Liquidity constraints and incentive contracts

Are firms and households constrained in the use of a productive input? Theo retical approaches to this question range from exogenously imposed credit a llocation rules to endogenous market failures stemming from some sort of li mited-commitment or moral-hazard problem. However, when testing for constra ints, researchers often simply ask firms or households if they would wish t o borrow more at the current interest rate and/or test fur suboptimal use o f inputs in production functions relative to a full-information, full-commi tment benchmark. We demonstrate that if credit is part of a much larger inf ormation-constrained (or limited-commitment) incentive scheme, then input u se may very well be distorted away from the first-best. Further, households and firms, in certain well-defined circumstances, may, at the true interes t rate or opportunity cost of credit, desire to borrow more (or less) than the assigned level of credit. In other, more constrained, contractual regim es, firms and households would say that they do not want to borrow more (or less), but these regimes are decidedly suboptimal, although the magnitude of the loss does depend on parameter values. We conclude with empirical met hods that, in principle, could allow researchers armed with enough data to estimate parameters and distinguish regimes. Researchers then could see if firms and households are truly constrained and, if so, what the welfare los s might be.