Inv. Finance + Hidden Action Problem

Question 1

What is the Demand for Loans?

Answer 1

Profits under Standard Debt Contract

- Participation Constraint: E(πi) = pi [Ri^s - (1+r)K]

Question 2

Under what Condition will Entrepreneur Borrow?

Answer 2

r ≤ (Ri^s - K) / K
= ri
If r becomes too high - Entrepreneur Switches to other project

Question 3

What is Incentive Compatibility?

Answer 3

Entrepreneurs will choose project beset for them - funders recognise this + Offer Incentives to choose actions Compatible w/ Funders’ Objectives

Question 4

What is the Incentive Compatibility Constraint?

Answer 4

For given r0, Type 1 Exp. Return ≥ Type 2 Exp. Return
- E(π1(r0)) ≥ E(π2(r0))
==> p1 [R1s - (1+r0)K] ≥ p2 [R2s - (1+r0)K]

Question 5

How do you find r^ (rhat)

Answer 5

Use ICC: p1 [R1s - (1+r0)K] ≥ p2 [R2s - (1+r0)K]
=> p1R1s - p2R2s ≥ p1(1+r0)K - p2(1+r0)K
=> p1R1s - p2R2s ≥ (1+r0) (p1 - p2) K
==> [(p1R1s - p2R2s) / (p1 - p2)K] ≥ 1 + r0
=>[(p1R1s - p2R2s) / (p1 - p2)K] - 1 == r^ (rhat) ≥ r0

Question 6

When do Entrepreneurs invest into Type 1 and Type 2 project?

Answer 6

Invest in Type 1: r ≤ rhat (ICC)
Invest in Type 2: r > rhat (ICC)
r now acts as Incentive Mechanism - not Selection Mechanism
– Affects actions taken by borrowers after obtaining Loan

Question 7

What is the Supply of Loans?

Answer 7

p (Rho) = rp1 , for r ≤ rhat
= rp2 , for r2 ≥ r > rhat
- Discontinuity point due to ICC

Question 8

Equilibrium in Loan Market, outcome of Case 1A: d* < P - Banks can observe Entrepreneurs choice?

Answer 8

Banks offer r~1 and r~2
- All Entrepreneurs choose A (r~1 < rhat)
Type 1 has greater Exp. Profit: (Rho1 - d) > (Rho2 - d)

Question 9

Equilibrium in Loan Market, outcome of Case 1B: d* < P - Banks can NOT observe Entrepreneurs choice?

Answer 9

No change from Full Info case

• Banks know ICC is satisfied - r~1 < rhat
• • Entrep. choose Project 1

Question 10

Equilibrium in Loan Market, outcome of Case 2A: d* > P - Banks can observe Entrepreneurs choice?

Answer 10

Banks offer r~1 and r~2
- All Entrepreneurs choose A
Type 1 has greater Exp. Profit: (Rho1 - d) > (Rho2 - d)

Question 11

Equilibrium in Loan Market, outcome of Case 2B: d* > P - Banks can NOT observe Entrepreneurs choice?

Answer 11

If Banks offer r~1 and r~2 - All Entrepreneurs accept r~1 BUT choose Project 2
–> Increased Profits from (Rho1 - A) to (Rho2 - C)
-Banks Lose- At C - Rho < d*
THEREFORE Banks ONLY offer r~2 - Only Project 2 undertaken
ICC NOT Satisfied: r~1 > rhat