Chapter 4 Credit Failures
4.2.1 Primitives
We consider an economy which lasts two periods t = {0,1}. All agents are risk- neutral and consume only att= 1.
There is a continuum [0,1] of two kind of agents: savers-workers and en- trepreneurs.
Thesavers-workers are endowed with l0 = ¯x units of time at date zero, and
l1 = 1 at date one. At each date, they can either enter the labour force, or remain
self employed. Self employment is a constant return to scale technology: every unit of labour supplied yields one unit of date one consumption good.
Theentrepreneurs privately know their type, indexed byθ, and it is common knowledge that types are drawn from a compact set Θ ≡ [θ, θ] with cumulative distribution function F(θ). An entrepreneur of type θ has potential access to a technology that produces date one consumption good by means of labour at time one f(l1,θ), where lt,θ denotes the labour demand of an entrepreneur of type θ at
datet. The probability that the entrepreneur can use his technology depends on (i) his type, (ii) an investment undertaken at date zero, and it is denoted byp(θ, l0,θ).
In particular: p(θ, l0,θ) = pθ ifl0,θ ≥x >0 pθ ifl0,θ < x >0
The technology is common for all entrepreneurs, and it exhibits decreasing returns to scale: f(l1,θ) = ξl1α,θ for some α∈(0,1) and ξ >0. Also, suppose thatpθ > pθ;
x <x¯ and, without loss of generality, letpθ > pθ0 whenever θ > θ 0.
All agents are risk-neutral and do not derive any utility from leisure. As a result, the workers save all their t= 0 income (both the labour income, and the income derived from self employment). It is useful to think that they deposit it into a bank, and have in mind the following circuit: (i) the bank lends to the entrepreneurs the amount they need to pay the workers at date zero; (ii) then, it gets the worker’s savings as a deposit; and (iii) finally, att= 1, it collects repayments from productive entrepreneurs and uses it to pay the workers.
The timing of the economy is as follows:
• date 0: The (privately informed) entrepreneurs decide whether to borrow from a bank and employ labourxor not. The workers decide whether to enter the labour force or remain self employed;
• date 1: labour is employed (for the technologies that are operative) and output is realised; obligations are repaid (whenever possible); consumption takes place.
Denote the wage at datet by wt and the (gross) loan rate by r. The t= 1
consumption good is taken as the num´eraire, and its price is normalised to one. Further, we can normalisew0 = 1.9 To simplify the notation, let w1=w.
Separating contracts. Under full information the credit market would be seg- mented: each type of entrepreneur would face a loan rater(θ) =pθ−1. The loan rate is easily pinned down by a no arbitrage condition: the return to storage (equal to one) must be equated to the expected return from lending to entrepreneur (rpθ).
When information is asymmetric, the loan rate r might depend on θ only at a (possibly partially) separating equilibrium. However, such equilibrium only obtains underrandom contracts, i.e. contracts that consist in both a loan rate, and a probability with which the loan is granted strictly between zero and one for all θ∈Θ\ {θ}. If contract are not random, we cannot haver(θ) such that r(θ)6=r(θ0). To see why, notice that the expected repayment of a type θ agent who declares to beθ0 and invests isr(θ0)x. All agents will chooseθ0 so thatθ0 = arg min{r(θ)}, and separation cannot occur.
We do not consider such contracts in the analysis for the following reasons:
• First, our qualitative results do not change if we allow for such contracts. In particular, random contracts never implement full investment because all types higher than θ have to choose a probability of investment strictly less than one. In contrast, we shall prove that full investment is implementable as a competitive equilibrium with government intervention;
• Second, they would require us to introduce incentive compatibility constraints in the definition of a competitive equilibrium;
• Finally, random contracts of this type are not observed empirically. Although this is not a valid critique, there may be a theoretical reason: these contracts 9
are not renegotiation proof. Suppose that an entrepreneur offers a random contract. After the contract is signed, there exists a Pareto improvement avail- able for both parties: increase the probability of investment to one and split the surplus. Since renegotiation would be anticipated, incentive compatibility would not be satisfied hence and no separation could take place.
