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Enforcement, Incomplete Contracts, and Firm Dynamics

This paper studies the relation between firm size, leverage, exit and growth in an environment of incomplete markets and lack of enforcement. In the data large firms have lower growth and exit rates yet higher leverage. The idea of the paper is that high productivity firms will be larger and have a greater degree of enforcement because their outside option relative to the value of their productive project is large. Thus big firms can sustain larger levels of debt and have larger leverage ratios without having incentives to default. However with incomplete markets a highly productive firm that receives a sequence of bad shocks will shrink over time as its debt increases and its value decreases. Thus highly leveraged firms are also more likely to exit if their high debt levels are due to a history of bad shocks. We quantify both mechanisms and calibrate our model to the firm data in Ecuador and find that our mechanism provides a unified rational for the relation between leverage, exit and size.