Dynamic adverse selection and debt

In many long-term relationships, parties may be reluctant to reveal their private information in order to benefit from their informational advantage in the future. We point out that the strategic use of debt by an uninformed party relieves the information revelation problem in dynamic contexts. Our argument is based on the idea that (renegotiable) debt is a credible commitment to end a long-term relationship if information is not revealed. We illustrate our argument by showing how a monopolist that sells a durable good to consumers whose valuation is private information can increase profits by levering up. The strategic value of leverage is shown to increase with good durability and is higher with production to order than with production to market. We briefly address the financing decision of a regulated firm. We also discuss how our basic insight can be extended to other settings which exhibit dynamic adverse selection problems. (C) 2001 Elsevier Science B.V. All rights reserved.