answer is moral hazard; principal-agent problem. This problem arises when there is a conflict of interest between a principal (e.g., a shareholder) and an agent (e.g., a company's executive), where the agent has an incentive to act in their own best interests rather than those of the principal, especially when the principal cannot perfectly monitor the agent's actions.

Question 17

Because of the adverse selection problem,

Accepted Answer

The answer of Because of the adverse selection problem,
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Question 18

As information technology improves,the lending role of financial institutions such as banks should

Accepted Answer

As information technology improves, it enables alternative lenders to enter the market and offer competitive rates and better service, leading to a decrease in the lending role of traditional financial institutions such as banks. Therefore, choice B is the best option.

Question 19

The ________ problem helps to explain why the private production and sale of information cannot eliminate ________.

Accepted Answer

The free-rider problem occurs when individuals can benefit from a good or service without paying for it, and it is often associated with information goods, such as news or software. In such cases, the private production and sale of information cannot eliminate free-riding because it is difficult to exclude non-payers from receiving the benefits of the information. Adverse selection refers to an imbalance in information between buyers and sellers, where buyers have more information than sellers and can use that information to their advantage, leading to a market failure. While adverse selection is also a problem for the market for information goods, it is not the main reason why private production and sale of information cannot eliminate free-riding. Meanwhile, the principal-agent problem refers to a situation where one party (the principal) hires another party (the agent) to act on their behalf but faces a problem in ensuring that the agent acts in their best interest. The principal-agent problem can also occur in the market for information goods, but it is not directly related to the issue of free-riding. Finally, moral hazard refers to a situation where one party takes risks because they are protected against the consequences of their actions, creating an incentive problem. While moral hazard is also a problem that may arise in the market for information goods, it is not directly related to the issue of free-riding.

Question 20

In the United States,the government agency requiring that firms that sell securities in public markets adhere to standard accounting principles and disclose information about their sales,assets,and earnings is the

Accepted Answer

The Securities and Exchange Commission (SEC) is the government agency responsible for regulating securities markets and mandating firms to adhere to standard accounting principles and disclose information about sales, assets, and earnings. The Federal Communications Commission (FCC) regulates communications industries, the Federal Trade Commission (FTC) regulates business practices, and the Federal Reserve System regulates monetary policy.

Quiz 8: An Economic Analysis of Financial Structure