SFB 303 Discussion Paper No. A - 440
Author: Nöldeke, Georg, and Klaus M. Schmidt
Title: Debt as an Option to Own in the Theory of Ownership Rights
Abstract: In a seminal paper Grossman and Hart (1986) developed a
theory of the optimal allocation of ownership rights based on
incomplete contracts. In their model the only contracts feasible
prior to investment decisions allocate ownership rights over
physical assets. We investigate the role of a collateralized
debt contract, which assigns ownership rights on an asset
conditional on the repayment of the debt, in this setting. By
allowing implicit conditioning on investments such a contract
yields an efficiency improvement over the contracts considered
by Grossman and Hart. In particular, if only one party has to
invest, then an optimally designed debt contract implements the
first best. Furthermore, the debt will be repayed in equilibrium.
Our work departs from most analyses of debt contracts by emphasizing
that debt contracts have an incentive effect on the creditor's
investment decision. The key effect is that the creditor's
relationship-specific investment affects the value of the
debtor's ownership right and thus whether or not he defaults
on his debt.
Keywords: Debt, Ownership Rights, Incomplete Contracts
JEL-Classification-Number: D23, G32, L22
Creation-Date: March 1994
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