Chapter 7
Markets with Adverse Selection
7.1 A market model
These notes introduce some ideas for modeling markets with adverse selec-
tion. Thisframeworkwasoriginallyintendedtodealwithmarketsthat
cannot be easily accommodated by the standard signaling game e.g., be-
cause there is two-sided adverse selection. For present purposes, however, it
is enough to deal with the simplest case in which there is adverse selection
on one side of the market only.
The use of the competitive paradigm to analyze markets with adverse
selection goes back to Spence (1973). The ideas presented here were devel-
oped in a series of papers Gale (1991, 1992, 1996). There are two mutually
exclusive classes of individuals (agents). We can think of them as buyers and
sellers, but nothing depends on this interpretation. The agents on one side
of the market have private information, so we call them the informed agents.
The agents on the other side of the market are the uninformed.Anagent’s
private information is represented by his type. There is a finite set of types
T. Each type consists of a (non-atomic) continuum of identical agents and
the measure of agents of type t is denoted by N(t) > 0.ThereareM>0
uninformed agents.
There is a finite set of contracts Θ. (Later the theory is extended to an
infinite set). Each contract involves one agent from each side of the market.
If an uninformed agent exchanges a θ contract with an informed agent of type
t, the uninformed agent’s payo? is u(θ,t) and the informed agent’s payo? is
v(θ,t). Each agent has a reservation utility, the utility he gets if a contract is
1
2 CHAPTER 7. MARKETS WITH ADVERSE SELECTION
not exchanged and he has to take his next best option. With an appropriate
normalization of the payo? functions, the reservation utility is 0 for every
type.
The equilibrium choices made by the agents are described by an alloca-
tion, that describes the number of agents of each type that chooses a given
contract. An allocation of agents consists of a pair of functions (f,g) where
f : Θ → R
+
and g : Θ × T → R
+
.Weinterpretf(θ) as the measure of
uninformed agents choosing contract θ and g(θ,t) as the measure of informed
agents of type t choosing contract θ. The allocation (f,g) is attainable if
X
θ
f(θ) ≤ M
and
X
θ
g(θ,t) ≤ N(t),?t.
The attainability condition contains an inequality because it is possible that
some agents will choose their outside option (i.e., no trade)
When an agent selects a contract θ he does not know the probability of
trade or the type of agent from the other side of the market that he will
be matched with. Let λ(θ,t) denote the probability that an uninformed
agent choosing contract θ will exchange the contract with a type-t agent and
let μ(θ) denote the probability that an informed agent choosing contract θ
will exchange the contract with an uninformed agent. Note that all agents
on a given side of the market have the same beliefs about their trading
possibilities, that is, the same probability assessment of trading with a given
type on the other side of the market.
The probability assessment (λ,μ) is consistent with the allocation (f,g)
if
λ(θ,t)=
g(θ,t)
m(θ)
,?t
μ(θ)=
f(θ)
m(θ)
,
for any contract θ such that m(θ) > 0,wherem(θ) measures the long side of
themarketforcontractθ,thatis,
m(θ)=max
(
f(θ),
X
t
g(θ,t)
)
.
7.2. STABILITY 3
If m(θ)=0consistency is automatically satisfied.
Then a market equilibrium consists of an (attainable) allocation (f,g)
and a probability assessment (λ,μ) such that the allocation maximizes the
payo? of each type, that is, f(θ) > 0 implies
X
t
u(θ,t)λ(θ,t)=u
?
=max
θ
(
X
t
u(θ,t)λ(θ,t)
)
,?θ;
and g(θ,t) > 0 implies
v(θ,t)μ(θ)=v
?
(t)=max
θ
{v(θ,t)μ(θ)},?θ,t.
The equilibrium (f,g,λ,μ) is said to be orderly if at most one side of the
market for any contract is rationed, that is,
max
(
X
t
λ(θ,t),μ(θ)
)
=1.
Without this requirement there exist many trivial equilibria.
7.2 Stability
A perturbation is an allocation (f,g) such that
f(θ)=
X
t
g(θ,t) > 0,?θ.
Define an equilibrium for the (ε,
?
f,?g)-perturbed market by replacing the
allocation (f,g) by (1?ε)(f,g)+ε(
?
f,?g) in the equilibrium conditions above.
