Optimal Financial Structure and Asset Prices
Abstract
I study the welfare properties of competitive equilibria in an economy with financial frictions. In the model, entrepreneurs raise funds to set up a firm, then they exert effort, and finally they trade assets. Private financial contracts do not internalize their impact on asset prices. On the one hand, lower prices depress the liquidation value - the collateral effect. On the other hand, lower prices boost entrepreneurs' incentives to achieve good performance - the incentive effect. I show that the latter effect outweighs the former, implying that a decrease in asset prices improves welfare.