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Adverse Selection, Moral Hazard, and Finance

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I've stated below the questions I'm having some difficulty with as well as my thoughts on the answer.

1) Households make four kinds of economic decisions (textbook, pp. 4-5). Suppose you have two households with the same income. Household A has one income earner and Household B has two income earners.
How would the four types of economic decisions differ between these two otherwise identical households?
(My thoughts: I think that the main difference between the two is that the one with two income earners can take more risks in all of the decisions.)

2) Adam Smith is often called the father of economics. His famous book, The Wealth of Nations, talks about an "invisible hand," which automatically allocates goods to the persons most able to put them to good use. The invisible hand operates through the price mechanism for goods and services, so that individuals who trade on the market, while seeking only their own goods, are actually efficiently allocating society's resources. His ideas, if applied to modern capital markets, imply that these markets would efficiently allocate investment capital to the firms that would use the capital most efficiently in producing goods and services for society. Yet, this would happen only if markets were left to operate without state intervention. Do you think modern governments should leave capital markets unregulated? Why or why not?

3) In each of the following situations, moral hazard or adverse selection may be present. Indicate which you think is present, if any, and explain your choice.
-An insurance company is thinking about issuing health insurance to a firm's employees. (My thoughts: Moral)
-An insurance company has issued health insurance to a firm's employees on the basis of their medical histories. (My thoughts: Adverse)
-An investor is asking for a bank loan to support a new business she wants to operate. She is unwilling to submit to a credit check. (My thoughts: Adverse)
-An investor has purchased shares in a new software company. He is just a shareholder, and is not going to be involved in the daily operations of the firm. (My thoughts: None)
-A grandfather has just given his grandson $100 as a birthday present. (My thoughts: None)

In each of the situations considered in question 2 and 3, what could be done to overcome the problem? (My thoughts: I'm not too sure, since I'm not 100% sure on the differences between the two)

4) Imagine a corporation with $1,000,000 of assets and a debt ratio of 40%. Return on equity (ROE) is expected to be 20% for the foreseeable future. Assume the firm keeps the same amount of debt indefinitely (as opposed to keeping the same debt ratio).
-What do you expect the firm's earnings to be for the next 3 years if the firm doesn't pay out any dividends or re-purchase any shares? (My thoughts: 1st - 600,000 x 20% = $120,000; 2nd - 720,000 x 20%= $144,000; 3rd - 864,000 x 20%= $172,800)
-If the firm doesn't pay any dividends or re-purchase any shares, at what rate would the firm grow from year to year? (My thoughts: 20%)
-If the firm pays 50% of its earnings as dividends, at what rate would the firm grow from year to year? (My thoughts: 10% (50% of 20%))
-If the firm uses 80% of its earnings to re-purchase shares from its shareholders, at what rate would the firm grow from year to year? (My thoughts: 4% (80% of %20=16%; 20-16=4))
-If the firm pays 50% of its earnings as dividends, and uses an additional 20% of its earnings to re-purchase shares from its shareholders, at what rate would the firm grow from year to year? (My thoughts: 6% (70% of 20%=14%, 20-14=6))
-What does the term "Sustainable Growth Rate" mean? Would the amounts you have calculated in parts b. to d. equal the Sustainable Growth Rate for the firm? (My thoughts: I don't have a clue)

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Solution Summary

Adverse selection, moral hazards and finance are examined.

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The four kind of decisions that the household make are:
How much to work?
What to buy?
How much to save?
How to invest the savings?
If we look at the above four decisions, we can say that Household A with a single income earner would prefer to work harder, buy less, save less, and would prefer to invest in less risky investments.
As far as household B with two income earners is concerned, people in this household would work as usual, they would buy more, save more and, at the same time, invest in risky assets.

No, government should not leave the capital market unregulated because the "invisible hand" comes later into the picture in the current economic scenario. In the modern economy, the role of the invisible hand is played by government watchdogs. If government intervention is not done, companies would create a huge moral hazard with increased level of competition in the market and, due to this, it will affect the economy with higher social costs and with less social benefits.

We have the following:

An insurance company is thinking about issuing health insurance to a firm's employees: Here, the moral hazard can come into ...

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  • MBA, Indian Institute of Finance
  • Bsc, Madras University
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