AdverseSelectionProblem

AdverseSelectionProblem - Economics 423 Josef Perktold...

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Economics 423 Josef Perktold Project Financing, Adverse Selection and Self-Selection K that can either give a high positive return of R; so that next period the wealth is (1+ R ) K; zero. The high return occurs with probability (the loss occurs with probability 1 ). Project di/er in their success probability, a fraction ± 1 = 1 = 2 has the low success probability 1 = 0 : 4 , and a fraction ± 2 = 1 = 2 has the highest success probability 3 = 0 : 8 : zero. Entrepreneurs can invest their own money. The cost of raising funds is given by the rate c B ; the total cost of raising an amount of K Dollars is (1 + c B ) K: Entrepreneurs can also borrow from a competitive banking industry. The cost of raising funds by banks is given by the rate c L ; the total cost of raising an amount of K Dollars is (1+ c L ) K: The 1 = 0 : 4 2 = 0 : 8 R = 3 ; c B = 0 : 4 ; c L = 0 : 2 ; K = 1 ± 1 = ± 2 = 1 = 2 ( Remark: This numbers have been chosen so that the calculations are easy. Do not be surprised if the interest rates are large.) a) Suppose entrepreneurs do not have access to borrowing and have to raise their capital inter- Answer:
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This document was uploaded on 10/28/2011 for the course ECON 423 at UNC.

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AdverseSelectionProblem - Economics 423 Josef Perktold...

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