Question

How can the adverse selection problem explain why you are more likely to make a loan to a family member than to a stranger?

Short answer

The trust factor is the only variable that makes people to give loan to family rather than a stranger.

Step-by-step solution

Step 1. Introduction

Adeverse selection problem refers to the situation where the lack of proper information causes an economic agent to make a decision that otherwise would not have been made with perfect information.

Step 2. Explanation

In any financial transactions, both parties may not have equal level of information. This may lead to one party making a decision which is otherwise not considered rational. When makign a loan to a family member, the lender is more likely to be aware of their ability to pay back. This is not the case with a stranger. So, any lender is more likely to give out a loan to a family member.