Sep 19, 2017


This paper concentrates on the primary theme of (LONG-TERM PROSPECTS AND THE SOFT BUDGET CONSTRAINT). PERFORM THE SAME ANALYSIS AS IN EXERCISE… in which you have to explain and evaluate its intricate aspects in detail. In addition to this, this paper has been reviewed and purchased by most of the students hence; it has been rated 4.8 points on the scale of 5 points. Besides, the price of this paper starts from £ 40. For more details and full access to the paper, please refer to the site.

(long-term prospects and the soft budget constraint). Perform the same analysis as in Exercise 5.3, with the difference that the date-0 choice of the entrepreneur does not affect the salvage value, which is always equal to 0. Rather, the date-0 moral hazard refers to the choice of the distribution of the second-period income in the case of continuation. This income is RL  0 or RH = RL + R, where R  0 is a constant. The distribution of RL, G(RL), or G(R ˜ L) is determined at date 0. Assume that g(RL)/g(R ˜ L) is increasing in RL. As usual, let pH and pL denote the probabilities of RH when the entrepreneur works or shirks ex post. And let ρ1 ≡ pHR and ρ0 = pH(R − B/∆p). Assume that RL is publicly revealed at date 1 before the continuation decision. Solve for the optimal state-contingent policy in the absence of the soft-budget-constraint problem. Show that the soft-budget-constraint problem arises (if it arises at all) under some threshold value of RL.

Exercise 5.3

(asset maintenance and the soft budget constraint). Consider the variable-investment framework of Section 5.3.2, except that the date-0 moral hazard affects the per-unit salvage value L. Date-1 income is now equal to a constant (0, say). Assets are resold at price LI in the case of date-1 liquidation. The distribution of L on [0, L] ¯ is G(L), with density g(L), if the borrower works at date 0, and G(L) ˜ , with density g(L) ˜ , if the borrower shirks at date 0. We assume the monotone likelihood ratio property

The borrower enjoys date-0 private benefit B0I if she shirks, and 0 if she shirks. The timing is summarized in Figure 5.11. As usual, let ρ1 ≡ pHR and ρ0 = pH(R − B/∆p). And le

(i) Determine the optimal contract {ρ∗(L), ∆(L)} (where ρ∗(L) and ∆(L) are the state-contingent threshold and extra rent (see Section 5.5.2)) in the absence of the soft budget constraint (that is, the commitment to the contract is credible). Show that

• ∆(L) = 0 as long as ρ∗(L) ≤ ρ1 − L;

• conclude as to when rewards take the form of an increased likelihood of continuation or cash (or both)

(ii) When would the investors want to rescue the firm at date 1 if it has insufficient liquidity? Draw ρ∗(L) and use a diagram to provide a heuristic description of the soft-budget-constraint problem. Show that the soft budget constraint arises for L ≤  L0 for some L0 ≥ 0.

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