UNEMPLOYMENT AND FINANCIAL CONSTRAINTS FACED BY SMALL FIRMS

A distinguishing feature of small firms is that most small business ow ners work for themselves and only employ relatives and friends. We exa mine conditions under which this labor market practice is an economic outcome and consider the link between this outcome and unemployment. T he model is motivated by empirical evidence that suggests that small f irms are subject to financial constraints that are supported by inform ation asymmetries. I show that, in a constrained equilibrium, sole pro prietorship and unemployment arise from an information imperfection in the credit market that makes infeasible the consummation of mutually beneficial contracts in the labor market.