Feb 28 2011

Wall Street, used cars, and the market failure of asymmetric information

This post is an introduction to the Academy Award winning documentary, ‘Inside Job’ for introductory Economics students

What do Wall Street investment bankers and used car salesmen have in common? Sometimes, the less their customers know about the products they’re selling, the more profits they both stand to earn. Imperfect information in markets can lead to market failure, and at its core, the failures of global financial markets during 2008 – 2009 was a result of imperfect information.

Last night, the film ‘Inside Job’ won the Academy Award for Best Documentary of 2010. The film focuses on the changes in the financial industry in between 2000 and 2007 that led to an overall increase in the level of risk undertaken by home mortgage lenders, investment banks, and ultimately the broader investment community the banking system serves.

The mis-aligned incentives motivating Wall Street banks and the asymmetry of information between the buyers and sellers of financial products, as well as the creation of new, complex derivative markets that allowed investment banks to bet against the very assets they were assembling and selling off to investors, contributed to the collapse of credit markets in 2007 and 2008 and ultimately a contraction of the level of economic activity worldwide during the “Great Recession” of 2008 and 2009.

The article below is an attempt to introduce the seemingly incomprehensible nature of global financial markets and understand what occurred in them between 2000 and 2007 in the context of an introductory Economics unit on Market Failure.

Imperfect Information as a Market Failure:

Imagine this. You’re in the market for a used car. You go to the used car dealership, speak with a salesman, and he takes you through rows of automobiles, telling you the features of each one and assuring you that each of his cars has been inspected by a third party garage for reliability. You find this re-assuring; after all you wouldn’t want to buy a car that hasn’t passed a basic inspection, since you don’t want it to break down once you’ve driven it off the lot.

After an hour or so of poking around the lot, you pick out the perfect car. A silver 2006 Audi, a great year for Audis, says the dealer. You have his word that it has been closely inspected and is in top notch shape. So you hand over $20,000 for the Audi and drive it off the lot, satisfied with your purchase.

What would you say, however, if you knew that soon after driving off the lot, the very salesman who convinced you to buy that Audi purchased an insurance policy that would pay the salesman $20,000  in the case that it broke down. Would that knowledge have made you question your purchase?

What would you say if you found out that the “third party garage” the salesman used to inspect the car actually followed orders from the dealer himself, and was 100% dependent on that dealer’s business. Therefore, the mechanic was under significant pressure to give each of the cars sent to him a high mark in its inspection. By doing so, the garage mechanic assures that the dealer is able to easily sell cars to the buyers who trust that the mechanic has given an honest appraisal of the car’s mechanical reliability. Since the dealer can sell cars given high inspection marks  for higher prices, the dealer is then able take out insurance policies that pay a greater amount when the car ultimately breaks down.

Would all of this knowledge have made you questions your purchase and the price you paid for your Audi? Chances are, if there had been perfect information in the market for used cars, you, and countless other people, would not have been willing to pay the price you paid for your Audi. Fewer used cars would have been sold, and they would have sold for lower prices. The existence of asymmetric information results in an over allocation of resources towards the market for mechanically unsound used cars.

So what does the story above have to do with the global financial crisis? Believe it or not, the fundamental cause of the near collapse of the global financial system in recent years is almost identical to our story about the used-car salesman, the corrupt garage mechanic, the dubious insurance policies and the sucker buyer, who was stuck driving a crappy car that broke down within days of driving it off the lot.

Financial Market Failure:

Between 2000 and 2007, financial innovation led to unprecedented increases in the availability of low interest loans to millions of low income American households for whom home mortgages traditionally would have been unobtainable. Banks which issued these “sub-prime” loans to households with very poor credit were able to sell them to Wall Street investment banks, which were re-packaging individual home mortgages with  thousands of similar loans from all over the United States into asset-backed securities, a form of bond that could then be sold to an investor to whom the interest payments made by the homeowners would accrue over the lifespans of the mortgages included in the bond.

