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

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  • Alberto Martin

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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Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 526.

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Date of creation: Dec 2010
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Handle: RePEc:bge:wpaper:526

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Keywords: Adverse Selection; Credit Markets; Collateral; Monitored Lending; Screening;

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  1. Adriano Rampini & Alberto Bisin, 2005. "Markets as Beneficial Constraints on the Government," 2005 Meeting Papers, Society for Economic Dynamics 325, Society for Economic Dynamics.
  2. Alberto Martin, 2009. "A model of collateral, investment and adverse selection," Economics Working Papers, Department of Economics and Business, Universitat Pompeu Fabra 1136, Department of Economics and Business, Universitat Pompeu Fabra.
  3. Alberto Martin, 2003. "On Rothschild-Stiglitz as competitive pooling," Economics Working Papers, Department of Economics and Business, Universitat Pompeu Fabra 917, Department of Economics and Business, Universitat Pompeu Fabra, revised Jan 2006.
  4. Pradeep Dubey & John Geanakoplos, 2001. "Competitive Pooling: Rothschild-Stiglitz Reconsidered," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1346R2, Cowles Foundation for Research in Economics, Yale University, revised Feb 2002.
  5. Robert Shimer & Randall Wright & Veronica Guerrieri, 2009. "Adverse Selection in Competitive Search Equilibrium," 2009 Meeting Papers, Society for Economic Dynamics 139, Society for Economic Dynamics.
  6. Alberto Bisin & Piero Gottardi, 2006. "Efficient Competitive Equilibria with Adverse Selection," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 114(3), pages 485-516, June.
  7. Besanko, David & Thakor, Anjan V., 1987. "Competitive equilibrium in the credit market under asymmetric information," Journal of Economic Theory, Elsevier, Elsevier, vol. 42(1), pages 167-182, June.
  8. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, American Economic Association, vol. 71(3), pages 393-410, June.
  9. Rothschild, Michael & Stiglitz, Joseph E, 1976. "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 90(4), pages 630-49, November.
  10. Bester, Helmut, 1985. "Screening vs. Rationing in Credit Markets with Imperfect Information," American Economic Review, American Economic Association, American Economic Association, vol. 75(4), pages 850-55, September.
  11. Gale, Douglas, 1992. "A Walrasian Theory of Markets with Adverse Selection," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 59(2), pages 229-55, April.
  12. Pradeep Dubey & John Geanakoplos, 2002. "Competitive Pooling: Rothschild-Stiglitz Reconsidered," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 117(4), pages 1529-1570, November.
  13. Hellwig, Martin, 1987. "Some recent developments in the theory of competition in markets with adverse selection ," European Economic Review, Elsevier, Elsevier, vol. 31(1-2), pages 319-325.
  14. 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, Springer, vol. 3(3), pages 427-51, July.
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