When to seek expert advice? A simple model of borrowers with limited liability

Abstract

We model the situation where a borrower can choose to acquire costly information about the outcome before implementing a risky project. The borrower is resource-constrained and faces a trade-off between incurring the cost of information or putting effort into the project. We provide novel insights about the type of project the borrower chooses and identify the conditions under which the borrower acquires information. We characterize the optimality conditions for the interest rate charged by a socially-motivated as well as a profit-motivated lender. We find that if the interest rate is high, the borrower is likely to choose riskier projects and acquire information about the outcome. If capital is moderately expensive for the lender, even the socially-motivated lender charges a higher interest and makes a positive profit. This provides an alternate explanation for the prevalence of high-interest rates in the rural credit market, despite the presence of socially-motivated lenders.