UNPRODUCTIVE INVESTMENT AND RENT EXTRACTION

This paper proposes a simple case of moral hazard in the credit market. A potential firm–entrepreneur needs outside financing to start up one potentially productive project. This agent has some initial illiquid endowment and is assumed to choose the amount of collateral to secure the financial debt. The model shows that, in the case of a monopolistic moneylender, only the minimum part of the endowment is offered as collateral and so invested in the productive sector. This occurs despite the fact that the loan received and, as a consequence, the final product will be the lowest possible. With perfectly competitive banks, instead, it is shown that it is possible to reach the first-best outcome.