Information economics

Part 1

During the 2008 credit crisis, lending on the interbank market nearly came to a halt. The reason was that Banks did not trust lending to each other.

1) Explain how information economics can improve our understanding of what happened.

2) A possible solution to the problem is having the government providing guarantees for loans in the interbank market. Evaluate the limits of this approach in the light of information economics.



The 2008 credit crisis as a whole featured numerous instances of asymmetric information. With regard to the credit crunch in the interbank market, it was a case of adverse selection. As a result of defaults with sub-prime mortgages many banks were technically insolvent and the assets that could be put up as collateral were toxic. However, this information was private to the bank in question and unknown to the rest of the market. This created an adverse selection problem similar to Akerlof's (1970)“The Market for Lemons.” In the present crisis, banks that had the potential to lend didn't know whether the counterparty was safe or risky[1]. If a bank had the ability to tell the difference between safe and risky banks, there then would be two separate markets. As the counterparty risk with risky banks would be higher, a higher rate of interest would be charged. However due to asymmetric information, lending banks did not have the ability to tell. Therefore lending banks, fearing counterparty default by lending to an insolvent bank, would charge a higher rate of interest to all borrowing banks. This higher interest rate would discourage safe banks so they wouldn't borrow at this rate. The risky banks would be willing, and therefore all those willing to borrow at this rate would be risky banks. Knowing this lending banks wouldn't lend at all, hoarding the cash instead, resulting in a “no-trade equilibrium” and market failure.[2]

This problem arose because of a prior asymmetric information problem, one of moral hazard. Moral hazard is “actions by economic agents in maximizing their own utility to the detriment of others in situations where they do not bear the full consequences . . . of their actions” (The New Palgrave: A Dictionary of Economics, 1987). Sub-prime mortgages were securitized into more complex financial instruments such as collateralized debt obligations (CDOs). The banks could sell these mortgage-backed securities. These securities were given AAA credit ratings so to the buyer the stream of payments seemed safe. Therefore banks could keep offering sub-prime, risky mortgages to individuals believing they could securitize the mortgages and sell the mortgage-backed security, thus passing on the risk of default to others. In other words maximising their own utility while not bearing the full consequences of their action. These assets were quite liquid, so a bank that needed cash could sell them quickly.

When house prices started to decline steeply, re-financing became more difficult and the number of mortgage defaults increased. As a result the value of mortgage-backed securities fell and the market realised that the AAA ratings were inaccurate. Now potential buyers of mortgage-backed securities were concerned whether the bank was selling them to raise cash or selling to rid itself of poor-performing or toxic assets. This asymmetric information lead to an adverse selection problem, again similar to Akerlof's “Market for Lemons,” and lead to the liquidity problems for banks.


Suarez (2008), amongst others, have supported the use of government guarantees for loans in the interbank market to jump-start the market and restore it to normal functionality. He sees guarantees as a complement to government supervision. However such an intervention would cause a moral hazard problem.

To explain this, first lets assume a banking system with no government guarantees on loans at all. In this system the funds that a bank lends are at risk. Lending banks are fully aware of this so it is in their interest to be careful to which banks they lend to. The borrowing banks also are aware of this, so they have to develop the lending banks' confidence. If they lose confidence, the sources of lending will dry up. Thus the borrowing banks risk-taking has to be moderate and the borrowing banks need to maintain high enough levels of liquidity reserves and risk capital to assure lending banks' confidence. Therefore financial health is linked to public demand, if they public want safe banks, there will get them. To do so the public may have to accept relatively low returns on their deposits and high interest rates on their loans (Dowd, 2009).

Now assume we have two borrowing banks. We have a “good” bank, one that acts prudently, and a “bad” bank, one that acts recklessly. The two banks compete for market share. When the economy is doing well, the “bad” bank appears more successful than the “good” bank, as it can attract depositors with higher deposit rates and attract shareholders with higher returns on its capital and lending banks have confidence in it. However when the economy is in a poor state, the “bad” banks excessive risk taking is exposed and lending banks' lose confidence. This causes the “bad” bank to have liquidity problems and cause a run on the bank, leaving the “good” bank remaining and the winner. Eventually the competitive process rewards the “good” bank and penalises the “bad” bank.

