Microeconomic Foundations of Financial Intermediaries
1. INFORMATION PRODUCTION MODELS 10
10 Information Production Models 1 Information Production Models 1.1 The Information Problem: Adverse Selection as a Consequence of Hidden Characteristics This chapter will center on an analysis of the following information-related problem: How can a firm be evaluated correctly if its quality is known only to the entrepreneur himself? For the sake of simplicity, we shall consider only two types of firms - good ones and bad ones. The value of a firm is equal to the sum of its future discounted net cash-flows. In efficient markets, the price is a reflection of all available information. The earnings of firms are given by a term IJ, known only to the entrepreneur, and the attributes of a random variable with a mean of zero and a given variance. This latter component cannot be influenced by the actions of the entrepre- neur and is costlessly observable ex-post. In other words, low or high net cash-flows may be attributable to the (true) nature of the firm, or to incidental factors. For an outsider it is not possible to distinguish a priori between good and bad firms. This situation corresponds to the "lemons" market for used cars described by Akerlof (1970): As the buyers cannot tell a good car from a "lemon", there will either be only poor-quality cars available on the market, or it will break down completely. As Kreps has shown, the information problem is not due to the restriction to a choice between only two types - a generali- zation for...
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