Investment banks turned to the big credit rating agencies (Standard and Poors, Moody’s), who inspected the make-up of these asset backed securities, declared them investment grade and gave them AAA ratings, essentially giving a thumbs up to the institutional investors who ultimately bought these bonds from the investment banks. An AAA rating assured investors who bought the bonds that they were very safe investments, in essence that they were in “good mechanical order”, just like the Audi you drove off the lot after being told it was in good mechanical order.

The investors who ultimately bought these bonds were not small time investors like you and me, rather they were institutions, such as state pension funds, hedge funds, money market funds, sovereign wealth funds, and so on, who often times used taxpayers money to buy bonds from big investment banks on Wall Street (such as Morgan Stanley, Goldman Sachs and Bear Stearns). These investors were assured by the banks that the bonds were of the highest quality and would therefore earn the investors interest payments for years, even decades. In addition, because of the high ratings given to these bonds by the rating agencies, the investors believed they would always be able to sell the bond if they needed the money back they had originally used to buy it.

The information given to investors was not always correct, however, it turned out that many of Wall Street banks assembling and selling these bonds were also betting against them in a parallel market for derivatives known as credit default swaps.

Here’s the catch… the Wall Street banks that bought millions of low-income Americans’ mortgages (the “sub-prime” type) were just like that used car salesman. They knew the bonds of their creation were of poor quality, but just had to get the investors to believe they were in good mechanical order to “get them off the lot” into the hands of an investor.

And just like the sleazy car salesman, as soon as the banks started selling these bonds to investors, they began taking out insurance policies against them in the case that they should lose their value. An insurance policy that pays out when the value of a bond collapses is called a “credit default swap” (CDS), and the market for these  became a multi-billion dollar industry in which big Wall Street banks bought insurance on the very bonds they created and sold to institutional investors, essentially betting that their own bonds would collapse in value. Of course, none of the investors knew the banks were betting against their own bonds, because this knowledge would have surely wiped out demand for them and led to collapse in business for the Wall Street banks.

The rating agencies inspecting the asset backed securities assembled from bad mortgages were just like the corrupt garage mechanic giving all the 2006 Audis a “thumbs up” to make them easier for the car dealership to sell. By giving sub-prime mortgage backed securities “investment grade” AAA ratings, the rating agencies made it easier for investment banks to sell them to sucker investors for high prices, which in turn enabled investment banks to take out insurance policies (CDSs) against them. And since the rating agencies knew the banks wanted AAA ratings for bonds that should have been given “junk bond” status, the agencies continued to give them the highest rating, since they were dependent on the Wall Street banks for their business.

In the end, just like the 2006 Audi you drove off the lot was of poor mechanical integrity and broke down just days after you dropped $20,000 on it, most of the bonds assembled and sold on to investors by Wall Street banks were themselves of very poor quality. The underlying assets, the sub-prime mortgages themselves, were made to American households who could not possibly pay them back, Americans whose incomes were so low that the monthly payment for the home loan often exceeded the income of the borrower himself.

Ultimately, when sub-prime mortgage borrowers began defaulting on their loans, the Wall Street investment banks that had assembled them into asset backed securities and the institutional investors who bought these bonds found themselves holding trillions of dollars worth of loans that were no longer being repaid. For the banks, however, things weren’t all that bad, because just like the corrupt car salesman, they had taken out hundreds of billions of dollars in insurance on the bonds, which assured that when they finally went bad, the banks, which had passed on most of the bonds to investors, could simply collect the insurance payouts from the issuers of credit default swaps.

Who were the insurance companies stupid enough to insure crappy bonds, you ask? You may have heard of AIG (American Insurance Group). This was the insurance company insuring most of the sub-prime mortgage backed bonds. When all the bonds started to go bad AIG quickly ran out of money as it paid the investment banks out the insurance they owed. When AIG ran out of cash, the US government stepped in and gave AIG $85 billion of taxpayer money in September 0f 2008, assuring that the Wall Street banks with insurance through AIG collected 100% of their insurance money.

