Financial Constraints, Investment, and Relational Contracts

Daniel Barron (Northwestern)
Jin Li (Northwestern)

Abstract: An entrepreneur borrows money from the credit market, then repeatedly motivates her employees to work hard. If output is not contractible, then the entrepreneur faces commitment problems with both creditors and workers. The principal's financial obligations constrain her promises to workers and so determine productivity. In a profit-maximizing equilibrium, output starts low, increases as the principal repays the creditor, and may continue increasing after the debt has been repaid. Productivity eventually converges to a steady state that is independent of the initial loan. We apply this framework to show how internal agency relationships shape investment dynamics, liquidation, and debt forgiveness.