2(2rRr-rD) < c < RR, and in this range kCS = rc and kreg = RrD +rD --8crr rD). The difference
kreg - kCS simplifies to
(rE - c)rD2 +(R +8c)rErD - 8crE2 =0
The relevant solution is
reD =
rr (R+8c) - √32c2+R2+16c(R+2rr )
2(c- rE)
which implies kreg > kCS only if rD > rD. □
Proof of Proposition 7: Assume that there is an excess supply of funds so that, as before,
consumer surplus is maximized by setting
rL =
R +(1 — k)c∙D
2
We can substitute this into the equation for q, recalling that cD = rD, and solve for q to
obtain q1 = 8C ^R + pR2 — 16crD (1 — k) ´ and q2 = -ɪ- (R — pR2 - 16crD (1 — k) ´. We
focus again on the Pareto dominant equilibrium with a higher level of monitoring (q1).
We proceed by maximizing CS with respect to the choice of capital, k. However,
we know from above that the combination of rL = R+(12 k)cD and the highest possible
k will be optimal for borrowers. We therefore introduce the participation constraint for
the bank, that Π = q(rL — (1 — k)cD) — krE — cq2 ≥ 0. Substituting for rL gives q =
8C (R + RR- — 16crd (1 — k) I, and we obtain
Π = cq2 — krE = c
fl
∖8c
П2
— krE = 0
Focusing on parameter values for which there is an interior solution for k, the solution is
kCS
1
2c (4ге — rD )2
R2rE + 2crD2
— 8crDrE — RqrE^R^rE'+ffcrD'—^lβrEcrD).
32
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