Moral Hazard in Credit Markets
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(g) with probability p(g). With probability 1-p(g), 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(b) with probability p(b). With probability 1-p(b), 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)p(b) and p(g)(1+r(g))>p(b)(1+r(b)).
The lender can’t distinguish between borrower types and so it charges all borrowers the same interest rate r(L). The lender lends an amount L and pays interest r(D)on funds acquired from depositors.
Q1. Which project would the lender prefer that the borrowers undertake?
Project B or Project G
Q2. Explain in words why your answer to the previous question is true.
Q3. Write down an expression for the profit that a borrower expects from Project G and submit an image file depicting your answer
Q4. Suppose r(g)=0.08, r(b)=0.10, p(g)=0.99, p(b)=0.3, r(D)=0.02, L=100. Find the value for r(L)* such that the borrower is indifferent between projects G and B. Round to three decimal places.
Q5. Either by hand or using a computer, graph the lender’s expected profit function E(π^L) for values of r(L) between 0.00 and 0.10. Make sure axes and r(L)* are clearly labeled.
Q6. Explain in words what is happening to the borrowers’ behavior at the discontinuity in the lender’s profit function that you graphed in the previous question.
Moral Hazard in Credit Markets
The borrower has two options on investing either in Project B or G. Project G pays the borrower a rate of return r(g) with a probability p(g) whole project B pays a rate of return of r(b) with a probability p(b). If the borrower does not get any return, then the project fails and the borrower is not able to repay back either the principal or the interest amount. In this case, the borrower will be indifferent in which project to undertake or invest.
The lender lends an amount of L and charges rl interest rate from the borrow. The lender has to pay an equivalent of rp on deposit. Therefore, the payoff to the lender when the borrower undertakes project G is derived as follows.
PLs.g = PsL + Ps.rl.L – L -Lrp
The payoff to the lender when the borrower undertakes project B is derived as follows:
PLs.b= PbL +Pb.rl.L – L-Lrp
As Pg>Pb the payoff to the lenders when Project G is undertaken is greater than the payoff when Project B is undertaken.
The profit to the borrower when project G is undertaken is derived as follows:
P(s.g) = L +PsL(rs) – PsL_ PsL(rl)
The profit to the borrower when project B is undertaken is derived below.
P(s.s) = L+Ps.L(rs) – PsL – PsL(rl)
When the borrower is indifferent between the project, the payoff from the two projects will be equivalent to: Ps.g = Ps.s
L +PsL(rs) – PsL_ PsL(rl) = L+Ps.L(rs) – PsL – PsL(rl)
100 + (0.3* 100*0.10) – (100*0.3) – (100*0.3*rl) = 100 +(0.99*100*0.08) – (100*0.99) – (100*0.99*rl)
1+0.03-0.3-0.3rl = 1+0.0792-0.99-0.99rl
0.73-0.3rl = 0.0892-0.99rl
0.6408 = -0.68rl
Answer rl = -0.984
The graph indicates that as better rates of return are offered, the borrower increase the amount until that point where he is indifferent between project B and G.
Consumers experience different forms of problem recognition. Explain each type of problem recognition and give an example of a purchase for each type
Types of Problem Recognition Experienced by Consumers
Consumers experience various types of problem recognition. Belch (2018) defines consumer problem as difference between a customer’s desired or preferred state of affairs and their exact state of affairs. Recognizing problems denotes that some perceptible degree of psychological or physical discomfort pushes consumers to embrace some action targeted at relieving such a discomfort (Belch, 2018). This paper explains the various forms of problem recognition experienced by customers by providing an example of a purchase for every problem recognition type. The types of problem recognition discussed in this paper are freshness, out-of-stock, fear of missing out, social competition, social information, marketing messages, new needs or wants changes, goals, related products or purchases, dissatisfaction, and end of life.
Freshness problem recognition involves the desire to keep pace with change (Belch, 2018). Examples of this form of problem recognition are enthusiasts of a category of product, who are often buying the newest item or service. When it comes to out-of-stock problem recognition, a consumer establishes a need to restock a product that he or she purchases regularly (Belch, 2018). An example of a natural depletion is when a consuming is running short of his or her favorite shampoo.
As a form of problem recognition, the fear of missing out occurs when a consumer embraces the notion that an event is occurring that she or he is about to miss (Belch, 2018). An example of such an event may be a big sale that triggers the buyer to identify novel purchases she or he would not have otherwise established. Other aspects that may trigger the missing out fear are trendy new products and shortages (Belch, 2018). On the other hand, social competition occurs when a consumer notices that all her or his neighbors have new solar panels on their house roof.
Social information problem recognition occurs when learning about a novel form of product or service from word of mouth (Belch, 2018). An example of a social information problem recognition is when a mobile user hears about a useful application that everyone is consuming or using. Marketing messages as a problem recognition occurs when a marketing message like a commercial influences a consumer (Belch, 2018). For instance, a buyer perceives a trailer for movie and chooses that she or he must see it.
New needs or wants changes are associated with consumers making changes to their situation or habits. For example, a child’s birth, shifting to a novel city, and commencing a new hobby may trigger lifestyle changes, which in turn may trigger a range of purchases. When it comes to the problem recognition of goals, a consumer may be seeking to advance things including diverse needs like home improvement, health, physical fitness, education, peak experiences, self-fulfillment, and self-improvement (Belch, 2018). For instance, a consumer who sets a goal to secure a workplace promotion may buy books on leadership. Related products or purchases problem recognition occurs when a consumer purchases something novel from a category of product from which they regularly buy. For instance, an avid reader may develop a need for novel or new books.
Dissatisfaction occurs when a consumer is displeased with a service or product and seeks to substitute it (Belch, 2018). For instance, a buyer may think his phone is no longer fashionable enough. In end of life, a product ages or breaks beyond its valuable lifespan (Belch, 2018). For instance, software that falls out of support may be categorized as an end of life problem recognition.
In conclusion, this paper has effectively discusses the various forms of problem recognition. The paper has also provided appropriate examples for every type of problem recognition identified.
Belch, G. (2018). Advertising and Promotion: An Integrated Marketing Communications Perspective. [VitalSource Bookshelf]. Retrieved from https://bookshelf.vitalsource.com/#/books/978125990026aced