Inefficient Credit Rationing and Public Support of Commercial Credit Provision

Credit contracting between a lender with market power and a small start-up entrepreneur may lead to the rejection of projects whose expected benefits are higher than their total costs when adverse selection is present. This inefficiency may be eliminated by government support in the form of credit guarantees or interest-rate subsidies. The principal-agent model of this paper compares different forms of government support and concludes that credit guarantees and interest-rate subsidies have an unambiguous positive effect on social efficiency, since they enable the funding of socially efficient projects that would not be financed otherwise.