Then a perfect market equilibrium (f,g,λ,μ) is definedtobethelimitof
a sequence of equilibria (f
ε
g
ε
,λ
ε
,μ
ε
) of the (ε,
?
f,?g)-perturbed market as ε
converges to 0. Note that in a perturbed market the probability assessment
is uniquely determined by the allocation and the consistency condition.
Call (f,g) an equilibrium allocation if (f,g,λ,μ) is a market equilib-
rium for some (λ,μ) and call (f,g) an equilibrium allocation for the (ε,
?
f,?g)-
perturbedmarketif(f,g,λ,μ) isamarket equilibriumof the (ε,
?
f,?g)-perturbed
market for some (λ,μ). An attainable allocation (f,g) is stable if, for any
4 CHAPTER 7. MARKETS WITH ADVERSE SELECTION
perturbation (
?
f,?g) there is a sequence of equilibrium allocations (f
ε
,g
ε
) such
that (f
ε
,g
ε
) is an equilibrium allocation of the (ε,
?
f,?g)-perturbed market and
lim
ε→0
(f
ε
,g
ε
)=(f,g).
Note that the probability assessments do not necessarily converge to a unique
limit. It is easy to see that (f,g) must be an equilibrium allocation if (f,g)
is stable.
Let (f,g) be a stable allocation and let t
0
be a fixed but arbitrary type.
For any type t,letu
?
denote the equilibrium payo? of the uninformed and
v
?
(t) the equilibrium payo? of type t. Then there exists an equilibrium
(f,g,λ,μ) such that for any contract θ and any type t 6= t
0
,
[v
?
(t) >μ(θ)v(θ,t)] =? λ(θ,t)=0.
To see this, let (f
k,n
,g
kn
) be the perturbation defined by
f
kn
(θ)=(k + |T|?1)/n
g
kn
(θ,t)=
?
1/n t 6= t
0
k/n t = t
0
.
By choosing k and n appropriately, we can ensure that (f
kn
,g
kn
) is an at-
tainable allocation. By stability, there exists a sequence (f
ε
,g
ε
,λ
ε
,μ
ε
) con-
verging to (f,g,λ
kn
,μ
kn
) as ε → 0,where(f
ε
,g
ε
,λ
ε
,μ
ε
) is an equilibrium for
the (ε,f
kn
,g
kn
)-perturbed game. By compactness, the sequence
?
(λ
kn
,μ
kn
a
has a limit point μ
0
and it is clear that if (f,g,λ
kn
,μ
kn
) is an equilibrium,
then so is (f,g.λ
0
,μ
0
).
Consider t 6= t
0
.Foreachθ,if
μ
kn
(θ)v(θ,t) <v
?
(t)
then, for all ε>0 su?ciently small,
μ
ε
(θ)v(θ,t) <v
ε
(t),
where v
ε
(t) is the equilibrium payo? in (f
ε
,g
ε
,λ
ε
,μ
ε
).Thenfort 6= t
0
λ
ε
(θ,t)=
g
ε
(θ,t)
m
ε
(θ)
=
1/n
m
ε
(θ)
≤
1/n
(k + |T|?1)/n
=
1
(k + |T|?1)
.
7.3. ROBUSTNESS OF SEPARATING EQUILIBRIUM 5
So, in the limit, λ
kn
(θ,t)=1/(k + |T|?1) and, taking limits as k,n →∞ ,
it follows that λ
0
(θ,t)=0. Since this is true for any θ and t, the desired
property holds.
Note that if (f,g,λ,μ) is a perfect market equilibrium then, by construc-
tion, (λ,μ) is orderly. The reason is that for any perturbation, the definition
of consistency implies that every (λ,μ) is orderly and it remains so in the
limit.
7.2.1 A continuum of contracts
The assumption of a finite number of contracts is convenient. It simplifies
the description of an equilibrium and makes the existence of equilibrium a
technically straightforward matter. For some purposes, it is more convenient
to have a continuum of contracts. In particular, when it comes to charac-
terizing the degree of separation in an equilibrium it is nice to be able to
consider “neighboring” contracts. So let us assume that Θ is a subset of
some finite-dimensional Euclidean space and suppose that u(·,t) and v(·,t)
are continuously di?erentiable functions of θ on some open superset of Θ.
