C8: An Economic Analysis of Financial Structure
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Last updated 6:25 PM on 3/29/26
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83 Terms
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What are transaction costs?
Costs of making financial transactions
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Why do transaction costs limit small investors?
They make small investments inefficient
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What problem do small investors face in diversification?
High costs prevent multiple investments
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Why are financial intermediaries needed?
They reduce transaction costs
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What are financial intermediaries?
Institutions that channel funds between savers and borrowers
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How do intermediaries reduce transaction costs?
By pooling funds and using economies of scale
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What are economies of scale?
Cost per transaction falls as transaction size increases
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Why do economies of scale exist in finance?
Transaction costs rise slowly relative to size
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Give an example of economies of scale
Buying 10,000 shares costs little more than 50 shares
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What is a mutual fund?
An intermediary that pools funds to invest in securities
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What are two benefits of mutual funds?
Lower costs and diversification
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Why do mutual funds reduce risk?
They hold diversified portfolios
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What is expertise in financial intermediation?
Specialized knowledge to reduce costs
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What services result from intermediary expertise?
Liquidity services and account management
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What are liquidity services?
Services that make transactions easier
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Example of liquidity service
Cheque-writing in money market mutual funds
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What is asymmetric information?
One party has more information than another
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Why is asymmetric information important?
It affects financial decisions
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What are the two types of asymmetric information problems?
Adverse selection and moral hazard
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What is adverse selection?
Hidden information problem before a transaction
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Who are most likely to seek loans?
Bad credit risks
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Why does adverse selection reduce lending?
Lenders avoid loans due to risk
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What is moral hazard?
Hidden action problem after a transaction
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Give example of moral hazard
Borrower takes excessive risk after receiving loan
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What is agency theory?
Analysis of behaviour under asymmetric information
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What is the lemons problem?
Bad quality drives good quality out of market
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Who introduced the lemons problem?
George Akerlof
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Why do good firms avoid markets under adverse selection?
Their securities are undervalued
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Why do bad firms dominate markets?
They benefit from average pricing
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What happens to markets under lemons problem?
They may fail or shrink
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Why are securities markets not primary financing sources?
Adverse selection limits participation
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What is direct finance?
Borrowers raise funds directly from savers
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What is indirect finance?
Financial intermediaries provide funds
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Which is more important globally?
Indirect finance
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Why are banks important?
They reduce asymmetric information
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Why do banks make private loans?
To avoid free-rider problem
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What is the free-rider problem?
People use information without paying for it
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Why does free-riding reduce information production?
No incentive to produce information
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What is private production of information?
Firms sell financial information
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Why is the private production and sale of information limited?
Free-rider problem
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How does government reduce adverse selection?
Regulation and disclosure requirements
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Why is regulation needed?
Private markets produce insufficient information
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Why do financial intermediaries solve adverse selection?
They specialize in information production
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How do banks profit from information?
Lend to good firms at higher returns
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Why are loans nontraded important?
Prevent others from free-riding
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Why are banks more important in developing countries?
Information is harder to obtain
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Why do large firms access markets more easily?
More public information available
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What is collateral?
Asset pledged to secure a loan
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Why does collateral reduce adverse selection?
Reduces lender loss in default
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What is net worth?
Assets minus liabilities
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Why does high net worth reduce risk?
Borrower has more to lose
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Why are lenders more willing to lend with collateral?
Lower expected loss
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What is moral hazard in equity contracts?
Managers act against owners’ interests
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What is the principal–agent problem?
Managers (agents) do not act for owners (principals)
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Why does separation of ownership and control matter?
Managers have weaker incentives
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Give example of principal-agent problem
Manager shirking or stealing profits
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Why is monitoring costly?
It requires time and resources
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What is costly state verification?
Expensive monitoring of firm performance
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Why does free-rider problem affect monitoring?
Investors rely on others to monitor
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Why is equity financing less common?
High monitoring costs and moral hazard
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How does government reduce moral hazard?
Regulation and fraud penalties
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What role do venture capital firms play?
Monitor firms closely
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What role do private equity firms play?
Control firms to reduce moral hazard
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Why do venture capital and private equity firms avoid the free-rider problem?
Because their investments are private (not traded), so others cannot copy their information
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What is a debt contract?
Agreement to pay fixed amounts
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Why does debt reduce moral hazard?
Less need to monitor unless default occurs
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When is monitoring needed in debt contracts?
Only when borrower defaults
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Why are debt contracts preferred?
Lower monitoring costs
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Why does debt dominate equity financing?
Less costly state verification
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What is moral hazard in debt contracts?
Borrower takes excessive risk
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Why might borrower take risky projects?
Upside benefits go to borrower
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What is incentive compatibility?
Aligning borrower and lender incentives
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How do collateral and net worth reduce moral hazard?
Borrower has “skin in the game”
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What are restrictive covenants?
Contract clauses limiting borrower behavior
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Why are covenants needed?
Reduce moral hazard
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Why are debt contracts complex?
They include many covenants
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Why is monitoring covenants costly?
Requires enforcement and verification
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Why does free-rider problem affect bond markets?
Investors rely on others to monitor
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Why are intermediaries better at monitoring?
They internalize benefits
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Why do banks dominate lending?
They reduce both adverse selection and moral hazard
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What are the 8 facts about financial structure?
Empirical patterns explaining financial systems
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What is the overall conclusion of Chapter 8?
Financial structure is shaped by transaction costs and asymmetric information
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What are four types of covenants?
Limit risk, encourage good behavior, protect collateral, provide information