Show Me the Market Failure:

So what makes this a “market failure” in the economic sense of the term? Well, the existence of imperfect information in the automobile market led to an over allocation of resources towards the market for used cars. Because the buyers were being duped by the sellers and the corrupt garage mechanics, demand for used cars was too high and the price they were being sold for was too high. With more perfect information, consumers would have demanded fewer cars and they would have been sold for a lower price.

With more perfect information in the financial markets, far fewer investors would have been willing to pay the prices they did for the bonds the Wall Street banks assembled from sub-prime mortgages. Far less credit would have been made available to low income American home buyers. Far fewer sub-prime mortgage loans would have been made, and fewer Americans would have purchased homes that they could not afford in the first place.

In addition, if the institutional investors who were ultimately stuck holding these bonds had known that the investment banks selling them were simultaneously buying insurance policies against them, the investors would have been much more wary about investing in them. Also, if the investors had known that the rating agencies giving the bonds AAA, investment grade ratings were essentially following orders from the investment banks, giving the bonds the high ratings the Wall Street bosses wanted them to get, then the investors would have  been less willing to buy the bonds and less credit would have ended up in the hands of low-income American home buyers.

The market for financial services failed because too many resources were allocated towards the provision of loans to low-income American households. With more perfect information about the value of the under-lying assets included in the bonds being sold by Wall Street banks (the sub-prime mortgages), and with the knowledge that the banks themselves were betting against the bonds they assembled and sold, far fewer investors would have been willing to buy the bonds and far less credit would have been made available to American home buyers.

A market failure exists anytime the free market produces at a level of output greater or less than that which is deemed socially optimal. Given the huge surplus of unsold homes in the United States right now, and the collapse of many institutional investors’ portfolios on whose financial strength hundreds of millions of real people around the world depend for their very livelihoods, it can be safely argued that the imperfect information in the market for mortgage-backed securities (bonds) led to an over allocation of resources towards homes for low income Americans.

Discussion Questions:

  1. Why is perfect information needed for a market to be perfectly efficient? How does imperfect information lead to a mis-allocation of resources in a market?
  2. In the case of financial markets, what information, if known by those who invested in sub-prime mortgage-backed securities, would have helped correct the market failure and prevented the global financial crisis?
  3. Another type of market failure we study in Microeconomics is negative externalities. Did the over-allocation of resources towards home loans for low income households create any negative externalities when the assets backed by the loans ultimately lost their value? What are some of the social costs of too many loans being made to low income borrowers in the early 2000’s?
  4. Some argue that the financial crisis was not a market failure, but a regulatory failure, meaning the government failed to notice the actions of Wall Street banks and stop them before they caused a financial crisis? To what extent should the government intervene in the functioning of free markets to assure that information asymmetry does not lead to similar crises in the future?
  5. Suggest one regulation the government could have enacted to prevent the over-allocation of capital towards the sub-prime mortgage market?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

19 responses so far

19 Responses to “Wall Street, used cars, and the market failure of asymmetric information”

  1. Markel Zuritaon 01 Mar 2011 at 9:10 pm

    Why is perfect information needed for a market to be perfectly efficient? How does imperfect information lead to a mis-allocation of resources in a market?

    – Perfect information is needed for a market to be perfectly efficient because resources would then be allocated efficiently since everyone would know the exact amount needed. Imperfect competition leads to a mis-allocation of resources in a market because of asymmetric information which leads to some people knowing more than others and allowing them to price discriminate.

    In the case of financial markets, what information, if known by those who invested in sub-prime mortgage-backed securities, would have helped correct the market failure and prevented the global financial crisis?

    – If the investors had knows that the bonds they were buying were of poor quality, they would not have bought them. No market failure would have existed if the investors had been aware of the quality of the bonds because the firms supplying the bonds would not have been able to sell them and insure the poor quality bonds.

