Tuesday, September 4, 2012

Should your lend money to your best friend?

Good morning all. Yesterday, I took a peek at the most popular keyword search results in Google and noticed that the question of lending money to one's best friend was coming up regularly. It seems that people are torn between the rational thing to do, namely, holding onto their money in times of crisis, and lending some of that money to their best friend. I will attempt to provide a solution using two games from Game Theory Economics.

There are two popular games that are played between two players in economics. The Dictator game and the Ultimatum game. In the Dictator game one player is labeled as the dictator and the other player as the receiver. The dictator is given some amount of money (let's say 10 Euros) and is asked to give any amount of that money to the receiver. The receiver has no ability to accept or reject the dictator's offer. He can only accept. Economic Theory, labeled as the "Nash equilibrium" predicts that the dictator will keep the money and make an offer of 0 to the receiver who is unable to influence the offer. This is the optimum behavior for the dictator to maximize enjoyment (keeping all the money). However, in real experiments we notice that dictators usually allocate some positive amount to the receiver. They are in other words altruistic.
When a friend asks to borrow money, this is exactly the game that is played. All of the power lies in the lender and the borrower does not have the option of rejecting a money offer. I realize that this does not answer the question of whether to lend money to your best friend or not. You should wonder though, what would your friend do if YOU had the need for a loan.

Examining the Ultimatum game could shed some light to answering this question. The Ultimatum game is very similar to the Dictator game, however, the receiver is now given the option of rejecting an offer from the person that makes the offer. If the receiver rejects, the game states that no money is given to neither the offeree or the receiver. Theoretically the receiver should accept any positive amount, and indeed the Nash equilibrium is a 9:1 split between the offeree and the receiver. However, in real life receivers tend to reject any offers below 20%. That is, they prefer to punish themselves and the offerees for not making a more fair split.

Back to our question. Should you lend money to your best friend? From the Ultimatum game we can see that if your friend had some power in the transaction, he/she would most probably punish you in some way. The answer is clear. If you have plenty of money lying around, you could entertain the idea of lending some small amount to your friend. If you are searching for an answer on the internet, then you are most probably NOT in a position to provide the loan. Politely reject the proposal and provide other alternatives to your friend, like applying for a loan from a financial institution. And explain that you are in no financial position to grant them their favor.

Always remember that a true friendship is not one based on financial rewards. Have a nice day!

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