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Wednesday, September 26, 2007 - 9:41 AM

real life application of economic theories

while preparing for my assignment for money and banking - my mind wanders. hah. so there are 2 very important concepts in banking (1) adverse selection (2) moral hazards

(1) adverse selection happens before a transaction (ie loans/bonds) occurs. in lay man terms, it is the situation where those who are desperate for money will be most enthusiastic to look for, in this case, loans. but these people are also most likely to be borrowers with bad credit risk and thus chances of default will be very high. what happens is banks will be more cautious in loaning out their money and this affects good people who will not default on their loan.

(2) moral hazards occur after the transaction where (let's say) this successful borrower used this money to gamble which creates unnecessary risk for the bank.

so because of asymmetrical information many forms of regulations are put in check to cushion the banks losses.

now we think about life. friendships and relationships. since, of course, there is asymmetric information, (i'm generalizing) those who wants to leech on you or get some benefits from you will actively want to be your friend but those good people out there would usu adopt a more passive role in making friends. well many people has got cheated/hurt before so they will be more cautious is knowing friends and because of this the chances of good people meeting good people is just rare.

of course after being friends/getting attached. who know what this person will do: they will steal from you, bad mouth you, break your heart, moral hazard is definitely in place. asymmetric information exists since u are not around that person all the time, you will never know everything the person is doing.

my question is this: in real life can we just put down rules and regulations to address these problems. in my opinion, we regulate such situations using this thing call TRUST and in the world today - unfortunately, even trust has no guarantee. also, even if we can cushion our losses, does it make a difference? how do we measure the pain. tragic.

told you economics is fun :)