Three essays on occupational choice, financial market frictions, learning and dynamic incentives

This thesis consists of three essays studying the ramifications of financial market frictions. The first two chapters focus on occupational choices in the presence of learning and market frictions (credit constraints and weak enforcement respectively). A common theme of the second and third chapters is strategic default and dynamic incentives in a microfinance market. In the first chapter, I develop a dynamic occupational choice model combining financial constraints with learning, i.e. the exploration of the agent’s own entrepreneurial ability. The occupational choice is between entrepreneurship and a fixed-wage job. What I find is that, if learning does take place, financial constraints not only postpones entrepreneurship, but also cause a long-run effect in reducing the number of entrepreneurs in the economy. In other words, learning perpetuates the welfare loss caused by borrowing constraints. Using PSID data, I find evidence consistent with learning. The observed business entry and exit patterns cannot be explained by borrowing constraints alone, but can be explained by my model with both borrowing constraints and learning. In the second chapter, I investigate the impact of loan enforcement on the experimenting time of the micro-entrepreneurs who rely on loans for their working capital in each period, and the impact on their expected lifetime payoff. Like in the first paper, I assume agents learn their entrepreneurial abilities by running business projects. I find that experimentation is less with default possibility than without. Besides, the possibility to default strategically leads to a lower expected lifetime payoff. In the third chapter, I analyze the efficacy of dynamic incentives. Shapiro (2015) points out an inherent fragility of dynamic incentives in microfinance without collateral or long-term loans. He shows that the dynamic incentive mechanism unravels for all except a single value of initial beliefs. In this chapter I show that his concern is overcome by a small (yet crucial) modification of the environment by introducing any proportion of “commitment type” borrowers who never default by nature. I prove that all inefficient equilibria in Shapiro’s model are ruled out by adding an infinitesimal proportion of commitment-type borrowers. Moreover, a unique efficient equilibrium exists. In the unique equilibrium the loan terms become more favourable over time, and the proportion of non-defaulters converges to one.