| May 21, 2015

In this problem set, we will think systematically about how the equilibrium interest rate is determined in the credit market. In particular, we will explore how the interest rate, the size of the economic surplus and the distribution of the surplus are affected by: A) Limited liability clauses, B) Market power and C) Asymmetric Information.
Credit Market Equilibrium under Multiple Activity/Investment Choice

Felipe is an entrepreneur who is considering between two investment projects. Both projects are risky and both require an investment of $100. Project 1 is opening an Economics Consulting Firm. Since Felipe is an excellent economist, this project is pretty safe: with 80% probability Felipe will be a successful consultant and earn $230 of revenues and with 20% probability Felipe will fail and earn only $100 of revenues. Project 2 is opening a “Filipino Fusion” Taco Truck. This project is much riskier. With 20% probability the Taco Truck is successful and generates $500 of revenues. With 80% probability the Taco Truck fails and generates only $60 of revenues.

Cristina is a banker who may offer Felipe a loan. Cristina’s opportunity cost of money is 10%. In other words, she would earn a 10% interest rate if she invested the money in a bank instead of lending it to Felipe. In questions 1 – 4, we will explore the equilibrium contract that Cristina will offer under different assumptions about liability, competition and asymmetric information.

Limited Liability Contract and Asymmetric Information. Finally, we look at the implication of asymmetric information when we have Limited Liability Contracts. Assume that contracts are limited liability as in question 3. But now Cristina cannot observe/enforce Felipe’s choice of project.
To generate intuition about the impact of asymmetric information, in a separate figure, graph Cristina’s expected profit as a function of the interest rate. Title this graph “Figure 3: Lender’s Profit under Asymmetric Information and Limited Liability”. Discuss the shape of your graph. (Make sure that you – like Cristina – consider how the interest rate affects Felipe’s choice of project!).
Find the equilibrium interest rate be if Cristina is a monopolist? Which project does Felipe choose?
What is Cristina’s expected profit from this equilibrium contract? What is Felipe’s expected income?
What will the equilibrium interest rate be if the credit market is instead characterized by perfect competition?
What is Cristina’s expected profit from this equilibrium contract? What is Felipe’s expected income?
Compare the total surplus generated under symmetric versus asymmetric information (question 3 versus question 4). Discuss your findings.

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