Consider a village money lender who lends to borrowers on a repeated basis and t

Question

Consider a village money lender who lends to borrowers on a repeated basis and the interest rate that she charges is fixed at 10%. The loans are informal and are not backed up by written contracts. The lender has no way to recover a loan if the borrower chooses to default. The lender, however, threatens to cut off credit in the future to any defaulting borrower. Borrowers use the loan in cultivation. Cultivation can be done using two techniques, both of which require an initial start-up capital of $200 (this would be the size of the loan needed). The first technique is risk free and generates a return of 20% while the second technique is new and riskier but generates a return of 50% if successful but nothing if it fails. There is a 60% probability of success using the second technique. A) From the borrower

Explanation / Answer

For the first technique, she has a 100% chance of getting a return of $40, while paying $20 in interest, making the expected return of the first technique $20.
For the second technique, she has a 60% chance of making a return of $100, and paying $20 in interest, for a return of $80, and a 40% chance of making nothing, defaulting on the loan, and paying no interest. So the expected return of the second technique is .6*$80 = $48

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