Now if we add government guarantees (or similarly have the central bank as the lender of last resort) the “bad” bank has a weakened incentive to avoid getting into difficulties in the first place. In both states the “bad” bank will win. In a good economy the “bad” bank pays higher deposit rates and generates higher returns to shareholders and can lend from lending banks. In a poor economy the “bad” bank, even though its risk taking is exposed, can still borrow from lending banks as the government will protect the lending banks. This would force the “good” bank to imitate the “bad” bank. The government intervention distorts the competitive process and encourages risky behaviour (adapted from Dowd (2009, pg. 158)).

Supporters of government guarantees could argue that it would only be a temporary measure till the interbank lending market returned to “normality”. However, if the interbank lending market did return to “normality” and there was another credit crunch, the government would need to provide guarantees again because the threat of letting risky banks fail would not be credible.

Renown economist and current Director of the White House's National Economic Council, Larry Summers has heavily criticised the use of the moral hazard problem to critique government bailouts and government guarantees. Summers (2007) states that “Moral hazard to recognise the special features of public action to maintain confidence.” He continues be saying that while financial institutions can fail because of insolvency, solvent institutions can also fail because of illiquidity with a lack of confidence causing creditors to rush to withdraw their funds and assets not being liquidated fast enough. To Summers (2007) government guarantees would avoid this panic and contagion. Despite Summers' objection to the use of moral hazard in this instance, most economists would agree that government intervention through government guarantees would lead to moral hazard.

Part 2


Below are two quotes from the abstract of two recent academic papers:

“ We survey 392 CFO's about the cost of capital, capital budgeting, and capital structure…We find some support for the pecking-order and trade-off capital structure hypotheses but little evidence that executives are concerned about asset substitution, asymmetric information, transaction costs, free cash flows, or personal taxes.”

..Graham J. R., and Campbell, R., Harvey. (2001), “The Theory and Practice of Corporate Finance: Evidence from the Field”, Journal of Financial Economics, 60, pp 187 - 243.

“ We survey 384 financial executives and conduct in-depth interviews with an additional 23 to determine the factors that drive dividend and share repurchase decisions…In general, management views provide little support for agency, signalling, and clientele hypotheses of payout policy. Tax considerations play a secondary role.”

…Brav. A., Graham. J. R, Harvey, C. R., Michaely, R., (2005), “Payout Policy in the 21st Century”, Journal of Financial Economics, 77, September, pp 483 - 527.

Are asymmetric information and agency cost theories relevant for the modern corporation? Discuss.


In corporate finance explanations of a firm's financial structure are hotly debated. Key theories in corporate financial structure are the pecking-order theory, with a key assumption of asymmetric information, and agency cost theories. However since the results of empirical studies by Graham et al (2001) and Brav et al (2005) the relevancy of asymmetric information and agency cost theories has been questioned with regard to corporate financial structure and dividend payout policy. These studies of financial executives found little support for asymmetric information, a key assumption of the pecking-order theory, and agency costs in payout policy.

Agency cost theories in corporate financial structure were largely developed in an article by Jensen and Meckling (1976). They noted that agency costs are inevitable, citing the differences between the firm that is 100 percent owned by managers and one that is owned by managers and outsiders. In the latter, managers act as agents for the outside shareholders. This creates a principal-agent problem, whereby the agents may act in their own interests, contrary to the interests of the shareholders. Agents should maximise firm value but may use free cash flow for their own interests and on wasteful activities. With regards to dividend payout policy, an increase in dividends should benefit the shareholders by reducing cash flow and thus managers' ability to pursue wasteful project and activities.

In pecking-order theory managers prefer to use external financing only when further internal financing is unavailable. If external financing is required managers prefer debt over equity. This is because it is difficult for managers to inform the market of the true value of the firm due to asymmetric information. Equity has a higher asymmetrical information problem than debt, as debt investors are less exposed to errors in valuing the firm because they have first claim on assets and earnings. Since potential investors cannot adequately value stock, it would generally be sold at a price below the price the managers think appropriate. So managers would prefer to issue debt rather than sell stock too cheaply (Poulson, A. 2009).

