Research Discussion Papers, Bank of Finland
No 6/2003:
Equilibrium in financial markets with adverse selection
Tuomas Takalo ()
and Otto Toivanen ()
Abstract: We study a financial market adverse selection model where
all agents are endowed with initial wealth and choose to invest as
entrepreneurs or financiers, or not to invest. We show that often a lack of
outside finance leads to the emergence of financial markets where
availability of outside finance leads to autarky. We find that i) there
exist Pareto-efficient and inefficient equilibria; ii) adverse selection
has more severe consequences for poorer economies; iii) increasing initial
wealth may cause a shift from Pareto-efficient to inefficient equilibrium;
iv) increasing the proportion of agents with positive NPV projects causes a
shift from inefficient to efficient equilibrium; v) equilibrium financial
contracts are either equity-like or ‘pure’ debt contracts; vi) agents with
negative (positive) NPV projects earn rents only in
(non-)wealth-constrained economies; vii) agents earn rents only when
employing pure debt contracts; and viii) removing storage technology
destroys the only Pareto-efficient equilibrium in non-wealth-constrained
economies. Our model enables analysis of various policies concerning
financial stability, the need for sophisticated financial institutions,
development aid, and the promotion of entrepreneurship.
Keywords: financial market efficiency; adverse selection; financial contracts; creation of firms; (follow links to similar papers)
JEL-Codes: D58; G14; G20; G28; G32; (follow links to similar papers)
48 pages, March 4, 2003
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