Costly State Verification and Truthtelling: A Note on the Theory of Debt Contracts

Economic Theory Bulletin, 6(2018), 129-139

Posted: 18 Mar 2019

See all articles by Josef Schosser

Josef Schosser

University of Passau

Jochen Wilhelm

University of Passau

Date Written: October 11, 2018

Abstract

When firms want to raise external financing, why do they resort to contracts with fixed repayment, i.e., standard debt contracts? The canonical work of Gale and Hellwig (Rev Econ Stud, 52(4):647–663, 1985) gives the following answer to this question: Assuming that only the entrepreneur can observe the project’s outcome free of charge, the standard debt contract proves to be an incentive-compatible financing design. However, this approach remains inadequate, as neither the lender nor the borrower is given the possibility to act strategically. The paper at hand takes up this aspect. By means of a simple game-theoretic model and focusing on a binary outcome setting, it is shown that every risky standard debt contract is dominated by at least one ownership contract. In this respect, costly state verification cannot act as a raison d’être of contracts with fixed repayment.

Keywords: Costly State Verification, Financing Contracts, Incentive Compatibility, Perfect Bayesian Nash Equilibrium

JEL Classification: C72, D82, D86, G32

Suggested Citation

Schosser, Josef and Wilhelm, Jochen, Costly State Verification and Truthtelling: A Note on the Theory of Debt Contracts (October 11, 2018). Economic Theory Bulletin, 6(2018), 129-139, Available at SSRN: https://ssrn.com/abstract=3342558

Josef Schosser (Contact Author)

University of Passau ( email )

Innstrasse 27
Passau, 94032
Germany

Jochen Wilhelm

University of Passau ( email )

Innstrasse 27
Department of Business Administration
94032 Passau
Germany
+49 / 851 / 509 2510 (Phone)
+49 / 851 / 509 2512 (Fax)

HOME PAGE: http://www.uni-passau.de/jochenwilhelm

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