The price of size and financial market allocations (Q852329)

It is said, ``The economy is populated by entrepreneurs who have access to risky investment opportunities but have no funds to meet their investment expenditures, and lenders who have funds but do not have access to these opportunities''. It is assumed that all borrowers and lenders are risk neutral so that they care only about expected returns they receive. Risk neutrality arises when borrowers and lenders have a linear von Neumann-Morgenstern (v.N-M) utility function, or when they have a concave v.N-M utility function but there is perfect insurance. By assuming risk neutrality, the author is able to highlight the price of size without distraction from considerations pertaining to risk aversion. It is also assumed that there is limited liability that prevents borrowers' asset from being negative. This paper articulates a costly-state-verification model of financial contracting with heterogeneous lender size. In section 2 the author introduces the basic model and analyses it in the subsequence sections. It is observed that is a non-rationing direct lending equilibrium: (1) financial contract in nonlinear in that expected rates of return on loans increase with loan sizes; (2) endogenous asset indivisibility arises; (3) the total social surplus under a nonlinear contract is less than that under a linear structure; (4) average debt size affects the market value of a firm. The analysis is also extended to the case of credit rationing and financial intermediation.