Incentive-compatible debt contracts: The one-period problem

Douglas Gale; Martin Hellwig

doi:10.2307/2297737

Incentive-compatible debt contracts: The one-period problem

Douglas Gale, Martin Hellwig

Research output: Contribution to journal › Article › peer-review

Abstract

In a simple model of borrowing and lending with asymmetric information we show that the optimal, incentive-compatible debt contract is the standard debt contract. The second-best level of investment never exceeds the first-best and is strictly less when there is a positive probability of costly bankruptcy. We also compare the second-best with the results of interest-rate-taking behaviour and consider the effects of risk aversion. Finally we provide conditions under which increasing the borrower's initial net wealth must reduce total investment in the venture.

Original language	English (US)
Pages (from-to)	647-663
Number of pages	17
Journal	Review of Economic Studies
Volume	52
Issue number	4
DOIs	https://doi.org/10.2307/2297737
State	Published - Oct 1985

ASJC Scopus subject areas

Economics and Econometrics

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abstract = "In a simple model of borrowing and lending with asymmetric information we show that the optimal, incentive-compatible debt contract is the standard debt contract. The second-best level of investment never exceeds the first-best and is strictly less when there is a positive probability of costly bankruptcy. We also compare the second-best with the results of interest-rate-taking behaviour and consider the effects of risk aversion. Finally we provide conditions under which increasing the borrower's initial net wealth must reduce total investment in the venture.",

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Incentive-compatible debt contracts: The one-period problem

Abstract

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