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Costly state verification and truthtelling: a note on the theory of debt contracts

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Listed:
  • Josef Schosser

    (University of Passau)

  • Jochen Wilhelm

    (University of Passau)

Abstract

When firms want to raise external financing, why do they resort to contracts with fixed repayment, i.e., standard debt contracts? The canonical work of Gale and Hellwig (Rev Econ Stud, 52(4):647–663, 1985) gives the following answer to this question: Assuming that only the entrepreneur can observe the project’s outcome free of charge, the standard debt contract proves to be an incentive-compatible financing design. However, this approach remains inadequate, as neither the lender nor the borrower is given the possibility to act strategically. The paper at hand takes up this aspect. By means of a simple game-theoretic model and focusing on a binary outcome setting, it is shown that every risky standard debt contract is dominated by at least one ownership contract. In this respect, costly state verification cannot act as a raison d’être of contracts with fixed repayment.

Suggested Citation

  • Josef Schosser & Jochen Wilhelm, 2018. "Costly state verification and truthtelling: a note on the theory of debt contracts," Economic Theory Bulletin, Springer;Society for the Advancement of Economic Theory (SAET), vol. 6(2), pages 129-139, October.
    • Handle: RePEc:spr:etbull:v:6:y:2018:i:2:d:10.1007_s40505-018-0137-8
    DOI: 10.1007/s40505-018-0137-8
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    References listed on IDEAS

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    More about this item

    Keywords

    Costly state verification; Financing contracts; Incentive compatibility; Perfect Bayesian Nash equilibrium;
    All these keywords.

    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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