office hours: 8:00AM – 8:50AM tuesdays LUMS C85 ECON 102 Tutorial: Week 13 Ayesha Ali www.lancaster.ac.uk/postgrad/alia10/econ102.html a.ali11@lancaster.ac.uk office hours: 8:00AM – 8:50AM tuesdays LUMS C85

Today’s Outline Exam Questions Is there anything you’d like to go over regarding Friday’s Test? In Week 17: You’ll have an exam recap with Kwok (in the lecture) and you get your marked exams back as well (in the tutorial). Week 13 Worksheet – Q1, and discuss Q5, Q6, Q7 Note: If you’re really interested in some of the financial crisis material from this week, the podcast has a couple of episodes on the financial crisis as well: http://www.npr.org/blogs/money/2013/09/13/222170187/episode-486-crisis-revisited

Question 1 This problem is an example of an expected value problem. Your textbook covers this and provides an example on pages 335-336 and 339. When we make choices under uncertainty, there is some degree of risk involved, so making the choice is similar to making a gamble. When we make a gamble or an investment, if we are thinking rationally, the first step is to figure out what the expected value is. So, the expected value of a gamble is: the sum of the possible outcomes of the gamble weighted by their probability of occurrence.  

Question 1 Consumers know that some fraction x of all new cars produced and sold in the market are defective. The defective ones cannot be identified except by those who own them. Cars do not depreciate with use. Consumers are risk-neutral and value non-defective cars at £10,000 each. New cars sell for £5,000 and used ones for £2,500. What is the fraction x?   So, we know that consumers value a non-defective car at £10,000, so we’re going to make the assumption that the only used cars for sale will be defective ones. The used car price of £2,500. Under our assumption, this is the value to consumers of a defective car. For a risk-neutral buyer, the reservation price for a new car will be the expected value of a non-defective car. That is the value of a good car times the probability of getting a good car, plus the value of a bad car times the probability of getting a bad car. So to find x, we solve: Expected value = (prob. of non-defective car) (value of non-defective car) + (prob. of defective car)(value of defective car) £5,000= 1−𝑥 £10,000 +𝑥 £2,500 So 𝑥= 2 3 .

Question 2 Ann and Barbara are computer programmers in Nashville, Tennessee, who are planning to move to Portland, Oregon. Each owns a house that has been appraised for £100,000. But whereas Ann’s house is one of hundreds of highly similar houses in a large, well-known suburban development, Barbara’s is the only one that was built from her architect’s design. Who will benefit more by hiring an estate agent to assist in selling her house, Ann or Barbara?   Because standardised homes are relatively well known commodities with many potential buyers, a seller can usually find a buyer on her own. In contrast, the market for an unusual house will typically involve many fewer informed and interested buyers. So, an estate agent who knows the pool of buyers would be of significantly more value to Barbara than to Ann.

Question 3 Brokers who sell stocks over the internet can serve many more customers than those who transact business by mail or over the phone. How will the expansion of internet access affect the average incomes of stockbrokers who continue to do business in the traditional way?   By shifting the supply curve of brokerage services to the right, increase internet access results in a lower price of brokerage services, and this reduces the incomes of brokers who continue to serve the same number of clients as before.

Question 4 How will growing internet access affect the number of film actors and musicians who have active fan clubs?   Fans of obscure musicians and actors are often too small in number to find one another and organise themselves into clubs by traditional means. But anyone can find the web page set up by a fan of an obscure performer. So the expansion of internet access should increase the number of fan clubs of performers.

Question 5 Can you explain why, in many countries, in the wake of the financial crisis, governments have moved to restrict or eliminate bonus payments to decision makers in the financial sector?  

Question 5 Can you explain why in many countries in the wake of the crisis governments have moved to restrict or eliminate bonus payments to decision makers in the financial sector? There are essentially three main reasons:   The first is based on the idea that bonus payments are often given if the manager has earned some very above-average returns. Often, to earn such high returns, high-risk investments must be made. So, in effect the bonuses basically incentivized or encouraged risky behaviour by decision-makers and/or may have discouraged decision-makers from closely supervising the behaviour of people working for them. On the other side, if a high-risk gamble doesn’t pay off, then, managers often don’t face the same level of risk that the firm faces. Even if a firm goes bankrupt, the manager could still look for a similar job at another investment firm. So that makes high-risk investments seem even more lucrative to financial decision-makers – they get the bonus if the risk pays off, and they can likely still work at the same level if the risk doesn’t pay off. So removing or reducing these bonuses, should effectively remove the reward for high-risk behavior.

Question 5 Can you explain why in many countries in the wake of the crisis governments have moved to restrict or eliminate bonus payments to decision makers in the financial sector? And the other two main reasons are:   Second, cutting bonuses is a form of cutting costs and potentially raising profits, which is especially relevant for a government that has bailed out some banks and is trying to recover its bailout funds. Third, since financial firm bailouts (including bonus payments) have been financed through general taxation, high bonus payments are much more difficult to justify politically. So the restriction or elimination of bonuses are considered for equity reasons and could be seen as an alternative to a rise in top income tax rates.

