Part 1Would you be more willing to lend to a friend if she put all of her life savings into her business than you would if she had not done so? Part 2
A. You would be less willing because putting her life savings into a business that can potentially fail makes it more risky for you to loan her money. If the business fails, she will protect her investment before she considers repaying you B. You would be more willing because putting her life savings into her business provides you protection against the problem of moral hazard C. Whether or not she puts her life savings into her business has no bearing on whether she repays the loan or not. Therefore, it should have no effect on your decision to loan her money D. You would be more willing because putting her life savings into her business provides you protection against the problem of adverse selection

Question

Part 1Would you be more willing to lend to a friend if she put all of her life savings into her business than you would if she had not done​ so? Part 2
A. You would be less willing because putting her life savings into a business that can potentially fail makes it more risky for you to loan her money. If the business​ fails, she will protect her investment before she considers repaying you B. You would be more willing because putting her life savings into her business provides you protection against the problem of moral hazard C. Whether or not she puts her life savings into her business has no bearing on whether she repays the loan or not.​ Therefore, it should have no effect on your decision to loan her money D. You would be more willing because putting her life savings into her business provides you protection against the problem of adverse selection

BlackTom AI · Accepted Answer

Question restated: Part 1 asks about willingness to lend to a friend, Part 2 presents four options.
Option A: 'You would be less willing because putting her life savings into a business that can potentially fail makes it more risky for you to loan her money. If the business fails, she will protect her investment before she considers repaying you.' This answer suggests risk increases for the lender because the borrower has committed her own funds, implying she prioritizes her own investment over repaying the loan. However, this statement confuses borrower risk with lender incentives: the fact that the borrower has invested personal funds does not inherently reduce the risk that she will repay; in some cases it could even increase moral hazard if she diverts funds. But the stated justification is flawed because it frames repayment behavior as being deprioritized in favor of protecting her own investment, which is not a standard or reliable mechanism for reducing default risk. The logic also conflates personal risk awareness with moral hazard, which is misaligned with typical lending theory.

Option B: 'You would be more willing because putting her life savings into her business provides you protection against the problem of moral hazard.' This option aligns with the concept that when a borrower has skin in the game, they have more incentive to avoid default, because failure also jeopardizes their own capital. In the context of lending, moral hazard refers to the risk that the borrower may take on riskier behavior after obtaining the loan since they do not bear full consequences. By investing her own money, she bears some of the downside, which can align her incentives with repayment, thereby reducing moral hazard and making you more willing to lend. This matches standard principal-agent and moral hazard reasoning in finance and entrepreneurship.

Option C: 'Whether or not she puts her life savings into her business has no bearing on whether she repays the loan or not. Therefore, it should have no effect on your decision to loan her money.' This view ignores the key insight of moral hazard and the incentives created by personal stake. If she has sunk personal capital, her repayment behavior is plausibly affected. Dismissing this effect is an incorrect application of loan decision theory, because lenders typically weigh incentives and risk-bearing asymmetries when assessing default risk.

Option D: 'You would be more willing because putting her life savings into her business provides you protection against the problem of adverse selection.' Adverse selection concerns the quality of borrowers before the loan is issued, not the behavior after the loan is made. The borrower’s own capital infusion is more directly related to moral hazard (post-transaction behavior) than to adverse selection (pre-transaction information asymmetry). Therefore, invoking adverse selection as the protective mechanism here misattributes the appropriate theory and misleads about when such protection would apply.

Additional nuance to consider:
- Moral hazard arises when the borrower has less to lose personally as a result of default; requiring or encouraging skin in the game can counteract this by aligning incentives.
- Adverse selection is about the lender’s inability to distinguish high-risk from low-risk borrowers before issuing the loan, which is not directly addressed by the borrower investing life savings after the fact.
- The strongest argument among the options is the one that correctly identifies the mechanism at play (moral hazard) and explains how personal stake reduces lender concerns about that specific risk.

Summary of the incorrect options’ flaws:
- A misattributes the impact of personal investment to a heightened perceived risk for the lender, and its reasoning about repayment order is inconsistent with standard risk-based lending logic.
- C incorrectly claims no bearing of personal capital on repayment decisions, ignoring established theories of incentives and behavior post-borrowing.
- D wrongly attributes protection against adverse selection to the borrower’s personal funds infused after the loan decision, confusing post-transaction behavior with pre-transaction information asymmetries.

Overall, the correct reasoning identifies that the lender would be more willing to lend because the borrower’s life savings introduce a personal stake, mitigating moral hazard and aligning repayment incentives.

Homework:Chapter 8 Homework

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