ECO349H5 Chap.7 Information Frictions and Credit Contracts
Information Frictions and Credit Contracts
Profitable does not mean financeable
A project can have positive expected surplus yet fail to attract outside finance. The obstacle is not always a shortage of aggregate value; it can be the amount of project income that can credibly be promised to investors while preserving the entrepreneur’s incentive to take the productive action.
Keep project efficiency and contract feasibility as separate questions from the start.
Name every constraint by its job
The incentive-compatibility condition compares the entrepreneur’s payoff from effort with the payoff and private benefit obtained from shirking. It places a ceiling on the payment that can be transferred to investors in the success state.
The entrepreneur’s participation condition ensures the contract is at least as attractive as the outside option. The investor’s participation condition requires expected repayment to cover external funds.
These inequalities need not all bind. First derive their directions, then identify which limits the proposed contract. Setting every constraint to equality can invent a solution that is neither necessary nor feasible.
Use a diagram or interval for the entrepreneur’s retained income: one bound comes from incentives, another from investor break-even, and finance exists only when the interval is non-empty.
Calculate pledgeable income
Pledgeable income is the largest expected payment outside investors can receive without inducing the wrong action.
It depends on the success probabilities under effort and shirking, the project payoff and any private benefit. A larger private benefit tightens incentives and lowers what can be pledged. Better effort productivity can relax the condition, but the exact direction should be shown from the inequality rather than guessed.
Internal capital closes the gap between the investment cost and pledgeable outside income.
More entrepreneur wealth can make a project financeable without changing its total productivity.
This result does not imply that wealth creates the missing surplus; it changes the amount outsiders must advance and can align incentives by leaving more value at risk with the entrepreneur.
Introduce monitoring carefully
A bank or intermediary may pay to observe actions, reduce private benefits or enforce a different contract.
Monitoring can raise pledgeable income and expand credit, but its resource cost must be deducted from total surplus. The relevant comparison is not monitored finance versus a costless ideal. It is the feasible unmonitored contract versus the feasible monitored contract after monitoring cost.
Monitoring can also create a second incentive problem if the monitor’s action is hidden.
A complete explanation states who observes whom, when the action occurs and which payoff motivates it.
Collateral, borrower equity and covenants can support incentives through different channels; do not treat them as interchangeable labels for any financing friction.
Use comparative statics economically
When private benefit rises, derive how the retained-income requirement changes and then infer the effect on outside finance.
When the project payoff rises, ask whether the increase is pledgeable or remains with the entrepreneur. When the success probability changes, update both total expected surplus and the incentive difference. One parameter can affect efficiency and feasibility through different equations.
For an exam solution, write the project technology, total investment and funding need first.
Derive incentive compatibility, then participation, then compare maximum pledgeable income with external finance required. State whether the failure is unprofitable investment or constrained finance. Finish with one policy or contract change and identify exactly which inequality it relaxes. This order turns a dense moral-hazard problem into a transparent feasibility test.
What this chapter covers
- 01
Moral hazard
- 02
Incentive compatibility
- 03
Participation constraints
- 04
Pledgeable income
- 05
Bank monitoring
Worked example · free
Cap repayment to preserve effort
- 3Compare the entrepreneur's retained success income under effort with shirking plus private benefit.
- 2Rearrange the incentive inequality to isolate the investor's success-state repayment ceiling.
Key terms
- Moral Hazard
- Moral Hazard occurs when hidden actions change payoffs after a contract is agreed.
- Participation Constraint
- A Participation Constraint ensures accepting a contract is at least as good as the outside option.
Information Frictions and Credit Contracts FAQ
Why can a positive project be denied finance?
The entrepreneur must retain enough upside to choose effort, which limits the income promised to investors. If pledgeable income cannot cover outside funding at its opportunity cost, the contract fails despite positive total surplus.
What does internal capital do?
More entrepreneur capital reduces the amount outsiders must supply and leaves more expected return available per outside unit. It also places more owner resources at risk, strengthening commitment in the model.
How can banks mitigate the friction?
Monitoring and screening can improve observability or success incentives, while resource pooling spreads the fixed information cost. The benefit must still be compared with monitoring expense and bank incentive problems.
Exam move
List every constraint by economic role, find the binding one, and explain how each parameter changes the feasible contract interval.
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