Effects of Government Credit on Investment Efficiency in the Presence of Adverse Selection

Abstract

This paper looks at the effects of adverse selection on investment efficiency and derives the conditions under which government credit can improve investment efficiency. The model produces more general results than those of previous studies by allowing both the return and the risk of each investment project to be random variables. Unsubsidized government credit has no net effect on investment efficiency. Subsidized credit can improve investment efficiency under certain conditions, but those conditions are restrictive. When many individuals with high-return projects fail to obtain credit due to adverse selection, subsidized credit can replace marginal projects with high-retun projects. The subsidy, however, also induces individuals with low-return projects to undertake their projects, making the net effect ambiguous.