Equity Markets and Economic Development: What Do We Know

capital producers whose expected return is low, and a fraction n₃ = n₁ -n₂ of unskilled capital
producers whose expected return is zero. These capital producers have access to a safe capital
project which yields a certain rate of return. Within each group, firms are heterogeneous
according to their efficiency in running a project. The efficiencies of firms within the risky
and safe project are indexed by αandβ, which are uniformly distributed on(0,1). The initial
outlay are a(α) and a(β) , respectively. Informational asymmetries stems from the fact that
while efficiency levels α and β are public knowledge, the type of firm is private information.
Besides, type-1 firms produce k₁ units of capital with probability p and 0 units of capital with
probability (1 - p), type-2 firms produce k₂ units of capital with probability p and 0 units of
capital with probability (1 - p ) such as k₂ < k₁ ; and type-3 firms produce 0 units of capital.
For a loan size of w and a linear production technology q , a type-3 firm yields [w - b(β)]q
units of capital from running the safe project. Letting r representing the equilibrium price of
capital, the model assumes that:

rpk₁ > pa(α) > pk₂                                                                    (1)

Consequently, households will never lend to type-2 and type-3 firms since they can always
earn pa(α) amounts of income by storage. It follows that these firms must masquerade as
type-1 firms in order to receive loans to finance risky projects. Type-3 firms may or may not
be motivated to do so depending on whether the returns from the risky projects are greater or
less than the returns from the safe project. Letting β * the fraction of type-3 firms who choose
to run the safe projects and (1 - β*) be the fraction of type-3 who masquerade as type-1
firms, the probability that a firm applying for a loan is actually a type-1 firm is equal to:

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