A colleague tells you that he can get a business loan from the bank, but the rate seems very high for what your colleague considers a low-risk loan. Use the following table to classify each explanation for the high rate as an instance of either adverse selection or moral hazard. Explanation for High Rate The bank cannot determine which borrowers are likely to pay back the loan and which are likely to default. The bank believes your friend, if given access to financing at low rates, would use the money frivolously. Adverse Selection Your advice is more likely to solve the problem of Moral Hazard You advise your friend to sign a contract that restricts certain types of risky investments that he can undertake with the funds from the loan.

A colleague tells you that he can get a business loan from the bank, but the rate seems very high for what your colleague considers a low-risk loan. Use the following table to classify each explanation for the high rate as an instance of either adverse selection or moral hazard. Explanation for High Rate The bank cannot determine which borrowers are likely to pay back the loan and which are likely to default. The bank believes your friend, if given access to financing at low rates, would use the money frivolously. Adverse Selection Your advice is more likely to solve the problem of Moral Hazard You advise your friend to sign a contract that restricts certain types of risky investments that he can undertake with the funds from the loan.

Principles of Economics 2e

2nd Edition

ISBN:9781947172364

Author:Steven A. Greenlaw; David Shapiro

Publisher:Steven A. Greenlaw; David Shapiro

Chapter16: Information, Risk, And Insurance

Section: Chapter Questions

Problem 1SCQ: For each of the following purchases, say whether you would expect the dogma of imperfect information...

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