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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 from banks. 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 borrow from banks. If an additional market is added to provide entrepreneurs with additional funds, efficiency can be attained in equilibrium. An important characteristic of this additional market is that it must be non-exclusive, in the sense that entrepreneurs must be able to simultaneously borrow from many different lenders operating in it. This makes it possible to attain efficiency by pooling all entrepreneurs in the new market while separating them in the market for bank loans.

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  • Alberto Martin, 2008. "Adverse selection, credit and efficiency: The case of the missing market," Economics Working Papers 1085, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 2009.
    • Handle: RePEc:upf:upfgen:1085
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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, 2019. "Optimal Redistributive Taxation in Credit Markets with Adverse Selection," Working Papers hal-02130458, HAL.
    2. Dosis, Anastasios, 2016. "Investment, Adverse Selection and Optimal Redistributive Taxation," ESSEC Working Papers WP1605, ESSEC Research Center, ESSEC Business School.
    3. David Nickerson, 2022. "Credit Risk, Regulatory Costs and Lending Discrimination in Efficient Residential Mortgage Markets," JRFM, MDPI, vol. 15(5), pages 1-17, April.
    4. 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.
    5. Anastasios Dosis, 2016. "Investment, Adverse Selection and Optimal Redistributive Taxation," Working Papers hal-01285163, HAL.
    6. Dosis, Anastasios, 2019. "The effects of redistributive taxation in credit markets with adverse selection," Economics Letters, Elsevier, vol. 184(C).
    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; 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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