Credit Rationing - Equilibrium Credit Rationing - Stiglitz and Weiss

Stiglitz and Weiss

The seminal theoretical contribution to the literature is that of Joseph Stiglitz and Andrew Weiss, who studied credit rationing in market with imperfect information, in their namesake 1981 paper in the American Economic Review. Stiglitz and Weiss developed a model to illustrate how credit rationing can be an equilibrium feature of the market, in the sense that the rationed borrower would be willing to obtain the funds at an interest rate higher than the one charged by the lender, who will not be willing to lend the extra funds, as the higher rate would imply lower expected profits. It is equilibrium rationing as there exists excess demand for credit at the equilibrium rate of interest. The reason for that is adverse selection, the situation where the lender is faced with borrowers whose projects imply different risk levels (types), and the type of each borrower is unbeknownst to the lender. The main intuition behind this result is that safe borrowers would not be willing to tolerate a high interest rate, as, with a low probability of default, they will end up paying back a large amount to the lender. Risky types will accept a higher rate because they have a lower chance of a successful project (and typically a higher return if successful), and thus a lower chance of repayment. Note that this assumes limited liability, though results could still hold with unlimited liability.