We have seen in class that when there is informational asymmetry between the entrepreneur and the investor, investment is lower than socially optimal. In the simple model of investment under imperfect financial market with costly state verification, we have shown that the optimal contract is a debt contract.

(a) What does a debt contract look like in this model?

(b) Explain why in states which are not verified, the entrepreneur must offer the same payment, say D. That is, the payment in states without verification cannot depend on the state.

(c) Explain why the payment D offered in states which are not verified must be higher than any payment offered in states which need be verified.

(d) Explain why any payment lower than D must entail state verification.

(e) Explain why whenever a state needs be verified, the payment is equal to the total realised output in that state.