Investment Decisions under Market Imperfections

Microeconomics for Finance

Juan F. Imbet

Master in Finance, 1st Year - Paris Dauphine University - PSL

Introduction to Market Imperfections

  • Real-world markets deviate from the perfect competition assumptions.

  • Market imperfections include:

    • Asymmetric information
    • Transaction costs
    • Taxes and regulations
    • Market power
    • Behavioral biases

  • These imperfections affect investment decisions and asset pricing.

Asymmetric Information

  • One party has more or better information than the other.

  • Types:

    • Adverse selection: occurs before transaction
    • Moral hazard: occurs after transaction

  • In financial markets: lenders vs. borrowers, insurers vs. insured, etc.

The Principal-Agent Problem

  • Principal delegates tasks to agent.

  • Agent may not act in principal’s best interest due to:

    • Different objectives
    • Information asymmetry
    • Incentive misalignment

  • Solutions:

    • Monitoring
    • Incentive contracts
    • Performance-based compensation

Moral Hazard in Financial Contracts

  • Agent (borrower/manager) takes actions not observable by principal (lender/investor).

  • Examples:

    • Borrower may invest in riskier projects than promised
    • Fund manager may trade excessively for personal gain
    • Insurance claimant may engage in risky behavior

  • Mitigation:

    • Collateral requirements
    • Covenants
    • Performance-based fees

Adverse Selection in Financial Markets

  • Occurs when one party has private information before the contract.

  • Examples:

    • Borrowers with high risk projects seek loans more aggressively
    • Sellers of “lemons” (low-quality assets) in used car markets
    • Investors with inside information

  • Solutions:

    • Screening
    • Signaling
    • Pooling equilibria

Corporate Finance under Imperfections

  • Capital structure decisions affected by:

    • Taxes (tax shield on debt)
    • Bankruptcy costs
    • Agency costs
    • Asymmetric information

  • Pecking order theory: firms prefer internal financing, then debt, then equity.

  • Trade-off theory: optimal capital structure balances tax benefits and costs of debt.

Investment under Asymmetric Information

  • Firms may underinvest due to:
    • Debt overhang: existing debt reduces incentives for new investment
    • Asset substitution: shareholders may increase risk after debt issuance
  • Solutions:
    • Convertible debt
    • Priority structures
    • Covenants restricting investment

Behavioral Aspects

  • Investors are not always rational.

  • Biases affecting investment decisions:

    • Overconfidence
    • Loss aversion
    • Mental accounting
    • Herding behavior

  • Implications for asset pricing and market efficiency.

Market Microstructure

  • How trades are executed and prices are determined.

  • Imperfections:

    • Bid-ask spreads
    • Market impact
    • Liquidity constraints

  • High-frequency trading and algorithmic trading.

Regulation and Market Imperfections

  • Government intervention to correct market failures:
    • Disclosure requirements
    • Capital requirements for banks
    • Insider trading regulations
    • Consumer protection laws
  • Trade-offs between regulation and innovation.

Conclusion

  • Market imperfections significantly affect investment decisions.

  • Understanding these imperfections is crucial for:

    • Corporate finance decisions
    • Investment strategy
    • Risk management
    • Financial regulation

  • Real-world financial decisions require balancing theoretical optimality with practical constraints.