Dynamic Adverse Selection and Debt
In many long-term relationships, parties may be reluctant to reveal their private information in order to benefit from their informational advantage in the future. We point out that the strategic use of debt by an uninformed party induces another party to reveal private information. Our argument, which is consistent with casual observation, is based on the idea that (renegotiable) debt is a credible commitment to end the long-term relationship if information is not revealed. We show that the strategic advantage of debt increases with good durability and we briefly address the financing decision of a regulated firm.
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