Yang, M; (2020) Optimality of Debt under Flexible Information Acquisition. The Review of Economic Studies , 87 (1) pp. 487-536. 10.1093/restud/rdz035.

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Abstract

This article studies a security design problem featuring flexible information acquisition. To raise liquidity, a seller issues a security backed by her asset in place at the price she proposes to a buyer. Before deciding whether to accept the offer, the buyer can acquire costly information about the underlying asset. This case differs from the existing literature on security design, in that the buyer has the full flexibility of choosing not only the amount of resources to spend in information acquisition, but also how to allocate them, depending on the shape of the security. Debt is shown to be the unique optimal security for the seller, as its payoff is the least sensitive to the value of its underlying asset. This minimizes the buyer’s incentive to acquire information and mitigates the resulting adverse selection. I do not assume monotonicity of the feasible securities nor impose various distributional assumptions on information structures. Instead, I identify conditions for general information costs that support the results.

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