Paper #1257

Title:

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

Author:

Alberto Martin

Date:

December 2010

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.

Keywords:

Adverse Selection, Credit Markets, Collateral, Monitored Lending, Screening

JEL codes:

D82, G20, D62

Area of Research:

Macroeconomics and International Economics

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