CHAPTER 11 Reducing Transactions Costs and...

Reducing Transactions Costs and Information Costs

CHAPTER

11The collapse of communist governments in the former Soviet Union andEastern Europe in the early 1990s led to much rejoicing and hope for the emergence ofindividual freedom, political democracy, and market economies. As attention turned togetting private businesses started, financial analysts foresaw a daunting task. Saversseemed unwilling to lend their funds to local borrowers, preferring to invest in govern-ment bonds or foreign exchange. Borrowers found financial markets too poorly devel-oped to be of much use. Hungary and Poland made strides in developing financialmarkets. Russia still struggled in the late 1990s and in the new century to do so. Oneprominent economist noted wearily that “hundreds of billions of dollars were being lefton the table” because eager entrepreneurs were unable to fund new businesses whilesavers were unable to earn returns on their savings. Most financial experts suggestedthat efforts should focus on organizing financial intermediaries.

Financial markets in the United States and many other industrial economies per-form the task of matching savers and borrowers more effectively than do those innewly emerging economies, but there are still obstacles to the efficient channeling offunds from savers to borrowers. In 2001 and 2002, major corporate accounting scan-dals in the United States drove this point home. In our discussions of financial markets,we assumed that borrowers were successful in raising funds in financial markets andthat savers could use the information contained in market prices to make informedportfolio allocation decisions. Financial markets don’t function quite as smoothly as weimplied. In this chapter, we describe the obstacles that exist in financial markets—transactions costs and information costs—to see how they are mitigated in our finan-cial system. Often, financial intermediaries such as banks reduce information costsmore effectively than financial markets do, as we will explain here.

Obstacles to Matching Savers and BorrowersSuppose that you saved $3000 from working part-time and you want to invest it.Should you invest the money in stocks? A stockbroker will tell you that the commis-sions you must pay will be large relative to the size of your purchases because you areinvesting a small amount of money. This cost is particularly high if you are attemptingto diversify by buying a few shares each of different stocks. Should you turn instead tothe bond market to buy, say, a Treasury bill? Your broker will tell you: sorry, but theminimum face value is $10,000.

Undaunted, you decide to bypass financial markets. Conveniently, your room-mate’s brother-in-law needs $3000 to develop a potentially successful new Internetbrowser. But how do you know that he is the best person to write and market this com-puter application? Perhaps you should seek out other borrowers and evaluate theirplans. If you decide to lend your money to the fledgling entrepreneur, your lawyer tellsyou that to draw up the contract describing the terms of your investment will cost

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$1500, or half the amount you have to invest. Hence you give up on the investment.The cost that you face and your decision not to invest also hurt the browser designer,who will have the same difficulty raising funds from other individual investors.

This example demonstrates transactions costs, the costs of buying or selling a finan-cial instrument, such as a stock or a bond. Information costs are the costs that saversincur to determine the creditworthiness of borrowers and to monitor how borrowers usethe acquired funds. These costs increase the cost of funds that borrowers must pay andlower the expected returns to savers, reducing the efficiency of financial markets. Thisinefficiency creates profit opportunities for individuals and institutions that can reducetransactions and information costs.

Transactions Costs

Brokerage commissions, minimum investment requirements, and lawyers’ fees are allexamples of transactions costs. There is obviously a need for a channel to match smallsavers and borrowers, and financial intermediaries have satisfied a need that financialmarkets are not filling. For example, mutual funds sell shares to many individual saversand, in turn, invest in a diversified portfolio of bonds or stocks. Banks accept depositsfrom individual savers and lend the funds to household and business borrowers. Theeconomy also benefits from the growth generated by financial intermediaries, while theintermediaries earn a profit by charging savers and borrowers fees for reducing trans-actions costs.

Financial intermediaries reduce transactions costs by exploiting economies of scale,the reduction of costs per unit that accompanies an increase in volume. In the case oftransactions costs, intermediaries’ costs fall as the size of the funds raised increases.Transactions costs per dollar of investment decline as the size of transactions increases.For example, the transactions cost of buying $1,000,000 of Treasury bonds is not muchgreater than that of buying $10,000 of bonds. Individual investors can reduce transac-tions costs by combining their purchases through an intermediary. Thus 100 investorswith $10,000 each to invest face lower costs per dollar if together they buy $1,000,000of bonds than if they purchased the bonds individually.

There are other ways in which intermediaries benefit from economies of scale—forexample, in drawing up legal contracts. Financial intermediaries spread legal costsamong many individual savers so that each saver who wants to invest in an invention,the corner drugstore, or an IBM bond doesn’t have to seek costly, customized legaladvice. Financial intermediaries also take advantage of economies of scale to purchasesophisticated computer systems that provide financial services, such as automatic tellermachine networks.

In Chapters 12 and 13, we examine in more detail how mutual funds, banks, andother financial intermediaries reduce transactions costs for savers and borrowers.

Asymmetric Information and Information Costs

In describing transactions in financial markets, we have assumed that savers and bor-rowers have the same information, or symmetric information. That is, individuals buy-ing shares in or bonds of a company have the same information as the company’smanagers. This assumption does not mean that the parties will have perfect information;conditions may unfold differently from their initial expectations. For example, a changein consumers’ tastes might mean that the borrower faces a more challenging market thanexpected and must default on bond payments. When the lender and borrower

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exchanged funds for a security, neither could perfectly anticipate market conditions oreconomic events, but both had the same information and could make informed deci-sions.

In the real world, borrowers may have private information. A company issuingbonds may be aware of a potential lawsuit or other unfavorable conditions, but thebuyer of those bonds may be uninformed. Asymmetric information describes the situa-tion in which one party in a transaction has better information than the other. Most typ-ically, the borrower has better information than the lender. The existence of asymmetricinformation makes it costly for savers and borrowers to make exchanges in financialmarkets. In the next two sections, we describe two costs arising from asymmetric infor-mation:

Adverse selection: a lender’s problem of distinguishing the good-risk applicantsfrom the bad-risk applicants before making an investment.

Moral hazard: a lender’s verification that borrowers are using their funds asintended.

In some cases, the cost of adverse selection and moral hazard can be so great that alender will lend only to the government or other well-known borrowers. However, moregenerally there are practical solutions to these problems, in which the markets or finan-cial intermediaries lower the cost of information needed to make investment decisions.

