On the impact of inequality on investment and occupational choice under imperfect capital markets

Direct finance such as stock and bond markets has provided an alternative source of funds for a large number of firms, which depends heavily on bank loans for credit previously. Bank loans are more expensive indeed than direct finance so that only those borrowers cannot access to capital markets turn to it. Such co-existence of alternative sources of finance has supplied prevalent issues for researches. The thesis focuses on investment choice and the selection of occupation with finance restriction under co-existence of finance sources. We also investigate the impact of inequality in imperfect markets. In Chapter 2 we develop a model in which agents differ according to their endowments of working capital. They can borrow their money to the capital market to earn interest, or invest in a CRS technology, which is an abbreviation of Constant Return to Scale. The return of CRS is a linear increasing function corresponding to its input. Hence it is a completely riskless investment. Individuals also can undertake a risky project which has a fixed set-up cost. On account of finance constraint, they make their investment and occupation choice. Because of imperfection in the market, lenders cannot obtain information about the real return of the risky project from borrowers, there is credit ration and many entrepreneurs invest at a sub-optimal status. We then introduce a monitoring technology to make it possible for external lenders to observe the return of the private project. Thus lenders who have the monitoring technology can supply any amount of money to borrowers and individuals have an alternative source to raise money. Our result shows the monitoring technology improve the economy. Part of poor individuals who are pure lenders in the previous situation can afford the set-up cost of the risky project. Meanwhile part of sub-optimally investment entrepreneur reach to a optimal status. Chapter 3 is an empirical test which is derived straightforwardly from the comparative statics results of Chapter 2. The comparative statics show that there are threshold effects of the model on income difference between the rich and the poor. In other words, if income difference is lower than a critical value, then the minimal investment level and the interest rate positively related to the mean wealth. Otherwise both of them negatively linked to the mean value. Comparing to the previous theoretical model, a significant improvement of the empirical model is that we substitute income inequality for income difference. In this chapter we discuss how the average wealth affects financial development over the different values of income inequality. We found both initial wealth and its distribution work together to determine the interest rate, the minimal investment level and consequently the size of the capital market. The empirical tests observe two important results. One is that a rise of average income does improve financial development as long as the income inequality is below a cut-off value. The other is that there is a strong threshold effect on income inequality. Chapter 4 modify the model of Chapter 2 from a continuous investment model to a fixed one while it introduce a labour market to analyze the markets equilibrium from both physical and human capital sides. We present a static model of an economy where individuals are heterogeneous in terms of initial wealth and there are credit constraints. Individuals are endowed with time resource which they can allocate between working and leisure to maximize their utility. What’s more, individuals can choose to either sell their labour in the labour market or self-employ. Put differently, depending on the opportunity costs of alternatives, they can supply as pure wage workers or become entrepreneurs by running a risky project. Workers receive fixed wages while entrepreneurs receive risky profits. Individuals make their decisions on either to be wage workers or entrepreneurs by comparing the utility from the wage work with that from the risky project. The endogenous interest rate adjusts to the point where the supply of credits is equal to the demand for funds while the wage rate meets the labour market clearing condition. We find that an increase in the mean wealth leads to a decrease in the interest rate. In equilibrium, the wage rate rises and so does the labour time. Meanwhile, both the optimal amount of labour and the minimal requirement of labour of the project decrease. Chapter 5 is a conclusion.