    Another type of market failure we study in Microeconomics is negative externalities. Did the over-allocation of resources towards home loans for low income households create any negative externalities when the assets backed by the loans ultimately lost their value? What are some of the social costs of too many loans being made to low income borrowers in the early 2000?s?

    – The over-allocation of resources towards home loans for low income households created negative externalities of production because as loans were made to low income borrowers in the early 2000s, the low income households who bought the home loans were not aware of the poor quality of the loans and therefore had to suffer economically when the loans ultimately lost their value.

    Some argue that the financial crisis was not a market failure, but a regulatory failure, meaning the government failed to notice the actions of Wall Street banks and stop them before they caused a financial crisis? To what extent should the government intervene in the functioning of free markets to assure that information asymmetry does not lead to similar crises in the future?

    – Government should intervene in the functioning of free markets when information asymmetry poses a threat to the national economy. If government officials are aware that information asymmetry in a free market can lead to large spillover costs to society, it is necessary for the government to act.

    Suggest one regulation the government could have enacted to prevent the over-allocation of capital towards the sub-prime mortgage market?

    – One regulation the government could have enacted to prevent the over-allocation of capital toward the sub-prime mortgage market could have been a tax. The tax would have controlled the over-allocation of capital and brought it to a socially efficient level.

  2. Cedricon 01 Mar 2011 at 11:00 pm

    1. Why is perfect information needed for a market to be perfectly efficient? How does imperfect information lead to a mis-allocation of resources in a market?

    Perfect information is needed for a market to be perfectly efficient because with perfect information, allocation would be efficient as optimal allocation would be known. Imperfect information leads to a mis-allocation of resources in a market because as firms/producers give out asymmetric information to consumers. Through asymmetric information, producers will tend to price discriminate.

    2. In the case of financial markets, what information, if known by those who invested in sub-prime mortgage-backed securities, would have helped correct the market failure and prevented the global financial crisis?

    The information that would have helped correct the market failure and prevented the global financial crisis would have been the quality of the bonds. If investors knew this information, market failure would not have occurred.

    3. Another type of market failure we study in Microeconomics is negative externalities. Did the over-allocation of resources towards home loans for low income households create any negative externalities when the assets backed by the loans ultimately lost their value? What are some of the social costs of too many loans being made to low income borrowers in the early 2000?s?

    Yes, the over allocation of resources towards home loans for low income households created negative externalities for them as these poor quality loans gave more credit to low income American home buyers who where not able to afford the houses they purchased. Some of the social costs of too many loans made to low income borrowers in the early 2000's is that these people started purchasing homes that were unafordable for them creating bigger economic losses.

    4. Some argue that the financial crisis was not a market failure, but a regulatory failure, meaning the government failed to notice the actions of Wall Street banks and stop them before they caused a financial crisis? To what extent should the government intervene in the functioning of free markets to assure that information asymmetry does not lead to similar crises in the future?

    I believe that the government should intervene in the functioning of free markets to assure that information asymmetry does not lead to a similar crisis in the future because it is up to their power to intervene when a similar situation arises that poses a threat to the economy. As information asymmetry lead to social and producer costs, it is the government's incentive to regulate this.

    5. Suggest one regulation the government could have enacted to prevent the over-allocation of capital towards the sub-prime mortgage market?

    One regulation that the government could have enacted to prevent the over allocation of capital towards the sub-prime mortgage market is taxing as it would have controlled regulation on the capital that was given out and would have reduced the over allocation to its efficiency level.

    4.

  3. Philippaon 01 Mar 2011 at 11:22 pm

    1. Why is perfect information needed for a market to be perfectly efficient? How does imperfect information lead to a mis-allocation of resources in a market?

