Improved governance:-

There are two dates, t = 0, 1, and a continuum of mass 1 of firms. Firms are identical except for the initial wealth A initially owned by their entrepreneur.

A is distributed according to continuous cumulative distribution G(A) with density g(A) on [0, I]. Each entrepreneur has a fixed-size project, and must invest I, and therefore borrow I - A, at date 0 in order to undertake it. Those entrepreneurs who do not invest themselves, invest their wealth in other firms. The savings function of nonentrepreneurs (consumers) is an increasing function S(r ), where r is the interest rate, with S(r ) = 0 for r 0 + c1 from consumptions c0 and c1. A project, if financed, yields R > 0 at date 1 with probability p and 0 with probability 1 - p.

The probability of success is pH if the entrepreneur works and pL = pH - ?p if she shirks. The entrepreneur obtains private benefit B by shirking and 0 otherwise. Assume pHR>I>pH(R - B/?p), that financing cannot occur if the entrepreneur is provided with incentives to misbehave, and that the equilibrium interest rate is strictly positive.

(i) What is the pledgeable income? Write the financing condition.

(ii) Give the expression determining the market rate of interest. How does this interest rate change when improved investor protection lowers B?