Chapt-2 Economic Analysis of FS handout.

. Business establishments are not classified in the service or manufacturing subsectors on the basis of their engagement in service or manufacturing activities, but rather because they collectively respond to the need for services or manufactured goods. Business establishments that respond to the need for materials that cannot be linked to a fundamental need (e.g. steel, wood pulp) are classified in the horizontal materials sector. 1564 M. Dalziel / Research Policy 36 (2007) 1559–1574 The third step is designed to differentiate amongst business establishments within the service and manufacturing subsectors. Again the dependency criterion is used to distinguish between central and complementary firms. Central firms provide products or services that are used by final customers or customer service providers, i.e. products or services upon which final customers depend, and complementary firms provide products or services that are used by central firms. The only services that are used by final customers are those offered by customer service providers, the central firms in the service subsector that operate at the top of the sector hierarchy. All other service providers are complementary firms that are classified relative to the firms that depend upon them for their services. Manufacturers are similarly classified as central or complementary on the basis of whether or not their products are used by the sector’s final customers or customer service providers. Central firms in the manufacturing subsector produce products that are ultimately used by the sector’s final customers or customer service providers, while complementary firms in the manufacturing subsector provide tools, equipment, or services that facilitate the design or manufacture of products, but that are not used by the final customer or customer service provider. The final step in designing a systems-based classification system involves distinguishing between possibly multiple levels of central firms in manufacturing subsectors. The modularity literature identifies two alternative roles for manufacturers, systems integrator and component supplier, where systems integrators are responsible for the design of the system and depend upon component suppliers for the provision of system modules (Baldwin and Clark, 2000; Brusoni et al., 2001). Using the same dependency criterion, the number of levels in manufacturing subsectors can be expanded as needed, but in most cases it will be practical to limit the number to three. Where manufacturers produce complex products, such those produced by firms in the transportation, communications, or medical equipment subsectors, three levels of manufacturing firms can be identified: system integrators, subsystem suppliers, and component suppliers. In the energy sector, it may be more natural to distinguish between providers of refined materials and providers of raw materials. In some cases it may be difficult to distinguish between the multiple levels of centra

1. Chapter Two Economic Analysis of Financial Structure 1 5/10/2021

2. Learning objectives: Basic facts about the Financial Structure Throughout the World Transaction Costs Asymmetric Information: Adverse Selection and Moral Hazard Financial Development and Economic Growth, and Factors Causing Financial Crisis. 2 5/10/2021

3. 2 .0. Introduction 3 5/10/2021 A healthy and vibrant economy requires a financial system. Financial system moves funds from people who save to people who have productive investment opportunities .

4. 2.1. Basic facts about the Financial Structure Throughout the World 5/10/2021 4 The financial system includes many different types of institutions: Banks , Insurance companies, Mutual funds, stock and bond markets, and so on , all of which are regulated by government . W e find eight basic facts about the financial system:

5. Cont… 1. Stocks are not the most important source of financing than others . Because: Asymmetric information (Adverse selection and moral hazard). It has not tax benefit . Debt Contract 2. Marketable securities (debt and equity) are not the primary source of financing than others. Because: Asymmetric information (Adverse selection and moral hazard). 5 5/10/2021

6. Cont… 3. Indirect finance is many times more important than direct finance. Because : They reduce transaction costs They reduce asymmetric information: Adverse selection and moral hazard . 4. Financial intermediaries, particularly banks, are the most important source of finance used to finance businesses. 6 5/10/2021

7. Cont… 7 5/10/2021 What makes banks so important to the workings of the financial system ? They reduce asymmetric information (Adverse selection and moral hazard). 5. The financial system is among the most heavily regulated sectors of the economy. to promote the provision of information (to reduce the asymmetric information, and to ensure the soundness (stability) of the financial system.

8. Cont… 6. Only large, well-established corporations have easy access to securities markets to finance their activities. Because as a regulation large firms are allowed to issue marketable securities . Collateral and Net worth 7. Collateral is a prevalent feature of debt contracts. Because: The presence of adverse selection in credit markets (loan defaults). It is guarantee, if borrower is unable to make debt payment. 8 5/10/2021

9. Cont… 8. Debt contracts typically are extremely complicated legal documents. Because: The presence of moral hazard problem (the borrower not to participate in other activities). Monitoring and enforcement of restrictive covenants. The borrower to be more care for their activities, etc. 9 5/10/2021

10. Cont… Example of Sources of External Funds For Nonfinancial Businesses 10 5/10/2021

11. 2.2. Transaction Costs How Transaction Costs Influence Financial Structure? Example : Say you have birr 5,000 you would like to invest, and you think about investing in the stock market. Because you have only birr 5,000, you can buy only a small number of shares. Even if you use online trading, your purchase is so small that the brokerage commission for buying the stock you picked will be a large percentage of the purchase price of the shares. If instead you decide to buy a bond, the problem is even worse because the smallest denomination for some bonds you might want to buy is as much as birr 10,000 , and you do not have that much to invest. 11 5/10/2021

12. Cont… How Financial Intermediaries Reduce Transaction Costs ? They help to reduce transaction costs, and They allow small savers and borrowers to benefit from the existence of financial markets. How? Economies of Scale Expertise   5/10/2021 12

