Welfare-Improving Adverse Selection in Credit Markets

James Vercammen
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James Vercammen: University of British Columbia, Canada

International Economic Review, 2002, vol. 43, issue 4, 1017-1033

Abstract: A model of simultaneous adverse selection and moral hazard in a competitive credit market is developed and used to show that aggregate borrower welfare may be higher in the combined case than in the moral-hazard-only case. Adverse selection can be welfare improving because in the pooling equilibrium of the combined model, high-quality borrowers cross subsidize low-quality borrowers. The cross subsidization reduces the overall moral hazard effort effects, and the resulting gain in welfare may more than offset the welfare loss stemming from distorted investment choices. The analysis focuses on pooling equilibria because model structure precludes separating equilibria. Copyright 2002 by the Economics Department of the University of Pennsylvania and Osaka University Institute of Social and Economic Research Association

Date: 2002
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