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Adverse Selection, Credit, and Efficiency: the Case of the Missing Market

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Author Info
Alberto Martin ()

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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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Publisher Info
Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 1085.

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Date of creation: Apr 2008
Date of revision: Sep 2009
Handle: RePEc:upf:upfgen:1085

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Web page: http://www.econ.upf.edu/

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Related research
Keywords: Adverse Selection; Credit Markets; Collateral; Screening;

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Find related papers by JEL classification:
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
G20 - Financial Economics - - Financial Institutions and Services - - - General
D62 - Microeconomics - - Welfare Economics - - - Externalities

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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, vol. 3(3), pages 427-51, July.
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  2. Alberto Martin, 2007. "On Rothschild–Stiglitz as Competitive Pooling," Economic Theory, Springer, vol. 31(2), pages 371-386, May. [Downloadable!] (restricted)
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  3. Pradeep Dubey & John Geanakoplos, 2001. "Competitive Pooling: Rothschild-Stiglitz Reconsidered," Cowles Foundation Discussion Papers 1346R2, Cowles Foundation, Yale University, revised Feb 2002. [Downloadable!]
  4. Gale, Douglas, 1992. "A Walrasian Theory of Markets with Adverse Selection," Review of Economic Studies, Blackwell Publishing, vol. 59(2), pages 229-55, April. [Downloadable!] (restricted)
  5. Hellwig, Martin, 1987. "Some recent developments in the theory of competition in markets with adverse selection ," European Economic Review, Elsevier, vol. 31(1-2), pages 319-325. [Downloadable!] (restricted)
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  6. 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, vol. 90(4), pages 630-49, November.
  7. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June. [Downloadable!] (restricted)
  8. Pradeep Dubey & John Geanakoplos, 2002. "Competitive Pooling: Rothschild-Stiglitz Reconsidered," The Quarterly Journal of Economics, MIT Press, vol. 117(4), pages 1529-1570, November. [Downloadable!] (restricted)
  9. Alberto Bisin & Piero Gottardi, 2006. "Efficient Competitive Equilibria with Adverse Selection," Journal of Political Economy, University of Chicago Press, vol. 114(3), pages 485-516, June. [Downloadable!] (restricted)
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  10. Besanko, David & Thakor, Anjan V., 1987. "Competitive equilibrium in the credit market under asymmetric information," Journal of Economic Theory, Elsevier, vol. 42(1), pages 167-182, June. [Downloadable!] (restricted)
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  11. Bester, Helmut, 1985. "Screening vs. Rationing in Credit Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 75(4), pages 850-55, September. [Downloadable!] (restricted)
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