Adverse SelectionThe used car market demonstrates the problems that adverse selection can pose forbuyers and sellers in a market.✝ Suppose that your parents are trying to sell their 2003Ford Taurus. Among all the 2003 Ford Tauruses in the newspaper ads, some are goodcars and others are “lemons” (cars that are constantly in the repair shop). Sellers, suchas your parents, know the quality of their cars, but uninformed readers of newspaperads do not. Because these potential buyers can’t distinguish good cars from lemons,they will offer the price of an average-quality 2003 Taurus to sellers of all 2003 Tau-ruses. Your parents view this price as too low and consider their good Taurus to beundervalued. The price delights the Sunkists down the street, who own a lemon. TheirTaurus is overvalued at the average price, and the Sunkists can hardly wait to unloadit. As a result of this pricing process, owners of good Tauruses may decide not to selltheir cars. Therefore the available pool of used Tauruses consists of cars of below-average quality, resulting in an adverse selection of potential used cars. In the used carmarket, buyers and sellers find trading among themselves costly.

To reduce the costs of adverse selection, car dealers act as intermediaries betweenbuyers and sellers. To maintain their reputations with buyers, dealers are less willing totake advantage of their private information about the quality of the used cars that theyare selling than are individual sellers. As a result, dealers sell both lemons and good carsfor their true values. In addition, government regulations require that car dealers dis-close information about the cars to consumers.

CHAPTER 11 Reducing Transactions Costs and Information Costs 229

✝ This example of adverse selection was first described by George Akerlof of the University of California,Berkeley. George A. Akerlof, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,”Quarterly Journal of Economics, 84:488–500, 1970.

“Lemons Problems” in Financial Markets

Just as in the used car market, lemons problems make lending in financial marketsmore costly, and financial information disclosure regulations again come to the rescue.How does adverse selection affect the stock and bond markets’ ability to channel fundsfrom savers to borrowers? First, let’s look at the stock market. Suppose that Hitechcois a new maker of computer chips. If the firm obtains capital, it will be able to financean exciting new technological development in chip making. If Hitechco issues newshares of stock, it can pursue the chip-making project. If it doesn’t, it loses the oppor-tunity.

At the same time, Lemonco is seeking funds to develop a product similar toHitechco’s, but, unknown to the market, Lemonco’s product is inferior. In fact, on thebasis of available information, investors can’t determine the quality of the firms’ scien-tific expertise and their productive capabilities. When Hitechco tries to sell stock, then,the market will assign the same value to it as to Lemonco’s stock, and Hitechco’s shareswill be undervalued. Hitechco’s cost of funds is higher than it would be if potentialshareholders had all the information the firm possessed.

Adverse selection is present in the bond market as well. Suppose that Hitechco andLemonco know more about the risk of their projects than do investors in the bond mar-ket. If an increase in interest rates on default-risk-free Treasury bonds makes them amore attractive investment than Hitechco or Lemonco bonds, lenders raise the interestrate they require to hold Hitechco and Lemonco bonds. In this situation, as lenders gen-erally raise their required returns on bonds, adverse selection occurs. The reason is that,at high interest rates, only very risky borrowers, such as Lemonco, will be likely to bor-row funds: If their projects are successful, both lenders and borrowers win big; if (as ismore likely) they aren’t, the lenders suffer. Lenders are aware of this problem and mayrestrict the availability of credit rather than raise rates to the level at which the quanti-ties of funds demanded and supplied are equal. This restricting of credit is known ascredit rationing. When lenders ration credit, borrowed funds become more costly forunknown firms—both good and bad.

Adverse selection is costly for the economy. When good firms have difficulty com-municating information to financial markets, their external financing costs rise. Thissituation forces firms to grow primarily through investment of internal funds, or invest-ment by firm insiders and accumulated profits.✝ Because the firms that are most affectedare usually in dynamic, emerging sectors of the economy, opportunities for growth ofphysical capital, employment, and production are likely to be restricted.

Reducing Information Costs

The costs to savers and borrowers of adverse selection make it difficult for good bor-rowers to raise money in financial markets and lower the returns obtained by savers. Sim-ilarly, good borrowers are willing to pay to communicate information about theirprospects. Some financial market participants charge fees for their services—to saverswho seek information about borrowers and to borrowers who wish to communicateinformation about their prospects to savers—but these fees are lower than the informa-tion costs of adverse selection. Other costs can be mitigated by regulation of financial


✝ If entrepreneurs have to avoid high information costs associated with external financing by investing mostof their savings in their businesses, they lose risk-sharing benefits of diversification.

markets. As we will see later, these costs can also be reduced by financial intermediarieswho can provide savers with information about the quality of potential borrowers.

Direct disclosure of information. In most industrialized countries, governmentagencies set requirements for information disclosure for firms that desire to sell securitiesin financial markets. In the United States, government regulations promulgated by theSecurities and Exchange Commission✝ require publicly owned companies to report theirperformance in financial statements prepared by using standard accounting methods. Suchdisclosure reduces the information costs of adverse selection, but it doesn’t eliminate them,for two reasons. First, some good firms may be too young to have much information forpotential investors to evaluate. Second, lemon firms will try to present the required infor-mation in the best possible light so that investors will overvalue their securities.

Private firms have tried to reduce the costs of adverse selection by collecting infor-mation on individual borrowers and selling the information to savers. As long as theinformation-gathering firm does a good job, savers purchasing the information will bebetter able to judge the quality of borrowers, improving the efficiency of lending.Although savers must pay for the information, they can benefit from the information byearning higher returns. Companies specializing in information—including Moody’sInvestor Service, Standard & Poor’s Corporation, Value Line, and Dun and Bradstreet—collect information from businesses’ income statements, balance sheets, and investmentdecisions and sell it to subscribers. Buyers include individual investors, libraries, andfinancial intermediaries. You can find some of these publications in your college libraryor through on-line information services. Private information-gathering firms cannot elim-inate adverse selection, but they can help to minimize its cost.

Although only subscribers pay for the information collected, others can benefit with-out paying for it. Individuals who gain access to the information without paying for it arefree riders. That is, they obtain the same benefits but do not incur the costs. The free-riderproblem hurts the information-gathering firm and lessens its effectiveness. Suppose thatyou subscribe to Infoperfect, a service that gives you the best possible information on thestocks and bonds of many companies. You are willing to pay a fee to subscribe to Info-perfect because it enables you to profit by buying undervalued stocks and bonds (usinginformation that is better than other investors have). While you are reminding yourself ofyour cleverness and foresight, Freeda Frieryde and her colleagues decide to buy and sellparticular stocks and bonds whenever you do. Because Freeda broadcasts your everymove, others are sharing in your profits. As a result, you are willing to pay less to Info-perfect, as are other investors. Deprived of the additional revenue, Infoperfect is less will-ing to collect as much information to sell to savers.