In Graham et al (2001) and Brav et al (2005) some aspects of the two theories were considered relevant to decisions by financial executives but asymmetric information and agency costs were not. Besides these studies other empirical studies on the evidence of the two points has been mixed. For example in a recent study Bharath, Pasquariello and Wu (2009) tested whether the pecking-order theory's key assumption, that of information asymmetry, is an important or perhaps the sole determinant of capital structure. They concluded that asymmetric information considerations are important but not the sole determinant of capital finance structure.

Fundamentally when looking at empirical studies of economic theories, especially those based on surveys of businessmen, it is important to remember the purpose of producing theories in the first place. Milton Friedman (1953) in a seminal work, “The methodology of positive economics”, outlined the purpose of economic theory. Foremost, Friedman saw confusion between descriptive accuracy and analytical relevance. To Friedman theories shouldn't be tested by comparing their assumptions directly with reality. He regarded complete realism as unattainable, rather it is whether a theory's predictions are good enough for the purpose in hand, whether they are better than the predictions from other theories or whether the theory has the ability for producing new ideas or lines of research.

Friedman (1953, pg. 31) explicitly stated that the surveys of businessmen on what they say they do are “almost entirely useless as a means of testing the validity of economics hypotheses.”[3] Instead Friedman regards such surveys as possibly valuable for revising and pursuing new hypotheses to account for such differences. He believed that if they act “as if” they do something then it is a reasonable test of a hypothesis.

Therefore following an “as if” rationality asymmetric information and agency cost theories are still relevant as they have added greater depth to debates on corporate financial structure and have opened up further lines of research for financial economists.

Part 3


Empirical evidence suggests that individuals who invest in higher education benefit from a substantial “education premium”, i.e. their future salaries are on averagehigher than those of individuals with only a high school diploma.

1) What are the costs of higher education? What method would you use to give a (monetary) value to a university degree?

2) Suppose you wanted to test the relationship between interest rates and the number of new master students in a particular year. What type of relationship would you expect?

3) “To some extent, the returns to human capital are random […]. Getting an MBA gives you a shot at being CEO, but it is not a guarantee.” (G. Mankiw). What adjustment should you make in order to take into account this comment when assessing the value of a university degree?



The costs of higher education are the tuition fees and the opportunity cost of not working during the period of the study. Costs such as living expenses, such as housing and food costs, are typically not included as these would be incurred regardless of whether the individual attends or doesn't attend higher education. Costs related to study, such as buying books, should be included, as the individual would not incur these if they didn't attend university.

As an aside with the recent growth in students attending foreign universities, if they come from countries with lower costs of living it may be pertinent for these individuals to include living expenses.

For an analysis of the investment decision three methods can be used: break-even point, internal rate of return and the net present value. To get a monetary value of a university degree the net present value method can be used.

Using a simple example:

Lets assume there is an individual who is considering whether to enrol for an MBA. Tuition fees are £50,000 for the two years paid at the start of the course. Currently he earns £50,000 a year. On completing the MBA he will earn £80,000. Wage growth is 10% and the discount rate is 5%. He will work for 8 years after graduating. For convenience the whole amount of salary is received at the end of the year.

Tuition fees: £50,000 for two years

Opportunity Cost (wage before MBA): £50,000

Wage after graduating: £70,000

Wage growth rate: 10%

Discount rate: 5%

So in this case the individual would invest in the MBA as the NPV is positive.


If we were to use a Net Present Value calculation we would expect that as interest rates rose the new number of new masters students would decline. This can be seen in the basic NPV formula below. As the interest rate rises the present value of future cash flows decreases, lowering the NPV. For some individuals the increase in the interest rate would create a negative NPV so they would change their decision from enrolling to not enrolling.

Now using the example from part 1 if we increase the discount rate to 10% from 5% we will see that the present value of future cash flows decrease resulting in a negative NPV. So in this case the individual would be better off not enrolling in the MBA programme due to the higher discount rate.

