Introduction. The Backward Bending Supply of Credit

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1 Informational economics II: Credit Rationing December 6, 2003 Introduction Asymmetric information can explain equilibrium unemployment and equilibrium credit rationing Equilibrium credit rationing, which occurs whenever some borrower s demand for credit is turned down, even if this borrower is willing to pay all the price and non-price elements of the loan contract. The Backward Bending Supply of Credit A loan contract: the borrower is obliged to repay the lender a payment of R (principal

2 interest) In case the borrower defaults (or simply runs away) later, the lender cannot get back all of R. Hence, the expected rate of return: R. What happens if R is not monotonic? ρ, Expected Return for the Bank ρ(r) R, Nominal Rate of the Loan R R * Figure 1: Expected Return for the Bank as a Function of the Nominal Rate of the Loan Banking Sector

3 Assume the banking sector is competitive. S SR: supply of loans When the demand for loan is low, say L D 1, no credit rationing. When the demand for loan is high enough such as L D 2, the equilibrium is at rate R and there is equilibrium excess demand Volume of Credit Equilibrium Excess Demand L 2 D, High Demand for Loan ρ(r) L 1 D, Low Demand for Loans S(ρ(R)), Supply of Loan R 1 R * R, Nominal Rate of the Loan Figure 2: Equilibrium Credit Rationing

4 An Adverse Selection Model A continuum population of risk neutral borrowers, each with a project at hand, with zero wealth, and parameterized by (X, p) X the expected return of each project is the same and commonly known p is the borrower s private information, and follows a uniform distribution Each project costs one unit of money; its return is X/p with probability p (success) and zero with probability 1 p (failure). Hence the expected return is X p p 1 p 0 X. Risk neutral banks offer standard debt contracts: Repayment of R in case of success and zero o.w. A firm will apply for credit if and only if its expected gain X pr 0orp X/R.

5 R : The probability that a borrower will be able to repay When R X, all borrowers will succeed in getting a loan. Hence, R 0 1 pdp When R X, only borrowers with p X/R 1 will get a loan. Hence, R 0 X R pdp 1 2 The expected rate of return for each dollar loaned out is RR. R RR dr dr 1 2 X R R/2 when R X. X 2 when R X. 2R 0 when R X. X2 2R 2 0 when R X. hen we have a backward bending supply curve. 2

6 ECON6021: Externality December 6, 2003 Externalities (Chapter 17, Frank) Externality An externality (or spillover) is a cost or benefit arising from an economic activity that falls on people who do not participate in that activity. Disposal of chemical wastes in a river (negative production externality) Proving a mathematical theorem (positive production externality) Consumption of Liquor (negative consumption externality) Consumption of education (positive consumption externality)

7 How effective do the private resolve the problem of externalities Consider a doctor whose ability to examine patients is disrupted by the noise of machinery operated by a confectioner (candy maker) in an adjacent building. Historically, the economic and legal view is simple and clear: the confectioner s noise is harming the doctor and should be restrained. This view is challenged by Coase (1960), who points out the reciprocal nature of the problem. The confectioner s noise does harm the doctor. But if we prevent the noise, we harm the confectioner. Coase s viewpoint is that social planner should avoid the larger of these two unpleasant outcomes. The Coase Theorem Suppose the damage inflicted by the confectioner to the doctor is 40, while the gain the confectioner receives from operating the shop is 60. When bargaining cost is low, the same efficient outcome prevails (the confectioner will keep on operating). If confectioner is liable for his damage to the doctor, he will pay the doctor in order to harass him. If not, the confectioner will simply ignore the doctor and keep on operating. Coase theorem states that: When the parties affected by externalities can negotiate costlessly with one another, the efficient outcome results no matter how the law assigns liability for damages. (In the absence of transaction cost, ownership does not matter.)

8 Gain to the confectioner from operating w/o soundproofing: 60; soundproofing costs 20; loss to the doctor: 40; cost of negotiation: 25. net benefit legal regime confectioner liable not liable outcome confectioner installs soundproofing at his oown cost confectioner does not install soundproofing; doctor shuts down doctor confectioner total In the presence of negotiation costs, the efficient outcome (confectioner to install soundproofing) emerges only when he is made liable for noise damage. Is Coase theorem relevant? Why the Coase theorem may not work in practice? Sunk costs--the one who initiates the negotiation will have some cost sunk upfront. Transaction costs--costs of negotiating, writing and enforcing a contract. Multiple parties--the issue may involve a large number of people, and reaching an arrangement among such a large number of people is prohibitively difficult. Is there any continuity at zero? That is, can we conclude that when transaction cost is arbitrary small, ownership is irrelevant? (an open problem researchers are still working on it)

