Empirical evidence suggests that capital market constraints prevent low-wealth individuals from setting up in business. This may be attributable to the hidden action problems banks face when learning to entrepreneurs, rather than hidden knowledge. Inability to identify entrepreneurial quality leads to excessive bank lending and investment in low return projects. The moral-hazard problem tends to mitigate this effect. As entrepreneurs become richer and need to borrow less, the subsidy to less able entrepreneurs is reduced, leading to exit. But, as entrepreneurs borrow less at higher levels of wealth, they have an incentive to undertake safer projects. The reduction in the probability of bankruptcy tends to reduce the fixed payment on debt, eliminate deadweigh costs and so promotes entry. If the incentive effects are sufficiently large there is a positive association between wealth and the volume of entrepreneurial activity. However, we show that if the wealth dependency of investment is positive but not too great the market cost of capital is too low for efficiency but if wealth dependency is positive and large the cost of capital is too high.
Download is not available
