Financing Constraints and Relational Contracts
We consider a model in which a principal must both repay a loan and motivate an agent to work hard. Output is non-contractible, so the principal faces a commitment problem with both her creditor and her agent. In a profit-maximizing equilibrium, the agent's productivity is initially low and increases over time. Productivity continues increasing even after the debt has been repaid, eventually converging to a steady state that is independent of the size of the initial loan. We apply the model to argue that a firm that relies on external debt will typically under-invest in the scale of its existing businesses, but might either over- or under-invest when expanding into new lines of business.
Daniel Barron, Jin Li
Barron, Daniel, and Jin Li. 2016. Financing Constraints and Relational Contracts.