    Perfect information is needed for a market to be perfectly efficient because then everyone would know the full story behind the thing that they were buying. It would allow people to make more responsible, effective decisions that would result in the least loss. In the used car example, the car wouldn't have been bought if the buyer knew that the "third party garage" had actually been more involved and was pressured to increase the ratings of the cars, or if the salesman had a large sum of insurance on the car. With this imperfect information, mis-allocation of resources occurs because the product that was made to seem better than it was, was bought. For example, the amount of cars sold is much higher because the buyer doesn't know that much about it. More mortgages were sold because the full status of the American household was not known.

    2. In the case of financial markets, what information, if known by those who invested in sub-prime mortgage-backed securities, would have helped correct the market failure and prevented the global financial crisis?

    If the investors of the sub-prime mortgage-backed securities had known about the true value of the underlying assets (houses) and how unlikely it was that the low-income families were able to pay back the mortgage. Also, if the investors knew that the bank had bet against its bonds by insuring against the failure of the mortgage paybacks, the investors would have realised there was more risk involved and the bonds were worth less than they had paid for them and less desirable. Finally, if the investors knew that the people giving the AAA rating were employed by the banks, and working in the banks interests, they would have suspected corrupt ratings and should have found out for themselves about the value of the underlying assets.

    3. Another type of market failure we study in Microeconomics is negative externalities. Did the over-allocation of resources towards home loans for low income households create any negative externalities when the assets backed by the loans ultimately lost their value? What are some of the social costs of too many loans being made to low income borrowers in the early 2000?s?

    When the value of the bonds collapsed and the pension fund, hedge fund etc. institutions that had bought bonds couldn't resell them at the price they bought them for, the value of the pensioners' investments dropped dramatically and the pensioners could no longer receive the sum they were promised. This is the social cost to the "third party" (pensioner), therefore a negative externality is present.

    All the tax money that the government used to pay AIG in order to keep the banks afloat to protect the money in ordinary bank accounts, could have spent elsewhere, e.g on education. This is a negative externality because the children of society who are the third party, did not receive better education.

    Overall, the whole world economy collapsed (financial crisis), which had great effects on society as jobs were lost etc.

    4. Some argue that the financial crisis was not a market failure, but a regulatory failure, meaning the government failed to notice the actions of Wall Street banks and stop them before they caused a financial crisis? To what extent should the government intervene in the functioning of free markets to assure that information asymmetry does not lead to similar crises in the future?

    Governments needs to intervene when information asymmetry causes negative externalities of both consumption and production in society, affecting things like the pension funds and the whole world's economy.

    Governments could set laws dealing with how much information the banks need to give the investors before completing a deal.

    5. Suggest one regulation the government could have enacted to prevent the over-allocation of capital towards the sub-prime mortgage market?

    There could have been independent evaluations and declaration of the underlying assets and the ability of the family to pay, therefore making the bonds less prone to fail.

    Limits could be set as to how large of a loan is allowed to be lent to the asset (house).

  4. Susanne Robertsonon 02 Mar 2011 at 12:08 am

    1. Why is perfect information needed for a market to be perfectly efficient? How does imperfect information lead to a mis-allocation of resources in a market?

    One cannot make a sound investment decision without perfect information. People will end up making investment decisions on the wrong information leading mis-allocation of resources.

    2. In the case of financial markets, what information, if known by those who invested in sub-prime mortgage-backed securities, would have helped correct the market failure and prevented the global financial crisis?

    If the banks overseas had been aware of the profile of the original borrowers, they would not have been as keen to invest, as the investment would not seem so attractive.

    3. Another type of market failure we study in Microeconomics is negative externalities. Did the over-allocation of resources towards home loans for low income households create any negative externalities when the assets backed by the loans ultimately lost their value? What are some of the social costs of too many loans being made to low income borrowers in the early 2000?s?

    The negative externality here is the failure of assessing the extent of the risk involved in these investments. As the banks collapsed, the government was forced to use tax-payer money to save the banks and many people were made redundant. The social costs is the use of tax payer money and the banks laying off of people, resulting in the government having to pay unemployment benefit.

