We analyze a standard environment of adverse selection in credit markets. In our environment,
entrepreneurs who are privately informed about the quality of their projects need
to borrow in order to invest. Conventional wisdom says that, in this class of economies, the
competitive equilibrium is typically inefficient.
We show that this conventional wisdom rests on one implicit assumption: entrepreneurs
can only access monitored lending. If a new set of markets is added to provide entrepreneurs
with ...
We analyze a standard environment of adverse selection in credit markets. In our environment,
entrepreneurs who are privately informed about the quality of their projects need
to borrow in order to invest. Conventional wisdom says that, in this class of economies, the
competitive equilibrium is typically inefficient.
We show that this conventional wisdom rests on one implicit assumption: entrepreneurs
can only access monitored lending. If a new set of markets is added to provide entrepreneurs
with additional funds, efficiency can be attained in equilibrium. An important characteristic of
these additional markets is that lending in them must be unmonitored, in the sense that it does
not condition total borrowing or investment by entrepreneurs. This makes it possible to attain
efficiency by pooling all entrepreneurs in the new markets while separating them in the markets
for monitored loans.
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