Optimal Interventions in Markets with Adverse Selection

1 Akerlof (1970) shows how asymmetric information can create adverse selection and undermine market efficiency. Economic and legal institutions, such as auditors, underwriters, accountants, or used-car dealers, often emerge to limit adverse selection and allow markets to function. As a result, direct government interventions are usually unnecessary. If a market does collapse, however—presumably following the failure of the institutions designed to prevent the collapse in the first place—a government might want to intervene. This article asks what form these interventions should take if the goal of policy is to improve economic efficiency with minimal cost to taxpayers. We study an economy with borrowing and investment under asymmetric information. Firms must raise capital to take advantage of profitable investment opportunities, but also have private information about the value of their existing assets. Optimal financial contracts can only partially limit adverse selection, and inefficiencies occur because the safest borrowers, facing unfairly high interest rates, drop out of the market. Competitive lenders then rationally charge a high rate to the remaining borrowers, lending and investment are inefficiently low, and there is scope for a government intervention. We characterize cost-minimizing interventions to improve lending and investment, and we propose implementations with standard financial contracts. The key novel aspect of our analysis is the interaction between the government’s intervention and the borrowing terms that firms face in the market. Potential lenders rationally Optimal Interventions in Markets with Adverse Selection