Explain problems of adverse selection in rural credit market

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Reference no: EM13185973

The table below presents three types of peasants in a rural village, each with a different probability of success and rate of return on their projects. The loan size under consideration is 100,000 pesos.

Peasant Type

Probability of Success

Rate of Return

Type 1

100%

20%

Type 2

90%

40%

Type 3

60%

50%

You must show your work methodically in you answers to the following questions:

A) What is the maximum interest rate that each type of peasant is willing to pay?

B) Suppose you are the lender and you have perfect information about the different types of peasants (information is symmetric) and there is no opportunity costs to your funds, what is the minimum interest rate that you have to charge each peasant type in order to recover the loan of 100,000 pesos?

C) Suppose instead that you (the lender) have no information on the type of borrower and you have to charge a single interest rate to all borrowers. Also assume that the probability that you will end up with each type of borrower is equal (e.g. 1/3 if there are three borrowers, ½ if there are two borrowers and so on. What is the minimum interest rate that you should charge in order to ensure that you can recover the loan of 100,000 pesos?

D) Suppose there is excess demand for funds at this minimum interest rate and you decided to raise the interest rate you charge the peasants by 10% above your answer in part C). Show what your expected profits are at this new interest rate.

E) Use you answers to parts C) and D) to explain the problem of adverse selection in rural credit markets.

Reference no: EM13185973

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