1Asymmetric Information &
Credit Rationing
ARE/ECN 115A
Nov 9, 2023
1
2Readings
 Today: Overview of Moral Hazard and Adverse
Selectin
Primary Reading: T&L, Ch. 12 pp 262 – 270
Primary Reading: T&L, Appendix 12A & 12B
Optional: Banerjee & Duflo: “The men from Kabul…”
 Tuesday: How do lenders overcome asymmetric information?
Primary Reading: T&L, Ch 12 pp 270 – 275
Optional: “The Microfinance Promise” by Jonathan
Morduch
 Lots of material on microfinance on Canvas/Module
2
3Business
 Problem Set 3
 Due next Thursday (11/16)
3
4Business
Sections next week
 Before 5 pm on Tuesday
 Watch two short videos, including a debate about microfinance.
 Complete “Pre-section Quiz” – questions embedded in the video
 Discuss and debate the merits of micro-finance in section
 Video will be posted by end of day on Friday
 As you watch the video
 What stood out to you?
 What are key arguments in favor of micro-finance as a poverty
alleviation strategy?
 What are key arguments against micro-fiancé as a poverty
alleviation strategy?
 Don’t forget to complete post-section quiz for this week’s section by
Sunday
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Asymmetric Info and the QUALITY
of a credit contract
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5
MYSTERY: Existence of Credit Rationing
(Excess Demand)
 Plenty of talented, hard-working poor have great ideas for
businesses or productive investments
 But lenders may be unwilling to offer loans even though
potential borrowers are willing to pay higher interest rates
 Why?? Why won’t lenders accept the higher interest rate and
offer these loans?
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7“Asymmetric Information” Paradigm
 Field of “Economics of information” emerges in the 1980’s.
 Stiglitz, Akerloff, and Spence win Nobel prize in 2001 – primarily for
economics of information.
 Powerful framework for understanding how information problems can cause
imperfections in many markets where contracts are critical.
 Revolves around two basic notions:
 Adverse Selection
 Moral Hazard
 These two concepts will help us answer the question:
 Why won’t the lender raise the interest rate to eliminate excess demand (get
rid of credit rationing)?
 Next week: Why is it so difficult to offer insurance?
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8“Asymmetric Information” Paradigm
 When you purchase most goods/services, you know exactly what
you are getting.
 As a buyer, you can easily evaluate the quality of clothes, a
toothbrush, a potato.
 But it’s not so easy for buyers to evaluate the quality of some
other goods/services, such as used cars and, as we will see,
credit and insurance.
 When the seller knows the quality, but the buyer cannot easily
evaluate quality, we say the buyer suffers from asymmetric
information.
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9“Asymmetric Information” in Credit Markets
 Let’s apply this framework to credit markets.
 To do so, we need to think about:
 Who is the buyer and who is the seller?
 What is actually exchanged/sold in a credit contract?
 How do we define quality?
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Who is buyer & seller in a credit contract?
 Asymmetric information usually is a problem faced by the buyer.
 So who is the “buyer” and who is the “seller” in a credit contract?
 The lender is the seller, right?
 I’m going to flip this: Lender is the buyer; Borrower is the seller.
 Why? Because of what is really exchanged in a credit transaction.
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What is Sold in a credit contract?
 A credit contract exchanges the inter-temporal use of resources.
 Lender gives up resources today in exchange for getting them back (with
interest) tomorrow;
 Borrower receives resources today in exchange for giving them back (with
interest) tomorrow
 Consider a $100 loan at a 10% interest rate.
 Borrower is the seller:
 He “sells” a promise to deliver $110 next year.
 In return, he gets to use the $100 he borrowed this year.
 Lender is the buyer:
 She “buys” the borrower’s promise to deliver $110 next year.
 In return, she must give up the $100 this year plus any returns (interest earned in a savings
account) she would have earned if she had not made the loan.
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What determines the Quality of a Credit
Transaction?
 The lender is buying a promise to get money in the future.
