Economics of Uncertainty

In all endeavours in life there exist some measure of Uncertainty, and a major determinant to this is lying and cheating. Where, even in the event of truth the mere fear of dishonesty and breach of promise can also do damage. However, key to uncertainty is the understanding of the role of information. Reference to Molho, in an understanding of this role (Information), he produces an Information dichotomy of Public and Private Information.

Public Information termed to be information that is known to everyone. Private Information on the other hand relates to information on some given facts that is “Privately observed” by those who have access to it and “Unobservable” to those who do not. The role of Private information is central to the understanding of lying and its presence creates an “Information Asymmetry” which invariably leads to a hidden action (Moral hazard). The Credit Market and its Equilibrium

The Credit market is termed to be a market that equilibrates the surplus and deficit economic units of funds, through the provision of either Loan or Equity finance. From the chart above the equilibrium in the loan market are said to be at points A and B. Note however, this equilibrium exist under the assumption that there is public information (Where the banks can observe the project which an entrepreneur invests). From this equilibrium the entrepreneurs will earn $13. 4 and $10 in projects 1 and 2 respectively

Consequently, based on the market assumption “that banks are not able to observe the project entrepreneurs invest in” gives room for information asymmetry and moral hazard then ensues. Where entrepreneurs obtain loans at a quoted rate of 30% and preferably invest not in type 1 projects but in type 2 projects because it yields an expected profit of $15 to entrepreneurs and an effective rate of interest of 15% to the banks. This increase in expected returns is at the expense of the bank that earns an effective rate or return of 15% if it charges a quoted rate of 30% for a type 2 project.

This loss to the bank will cause banks to charge the higher interest rate of 40% since It knows that this will induce the entrepreneurs to carry out their type 2 projects and enable it pay depositors the required rate of 20%. Thus driving equilibrium to point B only. The problem with this equilibrium is that type 2 projects yield a lower expected return of $10 than type 1. On the whole entrepreneurs loose because of information asymmetry in the credit (loan) finance market. The Equity option Loan finance in the face of hidden action causes adverse selection through higher interest rates.

The equity finance option gives percentage stake in the profits to entrepreneurs, consequently inducing him to invest in projects that yield the highest profits. From the chart above the equilibrium in the loan market are said to be at points A and B. Note however, this equilibrium exist under the assumption that there is public information (Where the banks can observe the project which an entrepreneur invests). From this equilibrium the entrepreneurs will earn $13. 4 and $10 in projects 1 and 2 respectively

Consequently, based on the market assumption “that banks are not able to observe the project entrepreneurs invest in” gives room for information asymmetry and moral hazard then ensues. Where entrepreneurs obtain loans at a quoted rate of 30% and preferably invest not in type 1 projects but in type 2 projects because it yields an expected profit of $15 to entrepreneurs and an effective rate of interest of 15% to the banks. This increase in expected returns is at the expense of the bank that earns an effective rate or return of 15% if it charges a quoted rate of 30% for a type 2 project.

This loss to the bank will cause banks to charge the higher interest rate of 40% since It knows that this will induce the entrepreneurs to carry out their type 2 projects and enable it pay depositors the required rate of 20%. Thus driving equilibrium to point B only. The problem with this equilibrium is that type 2 projects yield a lower expected return of $10 than type 1. On the whole entrepreneurs loose because of information asymmetry in the credit (loan) finance market. The Equity option Loan finance in the face of hidden action causes adverse selection through higher interest rates.

The equity finance option gives percentage stake in the profits to entrepreneurs, consequently inducing him to invest in projects that yield the highest profits. From the chart above the equilibrium in the loan market are said to be at points A and B. Note however, this equilibrium exist under the assumption that there is public information (Where the banks can observe the project which an entrepreneur invests). From this equilibrium the entrepreneurs will earn $13. 4 and $10 in projects 1 and 2 respectively

Consequently, based on the market assumption “that banks are not able to observe the project entrepreneurs invest in” gives room for information asymmetry and moral hazard then ensues. Where entrepreneurs obtain loans at a quoted rate of 30% and preferably invest not in type 1 projects but in type 2 projects because it yields an expected profit of $15 to entrepreneurs and an effective rate of interest of 15% to the banks. This increase in expected returns is at the expense of the bank that earns an effective rate or return of 15% if it charges a quoted rate of 30% for a type 2 project.

This loss to the bank will cause banks to charge the higher interest rate of 40% since It knows that this will induce the entrepreneurs to carry out their type 2 projects and enable it pay depositors the required rate of 20%. Thus driving equilibrium to point B only. The problem with this equilibrium is that type 2 projects yield a lower expected return of $10 than type 1. On the whole entrepreneurs loose because of information asymmetry in the credit (loan) finance market. The Equity option Loan finance in the face of hidden action causes adverse selection through higher interest rates.

The equity finance option gives percentage stake in the profits to entrepreneurs, consequently inducing him to invest in projects that yield the highest profits. Banks make an effective rate of 20% from equity finance to project 1 therefore they will be willing to trade while entrepreneurs also gain a higher return (13. 3) on project 1 as opposed to loan financing project 2 (10), while eliminating the hidden action dilemma. Basically, the equity option allows Pareto improvement as entrepreneurs gain and banks remain just as well off.

Conclusion Hidden action in debt finance brews adverse selection that ultimately deters Pareto optimality, however equity finance provides an incentive that in entirety breeds Pareto efficiency. This improvement could in some situations breed market collapse especially in projects with unequal project cost.

BIBLOGRAPHY

1. Molho, Ian, “The economics of information: Lying and cheating in markets and Organisations, Oxford Blackwell 1997. 2. Hillier Brian, “The Economics of Asymmetric Information” Chapter 3 and 4, 1997.