Two further points should be noted. Typically students have to take out loans to fund their tuition fees, so as interest rates increase the cost of borrowing increases. Also in a recession interest rates often go down in an effort to stimulate the economy. In recessions there has been an increase in postgraduate applications because people look to increase their qualifications in a more competitive job market, retrain or prepare themselves for when the economy improves (Guardian 17/02/2009).


For estimating the NPV, the individual would likely use statistics on the starting salary of recent graduates at the business school they are thinking of attending. These are frequently available on business school websites. An alternative that is considered more accurate is the use of salaries 5 years after graduating. If there is a concern that salaries are skewed, for example by the very high compensation of a few graduates, then the median rather than the mean can be used to reduce the importance of these outliers.

Alternatively a “CEO premium” could be included., whereby the extra salary by being a CEO is multiplied by the probability of becoming a CEO. This probability is likely to be related to the ranking or quality of the business school.

Of the two methods, using the median is simpler and less problematic.


Akerlof, G. (1970) “The Market for ‘Lemons'”: Quality Uncertainty and the Market Mechanism” in Quarterly Journal of Economics, Vol. 84, pp. 353-374

Bharath, S., Pasquariello, P., We, G. (2009) “Does asymmetric information drive capital structure decisions?” in Review of Financial Studies, Vol. 22, No. 8, pp. 3211-3243

Bodie, Z., Kane, A., Marcus, A. (2005) Investments, 6th ed. Singapore: McGraw-Hill

Brav, A., Graham, J.R., Harvey, C.R. & Michaely, R. (2005) “Payout policy in the 21st century” in Journal of Financial Economics, Vol. 77, No.3, pp. 483-527

Dowd, K. (2009) “Moral hazard and the financial crisis” in Cato Journal, Vol. 29, No. 1, pp. 141-166

Friedman, M. (1953) “The methodology of positive economics” in Essays in Positive Economics, Chicago: Chicago

Graham, J.R. & Harvey, C.R. (2001) “The theory and practice of corporate finance: Evidence from the field” in Journal of Financial Economics, Vol. 60, pp. 229-243

Jensen, M.C. & Meckling, W. (1976) “Theory of the firm: Managerial behaviour, agency costs and ownership structure” in Journal of Financial Economics, Vol. 3, No. 4, pp. 305-360

Jensen, M.C. (1986) “Agency costs of free cash flow, corporate finance and takeovers” in The American Economic Review, Vol. 76, pp 323-329

Myers, S. (2001) “Capital Structure” in Journal of Economics Perspectives, Vol. 15, No.2, pp. 81-102

Poulson, A. (2009) “Corporate Financial Structure” in The Concise Encyclopedia of Economics, (Accessed 4th January)

Ross, S., Westerfield, R., Jaffe, J., (2002) Corporate Finance, 6th ed. McGraw-Hill

Stiglitz, J. & Weiss, A. (1981) “Credit Rationing in Markets with imperfect information” in The American Economic Review, Vol. 71, No. 3, pp. 393-410

Suarez, J. (2008) “Bringing money markets back to life” (accessed 04/01/2010)

Summers, L. (2007) “Beware moral hazard fundamentalists” in the Financial Times, 23rd September 2007

Tirole, J. (2006) The Theory of Corporate Finance, Princeton: Princeton

The New Palgrave: A Dictionary of Economics, Vol. 3, 1987, p. 547.

The Concise Encyclopedia of Economics, Library of Economic and Liberty (accessed 04/01/2010)

Mankiw, G. (2006) (accessed 04/01/2010)

Guardian (2009) “Huge increase in demand for postgraduate degree courses” 17th February 2009

[1] Here I have used “safe” and “risky” rather than “solvent” and “insolvent”

[2] (Accessed 28th Dec 2009) also used as a guide

[3] Italics used as in Friedman (1953)

Please be aware that the free essay that you were just reading was not written by us. This essay, and all of the others available to view on the website, were provided to us by students in exchange for services that we offer. This relationship helps our students to get an even better deal while also contributing to the biggest free essay resource in the UK!