 From the lender’s point of view, the quality of the loan contract has two parts:
 The interest rate, which determines how much she receives next year if the borrower repays
and;
 The probability that the borrower defaults – i.e., does not repay.
 Information is asymmetric because the borrower knows this default probability, but
the lender may not!
 The probability of default depends on two things that lender cannot easily observe:
 BORROWER TYPE: Characteristics/traits of the borrower & borrower’s project (Adverse
Selection);
 BORROWER ACTIONS: What the borrower does with the loan (Moral Hazard)
 Recall our discussion about Perry’s Garage Services from Tuesday…
12
Lorenzo the loan officer evaluating
a loan application from…
Lorenzo must decide:
 Does he offer Kenneth a loan?
 If so, what interest rate does he
charge?
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Information Challenge #1
 Does Kenneth have reliable supply chain networks or risky supply
chain networks?
 Under Symmetric Information:
 Lender has full information about borrower type == characteristics of
borrower and borrower’s project that affect the probability of default;
 Lorenzo knows exactly which type of supply chain networks Kenneth has.
 Under Asymmetric Information:
 Lender does not have full information about borrower type.
 Lorenzo does NOT know what type of supply chain networks Kenneth has.
CLICKER QUIZ
What is this first type of Asymmetric Information problem facing Lorenzo?
A. Moral Hazard
B. Adverse Selection
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Adverse Selection
 General: A situation in which one party has greater information
than the other party about some (fixed) characteristic of product
quality.
 Credit Markets: Borrower has greater information about
characteristics of herself and her project that affect the probability
of default -- than the lender.
 Implication: The lender may be unwilling to raise the interest rate
even if there exists excess demand.
 Why? Because, by increasing the interest rate, the lender may adversely
affect the quality of the applicant pool and thus lower her own profit.
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Information Challenge #2
 How will Kenneth use the loan funds?
 Build a warehouse to store parts to reduce risk of supply chain
interruptions
 Invest in high return but risky emerging-market stock fund
 Under Symmetric Information:
 Lender can write a contract that specifies and enforces the borrower’s actions;
 Lorenzo can force Kenneth to build the warehouse and thus reduce risk of loan
default.
 Under Asymmetric Information:
 Lender cannot observe or enforce the borrower’s actions;
 Lorenzo cannot force Kenneth to build the warehouse.
 But he does know that Kenneth will choose the action that is most profitable to him.
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Moral Hazard
 General: A situation in which one party has more information than
the other about some action that the more informed party takes that
affects product quality.
 Credit Market: Borrower has greater information about the actions
that she takes after receiving the loan that affect the probability of
default -- than the lender.
 Implication: The lender may be unwilling to raise the interest rate
even if there exists excess demand.
 Why? Because by increasing the interest rate, the lender may induce
the borrower to take actions that reduce the probability of
repayment and thus lower her own profit.
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Looking forward…
 Our goal is to understand how Moral Hazard and Adverse
Selection may affect the credit market.
 In the real world, lenders face these two problems simultaneously.
 In order to learn the concepts, we will always deal with them
separately.
 In order to understand the impact of M.H. and A.S., we will:
 First find the credit market equilibrium under symmetric information
(lenders face neither M.H. nor A.S.)
 Then find the credit market equilibrium under asymmetric information
 If there is a difference in the equilibrium, we can attribute this difference
to asymmetric information.
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Structure of our Analysis Today
(similar to sections & PS3)
Information
Environment
Symmetric Asymmetric
Market
Structure
Perfect
Competition A B
Monopoly C D
Information
Environment
Symmetric Asymmetric
Market
Structure
Perfect
Competition A B
Monopoly C D
TODAY: ADVERSE SELECTION (Multiple TYPES)
SECTION: MORAL HAZARD (Multiple ACTIONS)
Monopoly
 Single lender with all
market power
 Lender will earn highest
possible ()
 Borrower must earn
() ≥ 0
Perfect Competition
 Many lenders competing
against each other
 Borrower earns highest
possible ()
 Lender must earn () ≥0
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Intro to Adverse Selection20
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Types of Potential Borrowers
 From lender’s point of view, high quality means low probability of
default.
