Adverse Selection and Risk Aversion in Capital Markets

We generalize Boadway and Keen's model of adverse selection in capital markets to allow for risk aversion on the part of entrepreneurs. We use the new model to analyze two types of policies. We first consider policies that would allow entrepreneurs to use a greater fraction of their total wealth in financing their projects, thus allowing them to reduce reliance on debt or equity finance by outside investors. We show that such policies may not be welfare-improving, because they expose entrepreneurs to more downside risk. This result highlights the importance of allowing for risk aversion, since policies that aim at alleviating inefficiencies associated with adverse selection may increase risk exposure and ultimately reduce welfare. We then consider how the tax treatment of losses affects social welfare. We show that if a society places a high value on distributional equity or if entrepreneurs are sufficiently risk-averse, a full-loss-offset system may be desirable even when there is excessive investment.