Essays on Institutional Frictions and Misallocation

In the first chapter of my dissertation, I build a model of firm defaults to analyze effects of the differences in recovery rates and bankruptcy costs on total factor productivity (TFP), output per capita, and the size of credit markets across countries. I extend a standard firm dynamics model and incorporate financial markets. In the event of a default, the firm negotiates on its debt with the lender (reorganization) or is acquired by the lender (liquidation). Recovery rates under reorganization are endogenously determined. In countries with lower recovery rates, firms face higher interest rate schedules and a higher dispersion in interest rates which in turn causes misallocation in factor inputs and leads to lower TFP. The size of the credit markets, average level of capital, and average debt display a U-shaped pattern as the recovery rates decrease. The model generates up to a 9 percent decrease in TFP and average recovery rates that range from 72 percent to 6 percent. Higher bankruptcy costs lead to lower average recovery rates, higher dispersion in interest rates, and lower TFP. I also show that when recovery rates are modeled as a function of the firm characteristics, as opposed to constant recovery rates across firms, the effect of the differences in recovery rates on TFP is much lower.

The second chapter of my dissertation quantifies the role of formal sector institutions in shaping the demand of human capital and the level of informality. We propose a firm dynamics model where firms face capital market imperfections and costs of operating in the formal sector.
Formal firms have a larger set of production opportunities and the ability to employ skilled workers, but informal firms can avoid the costs of formalization, entry costs, payroll taxes and the cost of tax compliance.
These firm-level distortions give rise to endogenous formal and informal sectors and, more importantly, affect the demand for skilled workers.
The model predicts that countries with a low degree of debt enforcement and high costs of formalization
are characterized by relatively lower stocks of skilled workers, larger informal sectors,
low allocative efficiency and measured TFP.
Moreover, we find that the interaction between entry costs and financial frictions (as opposed to the sum of their individual effects) is the main driver of these differences. This complementarity effect derives from the introduction of skilled workers, which
prevents firms from substituting labor for capital and in turn moves them closer to the financial constraint.