Incentive-Compatible Debt Contracts: The One-Period Problem

Douglas Gale () and Martin Hellwig

The Review of Economic Studies, 1985, vol. 52, issue 4, 647-663

Abstract: 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.

Date: 1985
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