When direct disclosure of information fails to provide enough information toreduce the likelihood of adverse selection, lenders can redesign financial contracts toreduce information costs by focusing on borrowers’ collateral and net worth.

Roles of collateral and net worth. When borrowers invest little of their ownmoney in their business, their loss is small if they default on their bonds. To make it


✝ The SEC also mandates firms’ ongoing disclosure of material information to the investor community. InAugust 2000, the SEC went further by approving Regulation Fair Disclosure (FD), which required U.S. com-panies to release material information to the general public at the same time it is issued to Wall Street pro-fessionals. Many economists argue that the regulatory change makes information dissemination to theinstitutional investors and analysts more difficult, while proponents see the new rule as empowering indi-vidual investors.

more costly for borrowers to take advantage of their asymmetric information, lendersoften require borrowers to pledge some of their own assets as collateral, which thelender claims if the borrower defaults. Suppose that Eleanor Riche wants to borrow$10,000 to start a home improvement business called Newvo Riche. If she owns a houseworth $250,000, a lender might not hesitate to lend her the money. In the event thatEleanor defaults, a lender could claim the house or other assets that she might havepledged as collateral. Collateral reduces the likelihood of adverse selection—lemon bor-rowers are unlikely to pledge their own funds—and is widely used in debt contracts forindividuals and businesses.

Net worth, the difference between assets and liabilities, satisfies the same assurancethat collateral does. If lenders can make a claim against net worth if the borrowerdefaults on its loans, the firm will be more cautious about making risky investments.When a firm’s net worth is high, the chance that it will default is low: Bondholders mustbe paid off—from the firm’s net worth, if necessary—before funds can be distributed toshareholders. As a result, costs of adverse selection are less likely in lending to borrow-ers with high net worth.

Concluding remarks. Adverse selection increases the information costs of chan-neling funds from savers to borrowers in financial markets. Increased information costsin turn increase the demand for financing arrangements in which information about bor-rowers can be collected at a lower cost. These arrangements include direct informationdisclosure and collateral and net worth.

Moral HazardEven though a lender might gather information about the borrower—when deciding tomake an investment or a loan or structure a bond agreement that minimizes the effectsof adverse selection—the lender’s information problems haven’t ended. There is alwaysthe chance that, after the borrower receives the funds, the funds will not be used asintended. This situation, known as moral hazard, is more likely to occur when the bor-rower has an incentive to conceal information or act in a way that does not reflect thelender’s interests. Moral hazard arises because of asymmetric information: The bor-rower knows more than the lender does about how the borrowed funds will actuallybe used, and the resulting problems increase the lender’s costs.

Moral Hazard in Equity Financing

Monitoring problems increases the information costs of raising funds through stock issues.For example, say that you buy stock in Bigdream, Inc. How do you know whether the firmis investing the funds in its research and development laboratory or in wood paneling for


As you read about the possibilities offered by the World Wide Web, you decideyou want to invest some of your savings in an Internet service provider. You notethat many small firms appear to be making a lot of money, but rating agencieshaven’t followed them closely. What information costs do you face if you go aheadwith your investment plans? Because it is likely to be difficult to distinguish goodand lemon Internet service providers, adverse selection may occur. Some of the firmsrushing to sell shares may be lemons. You will incur costs of acquiring informationabout the firms as a result. ♦

C H E C K P O I N T

the new executive dining room? The investment in research and development is likely toincrease Bigdream’s profits and your returns; the wood paneling is not. To find outwhether the firm is using funds in a way that will benefit you, you need to spend time andmoney monitoring its activities. When Bigdream’s managers tell you that your $1000investment earned no returns, how do you know whether the claims are true? Once youhave bought the stock, the firm has an incentive to understate profits and reduce your


C A S E S T U D Y

Recent Regulatory Changes to Improve Information Disclosure

The accounting scandals at Enron, WorldCom, and other large U.S. corporations in 2001 and 2002raised concerns that corporate governance—the system of checks and balances that guides the decisionsof corporate managers—was not working well. For market prices to provide the right signals for savingand investment, they should reflect the best available information. Questionable accounting practicesand a lack of transparency can reduce market liquidity and market prices—harming investors andemployees through losses of wealth and harming firms through a higher cost of capital.

The private sector’s response to the scandals was almost immediate. In addition to reexamination ofcorporate governance practices at many corporations, the New York Stock Exchange and the NASDAQput forth initiatives to ensure the accuracy and accessibility of information. In March 2002, PresidentBush announced a ten-point plan to improve incentives for honest and transparent information disclo-sure. Much of the president’s proposal became law that summer in the Sarbanes-Oxley Act of 2002. TheSarbanes-Oxley Act may promote the timeliness and accuracy of financial information. New disclosurerequirements mandate that directors and officers disclose their transactions in company stock morequickly to enable investors to react. Financial analysts and auditors must disclose whether any conflictsof interest might exist to limit their independence from considerations other than the desire to serveshareholders’ interests. Companies must make more information available about the quality of internalcontrol structures. The Act promotes management accountability by specifying responsibilities of corpo-rate officers and increasing penalties for managers who do not meet their responsibilities.

Perhaps the most noticeable corporate governance reform under the Sarbanes-Oxley Act is the cre-ation of the Public Company Accounting Oversight Board, a special national board to oversee the audit-ing of public companies’ financial reports. The board’s mission is to promote the independence ofauditors to ensure accurate information disclosure. Whether the Sarbanes-Oxley Act will be successfulin achieving its objectives is the subject of vigorous debate.✝ Proponents note that more accurate andtransparent information can promote more liquid markets, higher equity prices, and a lower cost of cap-ital. Some skeptics note that companies might have responded with similar changes on their own in thewake of the scandals and laws already on the books would be used to punish fraudulent reporting atEnron or WorldCom. Also, ambiguity in many of the law’s provisions may invite litigation and decreaseexecutives’ desire to take risk. Finally, some economists argue that the law does not address the needto provide better incentives for institutional investors, who control a majority of U.S. corporate equities,to be more engaged in corporate governance. On balance, most observers acknowledge that the Sar-banes-Oxley Act brought back confidence in 2002 and 2003 in the U.S. corporate governance system,though questions remain for the future.

