DP2037 Dynamic Adverse Selection and Debt

Author(s): Gilles Chemla, Antoine Faure-Grimaud
Publication Date: December 1998
Keyword(s): Debt, Durable Good, dynamic adverse selection, financial constraint, Ratchet Effect, Renegotiation
JEL(s): D42, D82, G32, L14
Programme Areas: Financial Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2037

In many long-term relationships, parties may be reluctant to reveal their private information in order to benefit from their informational advantage in the future. We point out that the strategic use of debt by an uninformed party induces another party to reveal private information. Our argument, which is consistent with casual observation, is based on the idea that (renegotiable) debt is a credible commitment to end the long-term relationship if information is not revealed. We show that the strategic advantage of debt increases with good durability and we briefly address the financing decision of a regulated firm.