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Adverse selection, credit and efficiency: The case of the missing market

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Abstract

We analyze a standard environment of adverse selection in credit markets. In our environment, entrepreneurs who are privately informed about the quality of their projects need to borrow in order to invest. Conventional wisdom says that, in this class of economies, the competitive equilibrium is typically inefficient. We show that this conventional wisdom rests on one implicit assumption: entrepreneurs can only access monitored lending. If a new set of markets is added to provide entrepreneurs with additional funds, efficiency can be attained in equilibrium. An important characteristic of these additional markets is that lending in them must be unmonitored, in the sense that it does not condition total borrowing or investment by entrepreneurs. This makes it possible to attain efficiency by pooling all entrepreneurs in the new markets while separating them in the markets for monitored loans.

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  • Alberto Martin, 2010. "Adverse selection, credit and efficiency: The case of the missing market," Economics Working Papers 1257, Department of Economics and Business, Universitat Pompeu Fabra.
    • Handle: RePEc:upf:upfgen:1257
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    1. Boyd, John H & Smith, Bruce D, 1993. "The Equilibrium Allocation of Investment Capital in the Presence of Adverse Selection and Costly State Verification," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 3(3), pages 427-451, July.
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    9. Martin, Alberto, 2009. "A model of collateral, investment, and adverse selection," Journal of Economic Theory, Elsevier, vol. 144(4), pages 1572-1588, July.
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    Cited by:

    1. Anastasios Dosis, 2016. "Investment, Adverse Selection and Optimal Redistributive Taxation," Working Papers hal-01285163, HAL.
    2. David Nickerson, 2016. "Asset Price Volatility, Credit Rationing and Rational Lending Discrimination," International Journal of Economics and Finance, Canadian Center of Science and Education, vol. 8(10), pages 140-158, October.
    3. Dosis, Anastasios, 2019. "The effects of redistributive taxation in credit markets with adverse selection," Economics Letters, Elsevier, vol. 184(C).
    4. Dosis, Anastasios, 2016. "Investment, Adverse Selection and Optimal Redistributive Taxation," ESSEC Working Papers WP1605, ESSEC Research Center, ESSEC Business School.
    5. Anastasios Dosis, 2019. "Optimal Redistributive Taxation in Credit Markets with Adverse Selection," Working Papers hal-02130458, HAL.
    6. David Nickerson, 2022. "Credit Risk, Regulatory Costs and Lending Discrimination in Efficient Residential Mortgage Markets," JRFM, MDPI, vol. 15(5), pages 1-17, April.
    7. Gormley, Todd A., 2014. "Costly information, entry, and credit access," Journal of Economic Theory, Elsevier, vol. 154(C), pages 633-667.

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    More about this item

    Keywords

    Adverse Selection; Credit Markets; Collateral; Monitored Lending; Screening;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • D62 - Microeconomics - - Welfare Economics - - - Externalities

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