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Dynamic adverse selection and debt

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  • Gilles Chemla
  • Antoine Faure Grimaud

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.

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Bibliographic Info

Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 196.

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Date of creation: Mar 1996
Date of revision: Dec 1996
Handle: RePEc:upf:upfgen:196

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

Related research

Keywords: Dynamic adverse selection; durable good; ratchet effect; renegotiation; financial constraint; debt;

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Cited by:
  1. Chemla, Gilles, 2004. "Takeovers and the dynamics of information flows," Economics Papers from University Paris Dauphine 123456789/6359, Paris Dauphine University.

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