lec11_with_answers - Econ 138 Financial and Behavioral...

Info icon This preview shows pages 1–8. Sign up to view the full content.

View Full Document Right Arrow Icon
Econ 138 Financial and Behavioral Economics Lecture 11: Diversi fi cation and Micro fi nance Ulrike Malmendier UC Berkeley Th, February 28, 2008
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Organization Lunches! Felipe and others remarked that many of you have class right after this one. Wed? (alternating) Midterm: Many impressive exams! Remember graded on a curve ... As long as you got Q1 AND part (a)-(g) of Q2, you are on track. If you were struggling with the fi rst 16 points ... red fl ag! Typically, this seemed to indicate some di culty with the basics (set up of the problem, general idea, ...). Come and talk to me!
Image of page 2
1 Diversi fi cation We have studied how debt capacity may be limited due to Moral Hazard. Diversi fi cation : Might it help if the manager has more than one invest- ment project? Intuition : Since manager is risk neutral, compensate only when both projects succeed. Lenders lose less money in the case of failure, and man- ager will want to work hard on both projects if paid enough: R m, 2 > 0 , R m, 1 = R m, 0 = 0 . Formally, we show (only) that there always exists one optimal incentive scheme with R m, 2 > 0 , R m, 1 = R m, 0 = 0 :
Image of page 3

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Given the above contract, when does the manager work? Works hard: p 2 H R m, 2 . Shirks: p 2 L R m, 2 + 2 B . Hence, manager works hard on both projects rather than shirking (con- straint 1, or ‘IC1’) on both if and only if: p 2 H R m, 2 p 2 L R m, 2 + 2 B ⇐⇒ ( p H + p L ) R m, 2 2 B p The manager works hard on both projects rather than shirking on one (constraint 2, or ‘IC2’) i ff p H R m, 2 p B
Image of page 4
(by shirking on one project, the manager reduces the probability of full success by p H , i.e. the probability that that project succeeds, times p , i.e. the reduction in the second project’s probability of success.) IC2 says: loss from shriking on 1 outweighs gain ( B ). Since p H > 1 2 ( p H + p L ) , the IC2 is automatically satis fi ed: ( p H + p L ) R m, 2 2 B p ⇐⇒ 1 2 ( p H + p L ) R m, 2 p B Hence the lowest R m, 2 = 2 B p ( p H + p L ) . Makes intuitive sense: the larger the bene fi ts of shirking or the smaller the di ff erence in probability the larger the reward needs to be to induce hard work.
Image of page 5

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Back to the big question: How does this compare to the baseline case? Can we fi nance the projects more often or less often? We derived R m, 2 = 2 B p ( p H + p L ) , and hence the expected payo ff of the manager (if working hard) is p 2 H R m, 2 = p 2 H 2 B p ( p H + p L ) . To simplify the notation, denote d = p L p L + p H , i.e., 1 d = p H p L + p H . Hence, the expected payo ff of the manager is 2 p H (1 d ) B p . Thus, both projects are funded if: 2 p H ( R (1 d ) B p ) 2 I 2 C . The right hand side is what investors are putting up, while the left hand side is the total expected return when the manager works hard, minus the expected payment to the manager.
Image of page 6
Simpli fi es to p H [ R (1 d ) B p ] I C .
Image of page 7

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 8
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern