entrepreneur is born not made
Equilibrium in Financial Markets with Adverse Selection*
Tuomas Takalo and Otto Toivanen
Bank of Finland and Helsinki School of Economics
This draft: 25th November, 2002
ABSTRACT
We study the determinants of equity and loan financing in an equilibrium model of financial markets with adverse selection. In our model all agents are endowed with initial wealth and choose to invest as entrepreneurs or financiers, or not to invest. We find that i) equilibrium financial contracts are either equity-like or “pure” debt contracts; ii) agents only earn rents when employing pure debt contracts; iii) When agents split in their occupational choices in equilibrium, they use equity-like contracts. We also show that iv) not having outside finance can lead to the emergence of financial markets where availability of outside finance would lead to autarky; v) increasing initial wealth may lead from a Pareto-efficient to an inefficient equilibrium; vi) adverse selection has severer consequences in poorer economies.
I. INTRODUCTION The aim of this paper is to explore the functioning of financial markets with asymmetric information when the roles of agents are determined within the model. In a departure from most of the existing literature, in our model all agents are endowed with some initial wealth and an investment project whose quality is their private information. To initiate a project, a would-be entrepreneur needs outside financing. There is an occupational choice in the sense that agents choose whether to participate and, if they participate, whether to become entrepreneurs or financiers. The set-up creates a natural environment to study whether a market for financial claims emerges in equilibrium, whether the eventual markets are efficient, and what kind of financial contracts are employed. Our model allows us to analyze the effects of different shocks to the economy, the need for more sophisticated financial institutions, and the usefulness of various policies such as
Tuomas Takalo and Otto Toivanen
Bank of Finland and Helsinki School of Economics
This draft: 25th November, 2002
ABSTRACT
We study the determinants of equity and loan financing in an equilibrium model of financial markets with adverse selection. In our model all agents are endowed with initial wealth and choose to invest as entrepreneurs or financiers, or not to invest. We find that i) equilibrium financial contracts are either equity-like or “pure” debt contracts; ii) agents only earn rents when employing pure debt contracts; iii) When agents split in their occupational choices in equilibrium, they use equity-like contracts. We also show that iv) not having outside finance can lead to the emergence of financial markets where availability of outside finance would lead to autarky; v) increasing initial wealth may lead from a Pareto-efficient to an inefficient equilibrium; vi) adverse selection has severer consequences in poorer economies.
I. INTRODUCTION The aim of this paper is to explore the functioning of financial markets with asymmetric information when the roles of agents are determined within the model. In a departure from most of the existing literature, in our model all agents are endowed with some initial wealth and an investment project whose quality is their private information. To initiate a project, a would-be entrepreneur needs outside financing. There is an occupational choice in the sense that agents choose whether to participate and, if they participate, whether to become entrepreneurs or financiers. The set-up creates a natural environment to study whether a market for financial claims emerges in equilibrium, whether the eventual markets are efficient, and what kind of financial contracts are employed. Our model allows us to analyze the effects of different shocks to the economy, the need for more sophisticated financial institutions, and the usefulness of various policies such as
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