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Dynamic adverse selection and debt

  • Gilles Chemla
  • Antoine Faure Grimaud

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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File URL: http://www.econ.upf.edu/docs/papers/downloads/196.pdf
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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
Contact details of provider: Web page: http://www.econ.upf.edu/

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  1. Mathias Dewatripont, 1988. "Commitment through Renegotiation-Proof Contracts with Third Parties," ULB Institutional Repository 2013/175990, ULB -- Universite Libre de Bruxelles.
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  4. Coase, Ronald H, 1972. "Durability and Monopoly," Journal of Law and Economics, University of Chicago Press, vol. 15(1), pages 143-49, April.
  5. Titman, Sheridan, 1984. "The effect of capital structure on a firm's liquidation decision," Journal of Financial Economics, Elsevier, vol. 13(1), pages 137-151, March.
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  8. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  9. Harris, Milton & Raviv, Artur, 1990. " Capital Structure and the Informational Role of Debt," Journal of Finance, American Finance Association, vol. 45(2), pages 321-49, June.
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  13. Freixas, Xavier & Guesnerie, Roger & Tirole, Jean, 1985. "Planning under Incomplete Information and the Ratchet Effect," Review of Economic Studies, Wiley Blackwell, vol. 52(2), pages 173-91, April.
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  15. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  16. Perotti, Enrico C & Spier, Kathryn E, 1993. "Capital Structure as a Bargaining Tool: The Role of Leverage in Contract Renegotiation," American Economic Review, American Economic Association, vol. 83(5), pages 1131-41, December.
  17. Oliver Hart & John Moore, 1997. "Default and Renegotiation: A Dynamic Model of Debt," STICERD - Theoretical Economics Paper Series /1997/321, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  18. Hart, Oliver D & Tirole, Jean, 1988. "Contract Renegotiation and Coasian Dynamics," Review of Economic Studies, Wiley Blackwell, vol. 55(4), pages 509-40, October.
  19. Patrick Bolton & David S Scharfstein, 1993. "Optimal Debt Structure with Multiple Creditors," CEPR Financial Markets Paper 0032, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ..
  20. Bolton, Patrick & Scharfstein, David S, 1990. "A Theory of Predation Based on Agency Problems in Financial Contracting," American Economic Review, American Economic Association, vol. 80(1), pages 93-106, March.
  21. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-29, May.
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