The equilibrium allocation of investment capital in the presence of adverse selection and costly state verification (Q1341443)

This paper describes the equilibrium allocation of investment capital in an environment with the following features: investment must be financed externally; investment opportunities are heterogeneous, differing in their probability distributions of returns; owners of investment projects are privately informed about the return distributions; and actual returns on any project can be observed by agents other than the owner only at some costs. Thus the market allocation of investment funds in the presence of adverse selection and costly state verification is considered. Of particular interest in the environment is who obtaines funds (or conversely, who might experience credit rationing) and what contractual terms emerge in equilibrium. A general equilibrium is defined under the assumption that the supply of funds is at least potentially adequate to meet demand. Conditions necessary for the existence of such an equilibrium and some comparative results are given. Further, the case where the supply of funds is inadequate to meet demand is considered, and how this would effect various results.