 Lender knows that two types of potential borrowers exist:
 SAFE Types (High Quality):
 Have projects/investments that are low risk.
 Might not be super-successful, but low probability that they fail
 So Safe types have low default probability
 RISKY Types (Low Quality):
 Have projects/investments that are high risk.
 Occasionally they strike it rich, but high probability that they fail
 So Risky types have high default probability
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Clicker Question
 If the lender CAN distinguish between SAFE versus
RISKY types, she would:
A. Charge higher interest rate to SAFE type than RISKY type
B. Charge higher interest rate to RISKY type than SAFE type
C. Charge same interest rate to both SAFE and RISKY types
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Under Symmetric Information
 If lenders could perfectly distinguish between high quality and low
quality borrowers, we don’t have a problem.
 Lender could offer different interest rates to each type. The interest
rate will reflect each type’s risk of default.
 Lender charges safe types a low interest rate
 Lender charges risky types a high interest rate
 So the equilibrium contracts would specify two terms: TYPE & Interest
Rate:
 (SAFE type, LOW interest rate)
 (RIKSY type, HIGH interest rate)
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Under Asymmetric Information
 When lenders CANNOT distinguish between high quality (Safe) and
low quality borrowers (Risky) things get complicated.
 Lender could offer the low interest rate and high interest rate
contracts and announce:
 “If you are a Safe type, please apply for the low interest rate contract”
 “If you are a Risky type, please apply for the high interest rate contract”
 Question: What do you think would happen?
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Under Asymmetric Information
 When lenders CANNOT distinguish between high quality (Safe) and
low quality borrowers (Risky) things get complicated.
 Lender could offer the low interest rate and high interest rate
contracts and announce:
 “If you are a Safe type, please apply for the low interest rate contract”
 “If you are a Risky type, please apply for the high interest rate contract”
 What do you think would happen?
 Risky types would lie to get the lower interest rate intended for Safe types.
 So under asymmetric information, the lender has to offer a single interest
rate.
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Under Asymmetric Information
 When lenders CANNOT distinguish between high quality and low
quality borrowers:
 Lender has to be very careful picking the interest rate, why?
 Because the interest rate she picks will determine which types of borrowers
apply for loans!
 Will end up having two choices for the interest rate:
 OPTION 1: Set it low enough so that BOTH types will want the loan.
 OPTION 2: Give up on SAFE types and instead set it high and deal only
with RISKY types
 So there will be a single equilibrium contract and it will only have
one term: Interest Rate
 But lender will know which types of borrowers will apply at that interest rate;
 So lender will know exactly what her () is.
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“A Tale of Two Types”
Example 1: Adverse Selection27
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 We’re going to make assumptions about:
 Projects and risk for two TYPES of borrowers;
 Opportunity cost of lenders
 Use those assumptions to find equations for the following as functions
of the interest rate:
 ௌ : Expected income of Safe Type of borrower
 ோ : Expected income of Risky Type of borrower
 ௌ : Expected profit of lender on a loan to a Safe Type of borrower
 ோ : Expected profit of lender on a loan to a Risky Type of borrower
 Graph these four functions to visually understand the equilibrium in the
specific context (symmetric vs asymmetric; monopoly vs competition)
 Mathematically find the specific interest rate(s) and what borrowers and
lenders will earn in equilibrium
General Strategy
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 Two Types of Entrepreneurs
 Both have $0 in liquidity/savings
 Both need $100 loan to start a business
 Both want to maximize ()
 Both must earn () ≥ 0, otherwise won’t take a loan.
 Half are Safe Types
 Revenues = 180 with probability 1 (always succeed)
 Half are Risky Types
 Revenues = 260 with probability 0.5 (success)
 Revenues = 0 with probability 0.5 (failure)
Entrepreneurs
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 Wants to maximize ()
 Opportunity cost:
 She could earn 10% interest if she kept the $100 in the bank
instead of lending.
