Welfare-Improving Adverse Selection in Credit Markets

17 Pages Posted: 5 Jan 2003

See all articles by James A. Vercammen

James A. Vercammen

University of British Columbia (UBC) - Sauder School of Business

Abstract

A model of simultaneous adverse selection and moral hazard in a competitive credit market is developed and used to show that aggregate borrower welfare may be higher in the combined case than in the moral-hazard-only case. Adverse selection can be welfare improving because in the pooling equilibrium of the combined model, high-quality borrowers cross subsidize low-quality borrowers. The cross subsidization reduces the overall moral hazard effort effects, and the resulting gain in welfare may more than offset the welfare loss stemming from distorted investment choices. The analysis focuses on pooling equilibria because model structure precludes separating equilibria.

Suggested Citation

Vercammen, James A., Welfare-Improving Adverse Selection in Credit Markets. Available at SSRN: https://ssrn.com/abstract=342745

James A. Vercammen (Contact Author)

University of British Columbia (UBC) - Sauder School of Business ( email )

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