The theory can be extended from a finite subset of Θ to the entire space
by taking limits, but for simplicity I shall assume that the definition of equi-
librium and the restrictions on beliefs, derived above, can be applied directly
to the limit market. With the assumption that (f,g) has a finite support,
the definition of equilibrium extends in the obvious way. A stable allocation
(f,g) is defined to be an equilibrium allocation such that for any type t
0
we
can find an equilibrium probability assessment (λ,μ) having the properties
derived in the proposition above.
7.3 Robustness of separating equilibrium
Let (f,g) be a stable allocation and suppose that there exists a contract θ
0
belongingtotheinteriorofΘ such that two or more types “pool” at θ
0
.We
can assume without loss of generality that there exists a pair t 6= t
0
and that
g(θ
0
,t) > 0 and g(θ
0
,t
0
) > 0.
Let u
?
and v
?
(t) denote the equilibrium payo?s to the uninformed and
type t, respectively, for the equilibrium allocation (f,g) and let
T
0
= {t ∈ T|v
?
(t)=μ(θ
0
)v(θ
0
,t)}
6 CHAPTER 7. MARKETS WITH ADVERSE SELECTION
Note that the definition of T
0
is determined by (f,g) independently of the
particular choice of (λ,μ). We assume that the types are ranked in the
following sense: for any pair t<t
0
,
u(θ,t) <u(θ,t
0
),
for any θ within a su?ciently small neighborhood of θ
0
. Because the number
of types is fixed and the utility functions are continuous, we can assume that
these inequalities hold within a fixed, compact neighborhood. Then there
exists an ε>0 such that u(θ,t)+ε<u(θ,t
0
) for any θ in the neighborhood.
Let t
0
be the best type in T
0
(from the other side’s point of view) and
let (f,g,λ,μ) be the equilibrium whose probability assessment obeys the
restrictions:
[v
?
(t) >μ(θ)v(θ,t)] =? λ(θ,t)=0,?t 6= t
0
.
To avoid some pathological cases, we assume that every t ∈ T
0
has a positive
equilibrium payo? v
?
(t) > 0. Without loss of generality we can normalize
the payo? functions so that v(θ
0
,t)=1for all t ∈ T
0
. Now suppose that
there exists a contract θ arbitrarily close to θ
0
satisfying
v(θ,t
0
) > 1 >v(θ,t),?t ∈ T
0
,t6= t
0
.
Then it follows that λ(θ,t)=0for any t 6= t
0
. Toseethis,notethatthe
equilibrium condition for t
0
implies that
μ(θ)v(θ,t
0
) ≤ μ(θ
0
)v(θ
0
,t
0
)=μ(θ
0
)
which in turn implies that
μ(θ) <μ(θ
0
),
because v(θ,t
0
) > 1,sothat
μ(θ)v(θ,t) ≤ μ(θ) <μ(θ
0
)=μ(θ
0
)v(θ
0
,t),?t ∈ T
0
,t6= t
0
.
For θ su?ciently close to θ
0
, u(θ,t
0
) ≈ u(θ
0
,t
0
) >
P
t
λ(θ
0
,t)u(θ
0
,s) so
P
t
λ(θ,t)=λ(θ,t
0
) < 1. Then orderliness implies that μ(θ)=1,contradict-
ing the equilibrium condition
μ(θ)v(θ,t
0
) ≤ μ(θ
0
)v(θ
0
,t
0
) ≤ 1.
7.4. EQUILIBRIUM RATIONING 7
Proposition 1 Let (f,g) be a stable allocation and (λ,μ) an equilibrium
probability assessment. For any contract θ
0
let T
0
= {t : μ(θ
0
)v(θ
0
,t)=
v
?
(t)}.Supposethatv
?
(t) > 0 for any t ∈ T
0
and that for any ε>0 there is
a contract θ that is ε-close to θ
0
such that
v(θ,t
0
) > 1 >v(θ,t),?t ∈ T
0
,t6= t
0
,
where t
0
is the best type in T
0
and v(θ
0
,t
0
)=1=v(θ
0
,t). Then there is at
most one type t such that g(θ
0
,t) > 0.
Note that this proposition does not imply that θ
0
is only optimal for one
type. Typically, there will be another type t
0
6= t such that μ(θ
0
)v(θ
0
,t
0
)=
v
?
(t
0
) although g(θ
0
,t
0
)=0.
7.4 Equilibrium rationing
We want the set of contracts to be “large”, to allow for “all possible con-
tracts”. This means that some contracts will not be traded in equilibrium, in
fact, some cannot be traded. For example, since contracts include the terms
of trade and it cannot be the case that contracts requiring di?erent “prices”
for the same “good” are available in equilibrium, some contracts must be
“rationed”. This kind of “rationing” is analogous to missing markets or the
e?ect of the classical budget constraint in ruling out the availability of some
commodity bundles.
