Question

How can the existence of asymmetric information explain issuing marketable debt and equity securities is not the primary way in which businesses finance their operations.

Answer 1

Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. Inndirect finance ia many times more important than direct finance. Financial intermediates , particularly banks are the most important source of external funds used to finance business.. Financial intermediaries have evolved to reduce transaction costs and allow small savers and borrowers to benefit from the exixtence of financial markets , this is done through economics of scale , where the bundling of investors funds together is done to reduce transaction costs and to reduce the risk through a diversified portfolio of securities. The reason for this regulation is the problems of asymmetric information . Adverse selection is a problem that occurs before the traction occurs. Debt contracts are extremely complicated legal documents that place substantials restrictive covenants on borrowers.

Tools to help solve adverse selection problems: One tool to help solve adverse selection problems is the private production and sale of information. However,even if this is done, there would still be a “free rider” problem that will continue to cause market failure. Freeriders are people who do not pay for information, but take advantage of the information that others have paidfor. Therefore, regulation is required.