Outside the United States, the European Commission released plans in 2003 to tighten corporategovernance rules, while Japan debated such reforms as well. The OECD recommended better gover-nance practices for several Asian economies.

✝ The disagreement extends even to the two namesakes. A year after the law’s passage, Senator Paul Sarbanes celebrated that companies werecleaning up their act, while Congressman Michael Oxley worried that the law might make managers too cautious and limit investment (seeDeborah Solomon, “Sarbanes and Oxley Agree to Disagree,” The New York Times, July 24, 2003). For a general discussion of pros and cons,see Chapter 4 of the 2003 Economic Report of the President and Bengt Holmstrom and Steven N. Kaplan, “The State of U.S. CorporateGovernance: What’s Right and What’s Wrong?,” Journal of Applied Corporate Finance, Spring 2003, pp. 8–20.

C A S E S T U D Y

dividend payments. To police such underreporting, outside suppliers of funds must auditthe firm’s finances every time an earnings report is issued—and such audits are costly.

The federal government and the business community itself regulate reporting byfirms to reduce the chance of fraud. In addition to regulating annual reports for the ben-efit of owners and potential investors, the Securities and Exchange Commission and thePublic Company Accounting Oversight Board—government agencies—and the Finan-cial Accounting Standards Board—a private agency—have set standard accounting prin-ciples for firms to use in reporting their earnings and overall financial condition. Theseaccounting principles are designed to help investors understand the financial conditionof the firms in which they have invested. In addition, federal laws have made misre-porting or stealing profits belonging to shareholders a federal offense, punishable bylarge fines or prison terms, or both.

Another information problem results from the behavior of a firm’s agents, who havedifferent goals than the principals. The shareholders, who own the firm’s net worth, arethe principals, and the managers, who control the firm’s assets, are the agents. Called theprincipal-agent problem, this type of moral hazard may arise when managers do not ownmuch of the firm’s equity and thus do not have the same incentive to maximize the firm’svalue as the owners do. Because a firm’s shareholders have a residual claim on its earnings,improvements in profitability (and hence in the firm’s stock price) accrue to them and notto the managers who are charged with controlling the firm’s assets. In the United States,for example, the majority of private economic activity occurs in large public corporations,whose managers do not own a significant part of the firm. Indeed, the stake of top man-agement in a firm’s ownership usually is less than 5%. Because management stakes in largeU.S. corporations are typically less than 5%, an increase in management stakes might ben-efit their shareholders, though evidence is mixed.✝


Are Stock Market SignalsAffected by AdverseSelection?In an efficient capital market, the valueof a company’s stock provides the bestsignal to managers about the prof-itability of new investments. Stockprices increase in response to goodnews, suggesting that more capitalshould be allocated to the firm’s linesof business. Similarly, a decline in stockprices reflects news about market pes-simism regarding the firm’s prospects.

How does asymmetric informationaffect these relationships? In the case

of adverse selection, or the lemonsproblem, for the stock market, shareprices of a good firm can be too low,sending inaccurate signals about itsprospects. In such a situation, man-agement knows that the firm’sprospects are better than the marketprice signals and will not turn to themarket. Instead, the firm mightchoose to avoid the market altogetherand use internal funds to financefuture growth.

A study of some 300 manufacturingfirms during the 1970s and 1980sfound that firms that rely heavily oninternal funds tend to be young, rap-

idly growing firms. Moreover, thesefirms’ capital spending is closely tiedto their internal funds. In contrast,capital spending by more maturefirms that are capable of raising fundsin financial markets is not. Henceadverse selection affects financingand investment decisions for manyU.S. firms.

Source: Steven M. Fazzari, R. Glenn Hubbard, andBruce C. Petersen, “Financing Constraints andCorporate Investment,” Brookings Papers on Eco-nomic Activity, 1:143–195, 1988; and the review inR. Glenn Hubbard, “Capital-Market Imperfectionsand Investment,” Journal of Economic Literature,36:196–229, 1998.

C O N S I D E R T H I S . . .

✝ For evidence in favor of the claim, see Randall Mørck, Andrei Shleifer, and Robert Vishny, “ManagementOwnership and Market Valuation,” Journal of Financial Economics, 20:293–315, 1988. For a dissentingview, see Charles P. Himmelberg, R. Glenn Hubbard, and Darius Palia, “Understanding the Determinants ofManagerial Ownership and the Link Between Ownership and Performance,” Journal of Financial Econom-ics, 53:353–384, 1999.

An example will demonstrate the principal-agent problem in stock ownership. Sup-pose that your neighbor, Reed Moore, asks you to join him in his new business venture,a bookstore. He needs $50,000 to open the bookstore, but he has only $2500. He readin the newspaper that you won the lottery and knows that you could invest $47,500.After you make the investment, you own 95% of the bookstore, and Reed owns theother 5%. You’re pleased with the investment. If Reed provides savvy tips on the bestbooks and chats with the customers over coffee, the bookstore could make $50,000each year after paying his salary. Your share would be $47,500, a 100% return; Reed’sshare would be $2500 (in addition to his salary). But maybe not. Reed might decide tobuy mahogany bookcases and oriental rugs and chat with customers over champagne,leaving no profit. Although Reed would forgo the $2500 in profits, he would stillreceive a salary—and enjoy working in plush surroundings. Nothing would be left overfor you.

The principal-agent problem exists in most equity contracts. Many uses of corpo-rate funds by managers are highly visible (such as spending on large-scale investmentprojects), but many are hidden from view (such as expenses for research, maintenance,management, and organizational efficiency). Although not fraudulent, expenses such ascorporate art collections, mahogany desks, limousines, and jets do not directly benefitshareholders. Managers often run firms to satisfy their personal goals, which mightinclude accruing prestige and power. If managers aren’t motivated to maximize a firm’svalue, nonmanagement shareholders may get shortchanged.

The shareholders own the firm, so why can’t they just fire bad managers? To deter-mine whether management is using corporate funds efficiently requires detailed andcostly audits. No individual small shareholder has an incentive to pay these monitor-ing costs. Even if some individual shareholder offered to do so, others might take a freeride on his or her efforts, preferring to wait and see what the individual learns. As aresult, most small investors lack the ability and motivation to evaluate managers.