There is a narrower sense in which rationing occurs in equilibrium. Sup-
pose that a contract is traded by some agents but the probability of trade
is less than one. This kind of rationing is di?erent from missing markets. A
market clearly exists for this contract but some individuals who attempt to
trade the contract will find themselves constrained ex post.
Suppose that m(θ) > 0 and that either μ(θ) < 1 or
P
t
λ(θ,t) < 1.In
that case, we say that the contract θ is actively rationed.
Now suppose that (f,g) is a separating, stable allocation and that con-
tract θ
0
is actively rationed. Suppose that g(θ
0
,t
0
) > 0 and consider first the
case where g(θ
0
,t
0
) >f(θ
0
).Let
T
0
= {t ∈ T|v
?
(t)=μ(θ
0
)v(θ
0
,t)}
where (λ,μ) is the equilibrium probabilitity assessment satisfying
[v
?
(t) >μ(θ)v(θ,t)] =? λ(θ,t)=0,?t 6= t
0
,
8 CHAPTER 7. MARKETS WITH ADVERSE SELECTION
for any contract θ 6= θ
0
su?ciently su?ciently close to θ
0
. As usual, we can
assume that t
0
is the best type, i.e., the type preferred by the other side of
themarketforanyθ near θ
0
.
If v
?
(t
0
)=0, thenwithout lossof generalitywecaneliminatethe rationing
of that type by reducing g(θ
0
,t
0
) until f(θ
0
)=g(θ
0
,t
0
).So,considerthecase
where v
?
(t
0
) > 0. To rule out di?cult cases, we assume that v
?
(t) > 0 for
all t ∈ T
0
. Then we can normalize v(θ
0
,t)=1for all t ∈ T
0
. Suppose there
exists a contract θ in the neighborhood of θ
0
such that
v(θ,t
0
) >v(θ
0
,t
0
)=1,
and
v(θ,t
0
) >v(θ,t),?t ∈ T
0
,t6= t
0
.
The equilibrium condition requires that μ(θ) < 1 so
P
t
λ(θ,t)=1.But
λ(θ,t) > 0 for t 6= t
0
only if μ(θ)v(θ,t)=v
?
(t). Suppose that this is true.
Then
v(θ,t)=
μ(θ
0
)
μ(θ)
≥ v(θ,t
0
),
contradicting our hypothesis. Thus, λ(θ,t)=0for all t 6= t
0
and λ(θ,t
0
)=1,
contradicting the equilibrium condition for the long side.
Suppose now that the uninformed side of the market is actively rationed
at θ
0
,thatis,g(θ
0
,t
0
) <f(θ
0
).Ifλ(θ
0
,t
0
)u(θ
0
,t
0
)=0then we can eliminate
the rationing by changing the allocation (f,g).Ifλ(θ
0
,t
0
)u(θ
0
,t
0
) > 0 and
λ(θ
0
,t
0
) < 1 then μ(θ
0
)=1. Suppose there exists a nearby contract θ such
that v(θ,t
0
) >v(θ
0
,t
0
)=1and
v(θ,t
0
) >v(θ,t),?t ∈ T
0
,t6= t
0
.
Then μ(θ) < 1 and λ(θ,t
0
)=1by the usual argument. But for θ su?ciently
close to θ
0
, continuity implies that u(θ,t
0
) >λ(θ
0
,t
0
)u(θ
0
,t
0
), contradicting
the equilibrium condition. Thus, we have proved the following result.
Proposition 2 Suppose the allocation (f,g) is stable and separating. Let θ
0
be a contract and T
0
the set of types for which θ
0
is optimal; suppose that
v
?
(t) > 0 for all t ∈ T
0
and v(θ
0
,t)=1for all t ∈ T
0
.Lett
0
be the unique
type that chooses θ
0
,thatis,g(θ
0
,t
0
) > 0. Then there is no active rationing
at θ
0
if the following conditions are satisfied: for any ε>0, there exists a
contract θ that is ε-close to θ
0
and satisfies
v(θ,t
0
) >v(θ
0
,t
0
)=1,
7.5. MORAL HAZARD AND CREDIT RATIONING 9
and
v(θ,t
0
) >v(θ,t),?t ∈ T
0
,t6= t
0
.
