I am so confused because I cannot set up the monopolist's profit maximization problem.What I did is the following one:

Picture 2

Any help will be appreciated. Thank you.


After obtaining the loan, entrepreneur has two possible strategies to choose from :

  • Strategy $a$ : Expected payoff from strategy $a$ is $\frac{3}{4} (12000-R)$
  • Strategy $b$ : Expected payoff from strategy $b$ is $\frac{1}{4} (16000-R)$

He'll choose strategy $a$ if $\frac{3}{4} (12000-R) \geq \frac{1}{4} (16000-R)$, and strategy $b$ if $\frac{3}{4} (12000-R) < \frac{1}{4} (16000-R)$. Or simply, he'll choose strategy $a$ if $R \leq 10000$, and strategy $b$ if $10000 < R \leq 16000$.

Bank will maximize it's expected profits by choosing $R$ taking as given the entrepreneur's strategy. Therefore, Bank's expected profits equal $\frac{3}{4}R - 1000$ if it chooses $R \leq 10000$, and $\frac{1}{4}R - 1000$ if it chooses $10000 < R \leq 16000$. Clearly, expected profits of the bank are maximum at $R^*=10000$. Observe that entrepreneur is willing to pay more for the loan than $R^*=10000$ since his expected payoff is $\frac{3}{4}(12000 -10000) = 1500 > 0$, but the bank will not charge more than 10000 because that would change the entrepreneur's choice of strategy to $b$ which is a more risky choice and yields lower expected returns to the bank.

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  • $\begingroup$ Dear Amit, honestly I do not know how to thank you. Ι am so grateful that you help me. I also post this question with Bertrand subgame perfect equilibrium. If you have time and if you can, it would be helpful to have a look.Thank you thank you in advance.economics.stackexchange.com/questions/22415/… $\endgroup$ – Stefanos Makridis Jun 12 '18 at 2:36

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