Lec 9: Costly State Verification Flashcards
What are the use of the two key models for this lecture?
Townsend model of effiient verificaiton and audit
Bolton and Sharfstein’s model of liquidation and staged financing
What is the key idea behind the revelation principle?
Any outcome that can be achieved through a mechanism can also be achieved through a truthful direct revelation mechanism. Hence, there is no lack of generality to considering only truth direct revelation mechanisms
What is a mechanism
A set of messages that an agent can send the principal, with a set of contracts. The agent selects a message, and the principal selects the contract
What is a direct revelation mechanism?
A mechanism that has messages = set of possible types
Who has the bargaining power in the Townsend model?
The entrepreneur has the bargaining power
Who bears the auditing cost in the Townsend model?
The investor/bank pays it directly, but since it is pushed to reservation, it must in the end be paid by the entrepreneur in the form of a less lucrative contract
How does the entrepreneur/lender optimize the contract?
He minimizes the auditing costs. Since the bank will always be paid the same, lowering auditing costs must increase profits
Who has bargaining power in the Bolton and Sharfstein model?
The investor/bank has the bargaining power
Does the Bolton and Scharfstein (1990) model of debt contracting focus on the effect of asymmetric information on capital structure? Please answer either “Yes” or “No” and then briefly explain.
No. The key idea is that cash flows are not verifiable and that they cannot be contracted upon. This problem may exist even if bank perfectly knows the cash flows, but is unable to verify them, e.g. cannot bring evidence up on court.
Nevertheless, the inability to contract upon cash flows could also stem from asymmetric information, but does not have to
How does the bank make the firm tell the truth in the Bolton and Sharfstein model?
By only providing refinance if the firm reports a high cash flows in period 1. Hence, if the firm has a high cash flow, it would not report a low cash flows, since this would lead to liquidation
Describe the inefficiency predicted by the Bolton and Scharfstein model?
The firm is liquidated when first-period profit is low (pi_1) even though the expected profit in period 2 is positive, and it would be efficient to operate. Returns are assumed to be i.i.d. so that a low return in 1 period has no predictive power over period 2
Could the bank benefit from renegotiating at period 2, if the firm reports a low cash flow.
No. Although the investment at period 2 would be NPV positive (in expectation). The investor would have no way of making sure he would receive more than the low payout in period 2.