Moral Hazard in Debt Financing

One way to decrease the information costs arising from moral hazard is to use debtrather than equity financing. For example, rather than investing $47,500 in equity inReed Moore’s bookstore and receiving 95% of the bookstore’s profits, you could lendReed $47,500 and require him to pay you a fixed interest rate of 10%. In this case, youwould get $4750 each year. Because the debt promises a fixed payment, you (or youraccountant) don’t need to audit Reed’s operation of the bookstore unless he fails tomeet the interest and principal payments and defaults on the loan. As long as Reedkeeps making debt payments to you, it doesn’t matter to you whether the bookstorereports earnings of $10,000 or $100,000 each year. The lower costs of monitoringmake debt more attractive than equity in many cases.✝

Even though debt financing can reduce moral hazard problems relative to equityfinancing in many cases, it does not eliminate moral hazard. Because a debt contractallows the borrower to keep any profits that exceed the fixed amount of the debt pay-ment, borrowers have an incentive to assume greater risk to earn these profits than isin the interest of the lender. To demonstrate, suppose that you think you are lendingmoney to Reed to finance the purchase of bookcases and a computer system.


✝ Many analysts believe that the dramatic increase in corporate borrowing and the decrease in the use of equity finance by corporations in the 1980s reflected an attempt to reduce the costs of principal-agent problems for shareholder value.

However, once the money is in Reed’s hands, he decides to invest the money in amachine that sends subliminal messages to shoppers, telling them to buy expensivebooks. If the machine works, the bookstore—and Reed—will make a fortune. In themore likely case that it doesn’t work, he won’t be able to repay you. Even with a debtcontract, the risk of moral hazard is present. Financial markets use restrictivecovenants in debt contracts to combat moral hazard in debt financing.

The basic problem caused by moral hazard that you encountered in making a loanto Reed was that he might use the proceeds for risky purposes. Even if he does not have$25,000 of net worth to commit to the venture, you may be able to reduce the likeli-hood of moral hazard by placing in the debt contract restrictions, known as restrictivecovenants, on Reed’s management activities. The most typical restrictive covenant inbusiness lending is a limit on the borrower’s risk taking. For example, the lender canrestrict the borrower to buying only particular goods or prohibit the borrower frombuying other businesses.

A second type of restrictive covenant requires that the borrower maintain a certainminimum level of net worth. For example, if you apply for a mortgage loan to buy ahouse, the bank may ask you to take out sufficient life insurance to pay off the loan inthe event that you die before the mortgage is repaid. Businesses may be required tomaintain a certain level of net worth, particularly in liquid assets, to reduce incentivesto take on too much risk.

Financial markets often address moral hazard in debt contracts by insisting thatentrepreneurs or managers of firms place their own funds at risk. In that case, takingon risky projects increases the chance that insiders like Reed Moore will lose their ownmoney if they make bad decisions, thereby reducing the incentive to use outsideinvestors’ funds in risky ways. Suppose that Reed invested $25,000, rather than $2500of his own net worth (his assets less his liabilities) in the bookstore. He is likely to bemuch more cautious in making management decisions. Thus, in general, the greater thenet worth (equity capital) contributed by a firm’s managers, the less likely is a problemcaused by moral hazard to occur, and thus the greater is the firm’s ability to borrow.


Can Falling Prices RaiseInformation Costs?High levels of borrower net worthreduce information costs associatedwith adverse selection and moral haz-ard. However, sudden reductions inborrower net worth can increaseinformation costs of lending, some-times to levels that sharply reduceborrowers’ ability to raise funds fornew plant and equipment and job cre-ation. The classic example of this linkamong net worth, financing, and theeconomy is debt deflation. In debtdeflation, falling prices raise the realvalue of firms’ outstanding debt,reducing their net worth. As a result,

savers know that the likelihood ofadverse selection and moral hazardincreases, and they reduce their will-ingness to lend to all but the safestborrowers (for example, the govern-ment). Faced with severe creditdeclines, firms significantly cut theirspending, reducing economic activity.

The best-known example of debtdeflation came during the GreatDepression of the early 1930s.Declining prices increased the realdebt burdens of borrowers by nearly40% between 1929 and 1933. Thecombined effect of declining outputand deflation sharply reduced bor-rowers’ net worth, constraining bor-

rowers’ ability to obtain credit andleading to a collapse in lending,investment, and employment. Morerecent episodes of debt deflation inparticular sectors include the collapsein Midwest farmland values in theearly 1980s, the fall in oil prices in themid-1980s, and the sharp decline incommercial real estate prices inBoston and New York in the late1980s and early 1990s. In each case,the collapse in borrower net worth ini-tiated by debt deflation raised thecost of funds to borrowers because ofthe increased severity of adverseselection and moral hazard.

C O N S I D E R T H I S . . .

At quite low levels of invested net worth, problems arising from moral hazard may pre-vent borrowing altogether.

A third type of restrictive covenant, common in consumer lending, requires the bor-rower to maintain the value of any collateral offered to the lender. For example, if youtake out a loan to buy a new car, you will have to carry a minimum amount of insuranceagainst theft and collision, and you can’t sell the car to a friend if you haven’t paid off theloan. If you take out a mortgage loan to buy a house, you will have to carry insurance onthe house, and you can’t sell your house without first repaying your mortgage loan.

However, restrictive covenants complicate debt contracts and reduce their mar-ketability in secondary markets for savers. The cost of monitoring whether firms actu-ally are complying with restrictive covenants further hampers marketability andliquidity. Finally, restrictive covenants cannot protect a lender against every possiblerisky activity in which the borrower might engage.

Information Costs and Financial IntermediariesThe presence of transactions costs and information costs increases the cost of fundsthat borrowers must pay and lowers the expected returns to lenders, reducing the effi-ciency of financial markets. We have examined the costs of adverse selection and moralhazard in equity and debt financing. In addition to responses by financial market par-ticipants to reduce those costs, financial intermediaries play key roles in the UnitedStates and most other industrial economies.

Recall that businesses raise most of their funds from current and accumulated prof-its, not from financial markets. Since World War II, nonfinancial corporations in theUnited States have raised more than two-thirds of the funds they needed internally. Asimilar pattern holds for other key industrialized countries. In Germany, Japan, and theUnited States, firms do not raise a substantial fraction of their financing from financialmarkets for stocks and bonds. Most external funds needed are raised through financialintermediaries such as banks, as shown in Table 11.1.