As a result, in our analysis the loan rater cannot depend onθ, and competi- tive equilibria are defined as standard. It is useful to present the three maximisation problems that agents solve at equilibrium:
At date zero, the bank chooses whether to lend to the entrepreneurs or not. Each entrepreneur who decides to invest needs to borrow x, because the wage at t = 0 has been normalised to one and it is never optimal to employ more that x. The bank chooses optimally lends an amountb∗ that solves:
b∗ = arg max
b∈R
b[r∗E[pθ|r∗]−1]
Clearly, the interior solutionb∗=xrequires the no-arbitrage conditionr∗E[pθ|r] =
1 to hold.
The entrepreneurs have two decisions: at date one – if they are productive – they decide how much labour to employ, andl∗1,θ solves f0(l1,θ) =w.
At date zero, they choose whether to employxunits of labour or not correctly forecasting their futurel∗1,θ, and for a given vector of prices:
l∗0,θ = arg max l0,θ∈{0,x} l∗0,θpθ{x−1[f(l∗1,θ)−wl∗1,θ]−r}+ (x−l0∗,θ)x−1p θ[f(l ∗ 1,θ)−wl ∗ 1,θ]
Before proceeding to the analysis, it is useful to recall the standard definition of a competitive equilibrium:
Definition 1: A competitive equilibrium (CE) consists of a vector of prices (r∗, w∗) such that: (i) all agents maximise expected utility subject to budget con- straints; (ii) markets clear.
Define the effective interest rate for type θ as rθ ≡ pθr. It is individually
rational for an entrepreneur of typeθ to invest if and only if the expected increase in his profits from production (i.e. (pθ−pθ)ξ(1−α)lθα) more than offsets the cost
of investing (given byrθx):10
(pθ−pθ)ξ(1−α)lαθ ≥rθx (4.1)
Furthermore, in equilibrium, each productive entrepreneur demands a quan- tity of labour such that its marginal productivity equals the wage rate w, i.e. lθ = (w∗/αξ)1/(α−1). The aggregate labour supply is inelastic: LS = 1, whereas
the aggregate labour demand is denoted by LD ≡
R
ΘlθdF(θ) and it is maximal
when all types invest. In this case, we would have:
LD
Full Investment (FI)=
w∗ αξ α−11 Z Θ pθdF(θ) = 1 =LS
As a consequence, under full investment we observe the highest feasible equilibrium wage: w∗FI = αξ(R
Θpθdθ)1−α; and hence the lowest individual labour demand by
any typeθ entrepreneur who is productive: l∗θ,FI= (RΘpθdF(θ))−1. We make the following assumptions on parameters:
Assumption 4.1. Investment has positive net present value for all types under full information: For everyθ: (pθ−pθ)ξ(1−α) Z Θ pθdF(θ) −α ≥x
where we substituted in (4.1): (i) the full information equilibrium loan rate for typeθ: rθ =pθ−1; and (ii) the lowest possible equilibrium labour demandl
∗
θ,FI.11
Assumption 4.2. Type-independent benefits from investment:
For everyθ: (pθ−pθ) =q
Assumption 4.2 is not needed to derive our results, however it greatly sim- plifies the notation and makes our results immediately comparable to those of other related models that make the same assumption such asPhilippon and Skreta[2012].
10
To obtain the expression for the expected increase in his profits from production notice that, sincef0(lθ) =w: (pθ−p θ) ξlαθ −wlθ = (pθ−p θ) ξlαθ −αξl α−1 θ lθ = (pθ−p θ)ξ(1−α)l α θ
11Evidently, the condition guarantees that for every equilibrium labour demandl∗
θ > l
∗
θ,FIinvest- ment is of positive net present value under full information.
Assumption 4.3. The distribution functionF(θ)is continuous overΘ andF(θ) = 0. Both pθ and pθ are continuous in Θ under the integral sign.
Assumption 4.3 is made for technical reasons, and it simplifies the arguments.