Econ107 Asymmetric Information

A competitive lender makes loans to a pool of borrowers that are identical. After borrowers have received their loans they choose one of two investment projects. Project G pays the borrower a rate of return of r_grg with probability p_gpg. With probability 1 − p_g1−pg, the project earns a zero rate of return, the borrower defaults on the loan, and the lender receives back the initial loan amount. Project B pays the borrower a rate of return of r_brb with probability p_bpb. With probability 1 − p_b1−pb, the project earns a zero rate of return, the borrower defaults on the loan, and the lender receives back the initial loan amount. We assume that r_g < r_brg p_bpg>pb, and p_g(1 r_g) > p_b(1 r_b)pg(1 rg)>pb(1 rb).

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