Outside (option) in the orchard: lemons or peaches?

Abstract

We study how an employment-related outside option affects equilibrium properties of credit markets plagued with asymmetric information, when returns to entrepreneurial ventures are ranked by first-order stochastic dominance. While greater separation of expected payoffs in paid employment than in entrepreneurship may involve credit rationing or market breakdown, a lemons problem in the outside option may produce multiple competitive equilibria, each featuring favorable selection in the credit market. Under these circumstances, informational asymmetries will not prevent high-ability individuals from pursuing entrepreneurship and yet induce more investment than is socially efficient. This prediction is consistent with recent empirical evidence on the relative importance of rationing vis-a-vis over-provision for credit seeking, informationally opaque firms.