Question 6 What kind of regulatory changes in banking structures might reduce the probability of a repeat of the financial crisis? Here are some of the regulatory changes that have been in discussion or are starting to be implemented: Separate different types of financial services (retail banking, mortgages, investment banking) into separate firms or separate parts within firms, which can be monitored separately. In the case of a bank failure, only parts of a firm could be bailed out, while the other is allowed to go bankrupt and its creditors have to shoulder the losses. This lowers the risk that a bank is “too big to fail” and, therefore, may reduce moral hazard. Restrict gearing and require higher capital ratios (capital asset ratios), so that banks are in a better position to survive a sudden change in the value of their assets (e.g. their loans). Expand regulatory objectives to include the monitoring of systemic risk posed by the behaviour of each individual bank. Restrict the size of firms and encourage a higher number of competing firms, i.e. do not allow some mergers and acquisitions in the financial sector to go ahead. This may lower the risk that a bank is “too big to fail”. Change the bonus culture; see the previous question.

Question 7 A bank obtains funds by accepting deposits, selling bonds and issuing shares. Depositors, bond-holders and even shareholders can be seen as “creditors” of a bank. Why should governments guarantee depositors, but not the others, against a bank failure? Here is the suggested solution for this question – it is basically another way of saying the same thing I’ve written above: The reason for not guaranteeing any creditors against the failure of a firm (whether it is a bank or not) is that it discourages the creditors from lending wisely, i.e. lending to those firms that have the best prospects given the risk. So creditors may decide to lend to riskier firms than they would do if there was no guarantee in place. The guarantee also means that creditors have less of an incentive to monitor the behaviour of the firm and penalise the firm (by not extending the credit) if the firm is not acting in the best interest of the creditors.   The reason for guaranteeing some of the creditors of banks i.e. depositors, is that it is difficult (very costly) for an individual depositor to find out which bank has the best prospects and to monitor the bank after making a deposit. A small individual shareholder may also face difficulties in selecting the best bank and monitoring its progress, except that there are financial intermediaries acting on behalf of the individual small shareholder. But there are fewer intermediaries helping us as depositors to decide where to open a bank account and telling us when to switch banks, so that we can penalise a bank which is mismanaging our funds. Yet depositors are needed for the financial system to work and to lend to other parts of the economy. If deposits are not guaranteed and there is a potential risk of bank failure, then households and firms have a greater incentive to keep funds outside of the financial system (at home under the mattress or in the office safe). By insuring depositors at least in part against bank failure, the government raises the level of trust in the financial system, so deposits held in banks increase and more funds (a larger money supply) is available to the economy.

Question 7 So, let’s look at why a gov’t would choose to not insure a creditor: Basically, by not insuring the creditor, it puts the responsibility of making good investments on the creditor. This means that creditors will only put their money into a bank (or other firm) if they think that doing so is a good investment (the expected value is high). This in effect, encourages banks to do well and can be seen a somewhat of a policing mechanism for banks. Those who do well will get creditors, those who don’t, won’t. So, that sounds fine, why then are governments not choosing to not insure all creditors – what makes depositors different from bondholders and shareholders? Why should the government want to insure depositors specifically? First, depositors are a very large share of the population (most people have a bank account), if the burden of doing the research on which bank will actually be able to return depositor’s money is placed on the depositor, then it becomes a rather high burden on society (because they are a large % of society). Second, if it is difficult to ascertain whether or not deposits will be returned (i.e. the risk of bank failure is high and deposits are not insured), then many people could simply not put their money into banks. The risk of bank runs would then be quite high. Also, the more money deposited in banks means a functioning banking sector.   Here is the suggested solution for this question – it is basically another way of saying the same thing I’ve written above: The reason for not guaranteeing any creditors against the failure of a firm (whether it is a bank or not) is that it discourages the creditors from lending wisely, i.e. lending to those firms that have the best prospects given the risk. So creditors may decide to lend to riskier firms than they would do if there was no guarantee in place. The guarantee also means that creditors have less of an incentive to monitor the behaviour of the firm and penalise the firm (by not extending the credit) if the firm is not acting in the best interest of the creditors.   The reason for guaranteeing some of the creditors of banks i.e. depositors, is that it is difficult (very costly) for an individual depositor to find out which bank has the best prospects and to monitor the bank after making a deposit. A small individual shareholder may also face difficulties in selecting the best bank and monitoring its progress, except that there are financial intermediaries acting on behalf of the individual small shareholder. But there are fewer intermediaries helping us as depositors to decide where to open a bank account and telling us when to switch banks, so that we can penalise a bank which is mismanaging our funds. Yet depositors are needed for the financial system to work and to lend to other parts of the economy. If deposits are not guaranteed and there is a potential risk of bank failure, then households and firms have a greater incentive to keep funds outside of the financial system (at home under the mattress or in the office safe). By insuring depositors at least in part against bank failure, the government raises the level of trust in the financial system, so deposits held in banks increase and more funds (a larger money supply) is available to the economy.

Next Class Week 14 Worksheet – Macroeconomics Discussion Questions – living standards & productivity Problems related to calculating GDP, productivity As we go through Macro – I’m going to be sharing links to a 20-minute long podcast that goes along with each week’s material. It’s not an alternative to the lecture & textbook, but hopefully complements them. Some weeks I’ll post a few, other weeks we might not have any. So, for next week, here’s the podcast. Also Note: this year, the course material is quite different from previous year’s; so if you’re use your friends’ old papers to revise, they might be less helpful for this first section of macro (they’ll be handy again for the second section though). Hopefully you’ll find this year’s material to be engaging. Note: If you’re really interested in some of the financial crisis material from this week, the podcast has a some episodes on the financial crisis as well: http://www.npr.org/blogs/money/2013/09/13/222170187/episode-486-crisis-revisited