Financial Intermediaries and Adverse Selection

Financial intermediaries, particularly banks, specialize in gathering information aboutthe default risk of many borrowers. Banks raise funds from depositors and, using theirsuperior information, lend them to borrowers that represent good risks. Because banksare better able than individual savers to distinguish qualified borrowers from lemons,banks earn a profit by charging a higher rate on their loans than the interest rate theypay to depositors.


Firms in cyclical industries—those whose profits rise and fall with economy-widebooms and busts—tend to borrow less than firms in noncyclical industries do. Ifmonitoring costs are lower for debt financing than for equity financing, why don’tall firms rely on debt? The strategy of using debt financing to reduce moral hazardproblems is based on the assumption that fluctuations in the borrowing firm’s profitsreflect the efforts of its managers. If most of the profit swings reflect movements ineconomy-wide profitability, too much debt could cause a firm to go bankrupt when itsprofits slump and it cannot repay debtholders. As a result, the use of debt is concen-trated in firms whose profitability depends less on economic movements. ♦

C H E C K P O I N T

Banks generally avoid the free-rider problem by holding the loans they make. Thusinvestors can’t observe banks’ activities and profit by mimicking them. By mainly hold-ing loans that are not traded in financial markets, banks earn a profit on informationcollection.

Banks’ information advantage in reducing costs of adverse selection accounts inlarge part for their role in providing external financing. Their specialization in evalu-ating borrowers to reduce the likelihood of adverse selection also explains why largelyunknown small and medium-sized businesses depend on banks when they need a loan,whereas large, mature corporations have access to stock and bond markets.

Financial Intermediaries and Moral Hazard

Large investors often have more success than small investors in reducing the free-riderproblem that arises in gathering information on the behavior of corporate managers. Ifa large investor, such as a financial intermediary, holds a large block of shares, theinvestor has an incentive to monitor closely how agents use their funds.

Some venture capital firms, which raise equity capital from investors and invest inemerging or growing entrepreneurial business ventures, use this method successfully. Ven-ture capital firms insist on holding large equity stakes and sitting on the firm’s board ofdirectors to observe management’s actions closely. In addition, when a venture capital firmacquires equity in a new firm, it holds the shares; that is, the shares are not marketable toother investors. As a result, the venture capital firm avoids the free-rider problem: Otherinvestors are unable to take advantage of its monitoring efforts. The venture capital firmis then able to earn a profit from its monitoring activities, reducing the information costsof moral hazard and improving the allocation of funds from savers to borrowers.

Not all efforts by intermediaries to reduce the costs of principal-agent problems aredirected at young firms. Corporate restructuring firms raise equity capital to acquire


Sources of Finance for Business FirmsBusiness firms rely more heavily on financial markets to raise external funds.

Financial Markets Financial Intermediaries

United States 45% 55%

Germany 12% 88%

Japan 14% 86%

Source: Data cover the period 1970–1996. U.S. data are from Board of Governors of the Federal Reserve System, Flow of Funds Accounts, variousissues. Data for Germany and Japan are taken from Reinhard H. Schmidt, “Differences Between Financial Systems in European Countries: Conse-quences for EMU,” in Deutsche Bundesbank, The Monetary Transmission Process: Recent Developments and Lessons for Europe, Hampshire: Pal-grave Publishers, 2001, p. 222.

TABLE 11.1

Why might the founder of a young firm in the growing biotechnology industry notraise funds by selling new shares in the firm, even to finance a very profitableinvestment opportunity? Adverse selection causes firms in emerging, growingindustries to have the highest information costs. Faced with the high information costsof distinguishing between good firms and lemons, savers investing in financial marketsrequire a higher return on investments in all firms in these industries to compensatethem for the risk of investing in lemons. As a result, shares of good firms will be under-valued, and entrepreneurial firms will prefer to grow by using internal funds or loansfrom banks, which specialize in reducing problems of adverse selection. ♦

C H E C K P O I N T

Web Site Suggestions:http://www.ventureeconomics.comOffers information ontrends in venturecapital.

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large blocks of the equity in mature firms to reduce free-rider problems (see the case studyat www.awlonline.com/hubbard). The leaders of many such firms (including Ivan Boesky,Carl Icahn, T. Boone Pickens, and Henry Kravis) became rich and famous (or notorious)in the 1980s.

Whenever monitoring is costly—as it is, for example, in debt financing whenlenders must ensure that borrowers adhere to restrictive convenants—free-rider prob-lems may occur. As an individual saver, you would find monitoring the activities ofReed Moore or General Motors (if you bought a GM bond) to be very expensive.Therefore you and others like you are likely to try to seek a free ride on the monitor-ing efforts of others. Borrowers who are aware of the difficulties that you and otherslike you have in monitoring their efforts, and who believe that lenders will not incurmonitoring costs, may be tempted to violate restrictive covenants.

Financial intermediaries, particularly banks, reduce this problem and earn a profit byacting as delegated monitors for many individual savers, who deposit their funds with theintermediary. (We examine this role for banks in Chapter 13.) When an intermediary suchas a bank holds the loans it makes, other investors are unable to gain a free ride on theintermediary’s monitoring efforts. As delegated monitors, financial intermediaries reducethe information costs of moral hazard and improve the channeling of funds from saversto borrowers. This result is a major reason that most lending takes place through finan-cial intermediaries rather than through the direct issuance of marketable securities.

Figure 11.1 summarizes the remedies used to fight problems of moral hazard andadverse selection.


Investor Protection andEconomic GrowthRecent research by economists usingcross-country data has documented alink between financial developmentand economic growth. Robert King ofthe University of Virginia and RossLevine of the World Bank, for exam-ple, presented the intriguing possibil-ity that the institutional factorsresponsible for financial developmentwere also important for the efficientaccumulation and allocation of capi-tal.✝ Their work raises an importantquestion: Might cross-country differ-ences in investor protection againstadverse selection and moral hazardpartly explain differences in economicperformance?

In a series of papers, Rafael La Porta,Florencio Lopez-di-Silanes, and Andrei

Shleifer of Harvard University andRobert Vishny of the University ofChicago document a wide variationacross countries in protection ofminority shareholders and creditorsand in the efficiency of the judicial sys-tem in adjudicating disputes.✝✝ Thoseresearchers show that in countries withweaker investor protection, such asFrance and Spain, firm insiders hold amuch larger share of the firm’s equitythan do firm insiders in countries withstronger investor protection, such asthe United Kingdom and the UnitedStates.

