What I found to be the most interesting model we studied in macroecon was Williamson’s model of costly monitoring. In the model, some entrepreneurs with high auditing cost do not receive credit from the bank, resulting in a failure of Pareto optimality. Could the government resolve this information problem?
What the government can do that the bank assumedly cannot is that it can “punish” the entrepreneur for lying. The bank in any contract can at most take all the money that the entrepreneur has (and the entrepreneur begins with no capital), while the government can impose additional cost to the entrepreneurs through imprisonment, etc. This allows the government to use mixed strategy; if the additional cost is high enough, the government can select a few random entrepreneurs to audit and still make the expected cost high enough for entrepreneurs to always tell the truth. In this case, the bank can make contract with all entrepreneurs without loss.
Of course, if the government is credibly committed, then the cost of punishment is irrelevant, since all entrepreneurs will be telling the truth and thus the government would not need to actually punish anyone.
How should the government collect its tax to pay for the auditing? I guess the answer is not so obvious since now the bank may use a different contract. This will be for later.
