Too Much Investment: A Problem of Asymmetric Information

Entrepreneurship and asymmetric information in input markets

“…This would add an occupational choice dimension to our analysis that would complicate things considerably. 3 These assumptions are equivalent to the de Meza and Webb (1987) case, as opposed to the undertake a project, an entrepreneur hires a fixed number of workers, taken to be one for simplicity. The probability of success of a project p depends upon both the ability of the entrepreneur a and the quality of the worker hired q according to: 4…”

“…This also leads to qualitatively similar results. 5 Adding a fixed capital cost that must be financed by credit, as in Stiglitz and Weiss (1981) and de Meza and Webb (1987), adds nothing of substance in our context since credit is already required to finance wage costs.…”

“…In the de Meza and Webb (1987) case where projects were pooled by their return R and the distribution of the probability of success p across entrepreneurs was given, credit rationing could not arise. Our model is an extension of the de Meza-Webb model to allow for p for a given entrepreneur to be endogenously determined by the quality of worker hired.…”

“…Moreover, the possibility of credit rationing exists which exacerbates the underinvestment. Subsequently, de Meza and Webb (1987) considered the case in which banks could observe ex post project returns but not the probability of success. In this setting, the findings of Stiglitz and Weiss were reversed: there would be overinvestment in low-probability projects and no possibility of credit rationing, leading to a presumption of taxing new firms.…”

“…The model we use builds on the one used by de Meza and Webb (1987) to study adverse selection in credit markets by adding an employment dimension. Entrepreneurs of varying ability each hire a fixed number of workers who are of varying quality.…”