Dynamic adverse selection and debt

Gilles Chemla () and Antoine Faure Grimaud

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

Abstract: This paper argues that the strategic use of debt favours the revelation of information in dynamic adverse selection problems. Our argument is based on the idea that debt is a credible commitment to end long term relationships. Consequently, debt encourages a privately informed party to disclose its information at early stages of a relationship. We illustrate our point with the financing decision of a monopolist selling a good to a buyer whose valuation is private information. A high level of (renegotiable) debt, by increasing the scope for liquidation, may induce the high valuation buyer to buy early at a high price and thus increase the monopolist's expected payoff. By affecting the buyer's strategy, it may reduce the probability of excessive liquidation. We investigate the consequences of good durability and we examine the way debt may alleviate the ratchet effect.

Keywords: Dynamic adverse selection; durable good; ratchet effect; renegotiation; financial constraint; debt (search for similar items in EconPapers)
JEL-codes: D42 D82 G32 L14 (search for similar items in EconPapers)
Date: 1996-03, Revised 1996-12
New Economics Papers: this item is included in nep-pke
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Related works:
Working Paper: Dynamic Adverse Selection and Debt (1998)
Working Paper: Dynamic Adverse Selection and Debt (1996)
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Persistent link: https://EconPapers.repec.org/RePEc:upf:upfgen:196

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