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Economic Theory Bulletin

, Volume 6, Issue 2, pp 129–139 | Cite as

Costly state verification and truthtelling: a note on the theory of debt contracts

  • Josef SchosserEmail author
  • Jochen Wilhelm
Research Article
  • 89 Downloads

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 

Notes

Acknowledgements

We are deeply indebted to an anonymous referee for thoughtful and constructive comments. For valuable discussions, we are grateful to Harald Kinateder and Michael Krapp.

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Copyright information

© Society for the Advancement of Economic Theory 2018

Authors and Affiliations

  1. 1.Faculty of Business Administration and EconomicsUniversity of PassauPassauGermany

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