Do these cross-country differencesmatter for economic performance?Yes. Poor investor protection againstadverse selection and moral hazard isassociated with less well-developedfinancial markets, and entrepreneurs

tend to hold poorly diversified portfo-lios in such economies, as they musthold more of their firm’s shares. Onerecent study also concludes that thefirms’ cost of capital for investmentand growth can be substantiallyhigher in countries with weakerinvestor protection than in countrieswith stronger protection.§ This linksuggests important influences of poli-cies to reduce information costs oneconomic growth.

✝ Robert G. King and Ross Levine, “Finance and Growth: Schum-peter Might Be Right,” Quarterly Journal of Economics,108:717–737, 1993.✝✝ Rafael La Porta, Florencio Lopez-di-Silanes, Andrei Shleifer, andRobert W. Vishny, “Law and Finance,” Journal of Political Economy,106:1133–1155, 1998.§Charles P. Himmelberg, R. Glenn Hubbard, and Inessa Love,“Investor Protection, Ownership, and Investment: Some Cross-Country Evidence,” Working Paper, Columbia University, 2000.

O T H E R T I M E S , O T H E R P L A C E S . . .


High

Information

Costs

Funds

Returns

Funds

ReturnsSavers Borrowers

Risk

SharingLiquidity

Adverse

Selection

and

Moral

Hazard

• Can’t tell good risks from bad risks• Can’t monitor how funds are used

• Private information about prospects• Private information about use of funds

Remedies

• Direct information disclosure• Government regulation• Collateral or net worth in lending• Debt finance• Financial intermediaries

Remedies for Problems of Adverse Selection and Moral HazardWhen borrowers and savers have private information about their prospects or use of funds, information costs to savers arise. With adverseselection, savers can’t tell good risks from bad risks; with moral hazard, savers can’t monitor how funds are used. These problems impede theflow of funds to borrowers and returns to savers.

FIGURE 11.1

KEY TERMS AND CONCEPTS

SUMMARY

1. Financial markets do not efficiently match savers andborrowers when the transactions and informationcosts of lending are high.

2. Transactions costs make investing in debt and equityinstruments in financial markets costly for smallsavers. Financial intermediaries take advantage ofeconomies of scale by pooling savers’ funds to lowertransactions costs. As a result, individual savers areable to earn a higher return on their savings, and bor-rowers realize a lower cost of funds.

3. Information costs result from two problems of asym-metric information: adverse selection—difficulty in

knowing the true prospects of the borrower before thetransaction—and moral hazard—the need to monitorthe borrower’s use of funds after the transaction. Infor-mation costs arising from adverse selection and moralhazard reduce returns for savers and increase the cost offunds for borrowers.

4. Strategies to reduce costs of adverse selection infinancial markets include direct disclosure of infor-mation and the use of collateral and net worth provi-sions in financial contracts.

5. The principal-agent problem, in which managers(agents) do not have the same incentive to maximize

Asymmetric information

Adverse selection

Moral hazard

Collateral

Corporate restructuring firms

Credit rationing

Economies of scale

Free riders

Information costs

Net worth

Principal-agent problem

Agents

Principals

Restrictive covenants

Transactions costs

Venture capital firms

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profits that shareholders (principals) have, illustratesmoral hazard in equity financing. Solutions to theprincipal-agent problem include regulation of infor-mation disclosure and use of debt instead of equityfinancing.

6. Costs of moral hazard problems in debt financing arereduced by net worth requirements and use of restric-tive covenants.

7. The important role played by financial intermediaries inchanneling funds from savers to borrowers is explainedby their relative success in lowering costs of adverseselection and moral hazard in financial markets.

REVIEW QUESTIONS

1. What advantages do financial intermediaries haveover small savers in dealing with the transactionscosts involved in making loans?

2. Distinguish symmetric information from asymmetricinformation, and state why the distinction is impor-tant for the financial system.

3. What is the difference between moral hazard andadverse selection? How does each contribute to mak-ing information asymmetric?

4. Explain why information collection in financial mar-kets is subject to the free-rider problem. How dobanks overcome the free-rider problem?

5. Explain what the “lemons problem” is. How doesthe lemons problem lead many firms to borrow frombanks rather than from individual investors?

6. Why might the number of loans that aren’t repaid tobanks rise as interest rates rise? What might be a bet-ter strategy for banks than raising interest rates?

7. Suppose that a bank makes a loan to a business andthat the loan contract specifies that the business is notto engage in certain lines of business. What is thistype of provision called? Why would the bank makesuch a provision?

8. What is the name of the main problem associatedwith the separation of ownership from management?What do managers do that owners don’t like? Whattypes of solutions are available?

9. Is a large firm with thousands of shareholders more orless likely to suffer a principal-agent problem than asmall firm with just a few shareholders? Explain.

10. Describe opportunities for specialized investors or finan-cial institutions in mitigating financing problems associ-ated with adverse selection and moral hazard.

11. At a used car lot, a nearly new car with only 2000miles on the odometer is selling for half the car’s orig-inal price. The salesperson tells you that the car was“driven by a little old lady from Pasadena” who hadit for two months and then decided that she “didn’tlike the color.” The salesperson assures you that thecar is in great shape and has had no major problems.What type of asymmetric information problem ispresent here? How can you get around this problem?

12. Why don’t insurance companies sell income insurance?That is, if a person loses his or her job or doesn’t get asbig a raise as anticipated, that person would be com-pensated under his or her insurance coverage.

13. In which of the following situations is moral hazardlikely to be less of a problem? Explain.

(a) A manager is paid a flat salary of $150,000.(b) A manager is paid a salary of $75,000 plus 10%

of the firm’s profits.14. A banker is thinking of making a loan to a small busi-

ness. The owner of the business also owns a houseand has a $40,000 investment in stocks and bonds.What kind of loan contract should the banker writeto minimize costs of moral hazard?

15. Describe some of the information problems in fi-nancial markets that lead firms to rely more heavilyon internal funds than external funds for investment.Do these problems necessarily imply that, as a result,too little good investment is being made? Why or whynot?

ANALYTICAL PROBLEMS

QUIZ

QUIZ

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Lack of good corporategovernance is a problemworldwide for investors,but the risks in Russia arevery different from thoseexperienced in the U.S. andEurope post-Enron. . . .

[T]he emphasis in Rus-sia is very much on gover-nance standards and thismonth The Banker pub-lishes a chart (overleaf),drawn from Troika Dialogresearch, listing leadingRussian corporates accord-ing to governance standards.

