Competition, Non-linear Pricing and Rationing in Credit Markets

Abstract

The empirical observation made by most students of credit markets is that rationing is being practiced in those markets. The early developers of the theory of imperfect competition, including Joan Robinson, viewed this as a reflection of monopolistic forces in the credit markets. Research over the past two decades has been suggesting that the credit market possesses some unique features which differentiate it from other markets and this perspective has altered our view of it. Two lines of research have been developed. One observed that lending institutions necessarily need to take the risk of default by their borrowers, and for this reason the interest rate charged by them depends upon the characteristics of the borrower and the amount borrowed. Thus, an upward-sloping interest rate schedule is nothing but a reflection of the ever-present risk of default rather than the imperfection of the credit markets (see Freimer and Gordon, 1965; Stigler, 1967; Stiglitz, 1970; Jaffee, 1971; Baltensperger, 1976; Kurz, 1976; Keeton, 1979; and others). A second line of research focused on the problems generated by the presence of asymmetric information in this market, resulting in either adverse selection of borrowers or in the existence of an incentive for borrowers to take greater risk of default than desired by the lenders (see Jaffee and Russell, 1976; Stiglitz and Weiss, 1981; Hammond, 1986).