Paper #196

Title:

Dynamic adverse selection and debt

Authors:

Gilles Chemla and Antoine Faure Grimaud

Date:

March 1996 (Revised: December 1996)

Abstract:

This paper argues that the strategic use of debt favours the revelation of information in dynamic adverse selection problems. Our argument is based on the idea that debt is a credible commitment to end long term relationships. Consequently, debt encourages a privately informed party to disclose its information at early stages of a relationship. We illustrate our point with the financing decision of a monopolist selling a good to a buyer whose valuation is private information. A high level of (renegotiable) debt, by increasing the scope for liquidation, may induce the high valuation buyer to buy early at a high price and thus increase the monopolist's expected payoff. By affecting the buyer's strategy, it may reduce the probability of excessive liquidation. We investigate the consequences of good durability and we examine the way debt may alleviate the ratchet effect.

Keywords:

Dynamic adverse selection, durable good, ratchet effect, renegotiation, financial constraint, debt

JEL codes:

D42, D82, G32, L14

Area of Research:

Finance and Accounting

Published in:

European Economic Review, Volume 45, Number 9, October 2001, pp. 1773-1792(20)

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