Question

Consider an economy with a large number of potential online game providers.

The provider lacks the funds to start their projects. There is a large number of investors

who have the funds but no desire to create online games. Each investor has 10 goods

to invest. Each online game requires 20 goods to create. Each investor can choose any

providers to fund their online games. Assume that 25% of a chance, an online game

project will fail and has a salvage value worth 10 goods. With 75% of a chance, the game

will succeed and can generate revenue equal to 40 goods. The status of failure or success

is private information to the provider. If other people want to know the status, they are

required to pay 1 good to investigate, otherwise, they rely on the provider's self-report.

Explain why in order to borrow and lend, each investor needs to incur the moni-

toring cost of 1 good when the provider announce that the project fails.

(b) Compute the gross expected rate of return for each investor when the investor

chooses 10 projects to fund.

(c) Compute the gross expected rate of return for each investor when the investor

chooses 1 projects to fund.

(d) Explain why the expected return is greater when the investor chooses to fund 1

project.

(e) Assume there is a perfectly competitive banking sector. Each bank can take

deposits and make loans but faces the same private information problem. Compute

the gross deposit rate that the bank will oer. Compare your result with part (c)

and explain the role of banks.