Economics of Uncertainty

These features are as follows:

Market Assumptions: 

• Parties are risk neutral
• All projects cost “K” and all return “K” if unsuccessful
• Banks are unable to observe the project which an entrepreneur invest
• Capital is provided under the standard debt contract.
•  The expected gross return of any project

Demand for Funds: 

• A firm demands funds at his maximum expected profit, if successful:

• An entrepreneur will invest in type 1 project as long as they yield a greater return than type 2.

• Interest rates serve as both incentive and selection mechanisms.
• Due to information asymmetry Moral hazard sets in and as interest rate rises an entrepreneur invests in projects that yields the bank a lower return than another project.

Supply of Funds:

• The ultimate suppliers of funds place their funds on deposit with banks at a rate of return (d*).
• Perfect competition in the banking industry implies that banks will be willing to supply loans as long as the effective rate of interest on loans P  is equal to d*
• The effective rate of interest P = rPi
• Banks expected gross return = K(1 + P)

Equilibrium in the Loan Market:

• This equilibrium exist at the Interest rate that produces an effective interest rate P that equates d*
• Entrepreneurs base their decisions on: -

1. Expected gross return = Probability of return + Probable Cost of Failure
2. Effective rate of interest = Interest rate * Probability of success

Using an empirical example to define the equilibrium in the loan market

We take a two projects (1 and 2) scenario.

Deriving the results which entrepreneurs base their decision will be as follows:

         P%                                                         P1

                                                                             P2

                

                                                                                                         20                                     A              B                             P = d*

                                                                                                                                                                        

                                                                                                      0                                30                  40                                     r%

From the chart above the equilibrium in the loan market are said to be at points A and B.

Note however, this equilibrium exist under the assumption that there is public information (Where the banks can observe the project which an entrepreneur invests). From this equilibrium the entrepreneurs will earn $13.4 and $10 in projects 1 and 2 respectively

Consequently, based on the market assumption “that banks are not able to observe the project entrepreneurs invest in” gives room for information asymmetry and moral hazard then ensues. Where entrepreneurs obtain loans at a quoted rate of 30% and preferably invest not in type 1 projects but in type 2 projects because it yields an expected profit of $15 to entrepreneurs and an effective rate of interest of 15% to the banks.

This increase in expected returns is at the expense of the bank that earns an effective rate or return of 15% if it charges a quoted rate of 30% for a type 2 project.

This loss to the bank will cause banks to charge the higher interest rate of 40% since It knows that this will induce the entrepreneurs to carry out their type 2 projects and enable it pay depositors the required rate of 20%. Thus driving equilibrium to point B only.

The problem with this equilibrium is that type 2 projects yield a lower expected return of $10 than type 1. On the whole entrepreneurs loose because of information asymmetry in the credit (loan) finance market.

The Equity option

Loan finance in the face of hidden action causes adverse selection through higher interest rates. The equity finance option gives percentage stake in the profits to entrepreneurs, consequently inducing him to invest in projects that yield the highest profits.

Features and Assumptions

• Shares are offered at a share price “V” obtained: -

• Funding the project would require “N” shares:

• Expected profits is derived by:

Assuming d* =20% and banks share of profit is 90%. Therefore: -

Banks make an effective rate of 20% from equity finance to project 1 therefore they will be willing to trade while entrepreneurs also gain a higher return (13.3) on project 1 as opposed to loan financing project 2 (10), while eliminating the hidden action dilemma.

Basically, the equity option allows Pareto improvement as entrepreneurs gain and banks remain just as well off.

Conclusion

Hidden action in debt finance brews adverse selection that ultimately deters Pareto optimality, however equity finance provides an incentive that in entirety breeds Pareto efficiency. This improvement could in some situations breed market collapse especially in projects with unequal project cost.

BIBLOGRAPHY

1. Molho, Ian, “The economics of information: Lying and cheating in markets and Organisations, Oxford Blackwell 1997.
2. Hillier Brian, “The Economics of Asymmetric Information” Chapter 3 and 4, 1997.