The Corporate Bankruptcy Decision

A central tenet in economics is that competition drives markets toward a state of long-run equilibrium in which those firms remaining in existence produce at minimum average costs. In the transition to long-run equilibrium, inefficient firms, firms using obsolete technologies and those producing products that are in excess supply are eliminated. Consumers benefit because in the long run, goods and services are produced and sold at the lowest possible prices. The legal mechanism through which inefficient firms most often are eliminated is that of bankruptcy. In 1984, around 62,000 business firms filed for bankruptcy. Two-thirds of them filed to liquidate in bankruptcy and the rest filed to reorganize in bankruptcy (Administrative Office of the U.S. Courts, 1985). The total liabilities of firms that filed for bankruptcy in 1985 came to approximately $33 billion (Dun & Bradstreet, 1986).1 Economic theory suggests that bankruptcy should serve as a screening process designed to eliminate only those firms that are economically inefficient and whose resources could be better used in some other activity. However, firms typically file for bankruptcy voluntarily. When they do, creditors are not all repaid in full and large redistributional effects occur. Managers of firms do not take creditors' losses fully into account in deciding either how to run the firm or whether and when to file for bankruptcy. This suggests that firms in bankruptcy might not always be economically inefficient and that inefficient firms might not always end up in bankruptcy. Rather, firms may shut down and file for bankruptcy versus continuing to operate because managers respond to the potential for redistribution from creditors to equity, rather