Entrepreneurs, legal institutions and firm dynamics

Neus Herranz, Stefan Krasa, Anne P. Villamil

Research output: Contribution to journalArticle

Abstract

This paper assesses the impact of legal institutions on firm dynamics in a model where entrepreneurs have heterogeneous risk aversion, credit constraints and may default. Entrepreneurs choose firm size, capital structure, consumption, default and whether to incorporate. We find that less risk-averse entrepreneurs tend to incorporate while more risk-averse entrepreneurs do not; this occurs because leaving some personal assets exposed by not incorporating allows more risk-averse borrowers to credibly commit to lower default rates. We show that incorporation is determined by two effects: the standard effect that bankruptcy insures low firm returns and a new “scale effect”—more risk-averse entrepreneurs run smaller firms and default more often. The more risk-averse choose to leave some personal assets unshielded in bankruptcy due to a commitment problem that dominates the value of insurance. The less risk-averse run larger firms, default less and incorporate.

Original languageEnglish (US)
Pages (from-to)263-285
Number of pages23
JournalEconomic Theory
Volume63
Issue number1
DOIs
StatePublished - Jan 1 2017

Keywords

  • Bankruptcy
  • Capital structure
  • Commitment
  • Credit constraints
  • Debt
  • Endogenous default
  • Entrepreneur
  • Firm size
  • Heterogeneity
  • Incorporated
  • Insurance
  • Legal environment
  • Risk aversion
  • Unincorporated

ASJC Scopus subject areas

  • Economics and Econometrics

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