7.5 Moral hazard and credit rationing
The phenomenon of credit rationing is important for several reasons. At the
empirical level, it has been argued that firms face constraints on their ability
to raise external finance,whichinturnraisesquestionsaboutthee?ciency
of the allocation of investment. At the theoretical level, the possibility that
“prices” do not adjust to clear markets goes to the heart of the perfect compe-
tition paradigm. Understanding credit rationing may help us to understand
phenomena such as unemployment, under-insurance, and so forth.
7.5.1 The Stiglitz-Weiss model
There is a continuum of entrepreneurs, each of whom has a single project.
The entrepreneur can choose one of two development strategies i =1,2
characterized by the parameters (θ
i
,y
i
),whereθ
i
is the probability of success
and y
i
is the payo? to the project in the event of success. An unsuccessful
project has a payo? ofzero.Weassumethat
θ
1
y
1
= θ
2
y
2
,θ
2
>θ
1
,y
2
<y
1
.
Each project requires an invesment of one unit of the numeraire good.
There is a continuum of investors each of whom has an initial endowment
of one unit of the numeraire and wants to invest in one project. All agents
are risk neutral. The entrepreneurs have a reservation utility of zero and the
investors have a reservation utility of one (suppose, for example, that their
alternative to investing in a risky project is to invest in a safe asset that has
azeronetreturn).
Investors and entrepreneurs are matched at random. Projects are financed
using a standard debt contract: in exchange for the investment of one unit
in his project, the entrepreneur promises to pay the investor r units after the
project pays o?.
When the contractual payment is r, the entrepreneur’s payo?from a type-
i project is θ
i
max{y
i
?r,0}. There is a unique contract 0 <r
?
<y
2
such that
the entrepreneur prefers type 2 if r<r
?
and prefers type 1 if r
?
<r<y
2
.
For r ≥ y
2
both projects earn zero for the entrepreneur.
10 CHAPTER 7. MARKETS WITH ADVERSE SELECTION
The investors expected payo? from the project is θ
2
r for r ≤ r
?
and θ
1
r
for r
?
<r<y
2
. NotethatIassumetheentrepreneurischoosing2 when
r = r
?
. This is not the only optimal choice for the entrepreneur, but it is the
only equilibrium choice: if the entrepreneur chooses 1 when r = r
?
then the
investor will prefer r = r
?
? ε for all ε>0 su?ciently small, which is not
possible in equilibrium.
Suppose, for example, that
θ
2
r
?
>θ
1
y
1
,θ
2
r
?
≥ 1.
Then it is an equilibrium for all investors and entrepreneurs to choose the
contract r
?
. This is the global optimum for the investors and it is the only
contract that can be traded in equilibrium by the entrepreneurs.
If there are more entrepreneurs than investors, there will have to be active
rationing at r
?
. An entrepreneur facing the prospect of rationing would gladly
pay r
?
+ε and get finance for sure. But a higher interest rate is not attractive
to the investors, who perceive that it violates the incentive constraint, leading
to the choice of the high risk project and lowering the investor’s payo?.
7.5.2 The Bester model
One of the reasons why we observe active rationing is that there is only one
variable in the contract, the interest rate, which cannot be used simultane-
ously to clear the market and provide incentives to choose the better project.
Bester (1985) shows how collateral can be used to improve the incentives in
the contract (relax the incentive constraint) and allow the interest rate to be
used to clear the market.
Suppose that eachentrepreneurhas an asset that can beused as collateral.
The total value of the collateral is K and the value surrendered in the event
of the failure of the project is 0 ≤ k ≤ K. Then a contract is an ordered pair
(r,k) and the entrepreneur prefers type-2 projects if and only if
θ
2
(y
2
?r)+(1?θ
2
)k>θ
1
(y
1
?r)+(1?θ
1
)k.
Given the assumption of equal expected outcomes θ
1
y
1
= θ
2
y
2
,type-2 are
preferred if and only if r<k.
The value of the collateral may be less to the investor than to the en-
trepreneur, in which case the use of collateral involves a deadweight loss.
Suppose that the value of the collateral to the investor is a fraction 0 <γ<1
7.6. ADVERSE SELECTION AND CREDIT RATIONING 11
of its worth to the entrepreneur. Then it will be optimal to minimize the use
of collateral and put r = k (putting r>kwill have no incentive e?ect and
consequently it will be of no value at all). Then as long as K>y
2
it will be
possible to achieve the no-rationing outcome. The equilibrium contract will
be (r
?
