In a standard intertemporal choice model, an individual has no wealth today but is guaranteed a large income in the future. If we introduce the real-world constraint that lenders often require collateral (initial wealth) to issue a loan, which component of the individual's decision-making model is most directly and immediately restricted?
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Ch.9 Lenders and borrowers and differences in wealth - The Economy 2.0 Microeconomics @ CORE Econ
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Model Prediction vs. Real-World Borrowing
A basic economic model predicts that a rational individual with high expected future earnings but no current savings will choose to borrow a large sum for a valuable investment today. However, in practice, this individual is often unable to secure the loan. What is the most likely reason for this discrepancy between the model's prediction and the real-world outcome?
The assumption that individuals can borrow without initial wealth makes basic lending models entirely useless for understanding any real-world borrowing behavior.
Evaluating a Core Assumption in Borrowing Models
The Rationale for Simplifying Assumptions in Economic Models
In a standard intertemporal choice model, an individual has no wealth today but is guaranteed a large income in the future. If we introduce the real-world constraint that lenders often require collateral (initial wealth) to issue a loan, which component of the individual's decision-making model is most directly and immediately restricted?
Critiquing a Simple Lending Model
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The assumption that individuals can borrow without initial wealth makes basic lending models entirely useless for understanding any real-world borrowing behavior.