Abstract: We develop a theory of capital-market imperfections to study how the ability to enforce contracts affects resource allocation across entrepreneurs of different productivities, and across industries with different needs for external financing. The theory implies that countries with a poor ability to enforce contracts are characterized by the use of inefficient technologies, low aggregate TFP, low development of financial markets, large differences in labor productivity across industries, and large employment shares in industries with low productivity. These implications of our theory are supported by the empirical evidence. The theory also suggests that entrepreneurs have a vested interest in maintaining a status quo with low enforcement since it allows them to extract rents from the factor services they hire.
Keywords: Macroeconmics, Capital Market Imperfections, Total-factor Productivity, Relative Prices, Sectorial Allocation, Limited Enforcement
JEL Classification: E2, E5, O16, O17, O41