,k
?
)=(y
2
,y
2
). At this contract, entrepreneurs are indi?erent between
undertaking a project and remaining inactive and investors are all willing to
accept the contract.
It is easy to see that investors prefer this contract to any other contract
of the form (r,r) such that r<r
?
andthatinvestorspreferittoanyother
contract of the form (r,r) such that r>r
?
. Since contracts of the form (r,r)
and (r,0) are the only Pareto e?cient contracts, we know that any contract
(r
?
,k
?
) is worse for either the entrepreneurs or the investors and so we can
use orderly rationing to support an equilibrium in which (r
?
,k
?
) is chosen.
7.6 Adverse selection and credit rationing
In the moral hazard model described above, entrepreneurs are identical and
choose projects of di?erent types. In a model of adverse selection, en-
trepreneurs are endowed with di?erent types of projects. Consider the ana-
logue of the two-type model above. There are two types of entrepreneurs
i =1,2 with projects (θ
i
,y
i
),whereθ
1
y
1
= θ
2
y
2
,θ
2
>θ
1
and y
2
<y
1
.Each
project requires an invesment of one unit of the numeraire good.
There is a continuum of investors each of whom has an initial endowment
of one unit of the numeraire and wants to invest in one project. All agents
are risk neutral. The entrepreneurs have a reservation utility of zero and the
investors have a reservation utility of one. We assume that there are more
entrepreneurs than investors, so rationing must occur in equilibrium unless
entrepreneurs are at their reservation level.
Suppose the face value of the debt is r>0.Thepayo?to an entrepreneur
of type i is
θ
i
max{y
i
?r,0}
and the payo? to the investor is
θ
i
min{y
i
,r}.
12 CHAPTER 7. MARKETS WITH ADVERSE SELECTION
7.6.1 Pooling equilibrium
There exists a pooling equilibrium in which all agents choose the contract r
?
.
Rationing occurs in this equilibrium because, although entrepreneurs would
be willing to accept a higher interest rate r = r
?
+ ε and get finance for
sure rather than face the prospect of rationing, investors are not attracted
to a higher interest rate because they believe that they are more likely to be
matched with a high-risk type at the higher interest rate.
Let μ(r) denote the probability that an entrepreneur can trade a contract
r and let μ
i
(r) denote the probability that an investor can trade a contract
r with an entrepreneur of type i =1,2. In the pooling equilibrium, the
entrepreneurs’ payo?sare
μ(r
?
)θ
i
(y
i
?r
?
) ≥ 0,i=1,2,
and the investors’ payo?sare
X
i
μ
i
(r
?
)θ
i
r
?
=
ˉ
θr
?
≥ 1,
where
ˉ
θ is the average probability of success. To support this equilibrium we
have to choose the probabilities μ(r),μ
1
(r) and μ
2
(r) so that no one wants
to deviate. Let ˉr denote the value of r satisfying
θ
1
ˉr =
ˉ
θr
?
and assume that
θ
i
max{y
i
? ˉr,0} <μ(r
?
)θ
i
(y
i
?r
?
),i=1,2,
whichwillbetrueifr
?
is not “too” low. Then set
μ(r)=0,μ
1
(r)=1,μ
2
(r)=0,?r
?
<r≤ ˉr
and
μ(r)=1,μ
1
(r)=0,μ
2
(r)=0,?r>ˉr.
For r<r
?
we simply assume that the investors believe that only the bad
types are forthcoming:
μ(r)=0,μ
1
(r)=1,μ
2
(r)=0,?r<r
?
.
7.6. ADVERSE SELECTION AND CREDIT RATIONING 13
It is easy to check that under the maintained assumptions the agents will
not want to deviate to a contract r 6= r
?
with these probability assessments.
This equilibrium is not “stable”, however. In particular, if we perturbed
the equilibrium by assigning a small measure of the good types to every
contract r, there is no way that the types could endogenously re-allocate
themselves to o?set the e?ect of the perturbation. The problem does not
arise with the higher interest rates r>r
?
; it arises with lower interest rates
r<r
?
. In an equilibrium of the perturbed model, contracts r<r
?
must be
more heavily rationed than r
?
in order to discourage defections from r
?
