Back in Ec 10 we discussed the two principal forms of market failure: moral hazard and adverse selection. Both are forms of information asymmetries, and lead to a loss of surplus and general lack of efficient resource allocation.
Moral hazard is the idea that if someone knows they are protected from risk, they will behave in a more risk-seeking manner. The information assymetry is that the risk-seeking party has more information about the consequences of its actions than the party insuring them.
- A person buys an expensive sports car. He drives it very carefully so nothing will happen to it. Then he realizes he could still get in an accident because of someone else's poor driving, and decides to buy car insurance. Since he has insurance, he begins to drive more recklessly.
- A bank buys a toxic CDO. It manages the risk carefully to avoid loss. Then it realizes that it's carefully calibrated risk management tools are completely wrong. The government calls up and says "We see you are incapable of managing your risk, so here's a few billion dollars to prop up your balance sheet." Since the bank is effectively insured, it engages in more risky behavior. The government calls up again and says "We've taken over a company you bought insurance from, too, so here's some extra money to make your CDS contracts whole." The bank takes these unexpected profits and invests them in high-yielding assets (which it must do, since it's leverage has been taken away). Finally, the government calls yet a third time to say "Not only are we going to bail you out, but we've lined up a bunch of private investors to help take bad assets of your balance sheet. Don't worry, we'll get through this." The bank takes its cash and invests it in risky assets.
Adverse selection is another form of information assymetry, in which buyers and sellers have different knowledge about a good.
- (The classic "Lemon Market" problem) The market for used cars contains many cars of varying quality. The seller knows the quality of the car; the buyer does not. Therefore, the buyer must assume that any given car is of average quality, and bid an amount in accordance with that expectation. Any seller with a car in good condition, knowing this, will take their car off the market since they can not get a "good" bid. Any buyer, realizing this, will lower their bids in turn since the average quality is now between "poor" and "average". In the end, only really bad cars ("lemons") are made available for sale, and buyers only bid low prices.
- The balance sheet of a large bank contains assets of varying quality. The bank knows the quality of all its assets; the PPIP investor does not. However, the PPIP investor does know that it is in the bank's best interest to offload its worst assets. Therefore, the buyer puts in a bid in accordance with that expectation. The bank, realizing this, wouldn't try to sell a good asset anyway, since it knows the investors - expecting bad assets - won't pay enough to buy it. In the end, only really bad assets are made available for sale, and PPIP investors only bid low prices.