13. 2.3. Asymmetric Information: Adverse Selection and Moral Hazard Asymmetric information a situation that arises when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decisions. The presence of asymmetric information leads to adverse selection and moral hazard problems . 5/10/2021 13

14. 2.3.1. Adverse Selection How Adverse Selection Influences Financial Structure Example : Suppose that Mr.Melaku the investor, a potential buyer of common stock, can’t distinguish between good firms with high expected profits and bad firms with low expected profits. In this situation, Mr.Melaku will be willing to pay only a price that reflects the average quality of firms issuing securities, a price that lies between the value of securities from bad firms and the value of those from good firms. If the owners or managers of a good firm have better information than Melaku , they know that their securities are undervalued and will not want to sell them to Melaku at the price he is willing to pay. The only firms willing to sell Melaku securities will be bad firms (because his price is higher than the securities are worth). Mr. Melaku is not want to hold securities in bad firms, if he has not full information about the securities market. Therefore , as a result of this adverse selection, the securities market will not work very well because few firms will sell securities in it to raise capital. 5/10/2021 14

15. Cont… Tools to Solve Adverse Selection Problems Private Production and Sale of Information Government Regulation to Increase Information Through releasing negative information about firms. By encouraging firms to reveal honest information about themselves through regulation. 3. Financial Intermediation 4. Collateral and Net worth 5/10/2021 15

16. 2.3.2. Moral Hazard Moral hazard is the asymmetric information problem that occurs after the financial transaction takes place, when the seller of a security engage in activities that are undesirable for the purchaser of the security. Moral hazard problem almost equivalent to the problem of honest. How Moral Hazard affects Equity Market: The Principal–Agent Problem Equity contracts are subject to a particular type of moral hazard called the principal–agent problem 5/10/2021 16

17. Cont… Example: To understand the principal–agent problem more fully, suppose that your friend Sisay asks you to become a silent partner in his ice cream store. The store requires an investment of $10,000 to set up and Sisay has only $1,000. So you purchase an equity shares for $ 9,000. If Sisay works hard to make tasty ice cream, keeps the store clean, etc, after all expenses (including Sisay’s salary), the store will have $50,000 in profits per year, of which Sisay receives 10% ($5,000) and you receive 90% ($45,000). But if Sisay doesn’t provide quick and friendly service to his customers, uses the $50,000 in income to buy artwork for his office, and even sneaks off to the beach while he should be at the store, the store will not earn any profit. 5/10/2021 17

18. Cont… Sisay can earn the additional $5,000 (his 10% share of the profits) over his salary only if he works hard and forgoes unproductive investments (such as art for his office). Sisay might decide that the extra $5,000 just isn’t enough to make him expend the effort to be a good manager; he might decide that it would be worth his while only if he earned an extra $10,000. If Sisay feels this way, he does not have enough incentive to be a good manager and will end up with a beautiful office, a good tan, and a store that doesn’t show any profits. Because the store won’t show any profits, Sisay’s decision not to act in your interest will cost you $45,000 (your 90% of the profits if he had chosen to be a good manager instead). 5/10/2021 18

19. Cont… Tools to Solve the Principal–Agent Problem Production of Information Government Regulation to Increase Information Financial Intermediation Debt Contracts 5/10/2021 19

20. 2.4. Financial Development and Economic Growth Why many countries stay poor while others? Because: A poor legal system (inadequate government regulation), Government intervention through directed credit programs Weak accounting standards, and State ownership of banks 5/10/2021 20

21. Cont… A poor legal system (inadequate government regulation ) 5/10/2021 21

22. Cont… b. Government intervention through directed credit programs Relatively , Which one has more incentive to solve adverse selection and moral hazard? Which one can lend to borrowers with the most productive investment sector? 5/10/2021 22

23. Cont… c. Weak accounting standards d. State Ownership of Banks 5/10/2021 23

24. Questions How can economies of scale help explain the existence of financial intermediaries? Describe two ways in which financial intermediaries help lower transaction costs in the economy. Would moral hazard and adverse selection still arise in financial markets if information were not asymmetric? Explain. How do standard accounting principles help financial markets work more efficiently? Which firms are most likely to use bank financing rather than to issue bonds or stocks to finance their activities? Why? How can the existence of asymmetric information provide a rationale for government regulation of financial markets? Rich people often worry that others will seek to marry them only for their money. Is this a problem of adverse selection ? “ The more collateral there is backing a loan, the less lender has to worry about adverse selection.” Is this statement true, false, or uncertain? Explain your answer. Explain how the separation of ownership and control in corporations might lead to poor management. How does the provision of several types of financial services by one firm lead to conflicts of interest? How can conflicts of interest make financial service firms less efficient? Describe one conflicts of interest that occur in accounting firms. You are in the market for a used car. At a used car lot, you know that the blue book value for the cars you are looking at is between $20,000 and $24,000. If you believe the dealer knows as much about the car as you, how much are you willing to pay? Why? Assume that you only care about the expected value of the car you buy and that the car values are symmetrically distributed. Now, you believe the dealer knows more about the cars than you. How much are you willing to pay? Why? How can this be resolved in a competitive market?   Why do financial crises occur and why are they so damaging to the economy, and give example? 5/10/2021 24

25. 5/10/2021 25 End of Chapter Two