Question

There are two types of potential borrowers in equal numbers among the population. All have projects that require an investment of $100, which must be borrowed. Type A projects yield a gross return of $130 in one year with probability .8; they fail and yield 0 with probability .2. Type B projects yield a gross rate of return of $250 with probability .4, but fail, yielding zero, with probability .6. Potential lenders require a gross return of $102 on $100 loaned. With symmetric information, who will get financing and why? Now suppose the project expected returns are private information. Lenders cannot distinguish one type from another. Will any lending occur? Why or why not? Explain in detail.

Answer 1

expected payoff :

Expected payoff from project A : (0.8)($130)+(0.2)($0) = $104

Expected payoff from project B : (0.4)($250)+(0.6)($0) = $100

loan amount to be repaid to lender : $102

A) WITH SYMMETRIC INFORMATION (LENDER CAN DIFFERENTIATE BETWEEN BOTH PROJECT)

people who are investing in project A will get financing because the expected payoff from project is more than the amount to be repaid to the lender. hence the investor can earn a profit of $2 and the lender will get his money back with interest, on an average. Hence good for both lender and borrower.

people who are investing in project B will not get financing because the expected payoff from project is less than the amount to be repaid to the lender. hence the investor will be in loss of $2 on an average. Loss to both lender and borrower.

B) WITHOUT SYMMETRIC INFORMATION (LENDER CAN'T DIFFERENTIATE BETWEEN BOTH PROJECT)

If both the investor are risk loving. Both the investors of project A and project B will borrow money as there are 0.8 chances in project A to repay loan and 0.4 chances to repay loan in project B.

if both investors are risk averse. Only investor of project A will borrow money has his expected earning is higher than the amount of loan repayment. investor of project B will not borrow as the expected return i low than the repayment loan amount.