Entrepreneurs, Legal Institutions and Firm Dynamics

Authors

Neus Herranz, University of Illinois Department of Economics
Stefan Krasa, University of Illinois Department of Economics
Anne P. Villamil, University of Illinois Department of Economics

Abstract

This paper assesses quantitatively the impact of legal institutions on entrepreneurial firm dynamics in a model with credit constraints and endogenous default, where entrepreneurs may differ in their willingness to bear risk. The paper shows: (i) Firm legal rules, credit constraints and default interact to generate significant welfare effects. Less risk averse entrepreneurs run bigger firms and it is optimal for them to incorporate. More risk averse entrepreneurs run smaller firms and generally are better off remaining unincorporated. (ii) Owners choose firm size, financial structure and default to manage firm risk, leading to interesting firm dynamics. More risk-averse owners tend to default more often than the less risk averse, though they carry less debt. (iii) Credit constraints bind for many but not all entrepreneurs. (iv) The model estimates modest differences in owner risk aversion, consistent with micro studies.