Loose accounting stan-dards are not necessarily aproblem if companies areaudited professionally andwith rigor. However this isoften not the case in Russia.While the Ministry ofFinance is now sole supervi-sor of the audit industry, it isestimated that only 40% ofaudit firms follow a clear setof audit procedures andnothing has been done asyet to prevent “singleclient” firms who are sodependent on one largeclient that their independ-ence must be questioned.Nearly 10% of the RASaudit market is run by “sin-gle client” firms—the firmwith the largest marketshare within this has Surgut-neftegaz (ranked 27 in ourtable) to thank for this.

Using auditors for con-sultancy services and theuse of off-balance sheet lia-bilities is common practicein Russia as in the U.S.While stock options arenot, they can be simulatedby “phantom shares” tocircumnavigate legislation.Loans to directors areunheard of, partly becausea director’s remuneration islarge and confidential.Recently LUKoil (rankednine), in a run up to anaborted American Deposi-tary Receipt (ADR) place-ment, revealed its CEO’sannual salary to be $1.5m,while the newly electednon-executive directorswould be paid nothing.

In fact the strongestdriver for reform of Russ-ian governance has notbeen the state regulatory

system, but the marketitself. In a desire to raise

capital abroad, firms areswitching to InternationalAccounting Standards(IAS). A total of 39 of thetop 57 companies now useIAS, 33 of which haveADRs outstanding. Tennew firms switched tothese or GAAP standardsin the 2001 reporting year(Bashinformsvyaz ranked23, Lenenergo ranked two, Magnitogorsk Metal

ranked 35, to mention afew). . . .

Securing foreign own-ership may encouragetransparency and greaterfinancial discipline, but isstill open to abuse. ManyADR holders do not realizethey have voting rights andso do not ask their custo-dian to exercise them.Russian directors oftenhave an agreement withthe custodians that theymay use unexercised votesthemselves—known as“discretionary voting.”They can therefore pushthrough proposals thatmay not be in the bestinterests of shareholders.

Despite all this it seemsthat corporate governancehas improved in Russiaand is likely to improve inthe future. There has beenmore shareholder represen-tation on boards of direc-tors such as CentralTelecom (ranked 10) andLenenergo (ranked 2).Charters have been revisedto give independent non-executives approval overmajor decisions, as in thecase of Norilsk Nickel(ranked 44), or limit theCEO’s powers to approvedeals in the company’sassets, as in the case ofAeroflot (ranked 25).

THE BANKER MAY 2003

Glasnost in the Boardroom

a

b

c

M O V I N G F R O M T H E O R Y T O P R A C T I C E . . .M O V I N G F R O M T H E O R Y T O P R A C T I C E . . .


Capital markets perform well in match-ing borrowers and savers when infor-mation costs are low. When investorshave poor information from businessowners and managers about theprospects and risks of the firm, costs ofadverse selection depress equity valuesand raise the cost of finance. In casesin which managers lack strong incen-tives to act in shareholders’ interest,costs of moral hazard also make raisingfunds expensive. Both private and gov-ernmental actions can reduce informa-tion costs and strengthen capitalmarkets, offering risk-sharing, liquidity,and information services to savers andborrowers. In the year after the col-lapse of the Soviet Union, Russia’s cap-ital markets struggled to become moreefficient. While the United States wasnot immune to corporate governanceconcerns—as the corporate accountingscandals in 2001 and 2002 madeclear—Russia in 2003 faced tough hur-dles in decreasing information costs inits capital markets.

The need to raise capital—partic-ularly from foreign investors—

means that Russian firms must reduceinformation costs to levels acceptablein international capital markets. Thelack of rigorous audits makes investorswary of the quality of information andadds costs of adverse selection tocosts of external financing.

The use of International Account-ing Standards reduces monitoring

costs and costs of raising funds. Evenin this case, to provide incentives formanagers to act in shareholders’ inter-ests, large shareholders need to beactively involved in corporate gover-nance and executive pay should reflectperformance. The legal system candecrease the scope for moral hazardby limiting opportunities for insiders totransfer wealth from outside share-holders to themselves.

These changes in governance,welcome in any economy suffer-

ing from costs of corruption and weak

capital markets, can spell good newsfor Russia’s economy. Lower informa-tion costs enable Russian companiesto raise funds more cheaply and growmore rapidly. Entrepreneurs can diver-sify their wealth more easily as mar-kets in which they can sell their equityflourish. Savers in Russia—andabroad—can benefit from higherreturns as Russia grows.

For further thought…

Suppose that to raise additional rev-enue, the Russian government raisedtaxes significantly on dividends paid bycorporations to their shareholders.How might such a policy change affectinformation costs and corporate gov-ernance?

Source: Excerpted from Alex Foreman-Peck, The Banker, May 2003.Copyright © The Banker. Reprinted with permission.

a

b

c

A N A L Y Z I N G T H E N E W S . . .A N A L Y Z I N G T H E N E W S . . .


16. Do you think that lemons problems are likely to beimportant in emerging stock and bond markets inEastern Europe? Why or why not?

17. Suppose that you own some corporate bonds issuedby the Buyusout Company. Would you be happy ifthe company underwent a leveraged buyout? Why orwhy not? Would you be happy if the company weretaken over by a much larger firm, reducing its defaultrisk? Why or why not?

18. In the early twentieth century J. P. Morgan placedrepresentatives from his firm on the boards of direc-tors of most of the companies in which his firm

invested. He was often denounced for what somecommentators saw as the excessive control he exer-cised in the business and financial world. Is it possi-ble that, given the existence of asymmetricinformation problems, Morgan’s policy of placing hismen on many boards of directors may have improvedthe workings of the financial system?

19. On average, Japanese nonfinancial corporations havegreater leverage than U.S. corporations do. Does thatimply that Japanese firms are more financially fragilethan U.S. firms? Why or why not?

DATA QUESTIONS

20. Suppose you believe that adverse selection problemsare important in the stock market. If a firmannounces that it will issue new shares, what patternwould you look for in data on the price of the firm’soutstanding shares following the announcement?Explain.

21. Thomson Financial’s Venture Economics divisionprovides information about the venture capital indus-try. Review Venture Economics Web site at

www.ventureeconomics.com. What does this site pro-vide that helps savers and investors deal with poten-tial moral hazard and adverse selection problems inthis industry? Look at the site’s “Statistics” link andlook up the most recent venture capital activityreported for your state. What trends do you see?How would the degree of taxes, regulation, and prop-erty right protection affect your state’s ability toattract venture capital?

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