RISK RATIONING AND ACTIVITY CHOICE IN MORAL HAZARD CONSTRAINED CREDIT MARKETS

This paper explores the productivity and income distribution effects of asymmetric information and risk preferences on the credit market. A model of contract design in the presence of moral hazard is developed in which competitive, risk neutral lenders offer contracts to risk averse agents who hold the option to invest capital and labor time in an entrepreneurial activity. The model gives rise to the potential for quantity rationing and an additional form of non-price rationing called risk rationing. Both quantity and risk rationed agents would seek credit and carry out the entrepreneurial activity in a first best, or symmetric information world. When information is asymmetric, the menu of available loan contracts shrinks. In equilibrium, neither type of agent ends up with a loan contract, and both undertake a safe, but low return wage labor activity. Quantity rationed agents are involuntarily excluded from the entrepreneurial activity because they are denied any loan contract. Risk rationed agents voluntarily retreat from the credit market and the entrepreneurial activity rather than choose among the limited set of high risk contracts available to them in the presence of asymmetric information. Analysis shows that both quantity and risk rationing are likely to be wealth-biased, inhibiting the activity choice and the income earning potential of low wealth agents, and reproducing initial inequality.