 So her opportunity cost is 100*(1 + 0.1) = $110
 Offers limited liability loans
 Borrower doesn’t have to repay anything if project fails
 (careful in PS3: pay attention to liability rule!)
 Must earn () ≥ 0, otherwise won’t offer a loan.
Lender
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 We now want to see how the interest rate affects:
 Expected income earned by each type of borrower;
 The lender’s expected profit.
 Need to find equations for the following as functions of the
interest rate:
 ௌ : Expected income of Safe Type of borrower
 ோ : Expected income of Risky Type of borrower
 ௌ : Expected profit of lender on a loan to a Safe Type of
borrower
 ோ : Expected profit of lender on a loan to a Risky Type of
borrower
Objective functions as a function of
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 Expected Income of Safe Type:
 ௌ = Pr ∗ + Pr ∗ ( )
“Setup Equation”
 ௌ = 1 ∗ 180 − 100 ∗ 1 + + 0 ∗ [0 − 0 ∗ 100 ∗ (1 + )]
“Final Equation”
 ௌ = −
 Expected Income of Risky Type:
 ோ = Pr ∗ + Pr ∗ ( )
“Setup Equation”
 ோ = .5 ∗ 260 − 100 ∗ 1 + + 0.5 ∗ [0 − 0 ∗ 100 ∗ (1 + )]
“Final Equation”
 ோ = −
Borrowers’ Expected Income as a Function of
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 Expected Income of Safe Type: ௌ = −
 Expected Income of Risky Type: ோ = −
Interpretation
 Each type of borrower’s expected income is decreasing in
interest rate.
 Question: Why does an increase in the interest rate lower
expected income more for Safe type than risky type?
Borrowers’ Expected Income as a Function of
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 Lender’s Expected Profit on loan to Safe type:
 ௌ = Pr ∗ + Pr ∗
Setup Equation
 ௌ = 1 ∗ 100 ∗ 1 + − 100 ∗ 1 + .1 + 0 ∗ [0 − 100 ∗ 1 + .1 ]
Final Equation
 ௌ = − +
 Lender’s Expected Profit on loan to Risky type:
 ௌ = Pr ∗ + Pr ∗ ( )
Setup Equation
 ோ = 0.5 ∗ 100 ∗ 1 + − 100 ∗ 1 + .1 + 0.5 ∗ 0 − 100 ∗ 1 + .1
Final Equation
 ோ = − +
Lender’s Expected Profit as a Function of
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 Expected Profit on loan to Safe type: ௌ = − +
 Expected Profit on loan to Risky type: ோ = − +
Interpretation
 Lender’s expected profit is increasing in interest rate.
 Question: Why does an increase in the interest rate raise lender’s
expected profit more on loan to Safe than risky type (i.e. slope is
higher 100 vs 50)?
 Let’s graph these 4 functions and find equilibrium under symmetric
information…
 She can tell Safe & Risky apart and offer them separate contracts.
Lender’s Expected Profit as a Function of
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-200
-150
-100
-50
0
50
100
150
200
250
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4
Interest Rate (i)
(_)
(_)
Interest rate
(_)
(_)
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Expected profit and income
0.1
36
-200
-150
-100
-50
0
50
100
150
200
250
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4
Interest Rate (i)
(_)
(_)
(_)
〖(〗_))
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-- Clicker Question --
Under symmetric information, what interest rate would
a monopolistic lender charge to the SAFE type?
A. 0.1
B. 0.6
C. 0.8
D. 1.4
E. 1.6
0.1
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-200
-150
-100
-50
0
50
100
150
200
250
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4
Interest Rate (i)
(_)
(_)
(_)
(_)
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Equilibrium Under Symmetric Info? (monopoly)
What interest rate would she charge to Safe Type?
If she can only make 1 loan, to whom does she offer it?
