Debt Contracts and Cooperative Improvements Stefan Krasa ∗ Tridib Sharma † Anne P. Villamil ‡ February 9, 2004 Abstract In this paper we consider a dynamic game with imperfect information between a borrower and lender who must write a contract to produce a consumption good. In order to analyze the game, we introduce the concept of a coalitional perfect Bayesian Nash equilibrium (cPBNE). We prove that equilibria exist and are efficient in a precise sense. Deterministic contracts that resemble debt are optimal for a general class of economies. The cPBNE solution concept captures both the non-cooperative aspect of firm liquidation and the cooperative aspect of firm restructuring. JEL Classification Numbers: C70, D60, G30, K40 Keywords: Debt Contract; Incomplete Information; Bankruptcy; Renegotiation; Liq- uidation; Efficiency; Fairness; Enforcement; Cooperative; Non-cooperative ∗ Department of Economics, University of Illinois, 1206 South 6th Street, Champaign, IL 61820 USA, http://www.staff.uiuc.edu/˜skrasa † Centro de Investigaci´ on Econ´ omica, ITAM, Ave. Camino Santa Teresa #930, M´ exico, D.F. 10700, sharma@itam.mx ‡ Department of Economics, University of Illinois, 1206 South 6th Street, Champaign, IL 61820 USA, avillami@uiuc.edu We thank Ludovic Renou, Nicholas Yannelis and an anonymous referee for useful comments. Krasa and Villamil gratefully acknowledge financial support from NSF grant SES-031839 and the Center for Private Equity Research at the University of Illinois.