Entrepreneurship and Technology Choice with Limited Contract Enforcement

Cross-country data shows a strong positive correlation between the level of financial contract enforcement and macroeconomic development. This paper emphasizes the role of entrepreneurial investment technology choice in explaining this empirical observation. We develop a life-cycle model with limited financial contract enforcement, entrepreneurial heterogeneity (ability and financial pledgeability) and a discrete investment technology choice. In the model production processes can be undertaken using either a Short-Term or a Long-Term technology investment. Depending on the entrepreneurial ability, the long-term technology investment is more productive relative to the short-term investment, but the latter can be exploited to build collateral in the short-run. In equilibrium the level of contract enforcement and entrepreneurial characteristics endogenously determine (1) the investment size and (2) the investment technology choice at the firm level. Key results of the paper indicate that when financial contract enforcement is weak, the investment size and the intensity of long-term technology use of entrepreneurial firms are positively correlated with financial pledgeability. We calibrate the model to study its quantitative macroeconomic properties. Quantitative experiments illustrate sizeable positive effects of financial contract enforcement on aggregate output and aggregate long-term investment. Specifically, the counterfactual policy analysis shows that if financial contract enforcement in Turkey improves to the U.S. level, output rises by 13-15%; and more importantly for our analysis, we can identify that one third of this change is due to the increase in the rate of long-term investment.