Enforcement Frictions and Optimal Lending

I consider an environment in which contract enforcement is a decision variable for the principal. I construct a model in which entrepreneurs cannot commit to repaying investors for the capital advanced, but investors can force repayment by spending resources. The principal uses enforcement to reduce the resources available to the agent after a default, thus providing incentives for the agent to stay in the relationship. She also ensures contract compliance by backloading the payments to the agent: expected utility rises over time, preventing a default. I consider an application of the framework developed in the paper to the area of firm dynamics. I show that enforcement and backloading are always used jointly. Firm size (measured by capital) grows with time and each firm converges to the efficient size. A second application is to the field of economic development. Costlier enforcement leads to the choice of suboptimal technology; secondly it leads to inefficient dispersion of capital across establishments. JEL classification numbers: D87, O16, O43