Max she can charge to Safe
Max she can charge to Risky
2.2
What interest rate would she charge to Risky Type?
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 Now Lender cannot tell the two types apart.
 She just knows that 50% are Safe Types and 50% are Risky Types
 What is the opportunistic behavior the lender is concerned about?
Equilibrium under Asymmetric Information?
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 Now Lender cannot tell the two types apart.
 She just knows that 50% are Safe Types and 50% are Risky Types
 What is the opportunistic behavior the lender is concerned about?
 Risky types will pretend to be safe types to get a lower interest rate.
 So…When she picks an interest rate, she must ask herself: At this
interest rate, who -- which type(s) – will apply for a loan?
Equilibrium under Asymmetric Information?
40
-200
-150
-100
-50
0
50
100
150
200
250
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4
Interest Rate (i)
(_)
(_)
(_)
(_)
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How does affect who applies for loan?
Over what range will both types apply?
Over what range will only 1 type apply?
What happens if lender raises a bit higher?
What happens if lender raises a bit higher?
2.2
Both types apply Only Risky apply Nobody applies
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 Who wants a loan?
 ≤ 0.8: Both Types
 0.8 < ≤ 1.6: Only Risky Types
 > 1.6: Nobody
 So Lender’s expected profit as function of interest rate is different for these
three ranges:
 ≤ 0.8: Both Types apply
 = Pr ∗ ௌ + Pr ∗ ோ
 = 0.5 ∗ −10 + 100 + 0.5 ∗ −60 + 50
 = − +
 0.8 < ≤ 1.6: Only Risky Types apply
 = ோ = − +
 > 1.6: Nobody applies
 =
Lender Expected Profit under Asymmetric
Information
These probabilities are just the fraction of
each type in the population!
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Equilibrium Under Asymmetric Info?
You’re a monopolistic lender. You can pick 1 interest rate to charge.
What interest rate do you pick?
-40
-30
-20
-10
0
10
20
30
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4
Interest Rate (i)
Lender Expected Profit under Asymmetric Information
Both Types Apply Only Risky Types Apply Neither Type Applies
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 In this case, Lender would charge the highest possible interest rate that
would keep BOTH safe and risky types in the market (i = 0.8)
 What if the lender only has $100 to loan out, but two people want a
loan?
 i.e., there exists “excess demand” for the loan
 Would she be willing to lend to somebody who offered to pay a
slightly higher interest rate?
 No!!
 Safe types would drop out of the market
 Lender would be left with only Risky types, so expected profit falls
 In this case, when she raises the interest rate as high as possible to Risky types,
she earns less profit compared to keeping both Safe and Risky types in the
market
 So…lender actually is better off NOT increasing the price
Cost of Asymmetric Information
DISCUSS…she would NOT be willing to raise the interest rate.
• She knows that only risky type would be willing to pay more than 80% interest rate.
• So if she raises interest rate, Safe types drop out of market.
• She’s left only with Risky type.
• She might be willing to do this IF she could raise interest rate very high so that she earns
big profit with only Risky types (possible when the revenue of success is very high for the
Risky types).
• But in this example, she would not be willing to do it.
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D
S
Q
i
ௌ < ஽
∗
஽
Excess Demand
Our Goal: Solve the Mystery!!
 Why would lenders choose to
NOT raise the interest rate even
though some people are willing
to pay a higher interest rate?
ௌ
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Summary: Adverse Selection
 Lender cannot observe borrower
“type”
 Lender must consider how her choice of
affects which type(s) apply!
 For low interest rates ( ≤ 0.8):
 Both types apply
 Not sure to which type loan was given;
 Just know 50% chance it went to Safe and
50% chance it went to Risky (fraction of
each type in the population)
 is weighted average of expected
profits on a loan to each type
 For intermediate interest rates (0.8 <
≤ 1.6):
 Lender knows that only Risky types apply
 = ோ
 For high interest rates ( > 1.6):
 Neither type applies
 So = 0 = .5 ௌ + .5 ோ =
− 35 + 75
= ோ = −60 + 50
= 0
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Equilibrium: Adverse Selection
 Under monopoly
 Lender just picks that gives highest value of

 Given the parameter values we picked for
this problem, monopolist will pick = 0.8.