    4. Some argue that the financial crisis was not a market failure, but a regulatory failure, meaning the government failed to notice the actions of Wall Street banks and stop them before they caused a financial crisis? To what extent should the government intervene in the functioning of free markets to assure that information asymmetry does not lead to similar crises in the future?

    In this case, the government had to intervene as the collapse of banks would have had disastrous consequences for society. However, in a free, functioning market banks should be left alone because of the incentive to be efficient.

    5. Suggest one regulation the government could have enacted to prevent the over-allocation of capital towards the sub-prime mortgage market?

    The government could have enforced quotas to set the optimal level of production. If less investment opportunities were available to banks overseas, the damage would not have been as severe towards the sub-prime mortgage market.

  5. Geoffroy the Frenchion 02 Mar 2011 at 7:13 pm

    1. Because if not all of the buyers know all of the prices and the quality of the good then some have the upper hand on others and the price will never be a equilibrium. Imperfect information leads to over allocation of a resource because the buyer does not know the full quality or prices of the good and hence buys it unknowing it’s a bad deal. These situations over allocate the good with imperfect information.

    2. If they had known that the how they were investing in were worth about nothing it could have helped prevent the crisis.

    3. The negative externality or effect on third party that this had was that people that didn't make any loans at all still went through the economic crisis . The social costs of too many of these loans was increased prices in just about everything, and many jobs were lost as a result of this.

    4. Well technically the government shouldn't include itself at all to be able to call it a "free market" but for the sake of saving it the government could have put some laws or educated/promoted to not investing without through knowledge of the good beforehand.

    5. First off they could have made a law about loans for low income people to decrease the amount people could borrow but they could have also could had taxed or put regulations on the sub-prime mortgage market.

  6. Lucea Jenningson 02 Mar 2011 at 8:03 pm

    Why is perfect information needed for a market to be perfectly efficient? How does imperfect information lead to a mis-allocation of resources in a market?

    Perfect information is needed for a market to be perfectly efficient because resources would be allocated efficiently as every consumer would know the right amount of a product to demand. Imperfect competition leads to a mis-allocation of resources in a market because asymmetric information leads to people buying something without knowing the full quality or price of a good.

  7. Bea G.on 03 Mar 2011 at 10:51 am

    1. Why is perfect information needed for a market to be perfectly efficient? How does imperfect information lead to a mis-allocation of resources in a market?

    -The less the Customers know about the product their selling, the major profit they will both earn. Imperfect information in markets will sometimes lead the to a market failure, and on top of everything, the failures on the global financial market during the years 2008 and 2009 were the result of : imperfect information.

  8. Danielon 03 Mar 2011 at 10:55 am

    1. Why is perfect information needed for a market to be perfectly efficient? How does imperfect information lead to a mis-allocation of resources in a market?

    Because if you have imperfect information, then the resources would be mis-allocated, causing a market failure. This is why it is important to have perfect information,in order to have an perfectly efficient market.

  9. keun-ho kimon 03 Mar 2011 at 1:12 pm

    1. The perfect information is needed for perfect efficiency because if having imperfect information, then the information would lead to mis-allocated efficiency, causing a market failure.Imperfect information leads to mis-allocation of resources in market. For example the outside looks like a new car, however since you don't have any information of the inside, it might be broken or untidy and dirty.

    2. If they had known not given almost all the loan to only low wages American, than they would not have the market failure. They didn't have perfect information about the value of the under lying assert included in the bonds being sold by wall street bank.

  10. Beni BGon 05 Mar 2011 at 5:20 pm

    1. With perfect information, on both the sellers and the buyers side, both parties know exactly how much of the product they want to demand (buy) and how much they want to supply.

    With imperfect information coming from the seller, the buyers might demand too much or not enough of the product compared to the quantity they would demand if they had all the information the seller has about the product.

