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How does collateral help to reduce the adverse selection problem in credit market?
Answer: Collateral is property that is promised to the lender if the borrower defaults thus
reducing the lender's losses. Lenders are more willing to make loans when there is collateral that
can be sold if the borrower defaults.
Diff: 1 Type: SA Page Ref: 170
Skill: Recall
Objective List: 8.1 Depict how asymmetric information results in adverse selection and moral
hazard
Explain the "lemons problem" as it applies to the used-car market. Why does this problem
exist? How does this market resolve this problem?
Answer: The lemons problem exists because of asymmetric information. Buyers of used cars do
not know if cars are lemons (bad) or peaches (good). The market price will be an average of the
price of a lemon and a peach. Because of this, owners of lemons are more likely to sell their cars,
an example of adverse selection. The resolution to this problem is that dealers (intermediaries)
sell most used cars. Dealers specialize in the production of information about used cars. They
can use this information to provide guarantees, or develop a reputation for selling quality cars.
Dealers help solve the adverse selection problem in the used car market.
Diff: 3 Type: SA Page Ref: 165 - 166
Skill: Recall
Objective List: 8.1 Depict how asymmetric information results in adverse selection and moral
hazard
Explain how government regulation can lessen asymmetric information problems but not
eliminate them using Enron as an example.
Answer: The government can regulate firms and require them to have independent audits and
disclose the results but as shown by the collapse of Enron, this is not 100 percent effective. That
firm had a complex set of transactions hidden from the auditors and eventually the financial
instability led to its collapse.
Diff: 2 Type: SA Page Ref: 168
Skill: Recall
Objective List: 8.1 Depict how asymmetric information results in adverse selection and moral
hazard