Question

Principal- Agent Problems (credit rationing) in the credit market a) What is general description of the principal agent problem? b) Who is the principal and who is the agent in the credit market?

c) What is the conflict of interest between lenders and borrowers in the credit market? d) How can the conflict of interest between the principal (lender) and the agent (borrower) be at least partly resolved? What types potential borrowers may not have access to credit? e) What is “credit rationing”? How does credit rationing increase income inequality?

Answer 1

1. Principal- Agent problem is a situation which arrises on account of differences in opinion and conflict of interest between a principal and an agent. A principal - agent is a relationship wherein the principal comes in contract with the agent,who works on behalf of the principal, in return receives incentives. Example - manager / ceo of a company working for the owner of the company ( shareholder)

2. In a credit market, borrower and lender form a principal agent relationship.

Here, the lender is the principal and borrower is the agent.

3. As in a credit market the lender provides loan to the borrower. There is chance of not getting back the amount given as loan. Hence it causes conflict between them.

4. So that such conflict doesnot arrise, lender asks for mortgage or pledging by borrower to get the loan . Borrowers who cannot pledge their assets or gurantee lender of their ability to pay back cannot avail loan. Thus they fail to secure a loan.

5. Credit rationing is a situation when lenders are unwilling to provide additional loan to borrowers even at the high interest rates. It is a type of market failure. This situation is highly unfavourable for the indigent/ the poor. As the poor , are the one who are in need of loan than the rich. They want loan for their survival. Nor they are able to pledge their assets. Hence this situation brings inequality.