Question

“Suppose that you have saved €1,000 this year. Borrowing or lending is not possible because there are no financial markets. If you do not have an investment opportunity that will permit you to earn income with your savings, you will just hold on to the €1,000 and will earn no interest. However, Carl the carpenter has a productive use for your €1,000: he can use it to purchase a new tool that will shorten the time it takes him to build a house, thereby earning an extra €200 per year. If you could get in touch with Carl, you could lend him the €1,000 at a rental fee (interest) of €100 per year, and both of you would be better off. You would earn €100 per year on your €1,000, instead of the zero amount that you would earn otherwise, while Carl would earn €100 more income per year.

As we have seen, Carl the carpenter needs €1,000 for his new tool, and you know that it is an excellent investment opportunity. You have the cash and would like to lend him the money, but to protect your investment you have to hire a lawyer to write up the loan contract that specifies how much interest Carl will pay you, when he will make these interest payments, and when he will repay you the €1,000. Obtaining the contract will cost you €500. When you figure out this transaction cost for making the loan, you realise that you can’t earn enough from the deal (you spend €500 to make perhaps €100) and reluctantly tell Carl that he will have to look elsewhere.” (Mishkin, Matthews, Giuliodori, The Economics of Money, Banking and Financial Markets, 2013).

Can the deal (contract) still be made even with the €500 charged by the lawyer? How? Which variable in the contract can be changed and by how much?

Answer 1

In this question we can see that there is a deadlock situation between you and carl, as there is a risk of investment loss in absence of contract. And hiring a lawyer looks like a costly affair.

The absence of a financial markets has created this situation that a small saver (who do not intend to invest in any big project) cannot lend money to an investor (Carl, who can utilize the borrowed money to get additional profit) due to the absence of a third party (which can be seen as an 'exchange') or a legal contract.

However to avoid this situation, a Financial Intermediary can come to rescue. Financial intermediaries can substantially reduce transaction costs by using a simple concept of 'Economies of Scale' (Economies of scale are cost reductions that occur when companies scale up the production). In current scenario, the reduction in transaction costs per dollar of transactions as the size (scale) of transactions increases.

So this problem can be solved in 2 ways:

1. You can ask the lawyer to make an air-tight contract for the loan provided to carl (by spending $500). Lend money to Carl. And now search some more people like Carl who needs to borrow money, if you can find more such people like carl then you can use the same contract for all your clients. thus it would help you to reduce your contract cost every time. So if you can find 5 new clients like carl, your average price per contract reduces to $100. thus your breakeven of return also reduces.

2. Carl can buy more tools that could further gain him extra income. So instead of $1000, if Carl can borrow $5000 from you and it can help to increase carl's overall gain by $1000 per year. Thus he can afford to pay $500 per year to you and that would break even the investment cost for you too, in a duration of 1 year.

Thus we see that the logic of economies of scale can be implemented on both sides of the transactions to both the counterparties.

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