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Adverse Selection and Risk Aversion in Capital Markets


  • Luis H. B. Braido
  • Carlos E. da Costa
  • Bev Dahlby


We generalize Boadway and Keen's model of adverse selection in capital markets to allow for risk aversion on the part of entrepreneurs. We use the new model to analyze two types of policies. We first consider policies that would allow entrepreneurs to use a greater fraction of their total wealth in financing their projects, thus allowing them to reduce reliance on debt or equity finance by outside investors. We show that such policies may not be welfare-improving, because they expose entrepreneurs to more downside risk. This result highlights the importance of allowing for risk aversion, since policies that aim at alleviating inefficiencies associated with adverse selection may increase risk exposure and ultimately reduce welfare. We then consider how the tax treatment of losses affects social welfare. We show that if a society places a high value on distributional equity or if entrepreneurs are sufficiently risk-averse, a full-loss-offset system may be desirable even when there is excessive investment.

Suggested Citation

  • Luis H. B. Braido & Carlos E. da Costa & Bev Dahlby, 2011. "Adverse Selection and Risk Aversion in Capital Markets," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, vol. 67(4), pages 303-326, December.
  • Handle: RePEc:mhr:finarc:urn:sici:0015-2218(291112)67:4_303:asarai_2.0.tx_2-h
    DOI: 10.1628/001522108X614141

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    References listed on IDEAS

    1. Esteban Jaimovich, 2010. "Adverse Selection and Entrepreneurship in a Model of Development," Scandinavian Journal of Economics, Wiley Blackwell, vol. 112(1), pages 77-100, March.
    2. Clemens Fuest & Bernd Huber & Philipp Tillessen, 2003. "Tax Policy and Entrepreneurship in the Presence of Asymmetric Information in Capital Markets," CESifo Working Paper Series 872, CESifo Group Munich.
    3. Robin Boadway & Michael Keen, 2006. "Financing and Taxing New Firms under Asymmetric Information," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, vol. 62(4), pages 471-502, December.
    4. Galina Vereshchagina & Hugo A. Hopenhayn, 2009. "Risk Taking by Entrepreneurs," American Economic Review, American Economic Association, vol. 99(5), pages 1808-1830, December.
    5. Evsey D. Domar & Richard A. Musgrave, 1944. "Proportional Income Taxation and Risk-Taking," The Quarterly Journal of Economics, Oxford University Press, vol. 58(3), pages 388-422.
    6. David de Meza & David C. Webb, 1987. "Too Much Investment: A Problem of Asymmetric Information," The Quarterly Journal of Economics, Oxford University Press, vol. 102(2), pages 281-292.
    7. Fuest, Clemens & Tillessen, Philipp, 2005. "Why do governments use closed ended subsidies to support entrepreneurial investment?," Economics Letters, Elsevier, vol. 89(1), pages 24-30, October.
    8. R. Glenn Hubbard & William M. Gentry, 2000. "Tax Policy and Entrepreneurial Entry," American Economic Review, American Economic Association, vol. 90(2), pages 283-287, May.
    9. Hellmann, Thomas & Stiglitz, Joseph, 2000. "Credit and equity rationing in markets with adverse selection," European Economic Review, Elsevier, vol. 44(2), pages 281-304, February.
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    Cited by:

    1. Mark Parsons, 2011. "Rewarding Innovation: Improving Federal Tax Support for Business R&D in Canada," C.D. Howe Institute Commentary, C.D. Howe Institute, issue 334, September.

    More about this item


    adverse selection; debt; equity; tax policy;

    JEL classification:

    • H20 - Public Economics - - Taxation, Subsidies, and Revenue - - - General
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading


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