Equilibrium Leasing Contracts Under Double-Sided Asymmetric Information

Abstract

We develop a non-tax rationale for leasing in a double-sided asymmetric information setting, and analyze how various contractual provisions in leasing contracts arise in equilibrium. In our model, a manufacturer of capital goods has private information about their quality; entrepreneurs (users of these capital goods) come to learn this quality only over a period of time. Each unit of the capital goods requires a certain level of maintenance in each period. Entrepreneurs differ in their cost of providing this maintenance; this maintenance cost is information private to each entrepreneur. Leasing emerges as an equilibrium solution to this double-sided adverse selection problem. Various contractual provisions in leasing contracts (e.g., short-term versus long-term leases with non-cancellation provisions, option to buy at lease termination, and service leases) also emerge as equilibrium solutions under alternative settings. Leases with metering provisions emerge in equilibrium when, in addition to maintenance cost, entrepreneurs differ in other dimensions such as their intensity of using the capital good, and their degree of risk aversion. Our model has implications for the lease versus sell decision, the situations under which various leasing contract provisions are appropriate, and for the relative magnitudes of sales prices and the leasing costs for leases with different contractual provisions.