Small Business and Liquidity Constraint

This essay will adapt the life-cycle theory of saving to the case of a small business proprietor who can invest his saving either in his own business or in financial securities, and may face a constraint on borrowing because of the limited liquidity of the business assets. This exercise does not seem to have been done before. For simplicity, certainty is assumed throughout. Thus risk and risk aversion play no explicit part, though it is assumed that there may be a margin between the rate at which the businessperson can borrow and the rate of return that she can obtain on financial capital and that there may be capital rationing by lenders. These elements may be consequences of risk in a more complex model that does allow uncertainty, but those considerations are beyond the scope of this essay, which aims only to extend the life cycle hypothesis to allow for investment in business capital and for a lending margin and capital rationing. The first section introduces liquidity constraint, with some very selective examples from the longstanding literature on the topic; the second presents a formal model, and the third gives a diagrammatic exposition of the model. These sections focus on the application to a small business. A following section discusses application to consumers in general. A brief summary and conclusions follow.