Question

You want to invest in the stock market. You are willing to pay $100 per share of stock of a well- run and profitable company. However, if the company is badly run, you are only willing to pay $10 per share of stock. You read a report that 80% of companies in the market are well run and 20% are badly run. Answer the following questions: a. Calculate your expected value of a stock chosen randomly among those for sale. b. Would the well-run companies be willing to sell stock at this price? c. What about the badly-run companies? d. Describe what will happen in the stock market. e. Explain what type of asymmetric information you have encountered? f. Describe the ways in which this type of asymmetric information can be mitigated in the stock market.

Answer 1

Part (a)

Expected value = 80% x 100 + 20% x 10 = $ 82

Part (b)

No, the well run companies will not be willing to sell the stock at the expected value of $ 82

Part (c)

All the badly run companies will be willing to to sell the stock at this price of $ 82

Part (d)

In the stock market, only the baldy run companies will be selling the stock while all the well run companies will abstain from selling the stock.

Part (e)

The seller of the stock knows what kind of stock (well run or badly run) he is selling. But the buyer will never be able to know what kind of stock is being sold. So, the seller is better informed while buyer is ill informed.

Part (f)

One way can be to make it mandatory for some king of rating or third party report to accompany each of the stock sale. A rating or third party report will certify what kind of stock is on on offer for sale. The buyer will thus have the complete information on what has been offered for sale. Thus the information asymmetry can be eliminated or bridged to such an extent.