Endogenous Credit Constraints and Factor Market Rigidities: the case of Bankruptcy

We develop a simple analytical model that highlights the effect of factor rigidities and credit constraints on bankruptcies. In our model, entrepreneurs receive random shocks –positive or negative-- to their working capital, which is needed to pay workers before the output of the firm is sold. If an entrepreneur receives a shock that lowers his working capital sufficiently, she requires loans in order to pay workers and continue operating. However, if the level of working capital is too low, Tirole’s (2000) condition implies the entrepreneur will not receive the necessary loans, due to moral hazard. In this case, the firm must adapt the number of workers to the available funds by firing workers, it is to survive. In the presence of labor rigidities, this may not be possible and the firm goes bankrupt. We show that there are several categories of entrepreneurs, depending on the magnitude of the shock: entrepreneurs who go bankrupt, entrepreneurs that can borrow but not enough to achieve their optimal capital-labor ratio, entrepreneurs that borrow but reach their optimal capital-labor ratio and finally entrepreneurs with that are the creditors in the financial market. We examine the effects of an increase in the labor rigidity on the demand for credit and on the efficiency of the economy. In a second stage, we simulate numerically the costs of these rigidities for sensible parameter values, to estimate bounds to the effects of the interactions between labor rigidity and credit constraints.