Investment Finance and the Selection Problem

Abstract

In this chapter we examine the implications of the selection problem in the market for investment finance. We begin in section 2.2 by assuming that the only way that entrepreneurs can raise finance for their projects is by borrowing from banks in a competitive credit market. This assumption allows us to ignore an important element in the analysis of an asymmetric information problem; that is, the form of contract offered by the principal to the agent. Section 2.2 shows that the selection problem in the credit market can lead to problems, including a socially inefficient level of investment. Section 2.3 considers whether it is possible to find a better form of contract than credit to provide funds for investment, and shows that the selection problem present in section 2.2 can be solved by the use of equity finance. Section 2.4 shows how the selection problem of the type presented in section 2.2 can lead to rationing in the credit market, which is an interesting result, since rationing is difficult to derive using conventional analysis. Finally, section 2.5 discusses a variety of the issues raised and possible responses to them. The chapter closes with recommended reading and some problems.