Incentive-compatible debt contracts: The one-period problem

Douglas Gale, Martin Hellwig

    Research output: Contribution to journalArticlepeer-review


    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 languageEnglish (US)
    Pages (from-to)647-663
    Number of pages17
    JournalReview of Economic Studies
    Issue number4
    StatePublished - Oct 1985

    ASJC Scopus subject areas

    • Economics and Econometrics


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