Investment Finance and the Hidden Action Problem

Abstract

In this chapter we examine the implications of the hidden action problem in the market for investment finance. As in the previous chapter, we begin by considering that entrepreneurs can raise finance for their projects only by borrowing from banks. Section 3.2 shows that the problem of hidden action can lead to problems in the credit market. Section 3.3 shows how those problems can be solved by the use of equity finance for the example we present in Section 3.2. Section 3.4 offers a different example, where neither simple credit finance nor simple equity finance would solve the problem of hidden action. There is a possibility that the market for funds may collapse in this example. Possible solutions to the problem involving either punishment for fraud or costly monitoring of actions are suggested and discussed. Section 3.4 discusses the use of such amendments to equity finance in the example provided and Problem 3.1, with which the chapter ends, extends a similar analysis to the credit market. Section 3.5 looks at the way in which the hidden action problem may give rise to credit rationing in similar manner to the analysis of section 2.4 above.