Question

Recall the following variation on the simple model of the credit market with moral hazard we discussed in the lecture. The firm seeks to finance an investment project through borrowing. Assume that the project requires an initial investment of 100. The firm may choose the good technology which gives return G = 200 with probability π_G = 0.7 in the case of success or return 0 with probability 1 − π_G in the case of failure or the bad technology which gives success return B = 400 with probability π_B = 0.2 or failure return 0 with probability 1 − π_B . The firm’s choice of technology or the size of the return is not verifiable. But it is verifiable whether the project was a success or failure. Therefore, the firm can promise to repay R to the lender in the case of success. At cost C, the bank can use monitoring to prevent borrowers from using type B technology. The repayment to the bank, when monitoring is used, is R_m.

1. Assume that firm can borrow from a bank with monitoring cost C = 20. Is bank lending sustainable in this environment?

2. What happens to the answer in the 1^st part if monitoring cost changes to C = 50?

Answer 1