9 Some applications of the Coase theorem why smoking in public is prohibited but in private is not? why protecting freedom of speech when it could be wrongly used? For a developer to build a hotel in the airspace above my land, he must first secure my permission. But the law permits commercial airliners to fly over my land without payment whenever they choose. Why this distinction? Externality and Supply Curve Supply after taking external cost into consideration Supply based on private cost only External cost per unit of output =marginal external cost quantity

10 Negative Production Externality Leads to Overproduction Price, cost, and benefit (dollars/ton of Al) SC 0 P 1 P 0 C 1 0 Point of allocative efficiency Supply when externality is taken into account Pollution cost (External cost) Competitive equilibrium D Q 1 Q 0 Quantity (tons of Aluminum) Supply when externality is not taken into account Public Policy on Externalities Government has a wide range of measures to deal with negative production externalities (e.g. chemical waste) Complete prohibition Quantity Restriction Pollution tax (Pigou tax) Marketable Permits Improvement in Pollution Abatement Technology

11 Quantity Restriction vs Pigou Tax Suppose there are two firms A and B each releasing 600 tons of wastes into water each year. And the government wants to restrict to a total of 600 tons each year. It could restrict each firm to release up to 300 tons of waste a year. (quantity restriction) Taxes can be used to provide incentives for firms A and B to cut back on its production that creates external costs. For instance, levy a pollution tax of $20K/ton of waste. (Pigou tax) Quantity Restriction vs Pigou Tax Suppose both measures can achieve the 600 tons target. Then which is better? Most economists think that taxation is better than quantity restriction. Suppose the cost of abatement for firm A is $10K per ton and for firm B is $50K per ton. Then each reducing to 300 tons of wastes requires a total cost of $10K x $50K x 300 = $18M.

12 Quantity Restriction vs Pigou Tax Clearly, the least costly way is to let firm A do all the abatement. Total cost = $10K X 600 = $6M. To implement this outcome, the government can levy a pollution tax of $20K per ton. Then firm A will do all the abatement. Marketable Permits Besides Pigou tax, government can also issue marketable permits to all involving firms. e.g. Issue a permit to firm A and firm B, respectively, to allow each of them to release up to 300 tons of waste a year. Then firm B will buy a permit of 300 tons from firm A to release up to 600 tons of waste. Market Environmentalism!!! Issuing marketable permits requires the least information on the part of government about the industry. Currently used by the EU countries to control carbon dioxide release.

13 Part II Public Goods and Common Resources (Optional, not included in final exam; see Ch. 18 of Frank) Nonrivalry and Nonexcludability Non-rivalry A good is nonrival if the consumption by one person does not decrease the consumption by another Non-excludability A good is nonexcludable if it is impossible, or extremely costly, to prevent someone from benefiting from a good

14 Public Goods and Private Goods Yes Rival? No Pure private goods Club goods Excludable? No Yes Food Car House Common resources Fish in the ocean Cable television Bridge, Noncongested toll road Pure public goods Lighthouse Air Congested highway National defense Non-cong. highway Common Resource Fisheries--Many fisheries have common access such that anyone can fish and no one has a property right to a fish until it is caught. Many species have been driven to extinction. The catch of Atlantic cod fell from about 4 million tons in the mid-60s to about 1 million tons today due to overfishing. The tragedy of commons!

15 Case: Easter Island: tragedy of commons? Easter Island is a small Pacific island over 3,200 km from the coast of Chile, with a population of 2.1k. Viewed as a major archaeological and anthropological mystery. Easter Island Enormous statues, carved from volcanic stone. Many rested on large platforms at various locations on the island largest moveable statues weigh > 80 tons the largest yet unfinished weighs ~ 270 tons

16 Easter Island the culture seemed too poor to support a large artisan class the statues were moved substantial distances; the population too small to move the larger statues the island had no trees suitable for making tools such as levers, rollers, rope and wooden sleds Conclusion: rising wealth and rising population, followed by decline. Easter Island: Brander & Taylor (1998) To explain: the cyclical overshooting on Easter Island vs the monotonic behavior on the major Polynesian islands All else the same: no a priori reason to believe difference in demographics, tastes, or technology. The only variable: nature of resource. palm tree on Easter Island is a very slow-growing palm (40 to 60 years to yield fruit). It grows nowhere else in Polynesia, and probably the only palm that can live in Easter Island s relatively cool climate.

17 Easter Island: Brander & Taylor The two most common large palms in Polynesia are the Cocos (cononut palm) and the Pritchardia (Fuji fan palm). Neither of these palms can grow on Easter Island, and both are fast-growing trees that reach fruitgrowing age in approximately 7 to 10 years. Resource and population dynamics: slow regeneration Key parameter: resource growth rate: 0.04 Resource and population stock 0 12,000 population Resource stock Year (A.D.)

18 Resource and population dynamics: fast regeneration Key parameter: resource growth rate: 0.35 Resource and population stock 0 12,000 Resource stock population Year (A.D.)