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 from banks. 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 borrow from banks. If an additional market is added to provide entrepreneurs with
additional ...
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 from banks. 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 borrow from banks. If an additional market is added to provide entrepreneurs with
additional funds, efficiency can be attained in equilibrium. An important characteristic of this
additional market is that it must be non-exclusive, in the sense that entrepreneurs must be able
to simultaneously borrow from many different lenders operating in it. This makes it possible to
attain efficiency by pooling all entrepreneurs in the new market while separating them in the
market for bank loans.
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