Problem 3.1 Consider the moral hazard problem of section 3.4.

(a)

(b)

If the funds for type 1 projects were provided via a credit market, what rate of interest would need to be charged to entrepreneurs under a standard debt contract if the suppliers of funds are to receive an expected rate of return of 8 per cent?

Assume that the act of investment can be observed, but that the lenders cannot tell in which project the entrepreneur invests, and that if he invests in the type 2 project he is able to keep the saving on investment costs.

Would an entrepreneur who borrowed funds of 100 under the debt contract calculated in part

(a) above choose to invest in his type I or his type 2 project? Would a punishment policy induce the entrepreneur to invest in his type 1 project? Explain your answer by showing how the punishment policy affects the incentive compatibility constraint.