Knowledge that Transforms

A model is presented in which firms optimally finance investment with both public and private debt. The two instruments are perfect substitutes, except that private debt can easily be renegotiated in insolvency states while public debt cannot. The option to renegotiate is beneficial ex post, as it allows the firm to avoid inefficient liquidation, but ex ante it may worsen asset substitution. The welfare effects of alternative bankruptcy regimes are then compared, taking into account that firms modify their financing decision in response to the regime change. Some suggestions for reforming Chapter 11 of the U.S. bankruptcy code are presented. Journal of Economic Literature Classification Numbers: G32, G33, K2.

Projects with negative expected value cannot obtain financing in competitive capital markets if all potential investors are risk neutral and have identical beliefs about the distribution of the project′s net revenue. We present a series of examples with heterogeneous beliefs in which it is possible for a project to obtain financing even though all investors in the project believe, conditional on the project being undertaken, that the project has negative expected value. An important feature of the examples is that the differences in beliefs are due only to differences in information, and are not simply arbitrary unexplained differences in opinions. Journal of Economic Literature Classification Numbers:D8, G1.

This paper investigates the incentives of a regulator to close depository institutions, recognizing that an institution′s risk taking will be influenced by the regulator′s policy regarding bank closure and that there are opportunity costs in closing banks arising from their intermediation function. The regulator focuses not on the current portfolio of the bank, but on the bank′s future portfolio. Even if the regulator seeks to maximize welfare, the first best is not obtainable because the regulator is unable to credibly commit to certain policies regarding closure. Journal of Economic Literature Classification Numbers: G2, L5, G1.

This paper develops a model of security broker behavior under price uncertainty. The model examines the process of matching orders and the determinants of equilibrium brokerage commission rates. Institutional arrangements, search efficiency, execution costs, volume, risk, and the unit price of the security are shown to affect equilibrium brokerage commission rates. Some stylized facts of security brokerage are explained.

This paper examines whether middle age American households purchase adequate amounts of life insurance. The analysis is based on SRI International's 1980, 1982, and 1984 surveys of the financial positions of American households. Our findings indicate that a significant minority of American wives are highly underinsured with respect to the possible deaths of their husbands. We find that 25 to 30% of wives are inadequately insured, by which we mean that they would suffer a loss in their rate of sustainable consumption of at least 30% in the event of being widowed. These findings on inadequate life insurance are even more striking if one focuses on those households in which over half of the couple's present expected value of resources is dependent on the husband's survival. The results of this paper together with those of the related literature strongly suggest that raising the share of social security benefits that are paid to surviving spouses as well as increasing employer-provided group life insurance could have a very considerable impact on the alleviation of poverty among widows, especially elderly widows.

This paper addresses the First Theorem of Welfare Economics in a moral hazard environment. An entrepreneur sells equity in a firm which he supplies with an unobservable, costly input. How much equity he retains determines his incentives and is observed by investors. The investors have rational expectaions which cause the equity price to increase in the amount of equity the entrepreneur retains. This gives the entrepreneur an incentive to retain equity and hence supply input. The entrepreneur may also be bound by an explicit incentive contract. In this framework, not all competitive equilibria are efficient, as defined relative to the moral hazard constraint. However, equilibria can be inefficient only if the entrepreneur's optimal input is nonunique or exhibits positive income effects.