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)|
|Number of pages||17|
|Journal||Review of Economic Studies|
|State||Published - Oct 1985|
ASJC Scopus subject areas
- Economics and Econometrics