 (careful on PS or exam: different parameter
values could lead to different outcome)
 Under perfect competition??
 Pick that makes borrowers as best off as
possible while allowing lender to earn
≥ 0
 This occurs at the lowest such that = 0.
 i.e., where −35 + 75 = 0
 So = ଷହ଻଴ = 0.47
 What about the other such that = 0?
(i.e., where −60 + 50 = 0 )
 Cannot be equilibrium! Another lender
would offer a slightly lower interest rate
and steal all the borrowers.
 Interest rate will be driven down until =ଷହ
଻଴ = 0.47 = ோ − 60 + 50
= 0
= .5 ௌ + .5 ோ =
− 35 + 75
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“A Tale of Two Actions”
Example 2: Moral Hazard48
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 Only 1 type of borrower: Perry’s Garage Doors
 2 possible actions
 Action 1: Build warehouse to eliminate supply chain risk
 Invest $120
 Generate $200 in revenues with certainty
 Action 2: Invest in stock market
 Invest $120
 50% of time successful, earning $240 in revenues
 50% of time failure, earning $0 revenues
Setup: The Borrower
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 Risk neutral monopolist: only cares about ()
 Opportunity cost of money = 0.10 (could earn 10% interest if he
saved instead of lending)
 Offers limited liability contract in which borrower repays
NOTHING if project fails
 Must earn () ≥ 0, otherwise won’t offer a loan.
Setup: Lorenzo the Lender
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 We again need to find equations for 4 functions
 For the borrower (Perry)
 ଵ : Expected income when he chooses action 1 (warehouse)
 ଶ : Expected income when she chooses action 2 (stock market)
 For the lender (Lorenzo)
 ଵ : Expected profit when Perry does action 1
 ଶ : Expected expected income when Perry does action 2
 Let’s find these 4 equations…
Incomes & Profits as Functions of i
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 Borrower’s expected Income depends on the action he chooses:
 ଵ = 1[200 − 1 + 120] + 0 0 − 0 ∗ 1 + 120 = −
 ଶ = .5 240 − 1 + 120 + .5 0 − 0 ∗ 1 + 120 = −
 Lender’s expected profit also depends on action chosen by
borrower:
 ଵ = 1 120 1 + − 120 1 + .1 + 0 0 − 120 1 + .10 = − +
 ଶ = 0.5 120 1 + − 120 1 + .10 + 0.5 0 − 120 1 + .10 = − +
 Let’s graph these and find equilibrium under symmetric
information…
 Lender can observe and enforce borrower’s choice of action and
write a contract that specifies which action she must use.
Incomes & Profits as Functions of i
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Credit Market Equilibrium under Symmetric Information &
Monopoly?
-100
-75
-50
-25
0
25
50
75
100
125
150
175
200
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5
Pr
of
it
an
d
In
co
m
e
Interest Rate
E(π1)
E(π2)
E(y2)
E(y1)
Clicker Question: What interest rate does Lorenzo charge?
A. 0.1
B. 0.33
C. 0.67
D. 1.0
E. 1.1
Best Lorenzo can do if he makes Perry
do action 1 (Safe warehouse)
Best Lorenzo can do if he makes Perry
do action 2 (Risky stock market)
0.33 0.67
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Credit Market Equilibrium under Symmetric Information &
Monopoly?
-100
-75
-50
-25
0
25
50
75
100
125
150
175
200
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5
Pr
of
it
an
d
In
co
m
e
Interest Rate
E(π1)
E(π2)
E(y2)
E(y1)
Equilibrium under Sym Info & Monopoly:
• Charge 0.67
• Require Cristian to do Action 1
Best Lorenzo can do if he makes Perry
do action 1
Best Lorenzo can do if he makes Perry
do action 2
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 Now Lorenzo cannot observe/enforce Perry’s choice of
action
 He can only pick an interest rate
 Lorenzo must ask himself: At each possible interest rate, which action
will Perry choose?
