A Model of Firm Behaviour with Equity Constraints and Bankruptcy Costs

Abstract

Based on Greenwald and Stiglitz (1988,1990), this work explores a simple model of microeconomic behaviour which incorporates the impact of capital markets imperfections generated by asymmetric information on firms ’ optimal investment decision rules. In particular, this paper analyses how a specific form of asymmetric information problem (adverse selection) may imply lower investment than otherwise through the reduction of the firms ’ ability to raise external financing – either in the form of credit rationing or the ‘voluntary ’ reduction of firms ’ borrowing activity. The natural follow-up to this work would be to formally show how a loan market where both contractual interest rates and loan sizes are (a priori) variable may be characterised by a credit rationing equilibrium.

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