A lender has to decide whether to extend a $100 loan in exchange for a promise by the borrower to repay the loan and 10 percent simple interest in one year. The borrower plans to invest the proceeds of the loan with a certain 11 percent rate of return. The lender believes there is a 95 percent chance that the loan will be repaid. If the lender moves first, the subgame perfect equilibrium for this game is:
A) {Lend 6 Repay}.
B) {Lend 6 Default}.
C) {Not lend}.
D) This is a dynamic game with incomplete information and does not have a unique subgame perfect equilibrium.

Question

Quizplus · Accepted Answer

In a subgame perfect equilibrium, the lender would choose to lend because the expected return (95% chance of receiving $110 on a $100 loan) exceeds the cost, and the borrower, having invested at an 11% return, would have enough to repay the loan with interest, making {Lend, Repay} the equilibrium.

A Lender Has to Decide Whether to Extend a $100