Signalling, Productivity, and Investment

Conventional wisdom argues that investment, output and welfare are all increasing in productivity. In this article, I show that this argument is not always correct. In particular, I study a simple model of a credit market with cashless, privately informed entrepreneurs who borrow from wealthy investors. Unlike related studies of credit markets with asymmetric information, I allow entrepreneurs to vary the scale of investment and hence, potentially, signal their type. Signalling crucially depends on the marginal productivity of investment of each type. Surprisingly, I show that aggregate investment and welfare might decrease in productivity. In some cases, an increase in productivity boosts investment but dampens welfare, as part of this increase arises from the attempt of high-type entrepreneurs to signal their type.