Problem
A bank is subsidized by the government. For each $1,000 loan it extends, it receives a subsidy of $200. The bank's manager is considering extending a $1,000 loan to two potential borrowers. Borrower A promises to give the bank 50 percent of the profit she earns from investing the loan, while borrower B promises only 10 percent of her profit. However, A can generate a gross return of $1,200 with probability 0.8 or get zero with probability of 0.2, but B can generate a gross return of $1,100 with certainty.
a. Which of the two projects is more socially efficient and why?
b. Which of the potential borrowers will the manager choose to finance if he aims to maximize expected profits and why?
c. Compare your answers to questions (a) and (b) and briefl y explain what this simple numerical exercise reveals about government intervention in credit markets.