entrepreneur is born not made

Topics: Economics, Equilibrium, Financial market Pages: 18 (5454 words) Published: February 25, 2014
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

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 development aid and the promotion of entrepreneurship.

We build on a strong foundation: Since Akerlof’s (1970) seminal article, a large literature on the effects of asymmetric information on the functioning of credit markets has emerged (for surveys, see, e.g., Clemenz and Ritthaler, 1992, and chapter 5 in Freixas and Rochet, 1997). While a substantial part of the literature is in a partial equilibrium setting, the supply of funds is explicitly modeled in a few influential studies such as Bernanke and Gertler (1989, 1990) and Holmström and Tirole (1997, 1998). The literature shares some common elements, and in particular, two key assumptions: First, there are potential borrowers with investment projects and potential lenders with funds, but without projects. Second, potential borrowers have private information about the ex-ante or ex-post value of their projects, or their choice of effort. In such an environment, the well-known problems of adverse selection, moral hazard, credit rationing (Stiglitz and Weiss, 1981, Williamson, 1987) and inefficient investment levels (de Meza and Webb, 1987) may emerge. Financial markets may even collapse. It is the first of the above two assumptions that we relax by allowing the agents to choose between becoming entrepreneurs or financiers, or not participating.1

It turns out that the occupational choice of agents mitigates the adverse effects of asymmetric information. As in standard models under adverse selection, the financial market may yield interim or Pareto inefficient outcomes, or the market may collapse to autarky. These observations provide a rationale for more sophisticated financial institutions than the one that we allow for. But, in stark contrast, we show that if the economy is initially sufficiently wealthy or has sufficiently productive projects, a simple form of financial market will emerge endogenously as an equilibrium institution and, for a wide range of parameter values, the financial market yields a...

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