Debt contracts with ex-ante and ex-post asymmetric information: an example (Q2494025)

The authors consider a simple model of lending and borrowing, combining two informational problems: adverse selection and costly state verification. The framework is as follows. There is a unique borrower and a unique lender, both risk-neutral and carrying only about second period consumption. The borrower has access to an investment project requiring some investment good which is possessed by the lender. The investment project gives a random return with the uniform distribution. There exists ex-ante asymmetric information (the borrower and the lender have different privately known opinion about the factors influencing the project return) and ex-post asymmetric information (the borrower freely observe the project return and the lender has to pay monitoring costs). The borrower maximizes his expected profit. The analysis is restricted to the case of secured simple debt contracts. In a simple debt contract the lender takes all the project return when the return is below some threshold value and receives a constant payment when the return is higher. It is shown that there exist a threshold value of monitoring costs, above which at the optimum the borrower offers a unique contract, while for lower monitoring costs the borrower offers two contracts. Moreover, for high monitoring costs, the costly state verification effect dominates the adverse selection effect.