.But
rationing hurts the high-risk entrepreneurs more than low-risk entrepreneurs,
because they have higher payo?s. Thus, if the low-risk entrepreneurs weakly
prefer r
?
to r, the high-risk entrepreneurs will strictly prefer r
?
to r. Formally,
μ(r
?
)θ
2
(y
2
?r
?
) ≤ μ(r)θ
2
(y
2
?r)
implies that μ(r) <μ(r
?
), and together with y
1
>y
2
this implies that
μ(r
?
)θ
1
(y
1
?r
?
) <μ(r)θ
1
(y
1
?r).
Thus, in an equilibrium of the perturbed model, the investors’ beliefs must
assign probability one to the high type, conditional on trading r<r
?
:
μ(r) <μ(r
?
),μ
1
(r)=0,μ
2
(r)=1,?r<r
?
.
But this is clearly inconsistent with equilibrium, since
X
i
μ
i
(r)θ
i
r = θ
2
r>
ˉ
θr
?
for r<r
?
su?ciently close to r
?
.Thus,r
?
cannot be a stable outcome.
7.6.2 Separating equilibrium
There exists a separating equilibrium in which each type of entrepreneur gets
a distinct contract. However, since every entrepreneur would prefer a lower
interest rate to a higher one, other things being equal, the only way two
constracts can be traded in equilibrium is if one of them is rationed.
As usual, the stability criterion will select the best (Pareto-dominant)
separating equilibrium. In this equilibrium, the high-risk types are not ra-
tioned and have issue debt with a high face value r
1
. The low-risk types issue
debt with a lower face value r
2
and accept a probability of trade μ(r
2
) < 1.
14 CHAPTER 7. MARKETS WITH ADVERSE SELECTION
To make the necessity of rationing very clear, we can assume that there
are more investors than entrepreneurs. Then the investors must trade with
probability one in equilibrium and they can do this only if they are at their
reservation utility. This implies that
θ
i
r
i
=1.
Thentheprobabilityoftradeforthelow-risktypeisdeterminedbythe
condition that the high-risk type is indi?erent between r
1
and r
2
:
θ
1
(y
1
?r
1
)=μ(r
2
)θ
1
(y
1
?r
2
),
or μ(r
2
)=(y
1
?r
1
)/(y
1
?r
2
) < 1.
To support this equilibrium we define the functions μ(r),μ
1
(r) and μ
2
(r)
as follows:
μ(r)=
?
?
?
0 r<r
2
(y
1
?r
1
)
(y
1
?r)
r
2
<r<r
1
1 r
1
<r;
(μ
1
(r),μ
2
(r)) =
?
?
?
?
?
(0,1) r<r
2
3
θ
2
r?1
(θ
2
?θ
1
)r
,
1?θ
1
r
(θ
2
?θ
1
)r
′
r
2
<r<r
1
(0,0) r
1
<r.
With these beliefs, the investors are unwilling to lend at r<r
2
and just
willingtolendatr
2
<r<r
1
. They are rationed at r>r
1
. The entrepreneurs
are rationed at r<r
2
and unwilling to borrow at r>r
1
. The high-risk type
is just willing to borrow at r
2
<r<r
1
and the low-risk type is unwilling to
borrowinthesamerange.
7.6.3 Collateral
Now suppose that each type of entrepreneur has an asset that can be used as
collateral. The asset is worth K to the entrepreneur and γK to the investors,
where 0 <γ<1. A contract now specifies an ordered pair (r,k) where r
is the repayment in the event of success and k is the value of collateral
surrendered by the entrepreneur in the event of failure. (It does not pay to
surrender collateral in the event of success because this weakens the incentive
to avoid risk).
7.6. ADVERSE SELECTION AND CREDIT RATIONING 15
Because surrendering collateral is ine?cient ex post, the contract should
minimize the use of collateral. The best (Pareto-dominant) separating equi-
librium will be one in which the high-risk type uses no collateral and the
low-risk type uses just enough to distinguish itself from the high-risk type.
Thus, if the equilibrium contracts are denoted by (r
1
,k
1
) and (r
2
,k
2
) we must
have
(r
1
,k
1
)=(1/θ
1
,0)
and
(r
2
,k
2
)=(1/θ
2
,k
2
)
where k
2
satisfies
θ
1
(y
1
?r
1
)=θ
1
(y
1
?r
2
)?(1?θ
1
)k
2
.
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