Specialization, Productivity and Financing Constraints

Abstract

We analyze optimal fi nancial contracts when the specifi city of investments is endogenous. Specialization decreases the liquidation value of assets, but it also improves the project's long term productivity. While the first eff ect is known to make financing more difficult, we show that the second eff ect can ease financing constraints and increase fi nancing capacity by improving an entrepreneur's incentive to repay. The overall impact of specialization on the terms of financing depends on which e ffect is more important. We provide several new testable predictions about how a firm's specialization decision interacts with the nature of investments, their timing, need for outside financing, and an entrepreneur's ability to commit to a level of specialization.