Friday, October 26, 2007

Information as a source for optimal allocation of resources (I)

Information availability allows economic agent the most efficient allocation for resources. Usually market competition works, on the assumption that all information is available with zero transaction cost .Otherwise , it is hard for economic agent to realize the best chances of making profit. Although information has transaction cost , rational behaviour assume that every agent ,will gather information up to the point marginal benefit = marginal cost. When it comes to goods transaction, information is self contained on each product characteristics, such as quality, value and price. If there are not perfect competition, advertising expenditures complement each product helping out to positioning itself on consumers mind with more information about its characteristics .It follows that markets is all about information as much as its institutional framework.. Given an institutional setting ,any restriction of any kind(biased reports) on information flows, will affect the efficiency of allocation of resources.
What about financial transactions ?. It apply the same. Economic agent, needs information about the quality of financial instrument available for investment decisions. However, quite on the contrary to the good case, this information is not self evident on every financial instrument as it is in the good transaction case. There is information asymmetry ,the seller of the financial instrument knows better the quality of it, because it has all the information to evaluate the present value of such asset. This situation leads to the adverse selection problem. Bad quality financial assets, are the predominant ones in markets transaction, because every investor do not have the chance of getting correct information ,any time it is needed.
Financial Markets evaluate the information available , asigning a price to each asset which match the risk associated to it. The riskier the asset the higher the return , but the lower the chance of finding a customer ready to take the risk of buying such asset, when markets behaviour turns out to be risk averse.-
Given the importance of a proper risk valuation , markets need the advise of the asset rating agencies, which classify asset according its different level of risk within a scale ranging from the top to the bottom. Those better qualified get the most ( AAA+) grade, which means low risk high profitable assets, which every one want to include on their portfolio. On the other hand ,those assets which do not get the best grade investment, are the ones which every investor would prefer to get away from. This was the case in the eighties and nineties with defaulted foreign government bond , which at that time allowed the development of the so called swap operation market.
All this discussion lead us to the current situation of mortgage sub prime market crisis, and the implications for market performance,as a case study in terms of the role of information. No matter the ignition factor, the fact of the matter it represent a market failure on two key variables: institutional framework and quality of information .From the quality of information stand point , any one in charge of asset information analisys, is the one to be questioned , about its procedures to properly grade the risk involve on this kind of sub prime transaction. Economic agent, followed and trusted the grade investment those rating agencies gave to every one of this new financial instrument and subsequent transaction.It seems that even with a weak institutional framework, proper and accurate information can make the difference between right or wrong allocation of resources .

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