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A Model of Firm Behaviour with Bankruptcy Costs and Imperfectly Informed Lenders

Author

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  • Pedro Rui Gil

    (Faculty of Economics, University of Oporto)

Abstract

Based on Greenwald and Stiglitz (1988,1990), this work explores a simple model of microeconomic behaviour that incorporates the impact of asymmetric information in capital markets on firms’ optimal investment decision rules. Starting from a model of equity-constrained firms, where expected bankruptcy costs (reflecting each firm’s quality) imply a higher user cost of capital and, thus, a lower investment by each firm, we move to a context of adverse selection in the debt market, where banks offer a ‘one-size-fits-all’ contractual interest rate. This implies that ‘poor’ firms tend to invest more vis-à-vis ‘good’ firms, since they now take into account that higher expected default rates may not be matched by comparably higher contractual interest rates, therefore weakening the impact of bankruptcy costs on firms’ investment decisions.

Suggested Citation

  • Pedro Rui Gil, 2005. "A Model of Firm Behaviour with Bankruptcy Costs and Imperfectly Informed Lenders," Notas Económicas, Faculty of Economics, University of Coimbra, issue 22, pages 6-22, December.
    • Handle: RePEc:gmf:journl:y:2005:i:22:p:6-22
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    File URL: http://notas-economicas.fe.uc.pt/pt/numbers/number022n.htm
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    More about this item

    JEL classification:

    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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