 Lorenzo can figure out which action Perry will choose by comparing
Perry’s expected income under each action…Lorenzo knows that Perry
will choose the action that gives the highest expected income.
Equilibrium under Asymmetric
Information?
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Credit Market Equilibrium under Asymmetric Information?
-100
-75
-50
-25
0
25
50
75
100
125
150
175
200
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5
Pr
of
it
an
d
In
co
m
e
Interest Rate
E(π1)
E(π2)
E(y2)
E(y1)
Over what range of will Perry choose action 1?
What happens if Lorenzo raises a bit higher?
Over what range will Perry choose action 2?
What happens if Lorenzo raises a bit higher?
Action 1 Action 2 No loan
Perry switches to tech 2 when
Lorenzo raises above 0.33
0.33
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 Let’s graph Lorenzo’s expected profit, ,
over all possible interest rates, taking into
consideration how the interest rate he
charges affects the action that Perry chooses!
 ≤ 0.33: Perry chooses action 1
 So Lorenzo’s profit corresponds to action 1:
 = ଵ = − +
 . 33 < ≤ 1.0: Perry switches to action 2
 So Lorenzo’s profit corresponds to action 2:
 = ଶ = − +
 > 1.0: Perry is better off with no loan
 =
Equilibrium under Asymmetric
Information?
Lorenzo’s Expected Profit = ଵ= − +
= ଶ = −7 + 6
=
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Credit Market Equilibrium under Asymmetric Information &
Monopolist?
Lorenzo’s Expected Profit
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 In this case, Lender charges relatively low
interest rate (33%) so that borrower chooses
action 1 (safe).
 If there is no excess demand at this interest
rate, there is no inefficiency from society’s
point of view because action 1 is the more
profitable technique.
 The lender, however, is worse off because he
cannot extract full rents (borrower is not driven
down to zero expected profit even though
Lender is a monopolist).
 Would lender be willing to raise the interest
rate if there was excess demand?
 No! He would earn negative profits.
 So if there is excess demand at an interest rate
of 33%, we would have credit rationing.
 Some entrepreneurs would get a loan while others
(who are equally productive) would be denied
credit.
Cost of Asymmetric Information
Lender’s Expected Profit
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D
S
Q
i
ௌ < ஽
∗
஽
Excess Demand
Our Goal: Solve the Mystery!!
 Why would lenders choose to
NOT raise the interest rate even
though some people are willing
to pay a higher interest rate?
ௌ
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Summary: Moral Hazard
 Lender cannot observe or enforce
borrower’s actions
 Lender must consider how her
choice of affects the action the
borrower chooses!
 For low interest rates ( ≤ 0.33):
 Borrower chooses action 1 (safe)
 = ଵ = −12 + 120
 For intermediate interest rates
(0.33 < ≤ 1):
 Borrower chooses action 2 (risky)
 = ଶ = −72 + 60
 For high interest rates ( > 1):
 Entrepreneur doesn’t want to borrow
 So = 0
= ଵ = −12 + 120
= ଶ = −7 + 6
= 0
How does interest rate affect borrower’s
project choice?
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= ଵ = −12 + 120
= ଶ = −7 + 6
= 0
How does interest rate affect borrower’s
project choice?
Equilibrium: Moral Hazard
 Under monopoly & asymmetric
info
 Lender just picks that gives highest
value of
 Given the parameter values we
picked for this problem, monopolist
will pick = 0.33.
 (careful on PS or exam: different
parameter values could lead to
different outcome)
 Under perfect competition??
 Pick that makes borrowers as best
off as possible while allowing
lender to earn ≥ 0
 This occurs at the lowest such that
= 0.
 i.e., where −12 + 120 = 0
 So = ଵଶଵଶ଴ = 0.1
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