    On the other hand, sellers might supply too much or not enough of a product if they receive imperfect information from the buyer about their demand and incentives. Thus through those possibilities the market might be over- or under-allocated with its resources.

    2. If the investors would have known that the value of the bonds they bought was much lower than they thought and that the rating agencies gave out the AAA-Ratings just to satisfy the investment banks and secure their income (even though the value of the bonds was quite crappy in a lot of cases) and that the investment banks were betting against their own bonds they were selling, by buying insurance policies against them, this might have helped correct the market failure and prevent the global financial crisis.

    3. When the assets backed by the low-income-household-loans lost their value this had a lot of negative externalities, of which big part had to be paid by tax-payers money.

    Some of the social costs (negative externalities) of too many loans being made to low income borrowers in the early 2000's was that a lot of taxes (social money) were used up to save the investment banks, institutional investors, and insurances that relied on the loans which the banks gave out to low income households.

    4./5.The government should at least make sure that the credit rating agencies are not dependent on the investment banks – maybe even owned by the government – and therefore give an unbiased, independent, and genuine rating to the investors. The government should also make sure that no loans are given out by banks to low-income-households where it doesn't seem realistic for them to be able to pay back the loan. And the government should forbid the investment banks to bet against their own sold assets by buying insurance policies against them.

  11. Francesca Perversion 06 Mar 2011 at 1:02 pm

    1. Perfect information is needed for a market because investors or consumers need to know the relevant information such as the quality or solidity of the product they buy before they make a conscious decision on their purchase. In this way resources are efficiently allocated. In the car dealer example, in fact, the customer most probably wouldn’t have bought the car for that price knowing all the information that were hidden to him.(i.e an “ok” from an independent mechanic is one thing but an “ok” from a mechanic who is depending economically form the car seller and driven by him is another thing). The mis-allocation of resources is due to the fact that there is a asymmetric information between the producer and the consumer.

    2. There are two crucial information that the investors should have known: the first is for sure the quality of the rating, most probably an AAA was over rated. Secondly the fact that the banks were insuring themselves against the failure of their own products. Of course investors thought that Moodys’ or Standard and Poors were actually independent companies but in reality they were at the “orders” of the big bankers in Wall Street so the rating was somehow fake. On the other hand also knowing that the banks had insured themselves betting on a bad performance of the products they were selling would have “rang a bell” for the investors.

    3. A negative externality is when someone other that the buyer or the seller experiences a loss as a result of the transaction. In the case of home loans for low income households resources were over-allocated because over-time the assets lost their value and the banks (or the insurances if they were assured ) got back instead of the money they gave an asset of a lower value. This generated a loss that had to be covered at the end of the process by the government using taxation resources that could have been used for social purposes. This is a loss for society.

    4. I think it was a market failure because the different subjects behaved in a tricky way and were more driven by short term and ungrounded profit than from a real balance between supply and demand generated by correct information. Nevertheless the government should also have increased controls of the banks and rating companies to avoid corruption and complacency and to guarantee the citizens – households and retired people – who were those finally affected by this market failure.

    5. Governments should have issued laws aimed at controlling the quality of the financial products. For instance before a bank could place on the market a complex financial this should be approved by an external independent company (as it is today with Moodys’ and Standard and Poors) but they should be accountable for wrong rating techniques applied. Another thing as it is in Italy, the loans should be given towards a realistic possibility for those who get it to refund the money. (amount a percentage of the total value of the asset and a minimum income that can allow survival while paying the loan).

  12. Isabellaon 07 Mar 2011 at 12:04 am

    1. Why is perfect information needed for a market to be perfectly efficient? How does imperfect information lead to a mis-allocation of resources in a market?

    Without perfect information, investors are essentially led to believe something that isn't true and, if this goes on for too long, it can lead to various third parties being eventually affected. Imperfect information leads to a misallocation of resources in a market because investors begin investing in areas that they believe will be profitable in the future when in reality they won't be and it would be better to invest elsewhere.

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